Texas Capital Bancshares (TCBI) – Merger Arbitrage – 13% Upside

Current Price: $28.5

Offer Price: $32.2

Upside: 13%

Expected Closing: H2 2020

Investor presentation

This idea was shared by Ilja.

 

All stock merger of equals between two Texas based banks.

On the 12th of Dec’19 Texas Capital and Independent Bank Group signed merger agreement. Consideration stands at 1.0311 IBTX shares for each TCBI share. Borrow for hedging is available and cheap. Shareholder approvals of both companies are required – meeting dates have not been set yet. So far in Q1 reports both companies have re-affirmed their intentions to proceed with the merger. Closing was expected in mid 2020, but might get delayed due to covid-19.

Pre-covid this merger used to trade at 1% spread and then for a short period of time (second half of March) the spread widened to 9%-13% (while the market was in panic mode and numerous other M&A spreads have exploded much more) and then returned to 5% levels. So the market seemed to have had relatively strong confidence in successful closing of this transaction. Nonetheless, since the end of April (after Q1 results) the spread has widened again. This was likely driven by large provisions on couple of TCBI loans as well as complete silence on the merger during IBTX conference call (all questions were met with ‘co comments’). TCBI decided to skip the call altogether citing pending merger. Lack of additional assurances from management were interpreted as signs that something negative might be developing behind the scenes.

 

However, this merger makes a lot of sense from a strategic perspective and I do not think that temporary hiccups from covid-19 will influence managements’ opinion. Both banks are founder led institutions and finding the right partner has taken considerable effort (TCBI CEO claims he was looking for a good fit for a few years already). Both companies focus on commercial segment, however, their business models seem quite complementary as IBTX deals more with the needs of small/medium-sized local businesses, commercial real estate and also has a portion of residential real estate loans whereas as TCBI is more prominent in corporate banking and has strong technological platform. According to TCBI CEO (press release):

Independent Bank Group is an outstanding complement to Texas Capital with its enviable commercial branch network, small business market leadership and solid deposit funding model in combination with our strong corporate banking practice and powerful technology and compliance infrastructure.

Business profile of both companies:

Note: Graphs are taken from the investor presentation.

Majority of IBTX loan portfolio is made of commercial RE to small/mid sized businesses (50% of LHI) – financing purchase of office buildings, retail centers, medical facilities and mixed-use buildings – and residential RE loans (13% of LHI), primarily made with respect to and secured by single-family homes, which are both owner-occupied and investor owned. Whereas for TCBI the key focus is on commercial lending (working capital loans, term loans, equipment financing and etc.) as well as mortgage finance (30 day mortgage warehousing, before these are syndicated and sold to other investors).

Additional points:

• Management expects substantial cost synergies: 26% EPS accretion for IBTX shareholders and 14% for TCBI. Target ROE stands at 15% and efficiency ratio at 49%.
• The merits of this transaction are more evident for IBTX shareholders. IBTX has been growing on the back of acquisition streak over the last 10 years and earlier transactions appear to be far more expensive (more below). Thus, pre-covid TCBI valuation of 1.2xTBV with historical ROE of 12% looks very favorable.
• Ownership split of the combined company (55% TBCI and 45% IBTX) appears to be have been determined based on equity value rather than tangible equity value. With almost $1bn of intangibles on IBTX balance sheet (goodwill from previous acquisitions), the bank is contributing relatively smaller proportion (c. 1/3) of tangible assets to the combined company compared to the ownership stake it receives. So in a way IBTX shareholders get credit for all the previous acquisitions and fast growth over the last decade.
• TCBI shareholder consent is a bit more questionable as historically TCBI was a more profitable although slower growing bank. However, the expected cost synergies and maintained control of the combined company (TCBI shareholders will receive 55% ownership and 7/13 board seats) should outweigh any issues especially given the lackluster Q1’20 results.
• At the time of the announcement TCBI was valued at 1.2x TBV vs 0.63x TBV currently. However, the same drop in valuation multiples applies across the whole banking sector (IBTX included). TCBI shareholders will nevertheless receive the same share in the combined company, irrespective of how low priced the company might currently appear from the P/TBV perspective and therefore this perceived low price is unlikely to influence shareholder vote.
• Both banks are founder-led institutions. IBTX CEO/Chairman David Brooks will continue to lead the merged company and TCBI’s CEO Keith Cargill will serve as Special Advisor.
• Despite its size, TCBI only has 12 branches, while the combined bank will operate with over 100 locations. In Q4’19 call TCBI CEO emphasized the need of expansion for future growth of the bank:

And so we want to be really thoughtful and any kind of fit, as I alluded to, over the years it kind of has to be that really just special, very difficult fit that we were looking for. And so, we found that here with David Brooks and Independent Financial. We knew over the last year or two that even with the success we’ve had with our different deposit verticals and mortgage finance and treasury business overall that a footprint of 12 branches, the same footprint we’ve had for well over 10 years was not optimum.

Nonetheless, there are certain worrisome aspects to consider as well:

• Q1 performance of both companies has been quite different and so far TCBI has been more impacted by covid, highlighting large provisions for 2 specific loans in energy sector and asserting that the rest of the portfolio is unlikely to be affected (Q1 press release):$55.0 million related to two large energy loans that were previously identified as problem loans that experienced further deterioration during the first quarter of 2020 exacerbated by the sharp drop in commodity prices. Nonetheless, TCBI has also cancelled its conference call, which did not help with market’s confidence on this transaction.
• IBTX has also refused to provide any comments on the merger during the conference call, which is quite strange given assuring language provided Q1 earnings press release. IBTX refused to confirm the timing as well, so the expected closing of mid-2020 might be delayed as well.
• Although Q1 results were relatively decent so far, IBTX has significant exposure to SMEs – segment which is expected to have the largest default rates in covid-19 driven recession.

In case the merger fails, the downside is unlikely to be material as stocks of both banks are already down more than Dow Jones bank index since the peak of the 21st of Feb: TCBI -48%, ITBX -42% vs Dow Jones bank index -37%.

 

Texas Capital Bancshares

TCBI operates 12 branches across Texas (Austin, Dallas, Fort Worth, Houston, San Antonio) and New York (1 location).

Performance:

Q1 showed a significant drop in performance and profitability due to covid situation, which resulted in $90m provisions (3% of BV) the majority of which ($55m) are attributed to two specific energy loans.

Shareholders (management owns only 0.6%):

 

Independent Bank Group

IBTX operates 62 branches in Texas (Austin, Dallas, Houston, Waco) and 31 branch in Colorado.

Performance:

Q1 performance of IBTX has been significantly better compared to TCBI and with only $8.4m provision (0.35% of BV).

The company has been implementing an aggressive growth through acquisitions strategy and since 2010 made 12 acquisitions (TCBI being the 13th). This has resulted in fast growing enterprise (assets up 3x since 2016) and correspondingly high valuation (2x-3x BV). It also seems that these mergers were well-digested and the company has maintained a decent level of efficiency. The amount of goodwill the company carries on its balance sheet is also substantial (BV/share = $55.44, TBV/share = $30.08).

Most acquisitions were paid by stock and done in Texas. Moreover, the multiple payed (at least in the two recent large transactions) seems to be quite high:

• 2019, Guaranty Bancorp (32 branches in Colorado, $3.81bn assets) – 3.19x TBV, 18.5x P/E.
• 2017, Carlile (42 branches in Texas/Colorado, $2.3bn assets) – 2.13x TBV, 17.5x P/E.

Shareholders (management owns 4.5%):

So 15% IBTX shares voting in favor seems pretty much guaranteed (Vincent J. Viola’s son is a director of IBTX).