Now Comes the Hard Part for First Niagara in HSBC Deal

Now that First Niagara Financial Group Inc. knows how many branches it has to get rid of to buy a hometown rival, the Buffalo bank can move on to the most important part of the deal: Figuring out how to pay for it.

Market watchers are anxious for First Niagara to clear up that not-so-tiny detail after the Justice Department on Thursday said it must sell 26 of the 195 branches it agreed to buy for $1 billion from HSBC Holdings PLC in July.

Europe's debt mess has muddled the financing for a deal that First Niagara Chief Executive John Koelmel has called a "strategic home run." He initially counted on financing it with the proceeds from selling up to 100 branches and issuing as much as $1.2 billion of equity and debt.

Then the markets tanked. First Niagara's shares are down 28% since the deal was announced in July, raising fears of a transaction that will be heavily dilutive to shareholders and its capital levels.

Investors have been fretting about that for months. But Koelmel has been short on assurances, blaming the holdup on new information on Justice's antitrust review. It would be able to release details "once Justice gives us the nod" on the branch divestitures, he said in the company's October earnings call with investors.

That wait ended Thursday. The order to sell $1.6 billion of deposits in the Buffalo area does not alter the fundamentals. Publicly available market share data gave a very good idea of how many branches First Niagara would have to spin off.

The timing of the order is what matters, and it is a mixed blessing for Koelmel.

A chief reason its shares are so deeply depressed is because investors are worried it will issue stock right now. Koelmel is freer to clear up some of the uncertainty, which might help its share price.

Yet the wait for Justice to act was a valid excuse to put off moving forward in less than ideal conditions, particularly the branch sales. First Niagara has eight months to close the deal under the original timeline the parties set. That is a long time on Wall Street. The transaction is not in peril yet, it just does not look as lucrative. Market chaos ultimately will subside. Raising the money as planned right now would be painful.

First Niagara had said in August that it expected the deal to dilute the value of its tangible book by 17% to 18%. The actual dilution could be as much as 26%, analysts at Sterne Agee & Leach Inc. said in a report last month. First Niagara may also have to issue as much as 90 million shares, or 10 million more than planned, Guggenheim Securities LLC said in a separate report in October.

The bigger dent the deal puts in First Niagara's tangible book, the longer it will take to earn enough money to replenish the capital it loses in the deal. As things stand, the earn-back period is already a relatively lengthy four to five years.

One way to minimize the impact to tangible book would be to sell even more branches. That is not ideal right now either.

The acquisition will still be a strategic boon. It is paying for it in a way that delivers acceptable shareholder returns that is the issue.

HSBC has a number of out-of-the-way branches in northern and western New York First Niagara could keep but always planned to sell. If it wants to sell more branches, it would probably have to start considering those in key markets such as Albany, Syracuse, and Rochester.

It would risk sacrificing the strategic parts of the deal that still make sense. Also, unloading more branches means First Niagara could end up simply paying a high price for a smaller asset.

It is a bad time to sell any kind of property right now: buyers are skittish and prices are depressed.

Obvious buyers of the branches First Niagara is marketing such as Community Bank System Inc. or Tompkins Financial Corp. would probably have to raise equity to pay for them. That limits how much they could pay.

The more branches it sells at a bad price, the more it may end up paying for the ones it is keeps. That is because it is already paying a relatively rich deposit premium of 6.67%. Analysts have speculated it may only get a premium of 4% to 4.5% on the branches it sells, given market conditions and the nature of tertiary branch divestitures.

Selling something for less than you bought it is pretty much the equivalent of overpaying. Every branch it sells at a loss drives up the implied premium of what it pays for the assets it keeps.