Thursday, December 22, 2005

Takeover Potential Raises Value of Small US Financial Institutions

The Wall Street Journal, Ian McDonald, 22 December 2005

The stocks of little banks have big price tags -- and vice versa. For the scads of investors holding shares of small community banks hoping they will be acquired by a bigger player, that could be a problem.

When smaller banks trade at prices that are higher multiples of their per-share earnings than their bigger brethren, as they have for about two years, that is often a sign that investors are betting on takeover activity. But there is a catch: Today's lower valuations for shares of big banks -- despite fatter dividends than smaller banks -- could keep them from going on a buying spree. Purchasing higher-priced smaller fries would dilute the acquirer's per-share profits.

Shares of the nation's five biggest banks ranked by assets -- including titans like Citigroup and Bank of America -- trade at about 11 times their expected per-share earnings for 2006, according to Thomson Financial.

For their part, community banks with local branches sprinkled across a given region are trading at multiples of their earnings that are more than 30% higher, just a hair below the average earnings multiple for the broader stock market. Shares of small community banks like Century Bancorp in Massachusetts and Capital City Bank Group in Florida, for instance, trade at more than 19 times their projected per-share profits for next year.

The persistence of this valuation gap between big and small banks has many professional investors baffled. Indeed, many pros are now buying shares of big banks while eschewing the pricier shares of smaller players.

"I think the width of the valuation gap today is a bit of an anomaly, and it's preventing many deals from taking place," says James Schmidt, manager of the $2.1 billion-in-assets John Hancock Regional Bank Fund. "I'd say the bigger banks are undervalued. We have a lot of small banks in the fund that trade at 18 to 19 times their earnings, while names we normally wouldn't look at like Wachovia and Bank of America are looking attractive."

In addition to having lower valuations, bigger banks are also paying higher dividend yields than smaller players. A stock's dividend yield is the company's per-share dividend payout over the past 12 months divided by the stock's current market price.

The nation's five biggest banks all yield more than 3.2%. The average community bank yields a little over 2%, and the average stock in the Standard & Poor's 500-stock index yields 1.8%.

So-called superregional banks like Wachovia, Wells Fargo and BB&T also average yields of more than 3%.

"These banks won't do acquisitions that are dilutive," says Michael Holton, manager of the $374.3 million T. Rowe Price Financial Services Fund. "So you look at smaller banks trading at premium prices, and you think hardly any of them will be taken out at their current prices."

Others may have the same idea. The KBW Bank Stock Index is up more than 12% from its lows in October, with shares of many big banks leading the way.

So why the lower valuations for big banks? Investors may be worrying about the flatter "yield curve" -- another way of saying short-term and long-term rates are at similar levels -- because it cuts into these banks' profit margins. Banks typically make money by paying low short-term rates on deposits, lending that money at higher rates and pocketing the difference -- measured by a metric called "net interest margin." So, a flattening yield curve boosts the amount a bank has to pay depositors while lowering the amount it can earn on their loans.

Bank profits could also be hurt if overburdened consumers start defaulting on their loans or if the overall economy slows, which would hurt loan growth.

Yet professionals wonder if smaller investors have failed to note that smaller banks would face many, if not all, of these same problems. Also, recent earnings indicate that the yield curve isn't hurting profits at the big banks as much as some might have feared.

"What we saw in banks' third-quarter earnings reports was stabilized net-interest margins," says Jim Callahan, an analyst who covers regional and superregional banks at Chicago researcher Morningstar Inc.

To be sure, small banks sometimes get a premium valuation because a string of smart, small deals can increase a small bank's profits by leaps and bounds but wouldn't move the needle much for a behemoth bank. Also, some analysts and investors have theorized that small-bank valuations have stayed high because smaller players may merge to trim out costs and boost profitability.

But, as interest rates rise, small banks may be at a disadvantage in coming quarters since community banks typically lack the fee-based asset-management, investment-banking and capital-markets revenues of many big players. At most titans, more than 40% of revenues come from units with profits that aren't tied to the yield curve, Morningstar's Mr. Callahan notes.

The yield gap between big and small banks strengthens the case for owning the Goliaths. With many of the more-dour market shamans predicting mid-to-high single-digit annual returns from stocks in coming years, Bank of America's 4.3% yield would seem striking.

The higher valuations and lower yields found among many smaller banks imply that many investors may have wrongly been taking acquisition plans to the bank.

"I firmly expect the multiple premium for small banks to shrink over the next year," T. Rowe Price's Mr. Holton says.