Feb. 08 2019 — The days of large bank acquirers pursuing deals to plant a flag in a new market might be receding as more buyers see transactions as a way to support much needed investments in technology.

In the latest Street Talk podcast, we discuss how BB&T Corp. touted that prospect when announcing its merger with SunTrust Banks Inc. and talk about the implications for future big-ticket transactions.

BB&T said the deal, one of the largest in U.S. banking history, will create a premier financial institution fueled by increased capacity to invest in innovation and talent. That stands in stark contrast to other blockbuster deals announced before the financial crisis, when buyers sought to create financial supermarkets or extend their footprints to new markets.

The size of BB&T's landmark transaction might have caught some members of the investment community off guard since Chairman and CEO Kelly King suggested the company was focused on organic growth and internal initiatives to drive costs lower. Still, while the merger of equals, the largest in BB&T's history, might have come as a surprise, it is part of a small group of large deals that received applause from the Street. The projected tangible book value accretion certainly played a role, but King also emphasized that the expansion would allow BB&T to achieve its previously stated goal of investing in technology to meet growing client demands.

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"We'll transform platforms to drive out cost, that's important, supporting a more technologically enabled business. And we will gain incremental efficiencies through automation by enabling faster, smarter and more secure way of doing business," King said on a call to discuss the deal.

Investment bankers have suggested others could follow BB&T's move and use cost savings from transactions to upgrade technological offerings. Some advisers even predicted an increase in larger deals before the BB&T/SunTrust transaction surfaced, arguing that regional banks needed to play catch up with the nation's largest institutions and upgrade technology and digital channels to keep their clients happy.

For his part, King emphasized that the world has changed considerably, even in just the last 12 months. King echoed comments made during BB&T's investor day in November 2018, when the company rolled out a new initiative, dubbed "Disrupt or Die," focused on improving efficiency while investing in delivery platforms.

"We talked about disrupt to thrive. And this is it, this is kind of the ultimate disrupt to thrive," King said on the SunTrust call.

That theme has recently become more common in larger bank deals. Chemical Financial Corp. and TCF Financial Corp., for instance, highlighted the opportunity to invest in technology as a combined franchise when discussing their $3.55 billion MOE announced a few weeks ago. The companies said the deal would allow them to invest and innovate more efficiently, enhance customer-facing digital service offerings and streamline internal systems and processes.

WSFS Financial Corp. offered a similar assessment when announcing plans to buy Beneficial Bancorp Inc. for $1.5 billion in August 2018. While WSFS took heat for the price paid on the deal, the buyer outlined plans to use some expected cost savings to invest in digital channels and shrink its branch network considerably.

"This combination allows us to economically address the question in every bank's boardroom," WSFS Chairman Mark Turner said on the call. "That is, how and when are we going to adjust to the new realities of banking delivery to meet the changing customer behavior and their needs."

The Street seems to think it makes sense to spend on technology to play offense. Jeff Davis, managing director at Mercer Capital and a S&P Global Market Intelligence contributor, said in a recent blog post that scale might be required to protect existing returns in the face of improving technology. He said the Amazon effect could apply to deposit pricing as "informed depositors with mobile technology" could force increased competition. Davis said the same thing occurred in the asset management business, where cost-conscious investors utilized widely available information and easy-to-use technology to upend the industry's pricing model.

BB&T seems to recognize the threat of fintech and other technology providers creeping into its space. As King noted on the conference call to discuss the SunTrust merger, he wants to get ahead of that sea change and lead rather than follow.

Mar. 20 2018 — The race to become the first trillion dollar company is heating up, with everyone paying close attention to the tech mega-caps — Alibaba Group Holdings Ltd. (NYSE: BABA) and Amazon.com Inc. (NASDAQ: AMZN).

Despite a lack of consensus over who will take the crown, one thing is evident: no two companies in the race are as neck and neck and as similar in business strategy and operations as Amazon and Alibaba. Both champion the e-commerce landscape in their specific countries – Amazon in the U.S. and Alibaba in China - and both have made their forays into new industries such as food and healthcare.

Wall Street is following these companies closely, with Alibaba slightly in the lead in terms of analyst recommendations. As of April 2, 2018, the Chinese e-commerce behemoth has received 37 buy ratings and just two hold, according to S&P Global Market Intelligence data. The average analyst price target of $226.44 suggests upside potential of roughly 23%. Amazon, in contrast, has received 31 buy ratings and two hold. The average analyst price target of $1,709.05 suggests upside potential of roughly 18%.

To keep a tally of the race, we used the RatingsDirect® Monitor, a data visualization portfolio monitoring tool that provides risk/return insights and helps track and analyze market movements for publicly-traded companies that are rated by S&P Global Ratings.

Figure 1: Tech Mega-Caps: S&P Issuer Credit Rating (FCLT) vs. 3M Stock Price Volatility (%)

For illustrative purposes only.

At a market cap of $471.6 billion, Alibaba is not too far off from catching up to Amazon’s $700.7 billion cap. Alibaba stock’s price has observed a three-month price volatility of 40.1%, the largest among the tech titans and far surpassing Amazon’s 30.8%.

Although the higher volatility and lower S&P Global Ratings’ long-term credit rating present more risks for investors, Alibaba’s higher return on assets and lower P/E and leverage ratio suggest more opportunities for the Chinese e-commerce behemoth to grow and reach the $1 trillion valuation first.

Comparing disruptive levels of innovation

To compare the disruptive level of innovation in the various sectors that Amazon and Alibaba have entered, we selected comparable events between the two conglomerates and examined industry-level probability of default (PD) changes of the PD Market Signal Model, a structural model that calculates the likelihood of a company defaulting on its debt or entering bankruptcy protection over a one-to-five year horizon.

The war for groceries

Both Amazon and Alibaba have been stepping up their battle in the grocery business. Just last year, Amazon’s announcement to purchase Whole Foods Market Inc. for $13.7 billion shocked investors, with shares of some of U.S. food’s largest players – Kroger Co. Supervalu Inc., Costco Wholesale Corp., Target Corp., and Wal-Mart Stores Inc. – dipping on the news. The market perceived credit risk of the U.S. food retail industry also escalated. One week following the announcement, the U.S. food retail PD jumped from 3.73% on June 15, 2017 to 4.85% on June 23, 2017, or about a 30% increase in the industry’s probability of default.

Figure 2: U.S. Food Retail Median Market Signal Probability of Default: June 15, 2017 – June 23, 2017 (%)

Alibaba also aggressively expanded its food footprint in 2017 with its rollout of new supermarkets under the Hema Xiansheng brand and its $2.9 billion investment in China’s largest hypermarket operator Sun Art Retail Group. Just this year, reports that Alibaba held early development talks with Kroger Co. left the Chinese food industry shaking. One week following reports of the discussions by Reuters and New York Post, China’s food retail PD increased 109.10% from 3.05% on January 23, 2018 to 6.39% on January 31, 2018. [i] [ii]

Figure 3: China Food Retail Median Market Signal Probability of Default: January 23, 2018 – January 31, 2018 (%)

The battle for pharma

Pharmaceuticals have been another potential battleground for the e-commerce giants.

According to an October 5, 2017 note published by Leerink Partners managing director Dr. Ana Gupte, Amazon is “hiring relevant talent and are in active discussions with mid-market PBMs [pharmacy benefit managers] and possibly even larger players such as Prime Therapeutics.” Following publication of the note, the U.S. drug retail PD escalated 22.55% from 16.16% on October 4, 2017 to 19.81% on October 12, 2017.

Figure 4: U.S. Drug Retail Median Market Signal Probability of Default: October 4, 2017 – October 12, 2017 (%)

Similarly, China’s drug retail PD jumped 90.67% from 1.55% on February 1, 2018 to 2.96% on February 9, 2018, following Alibaba’s February 2, 2018 announcement to partner with European pharma giant AstraZeneca PLC.

Figure 5: China Drug Retail Median Market Signal Probability of Default: February 1, 2018 – February 9, 2018 (%)

The risks of innovation

In summary, our PD Market Signal model shows that Alibaba disrupts the short-term market perceived credit quality of firms more than Amazon does. The Chinese e-commerce behemoth is viewed by many investors as a proxy for China's consumer economy and growing middle class, whereas Amazon is not, and PD movements are reflective of this. As illustrated by our RatingsDirect® Monitor, Alibaba has a much lower leverage compared to Amazon, with a last-twelve-months Debt/EBITDA ratio of 1.4, compared to Amazon’s 2.9. Alibaba also has higher growth potential from the perspective of ROA and P/E. Alibaba’s ROA stands at 7.4%, compared to Amazon’s 2.4%. Further, Alibaba’s lower P/E ratio of 46.3, compared to Amazon’s 235.3, suggests that the Chinese firm may be undervalued.

Figure 6: Tech Mega-Caps: ROA (%) vs. Debt/EBITDA (x)

For illustrative purposes only.

Figure 7: Tech Mega-Caps: ROA (%) vs. P/E Ratio (x)

For illustrative purposes only.

Whether Alibaba will claim the $1 trillion title before Amazon, however, remains to be seen. A fast growing company, Alibaba faces significant challenges from China’s ever-changing business environment, including potential regulatory, litigation, and international expansion risks, as outlined in roughly 45 pages of the firm’s most recent annual report.

Despite the inherent risks, what sets Alibaba apart is its domination of China’s online marketplace, which is the single-largest in the world. Founder Jack Ma has also been faster than Bezos to expand his business lines. The use of Alipay, one of the world’s largest mobile payment platforms, and the firm’s roughly $350 million investment in Chinese electric-vehicle maker Foxconn Technology Group are just a few examples of the firm’s growing economies of scale.

[i] Alibaba, U.S. grocer Kroger had early business development talks: source. (n.d.). Retrieved March 01, 2018, from https://www.reuters.com/article/us-kroger-alibaba/alibaba-u-s-grocer-kroger-had-early-business-development-talks-source-idUSKBN1FE0EF

[ii] To battle Amazon, Kroger eyes Alibaba alliance. (n.d.). Retrieved March 01, 2018, from https://nypost.com/2018/01/24/krogers-answer-to-amazon-go-alibaba/

Feb. 02 2018 — The implementation of a new accounting standard that changes the way banks reserve for loan losses could have a far more punitive impact on community banks than their larger counterparts.

The accounting standard, known as the current expected credit loss model, or CECL, becomes effective for many institutions in 2020 and will require banks to set aside reserves for lifetime expected losses on the day of origination.

The new standard will mark a considerable shift in how banks currently reserve for losses. Today, banks record losses when it becomes probable that a loan will be impaired. That means reserves are dispersed over time, but CECL will cause banks to significantly build their allowance for loan losses on the date of adoption, according to Josh Siegel and Ethan Heisler.

The two bank observers said in the latest Street Talk podcast that the increase will be even larger for institutions with higher concentrations of longer-term loans since reserves for those credits are currently spread out over longer periods.

"The same credit, the same view, the same company, if you have a two-year loan or a 20-year loan, the reserve you're going to have to put it against it is dramatically different," Siegel, managing partner and CEO of StoneCastle Partners LLC, an investor and adviser to community banks, said in the episode.

He said a reserve for a loan with a two-year term under CECL might not be dramatically different than the current methodology since it requires banks to look ahead 12 to 18 months for losses. Loans with far longer terms such as real estate credits, however, could require multiples of currently required reserves. The burden of the new accounting standard could prove far greater for community banks since those institutions are much more heavily concentrated in real estate.

Siegel and Heisler — president of the Bank Treasury Newsletter, which highlights industry trends impacting bank treasurers — co-authored a white paper analyzing CECL's impact on banks with less than $50 billion in assets. The analysis found that hundreds of banks could be at risk of falling below well-capitalized status after adopting CECL, at least when it comes to meeting total risk-based capital requirements. Any reserve build required through CECL will be deducted from capital and could have the greatest impact on total risk-based capital ratios because the Basel III rules cap the inclusion of reserves at 1.25% of risk-weighted assets.

The required build under CECL could push reserves well above that level, according to Siegel and Heisler's analysis. They examined the banking industry's results since 2004 and assumed institutions adopted CECL beginning in 2005. The analysis further assumed that all loan portfolios had five-year terms, loans were originated at year-end and bankers were fully aware of the losses that would come between 2005 and 2016. The analysis assumed provisions equaled cumulative net charge-offs in the five years after adoption and considered a number of scenarios, with CECL implementation beginning in different years.

In the most severe scenario, where banks would have adopted CECL beginning in 2007, the analysis found that banks in aggregate would need as much as $70 billion to repair the capital shortfall. In the least severe scenario, with CECL adoption beginning in 2011, banks would need to raise close to $10 billion.

"It's not just a small change. You could today be very well-capitalized and wake up and not even be adequately capitalized," Siegel said. "You could be deemed undercapitalized and immediately be put under a cease and desist order."

Siegel said banks should begin calculating CECL's impact, even in a rough approximation, to see if they have a capital shortfall. For an institution falling short, they recommended that banks should consider issuing subordinated debt to bolster their balance sheets.

Siegel has encouraged community banks to utilize sub debt in the past, given that it allows banks with holding companies to raise funds, downstream them to their banking subsidiaries and count them as equity capital in far more cost-effective manner. He and Heisler noted that issuing sub debt today remains relatively cheap while interest rates continue to be low.

"Sub debt is a natural offset, a way to prepare for CECL," Heisler said in the episode. "Think of Tier 2 sub debt almost as a CECL buffer."