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Execution rather than dilution is what matters most now for Fifth Third

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Execution rather than dilution is what matters most now for Fifth Third

Jeff Davis, CFA, is a veteran bank analyst. The views and opinions expressed in this piece are those of the author and do not necessarily represent the views of S&P Global Market Intelligence or Mercer Capital, where he is the managing director of the financial institutions group.

For roughly three decades bank investors have been regularly treated to an "oh hell yes" moment when walking into the office in the morning to learn that a bank in their portfolio will be acquired. Investors in the shares of the buyers often have a different reaction that ranges from grudging acceptance to an angry mob carrying pitchforks and torches.

Fifth Third Bancorp's announcement on May 21 that it will acquire Chicago-based MB Financial Inc. may fall toward the latter judging by the 8% reduction in its shares the day following the announcement. I am not so sure investors are right in their one-day assessment, although the burden of proof lies with Fifth Third. MB Financial shareholders got to cheer given the 24% one-day premium to the announced per share value.

Based on the $54.20 per share value at announcement (i.e., before Fifth Third's shares tanked), pricing was full in terms of post-crisis multiples at 276% of tangible book value and about 19x the $2.82 per share FY18 consensus estimate. About 90% of the $4.7 billion of consideration will consist of Fifth Third common shares, which as of May 18 traded at pedestrian multiples of about 13x the FY18 consensus estimate and 186% of tangible book value. Wide valuation differentials between what the seller receives (on paper) and where the buyer trades produce dilution to tangible book value per share (TBVPS) and EPS before factoring in expense savings.

I suppose investor ire toward Fifth Third was centered on the seven years management projects it will take to recover 8% dilution to TBVPS even though the earnback period includes a seemingly aggressive 45% expense saving assumption. The corollary is that 7% projected earnings accretion in 2020 — if realized — is not insignificant for a slow-growing superregional bank.

Fifth Third has plenty of company among bank acquirers who saw their shares fall on the news of an announcement, including Ohio-based competitors Huntington Bancshares Inc. and KeyCorp. Huntington's shares fell more than 8% on Jan. 26, 2016, on the news that it would acquire FirstMerit Corporation. KeyCorp's shares fell 7% on Oct. 30, 2015, the day it announced it would acquire First Niagara Financial Group. Among the issues cited for the drops were dilution to TBVPS and long earnback periods.

Ironically (or not), KeyCorp's shares have modestly outperformed and Huntington's almost match the price change in the SNL Bank Index from the day before each respective acquisition announcement was made through May 25, 2018. The unprovable counterfactual is whether their shares would have performed better had the acquisitions not occurred. I think good execution by each management team and maybe luck in the trajectory of the economy over the past few years has been much more important than the TBVPS dilution calculus.

I have mixed emotions about the focus on TBVPS dilution. Earnings drive stock prices in my view, not tangible book value as a stand-alone proposition absent the context of return. Acquisitions that dilute ROE are not good, but acquisitions that are long-term accretive to ROE at the cost of near-term dilution may not be a bad trade for shareholders. That said, I get it to the extent most bank transactions entail immediate dilution to TBVPS and uncertain timing as to when or even if EPS accretion occurs.

Investor ire notwithstanding, trophy franchises like MB Financial are not cheap, especially at this point in the economic cycle. I do not know what the board's calculus for the transaction was, but absent First Midwest Bancorp Inc. or Wintrust Financial Corp. putting themselves on the market, Fifth Third gets one shot to meaningfully boost its deposit market share in Chicago. The board took it.

Is the decision worth it for shareholders? Only time will tell. Lay-ups in M&A only occur in hindsight. Fifth Third was a star during the 1980s and 1990s because it produced great earnings growth through a combination of organic and acquisition growth that led to a premium valuation. However, the 2000s were mixed at best even before Fifth Third's shares crashed in the financial crisis. Among the issues I think investors would cite were two acquisitions that were priced in the vicinity of 6x tangible book value (Franklin Financial Corp. and First National Bankshares of Florida Inc.) and one that had a poorly structured exchange ratio mechanism (First Charter Corp.). It was a great time to be a seller of Fifth Third's shares.

Fifth Third has to execute to justify the price, and it will help to be lucky from a timing perspective. If the economy enters recession in the next two years or Chicago implodes as taxes are hiked to fund public worker pensions, MB Financial could look like just another top-of-the-cycle transaction that rewarded selling shareholders and impoverished the shareholders of the buyer. Or, maybe Fifth Third will surprise the market and disappoint the shorts by over-delivering through a really well executed transaction that produces more value for shareholders than if the board had not acted.