Quick Pitch: Luther Burbank Corp (LBC)

Merger Arbitrage – 7% Upside

SVB collapse caused strong turbulence in the banking sector, causing a major sell-off of financial stocks this week. The bank merger spreads have widened as well. At this point, it is hard to tell whether these wider spreads reflect an increased risk of transactions falling apart (e.g. due to the fleeing of deposits from smaller banks into the largest national banks) or whether this is just a panic-driven sell-off. I am leaning toward the latter and expect the spreads to revert to the previous levels soon, especially for LBC. FHN is a much larger transaction with a wider following among investors/analysts, and therefore its market price is more likely to correctly reflect the risks.

The LBC / WAFD merger spread used to stand at minimal levels (under 2%) before the bank sector sell-off this week. Current spread stands at 7%-8%. California-focused community bank Luther Burbank ($574m market cap) is set to merge with western regional bank Washington Federal (WAFD, $2.2bn market cap). Consideration stands at 0.3353 WAFD shares for each LBC. Plenty of cheap borrow is available for hedging. The merger is expected to close in Q3’23.

The approvals from shareholders on both sides as well as regulatory consents are still pending, but none are likely to be an issue. WAFD shareholders are getting a bargain with the acquisition of LBC below TBV and materially below the median 1.9x TBV acquisition multiple for small western banks. WAFD itself trades at 1.2x TBV. Both banks operate profitably having generated 12% ROE last year. Despite the seemingly low-ball offer, LBC shareholders are  likely to approve the merger given 28% ownership by management and no opposition thus far (the merger is already 4 months in the making). Regulatory pushback is unlikely due to the rather small transaction size and very limited geographic overlap of both banks – WAFD currently has no presence in California, where 10 out of 11 LBC’s full-service branches are located.

The risk of the transaction falling apart due to the post-SVB turmoil seems minimal. WAFD is getting a bargain entry into the Californian market and therefore unlikely to walk away even if there is a dip in LBC’s customer deposits. From LBC’s perspective, this merger only increases the size of the bank and in turn the credibility in the eyes of depositors. Also, I doubt any of the depositors think LBC or WAFD is susceptible to the same risks as SVB. Both banks have old-fashioned business models and focus on RE loans. LBC’s book is comprised of 66% multifamily and 31% single-family residential loans, whereas WAFD portfolio is made of single-family residential (30%), construction (20%), commercial RE (16%), multifamily (13%) and commercial and industrial (13%) loans.