Heritage Deal Shows Scale and Efficiency Are Worth a Premium

A small deal in the Pacific Northwest could change the way banks in the region, and perhaps the country, view M&A.

Heritage Financial (HFWA) in Olympia, Wash., agreed last week to acquire Valley Community Bancshares in Puyallup, Wash., for what is viewed as a generous cash-and-stock offer of $44.2 million.

The $1.35 billion-asset Heritage would strengthen its presence in Pierce County and deploy part of its capital stockpile. It raised $100 million during the downturn in hopes of picking up failed banks and weary, open ones.

However, Valley Community is selling from a position of strength, as evidenced by its price tag of nearly 1.5 times tangible book value. In that regard the deal fits into a broader narrative that has emerged this year — buyers are paying a little extra for scale and efficiency instead of hunting for bargains.

"We are transitioning out of a period where buyers were buying on the cheap and moving more toward buyers looking at things that will enhance earnings over the long term," says Tim Coffey, an analyst at FIG Partners. "That is a really good sign because it means multiples will likely start going up."

That Heritage is the buyer is also telling, another expert says.

"Heritage tends to be a bellwether on the caution front," says Tim O'Brien, an analyst at Sandler O'Neill. "They always kind of corner the market on a conservative approach. …When you hear something incrementally different about them, it is notable."

O'Brien pointed out that Heritage's stock has risen 8.5% since its close of $13.34 on March 11, the day before the deal was announced.

"So they are paying an eyebrow-raising price, but the market has effectively validated what it is paying. That raises the other eyebrow," O'Brien says. "Other buyers might view this and think, 'Maybe M&A is not such a big, scary world, and let's not waste our time trying to save every nickel and dime off sellers.'"

Going forward, deals will probably be a mixture of ones like that for the $242 million-asset Valley and the $72 million-asset Northwest Commercial Bank, which Heritage acquired in January. Northwest was well capitalized but had a high level of troubled assets.

"It is easier to do a deal with a clean bank because of the confidence you have," Brian Vance, the chief executive of Heritage, said in an interview last week. "We could do either kind of deal. We are not interested in troubled banks but maybe ones that have their issues predominately behind them, and well-managed banks."

Though Heritage would pay a higher multiple than many other recent buyers, the agreement's credit risks and cost-cutting potential are more favorable compared with other deals.

The consideration includes a 2% credit markdown, essentially the amount that Heritage anticipates having to adjust the portfolio for a correct valuation. Deals in the current environment have carried markdowns between 5% and 6%, O'Brien says.

Also, Heritage is expecting to trim Valley's expenses by 45% to 50%. That estimate includes the back-office savings often found in acquisitions and the benefits of closing half of Valley's eight branches in Pierce County, where the buyer and seller have a big overlap.

"If only all deals had these kind of cost saves," Jacquelynne Chimera, an analyst at KBW, wrote in a research note.

Most transactions in the same or adjacent markets produce cost cuts of 25% to 35%, analysts say.

That level of cost savings would be considered high even during more robust M&A markets, says Jeff Rulis, an analyst with D.A. Davidson.

The deal is the fourth for Heritage since it raised capital in separate offerings in 2009 and 2010. It has bid on roughly a dozen failed banks between Seattle and Portland, Ore., Vance says. It won two, the $489 million-asset Cowlitz Bank and the $221 million-asset Pierce Commercial Bank in 2010.

"We had strong feedback in the sense that the market liked the offerings, but in retrospect we probably raised too much," Vance says. "We felt there were going to be more failures, more consolidation and it was going to happen faster. It surprised all of us. I do think consolidation is going to happen, but it has been delayed."

At Dec. 31, Heritage had a tangible common equity ratio of 13.9%. The deal would bring it down to 11.7%. Analysts generally like to see that ratio around 7% to 8%, but Vance says his target is around 10% for now.

"We do want to expand, but we understand the risk," he says. "In the short term, I want that ratio at around 10%. There are still concerns about the general, slow-growth economy."