First Niagara May Have Bitten Off More Than It Can Chew

First Niagara Financial Group Inc.'s $1 billion deal for more branches is an ambitious gamble.

The short-term risks in buying 195 branches in upstate New York and Connecticut from HSBC Holdings Plc are considerable — including a hefty capital raise in a volatile market and a taxing number of branch divestitures. It expects to close or sell as many as 100 locations to satisfy antitrust requirements and save money.

First Niagara is also in the middle of another big integration, having closed its purchase of NewAlliance Bancshares Inc., of New Haven, Conn., in April.

But the upside in acquiring the legacy operations of Buffalo's Marine Midland Bank could be huge.

First Niagara said it would vault to first place from fifth in deposit share across the upstate region while collecting some $11 billion in cheap deposits, 650,000 new customers and one million new deposit accounts.

It would strengthen First Niagara's balance sheet, too. The bank should be able to earn more money making loans by paying less to borrow: The deposit influx would let it pay back most of its costly wholesale borrowings, lowering its funding costs by about a third and helping boost its net interest margin by a percentage point.

Though First Niagara has earned its stripes as an effective consolidator, investor skepticism of any banks on a buying spree could make the deal more dilutive to shareholders than the company expects, said Matthew Kelley, an analyst with Sterne Agee & Leach Inc.

Its share price could remain pressured because serial acquirers tend to hit "bumps in the road," he said.

"There is modest downside potential," he said. "So far what they have shown to the Street after a series of deals over the last three years has been pretty solid."

As of mid-day Monday, the bank's shares were down nearly 3% in heavy trading, to $11.89, on another off day for the market.

Strategically, the transaction makes sense. It puts First Niagara on equal footing with hometown rival M&T Bank Corp., another serial acquirer that has emerged as a Northeastern banking powerhouse during the downturn. The relative soundness of the upstate New York economy is a chief reason for their ascent. Now that market will be carved up between two banks that experts say are run well.

It is paying a 6.67% premium for $15 billion of deposits, $4 billion of which it expects to divest. First Niagara projects an internal rate of return on the transaction of 20% to 22%; it is expected to boost operating earnings per share by 10% to 12% in 2012 and 2013.

"This transaction is a strategic home run for us," Gregory Norwood, First Niagara's chief financial officer, said in a call with analysts and investors on Monday. "This is our own backyard where we have extensive experience….The pricing is very attractive given the significant value over the long term."

Sterne Agee's Kelley had forecast that the branches would fetch a much lower 3.5% deposit premium. But that assumption was based on more than twice as many loans being included in the deal. The estimated 17% to 18% dilution to First Niagara's book value is also higher than he had expected. He is worried that the transaction could be even more dilutive on a good chance that First Niagara divests branches at a lower premium than it paid for them.

Norwood said the transactions' "earn-back" period of four to five years is "reasonable" and "better than recent deals in the marketplace." Earn-back period is the amount of time it takes for a post-merger rebound in an institution's tangible book value. A good earn-back period is anything less than three years. A five-year earn-back is acceptable, if not sometimes preferable, experts say.

First Niagara indicated that its earn-back timeline could be shorter because it is based on "conservative" earnings and cost-savings assumptions. With about 30% of First Niagara's and HSBC's branches within a mile of each other, it could save can save substantial money through closures.

In another potential complication, First Niagara said it will pay for the transaction by issuing $750 million to $800 million in common equity and $350 million to $400 million of debt before the deal is expected to close in the first half of 2012.

The timing has yet to be determined, and the big risks are that First Niagara's offering is either poorly received or brings in cash that goes unused should the deal be hampered by regulatory or other considerations.

John Koelmel, First Niagara's chief executive, said during the conference call that the strategic and financial benefits of the transaction will win over investors to an offering. The turbulent markets should also settle between now and the middle of next year, he said.

"We'll be patient," he said.

He said there had been a lack of public information about the assets HSBC Holdings Plc planned to sell. The London company said earlier this year it planned divestitures as part of an overhaul of its U.S. strategy. Koelmel said one of his "main objectives" was to "inform and educate" investors and media members about what it is buying and why, "rather than continue to churn on a lack of information."

The anti-competitive issues and branch divestitures should be manageable too, he said. First Niagara sold branch sales upstate before in prior acquisitions, and it has a good grip on the anti-competitive issues that will force it to sell branches in Western New York, he said, so there will be no surprises on that front.

For its part, First Niagara said the 6.67% deposit premium is lower than the median 8.4% deposit premium in mergers with banks of at least $1 billion of deposits during the last 12 months.

The very public nature of the HSBC auction drew attention from "a very long list of buyers who weren't qualified to tackle the whole transaction that have contacted us," Koelmel said.

Branch acquisitions are less complicated and risky than whole-bank takeovers, he said. First Niagara understands the region and has a similar culture with the HSBC franchise, which is populated with many Marine Midland veterans.

"It's an in-market branch deal — inherently, that makes it lower risk," Koelmel said.

It has done them before, having purchased 57 former National City Corp. branches in 2009 from PNC Financial Services Group Inc.

The deal also has little credit risk, he said. Half the $2.8 billion of credit card, business, and home loans it is acquiring are already marked to market. The other half are of relatively high quality because upstate New York has fared better than other parts of the country during the recession.