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Long Term M&A Cycle Creates Opportunity In Banking Industry..

Long Term M&A Cycle Creates Opportunity In Banking Industry..



White Paper on Coming M&A Boom in the Community and regional Bank Sector

White Paper on Coming M&A Boom in the Community and regional Bank Sector



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    Long Term M&A Cycle Creates Opportunity In Banking Industry.. Long Term M&A Cycle Creates Opportunity In Banking Industry.. Document Transcript

    • White Paper UpdateLong-term M&A Cycle Creates Opportunity in Banking Industry 2011 in Review February 9, 2012 www.fjcapital.com
    • Table of ContentsExecutive Summary 3Value Proposition Similar to Early 1990s 42011 Transactions in Review 5Buyer Post-Transaction Price Performance 6Bank & Thrift Deal Valuation Trends 7Recent Transaction Highlights 8-10Sector Performance Review 11Industry Fundamentals 12Review of Merger Trends: 1990 to 2011 and Beyond 13Recent M&A Quotes from Industry Participants 14Board Perspective and Consolidation Drivers 15Why Banks Want/Need to Merger — 2011 in Review 15-16Impediments to M&A 16-17The Banking Landscape 18Summary of Potential Market Opportunity 19Update on FDIC-Assisted Acquisitions 20About FJ Capital Management 21 www.fjcapital.com 2
    • Executive Summary In this second annual white paper on bank M&A, we update our thesis on the emerging M&A boom in the U.S. small cap bank sector. We examine the current banking environment and opine on pricing and other trends that should lead to an unprecedented level of bank transactions during the next several years. In establishing this view, we examine the factors that should create the need and opportunity as well as present the challenges that have slowed substantial consolidation activity. Conditions highlighted in last year’s paper remain intact, with many recent acquisitions driving very attractive shareholder returns. While U.S. banking fundamentals remain challenged, albeit improving, and the coming M&A boom cannot be timed precisely, history shows stock performance often front-runs such major trends as well as actual economic recovery. Given the extremely compelling potential returns offered by heavily discounted bank valuations, the time to invest is likely sooner rather than later. The 159 bank M&A transactions in 2011 had an average one-day premium of 69% over the prior day closing price. While transaction volume moderated compared to 175 transactions in 2010, outsized market premiums remain about the same. Still, beyond industry publications and local media, small bank M&A continues to draw little attention. The U.S. economy continues to grow below trend following the great recession. Our thesis takes into account a slow and uneven recovery, regulatory changes and a more realistic view of long-term banking conditions. We believe that as these factors sink in, M&A will pick up steam and produce a record number of transactions. Challenges to our thesis also remain in place. With overall equity prices of buyers still relatively undervalued and sellers expectations still lofty, the clearing price for record M&A has not presented itself. Furthermore, the government’s delay in writing the new regulations has caused banks to retrench and wait for clarity on the rules of engagement in this changing regulatory world. Finally, the accounting for transactions creates challenges for buyers and sellers to get on the same page with respect to potential credit marks. These realities have caused a more cautious stance and thus a slowdown in consolidation activity. The irony is that the same challenges recounted above, eventually will lead to a pick up in M&A activity. Smart executives and boards of community banks that lack the scale to handle these exogenous factors will grow more weary of the tough operating and regulatory environment and depressed equity valuations. As managers execute their 2012 budgets, they see headwinds regarding both revenue and expenses. Revenues are lower due to the interest rate environment (a result of Operation Twist and lower asset yields) and weak loan demand (as the economy grows below trend). Additionally, the prospects of new assaults from regulatory changes (Durbin and CFPB) create pressure to grow the top line. On the expense side of the equation, companies will incur significant costs in putting the necessary infrastructure in place to handle the roughly 400 regulations that have yet to be written. www.fjcapital.com 3
    •  It is a buyers market, yet sellers benefit — we will look at how banks capitalize on this trend. Banks that produced solid returns throughout the downturn, armed with strong balance sheets bolstered by excess capital have opportunities to grow their franchises at historically low multiples. Prudent managers and bank boards that choose to partner with stronger and larger institutions are receiving currency that looks attractively valued and poised to recover as the economy stabilizes.Value Proposition Similar to Early 1990s If the past is prologue, prudently investing in the space before the M&A boom takes full force and the credit cycle has fully normalized likely will lead to outsized returns. We refer to the early 1990s when bank equity valuations recovered well before credit deterioration reached its peak (see below chart). While banks surely have more losses to take, the worst appears to be behind them; and investors must consider that these losses already may be baked into bank equities, which are trading at historically depressed levels. A focus on healthy, smaller banks with strong balance sheets, marked by excess capital and solid credit quality, can produce outsized, risk-adjusted investment returns over a multi-year period. Current bank equity valuations aside, these institutions are NOT all equal. In fact, the fundamentally strong banks view this environment as a generational opportunity to strengthen their franchises by taking market share from weaker players. Valuation (P/TBV) vs. Credit Quality (NPAs) Over Time 250% 3.50% Similar to early 1990’s, P/TBV is poised to rise as 3.00% 200% NPAs/Assets fall 2.50% NPAs/Assets 150% 2.00% P/TBV 100% 1.50% 1.00% 50% 0.50% 0% 0.00% 1990Y 1991Y 1992Y 1993Y 1994Y 1995Y 1996Y 1997Y 1998Y 1999Y 2000Y 2001Y 2002Y 2003Y 2004Y 2005Y 2006Y 2007Y 2008Y 2009Y 2010Y 2011Y P/TBV NPAs/Assets Sources: SNL Financial LC & FJ Capital Research www.fjcapital.com 4
    • Transactions in ReviewIn FJ Capital’s inaugural 2010 white paper, we highlighted our outlook for bank M&A. Thetheme of the paper was that a boom in M&A would drive the community and regional banksector in the coming years. Our view was and continues to be that the next M&A cycle willrival the last major U.S. bank consolidation wave in the mid 1990s. While the past 12 monthshave seen a year-over-year decrease in the number of transactions, deal value increased duringthis time. There were 159 transactions in 2011, with an aggregate deal value of $16.9 billionvs. 175 transactions worth $12.2 billion in 2010. The long-term trend of industry consolidationcontinues intact as the United States has 3% less banks today than it did in 2010. We expectactivity to increase modestly thorough 2012 and pick up steam in the 2013 to 2015 timeframeas the conditions highlighted in this paper come to fruition.Recent M&A Activity Summarized by Year Period Number of Deals Aggregate Deal Value ($M) Avg. Deal Size ($M) Averag e P/TBV (%) Market Premium (%) 2011 159 16,941 182 108 68.5 2010 175 12,172 112 117 70.6 2009 119 1,328 20 114 64.9 2008 143 35,606 304 170 64.9 Sources: SNL Financial LC & FJ Capital Research Data as of December 31, 2011One day market premiums (below) continue to support our thesis that the equity markets are notaccurately reflecting the franchise value of many community banks. In fact, the mediancommunity bank with below $250 million in market cap currently trades at just 70% of tangiblebook value. While sellers must adjust their valuation expectations, with peak pricing likelybehind us, we continue to see opportunities to earn 25%+ IRRs over the next 3-5 years byinvesting in select companies.Public Whole Banks & Thrifts M&A TransactionsExcludes FDIC-Assisted Transactions1/1/2011 Through 12/31/2011 Deal Price/ 1 Day Target Target AnnouncementRank Buyer Name/ Target Name Value Tangible Premium S tate Ticker Date (m/d/yyyy) ($M) Book (%) (%) AVERAGES 137.8 127.5 68.5 MEDIANS 37.6 125.0 51.1 1 Beneficial M utual Bancorp, Inc. (M HC)/ SE Financial Corp. PA SEFL 12/5/2011 32.2 110.5 249.4 2 S&T Bancorp, Inc./ M ainline Bancorp, Inc. PA M NPA 9/14/2011 21.4 125.9 191.4 3 SCBT Financial Corporation/ Peoples Bancorporation, Inc. SC PBCE 12/19/2011 41.4 61.4 164.4 4 Opus Bank/ RM G Capital Corporation CA RM GC 6/6/2011 49.2 130.6 147.1 5 F.N.B. Corporation/ Parkvale Financial Corporation PA PVSA 6/15/2011 130.7 197.6 106.7 6 ESSA Bancorp, Inc./ First Star Bancorp, Inc. PA FSSB 12/21/2011 24.7 49.3 90.2 7 Sandy Spring Bancorp, Inc./ CommerceFirst Bancorp, Inc. MD CM FB 12/20/2011 25.4 106.7 79.7 8 AltaPacific Bancorp/ Stellar Business Bank CA SLRB 9/14/2011 17.4 98.8 72.7 9 Grandpoint Capital, Inc./ Orange Community Bancorp CA OCBN 3/10/2011 32.1 134.6 67.1 10 NBT Bancorp Inc./ Hampshire First Bank NH HFBN 11/16/2011 45.2 144.0 65.9 11 Brookline Bancorp, Inc./ Bancorp Rhode Island, Inc. RI BARI 4/19/2011 233.7 193.3 57.1 12 First PacTrust Bancorp, Inc./ Beach Business Bank CA BBBC 8/30/2011 37.1 119.1 53.8 13 Embarcadero Bank/ Coronado First Bank CA CDFB 3/22/2011 9.3 99.7 48.4 14 Susquehanna Bancshares, Inc./ Tower Bancorp, Inc. PA TOBC 6/20/2011 342.1 149.3 40.6 15 Berkshire Hills Bancorp, Inc./ Connecticut Bank and Trust Compa CT CTBC 10/25/2011 30.0 143.2 33.0 16 Peoples United Financial, Inc./ Danvers Bancorp, Inc. MA DNBK 1/20/2011 488.9 184.1 32.9 17 Comerica Incorporated/ Sterling Bancshares, Inc. TX SBIB 1/16/2011 1028.9 229.7 29.8 18 Valley National Bancorp/ State Bancorp, Inc. NY STBC 4/28/2011 266.9 188.2 25.7 19 Home Bancorp, Inc./ GS Financial Corp. LA GSLA 3/30/2011 26.4 95.4 21.7 20 Park Sterling Corporation/ Community Capital Corporation SC CPBK 3/30/2011 32.3 69.7 21.2 21 Kentucky First Federal Bancorp (M HC)/ CKF Bancorp, Inc. KY CKFB 11/3/2011 10.5 80.8 16.4 22 California United Bank/ Premier Commercial Bancorp CA PCBP 12/8/2011 38.1 91.6 15.9 23 Susquehanna Bancshares, Inc./ Abington Bancorp, Inc. PA ABBC 1/26/2011 273.8 124.1 13.8 24 BankUnited, Inc./ Herald National Bank NY HNB 6/2/2011 70.0 132.0 0.1 Sources: SNL Financial LC & FJ Capital Research Data as of December 31, 2011 www.fjcapital.com 5
    • Overall, buyer stock price performance has been positive following the announcement of atransaction to purchase a target bank. This trend is illustrated in the below table. Median Buyer Price Performance Post‐Transaction Announcement Year 1 Month (%) 3 Months (%) 6 Months  (%) 1 Year (%) 1990 0.0% 0.0% ‐0.5% ‐4.5% 1991 0.4% 8.5% 18.4% 30.3% 1992 2.7% 6.5% 5.3% 19.2% 1993 0.4% ‐0.3% ‐0.5% ‐1.2% 1994 0.0% 1.2% 1.8% 9.5% 1995 1.5% 6.5% 9.8% 20.9% 1996 1.4% 7.6% 15.6% 40.8% 1997 3.9% 9.5% 20.0% 25.2% 1998 0.2% 0.0% ‐4.0% ‐9.5% 1999 ‐2.0% ‐5.2% ‐12.2% ‐18.3% 2000 2.2% 4.9% 7.5% 19.4% 2001 2.8% 2.8% 12.9% 11.9% 2002 ‐1.0% 1.4% 0.0% 15.6% 2003 1.6% 5.2% 10.4% 17.5% 2004 1.3% 1.6% 0.3% 5.9% 2005 ‐0.3% 0.6% 2.9% 4.8% 2006 0.3% 0.7% 0.0% ‐4.0% 2007 ‐1.3% ‐5.5% ‐8.2% ‐21.7% 2008 0.0% ‐5.3% ‐16.7% ‐24.0% 2009 ‐1.1% ‐1.2% 0.9% 0.6% 2010 0.8% 3.4% 3.6% ‐1.8% 2011 ‐0.1% ‐5.3% ‐9.3% NA Grand Medians 0.7% 1.7% 2.7% 6.0% Sources: SNL Financial LC & FJ Capital Research Data as of January 5, 2012While this table highlights post-transaction announcement performance for all acquisitivebanks, the stock performance of the successful acquirers is muted by the stock performance ofthe less successful acquirers. The result of an industry with so many banks and so many dealsis that a certain number of acquisitive banks have actually become quite successful acquirersand have turned it into a business in its own right. These institutions have seen much betterstock performance than what is shown above, and represent another way to invest in bankingconsolidation. www.fjcapital.com 6
    • The next chart highlights M&A pricing trends and offers some key takeaways. During recessionary periods, transaction pricing averaged 125% to 150% of tangible book value. The peak level of 264% of tangible book value was reached in 1998 due to a debt-enhanced economy that is unlikely to repeat in the foreseeable future. Contrary to expectations, transactions are getting done, albeit at lower pricing of 125% to 150% of adjusted tangible book. Since 2009, over 450 deals have been announced. Bank & Thrift M&A & Deal Valuations (P/TBV) 600  300  Early 1990s Early Housing crash, credit Banking Crisis 2000s crisis and recession Recession (2007 to Present) 500  250  400  200  Transaction P/TBV (%) Count 300  150  200  100  100  50  ‐ ‐ 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Transactions 203  299  380  470  526  436  443  450  476  334  254  251  212  261  269  270  293  288  143  119  175  159  P/TBV (%) 145  139  151  172  172  178  186  223  264  229  202  187  188  216  224  229  244  230  170  114  117  108  Sources: SNL Financial LC & FJ Capital Research Data as of January 5, 2012In 2010, failed bank or FDIC-assisted transactions created a slowdown in whole bankacquisitions, a trend that began to reverse in 2011. The open-bank consolidation trend shouldcontinue as banks better understand the value of their balance sheets.We will later examine other factors that drive M&A and draw conclusions on the next greatconsolidation boom. But first, let’s review some of the recent transactions that highlight thecompelling opportunity we foresee during the next several years. www.fjcapital.com 7
    • Recent Transaction Highlights Buyer: F.N.B. Corporation (FNB) Seller: Parkvale Financial Corporation (PVSA) Announcement: June 15, 2011 Deal Value: $130 million Valuation: 198% of TBV 1-Day Market Premium: NM 1-Month Market Premium: 120.8% Seller ROA: 0.4% Seller ROE: 6.6% Buyer Expectations: TBV Accretion: Flattish without equity raise and 5.7% accretive with equity raise Earnings Accretion: 6% in year 1 TBV Earn Back Period: N/A Transaction Rationale: In-market consolidation to strengthen FNB’s status in Pittsburgh, PA market, where MSA market rank increases from #7 to #3. Parkvale had security issues that detracted from a valuable Pittsburgh franchise. FNB capitialized on the opportunity to significantly add to its density in the Pittsburgh MSA. Buyer: Brookline Bancorp, Inc. (BRKL) Seller: Bancorp Rhode Island, Inc. (BARI) Announcement: April 19, 2011 Deal Value: $234 million Valuation: 193% of TBV 1-Day Market Premium: 57.1% 1-Month Market Premium: 58.5% Seller ROA: 0.6% Seller ROE: 7.7% Buyer Expectations: TBV Dilution: 22% or $1.66 per share Earnings Accretion: 25% accretive to EPS in 2012 TBV Earn Back Period: > 8 years Transaction Rationale: Out of market expansion to leverage excess capital via acquisition of a target in a less competitive market. Focus on long run EPS growth versus TBV. BRKL paid a full price to gain market share in Rhode Island. BRKL was searching for a catalyst to drive EPS and leverage its excess capital. www.fjcapital.com 8
    • Recent Transaction Highlights (continued) Buyer: Susquehanna Bancshares, Inc. (SUSQ) Seller: Tower Bancorp, Inc. (TOBC) Announcement: June 20, 2011 Deal Value: $342 million Valuation: 149.3% of TBV 1-Day Market Premium: 40.6% 1-Month Market Premium: 38.4% Seller ROA: 0.1% Seller ROE: 0.5% Buyer Expectations: TBV Dilution: 8.5% (PF TBV from $7.16 to $6.55 with Abington and Tower) Earnings Accretion: 10% TBV Earn Back Period: ~5 years Transaction Rationale: In market transaction improves Pennsylvania deposit market share from #12 (PF with Abington) to #5 Buyer: Berkshire Hills Bancorp, Inc. (BHLB) Seller: Connecticut Bank and Trust Company (CTBC) Announcement: October 25, 2011 Deal Value: 30 million Valuation: 143.2% of TBV 1-Day Market Premium: 33% 1-Month Market Premium: 29.4% Seller ROA: 0.7% Seller ROE: 7.2% Buyer Expectations: TBV Dilution: 4% or $0.65 per share Earnings Accretion: Core EPS accretion of $0.03 in 2012 before net deal costs TBV Earn Back Period: >8 years, per Sandler O’Neill research Transaction Rationale: Future accretion to benefit from revenue synergies and regional expansion. Demographically accretive, reflecting the comparatively high income and population densities in the Hartford, CT market. CTBC’s TARP to be repaid at/near closing. www.fjcapital.com 9
    • Recent Transaction Highlights (continued) Buyer: People’s United Financial, Inc. (PBCT) Seller: Danvers Bancorp, Inc. (DNBK) Announcement: January 20, 2011 Deal Value: $489 million Valuation: 184.1% of TBV 1-Day Market Premium: 33% 1-Month Market Premium: 38% Seller ROA: 0.7% Seller ROE: 6.1% Buyer Expectations: TBV Dilution: 6.7% Earnings Accretion: 2012 operating EPS accretion of ~$0.08 TBV Earn Back Period: ~7 years Transaction Rationale: Leverages excess capital and accretive to EPS. Immediately adds scale to existing Boston MSA presence. Pro forma PBCT improves to 7th largest bank in Massachusetts (from #16) and Boston MSA (from #15) and 2nd largest bank in Essex County, MA (from #9). Buyer: Home Bancorp, Inc. (HBCP) Seller: GS Financial Corp. (GSLA) Announcement: March 30,2011 Deal Value: 26.4 million Valuation: 95.4% of TBV 1-Day Market Premium: 21.7% 1-Month Market Premium: 82.6% Seller ROA: 0.2% Seller ROE: 1.4% Buyer Expectations: TBV Dilution: Minimal Earnings Accretion: 10% accretive to EPS when cost savings fully phased in by 2012 TBV Earn Back Period: N/A. Continued positive TBV growth, even during quarter in which transaction closed. Transaction Rationale: Expands Louisiana franchise via addition of GSLA’s presence into Orleans and Jefferson Parishes and leverages excess capital with a transaction priced below TBV. www.fjcapital.com 10
    • Sector Performance ReviewThe anemic U.S. economic recovery drove the smaller cap bank index down 4.04% in 2011,while the NASDAQ Bank Index was down 12.4%. In 2010, the banking sector experienced arebound as the economic picture looked “less bad”. The higher returns were led by the largercap banks, which advanced 11.4%, while the smaller cap banks were up 5.2%.The relentless negative headlines centered around mortgage abuses coupled with economicheadwinds and regulatory pressures caused a major break in large cap bank stocks in 2011.Smaller community banks fared better as their equity prices have not materially advanced sincethe start of the economic downturn in 2007. The volatility in the sector continued, as most ofthe declines were registered in August and September of last year, with the NASDAQ Bankindex down 19% in the two-month span. Smaller cap bank stocks experienced less volatilitythan their larger brethren in 2011, outperforming the bigger banks and money centers by morethan 20%. We believe this return disparity is justified due to the current steeply discountedmultiple of book value for small cap banks stocks and the resurgence of both actual M&Aactivity as well as projected activity over the next few years. We would also add that theeconomic conditions of the “survivors” of the past cycle are stronger now than in 2007, asmany of the non-performing loans continue to work through the resolution process. For sure,many headwinds exist, including continued weak economic activity characterized by fits andstarts, margin pressure as a result of Fed intervention, and a lack of revenue resulting from thebelow trend U.S. economic environment.As shown in the following chart, since Nov. 30, 2006, the average market multiple has driftedwell below tangible book value, with the current median at only 70% of tangible book value.The index that tracks 1,000 public banks and thrifts has traded off nearly 70% during this time. Index SNL Bank & Thrift Index1 Index Total Return (1,000 companies with < $250 million Market Cap) P/TBV 1000% 300% 241% 250% 800% Down 3 69% 200% 600% FJ Starts 150% 400% 2/1/2008 100% 200% Historically low 50% valuation and prices 2, 0% 0% Dec-1994 Dec-1998 Dec-2002 Dec-2006 Dec-2010 Source: SNL Financial LC. 1 The historical chart-line reflects a market-weighted index. 2 The 12/31/2011 Micro-Cap (excluding MHCs) median valuation of 70% is based on an equal-weighted index. 3 Micro-cap banks fell 18% from the 3/23/07 peak through 2/1/2008, then fell 58% more through 11/25/2011 for total fall of 70%. www.fjcapital.com 11
    • Industry FundamentalsThe banking industry’s fundamentals have generally improved year-over-year (Y/Y). FDICdata shows that, despite 3.3% Y/Y industry asset growth, loans fell by 0.7%, a testament to animportant challenge many banks face in growing earnings. In contrast, deposit growth has beenvery robust, up 9.9% Y/Y. Given the lack of lending opportunities, more deposits have beeninvested in securities, typically at lower yields than loans. The confluence of these trends canbe seen in declining net interest margins (NIMs) in many recent earnings reports, although thebelow table, based on data from SNL Financial LC, shows marginal year-over-yearimprovement at the end of the recent September quarter.A significant aspect of the banking industry is a major bifurcation in the financial condition andperformance of banks. In short, not all banks are equal, with many banks performing well orwell-enough, and many other banks facing almost insurmountable challenges to manageproblem loans, rising expenses and major growth headwinds. Select Banking Industry Metrics 9/30/2010 9/30/2011 9/30/2010 9/30/2011 9/30/2010 9/30/2011 Median Median Percentile: > 50 Percentile: > 50 Percentile:  < 50 Percentile:  < 50 ROAA (%)              0.48              0.61                           0.95                        1.03                          (0.81)                        (0.37) ROAE (%)              4.75              5.69                           9.61                      10.12                        (12.28)                        (6.93) Net Interest Margin (%)              3.71              3.75                           4.25                        4.30                            3.19                          3.26 TCE/TA (%)              8.57              8.84                        11.83                      12.06                            6.26                          6.33 Reserves/ Gross Loans (%)              1.71              1.80                           2.72                        2.78                            1.22                          1.28 NPAs/ Assets (%)              2.63              2.79                           1.25                        1.35                            6.06                          6.49 NCOs/ Avg Loans (%)              0.54              0.44                           0.15                        0.11                            2.32                          1.80 Sources: SNL Financial LC & FJ Capital ResearchThe first two data columns of the above table highlight Y/Y comparisons of industry mediansfor select metrics. The third and fourth data columns highlight the Y/Y comparisons of themetric averages for the top half (50th to 100th percentile) of the metrics reported by all publicbanks (i.e., higher performers). The fifth and sixth data columns highlight the Y/Y comparisonsof the metric averages for the bottom half (below 50th percentile) of the metrics reported by allpublic banks (i.e., lower performers). For instance, the top half of the banking industry is muchmore profitable than the bottom half, as the third quarter 2011 ROAA of the former is 1.03%and the ROAA of the latter is (0.37%). Comparisons made between the two sub-groups’ creditmetrics and capital levels also demonstrate significant financial differences.Clearly, many banks are facing industry challenges much more successfully than others. Onthis front, size matters, and a rule of thumb used by many industry experts is that most bankseventually will need to be $1 billion in assets or greater in order to achieve the scale necessaryto operate as an independent entity. Notably, non-interest income growth is currently anemicdue in no small part to regulatory pressures against bank fees (i.e., Durban Amendment of DoddFrank). Meanwhile, non-interest expense cuts can be achieved given the slower growth andimproving credit trends, but this is tough for smaller banks that lack the asset base over whichto spread rising regulatory costs. Cost cuts are more likely to come via M&A synergies.Looking forward, many banks will have too high a hurdle to clear in finding levers to pull thatwill achieve acceptable returns. This will drive a good number of these banks to the M&A alter. www.fjcapital.com 12
    • Review of Merger Trends: 1990 to 2011 and BeyondAs demonstrated below, consolidation is clearly the dominant trend in the bank sector, with thenumber of banks and thrifts dropping by about half, from almost 16,000 in 1989 to well below8,000 today. Furthermore, based on the “new normal” operating environment, there could be asimilar decline during the next five years. In short, we believe conditions exist for a substantialrebound in M&A that could equal or exceed 1994 peak levels. Number of U.S. Banks & Thrifts 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 6/30/1… 1990A 1991A 1992A 1993A 1994A 1995A 1996A 1997A 1998A 1999A 2000A 2001A 2002A 2003A 2004A 2005A 2006A 2007A 2008A 2009A 2010A 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 201 6/30/201 0 1 1 58 1 5,1 4,482 13,853 13,221 12,604 1 ,971 1 ,454 1 1 1 0,923 10,464 10,222 9,904 9,61 9,354 9,1 8,976 8,833 8,680 8,534 8,305 8,01 7,657 4 81 2 7,418 2012 2013 2014 2015 2016 201 201 7 8 2019 2020 Sources: FDIC & FJ Capital Research 7,281 6,917 6,571 6,243 6,056 5,874 5,698 5,527 5,361 Data as of June 30, 2011The above chart highlights the trends in bank transactions during the last 20 years, and ourestimate of what they likely will look like going forward. The last major boom in M&A wasthe period from 1991 to 1998. After the 1990 to 1991 recession, which was particularlyharmful to real estate lenders, there was a spike in consolidation activity as the economy beganto show signs of improvement. Moreover, deals exploded to a peak of 526 transactions in 1994.Steady consolidation activity slowed considerably in 2000, however, as bank stock valuationstook a back seat to the dot-com bubble and the resulting 2001 to 2003 recession. Thereafter,bank deals began to pick up until the recent financial crisis of 2007, the effects of whichcontinue to plague bank balance sheets even today. The current recession is again centered onreal estate and has crippled many companies in the sector. www.fjcapital.com 13
    • Recent M&A Quotes from Industry Participants A December 2011 article in SNL Financial highlighted the inevitability of bank M&A. “Declines in lending and spreads, coupled with higher capital requirements, will over the next three to four years leave some 3,000 banks — the vast majority of them community banks — unable to generate a sig- nificant return on capital,” said Kamal Mustafa, Chairman of Invictus Consulting Group and a former Citigroup Inc. banker in charge of M&A. Moreover, a “massive wave of consolidation” is inevitable as small community banks pair up or sell to larger players in order to gain the size needed to compete with the big banks and, equally important, to “eliminate destructive competition” among smaller banks, Mustafa said. He added, “It has to happen. There’s been a paradigm shift across the board, and there’s no other way to make it. There are 7,500-plus banks now. In five years, 5,000 would be too many.” “It’s about scale. It’s about size. It’s about the ability to absorb the increase in operating costs in an environment that is difficult to grow your earnings,” “Revenue growth was becoming a challenge. As we forecast it out over the next couple of years, we feel that it is going to continue to be a challenge while costs are going to continue to increase,” said John Keach Jr., CEO of Indiana Community Ban- corp, which announced its sale to Old National Bancorp on Jan. 24, 2012. “There’s been a lot more engagement recently from banks, people really starting now to explore their options, starting to have serious discussions” about possible sales, said John Boulware, Managing Director at Community Capital Advisors. “And at some point, things will begin to snowball — M&A activity will beget more M&A activity.” "Theres definitely something in the water," said Lee Bradley, Senior Managing Director at Commu- nity Capital Advisors. "There are more people looking to sell, and more buyers at least showing some interest." In an October SNL Financial article, Bradley said smaller banks — those with roughly $250 million in assets or less — are likely to account for the largest share of sellers, as such compa- nies with smaller bases over which to spread new expenses struggle the most to absorb rising compli- ance costs linked to the Dodd-Frank legislation. “The ability to reduce costs through consolidation is one of the few tools that bankers have to improve operating results, as the fundamental business drivers will likely stay soft and banks face heightened regulatory compliance costs,” said Tom Tullidge Jr., a Managing Director at Cary Street Partners LCC. “I know for a fact that a lot of thrifts are thinking hard about changing their charters to become a com- mercial bank…thrifts by regulation had to have 65% of their balance sheet in housing and housing- related assets. If weve learned any lesson its that those levels of concentration dont make any sense and that the real future of community banking is in diversification. I do think its on the mind of a lot of thrift executives and a lot of thrift boards — how do they find the right partner and what is the process they need to achieve a more diversified balance sheet.” — C.K. Lee, investment banker and former regulator “We think [banking consolidation] will occur in the next 24 to 30 months as a result of earnings pres- sure and the Fed’s flattening of the yield curve...” — Berry, CEO & President, Equity Development www.fjcapital.com 14
    • Board Perspective and Consolidation DriversThe big question on the minds of bank management and directors is when is the right time toconsider consolidation. Some sellers are pining and holding out for the peak pricing ofprevious cycles, while others recognize the challenges of the current environment and havedecided to look for a partner. We believe peak pricing levels may be behind us as the economyhas structural issues that will take an extended period to adjust. First, peak pricing was a resultof a “hyper” economy driven by extreme levels of debt and irrational real estate gains. Thehangover will last for some time and will be characterized by slower growth and higher-than-desired unemployment.Bear in mind that many banks have just been through one of the toughest recessions in memoryand are dealing with the after effects, namely an extended low-rate environment that ispressuring revenue. Additionally, the pendulum of regulatory involvement has swung to theextreme with the final regulatory orders yet to be determined. So in addition to the past fiveyears of economic weakness and financial meltdowns, they are faced with another three to fiveyears of tepid growth, unnatural intervention by the Fed and a fight for well priced and solidcredits to add to the loan portfolio.Why Banks Want/Need to Merge — 2011 ReviewGenerally speaking, the same drivers that existed in the early 1990s exist today. However,there are new important drivers not present in 1994. For starters, there continue to be too manybanks competing for the same marginal deposit and loan. Major consolidation factors include: Cost Savings – The typical merger can save 20% to 40% in operating costs, therebycreating significant earnings accretion for the combined entity. Lack of Loan Growth – Due to banking competition and the over saturation of banks, loangrowth could be muted in even the best of times. This is especially true in the current economicenvironment, with large businesses hoarding record levels of cash and small businesses notseeing the end demand needed to make capital investment. In addition, many individuals andhouseholds are working to repair damaged balance sheets and de-lever. Lack of Access to Capital Markets – Most small cap firms have limited access to the capitalmarkets. Even if they have access, the punitive pricing commonplace in today’s market meansthis route may not be an economically viable capital raising option for many smaller bankinginstitutions. Therefore, capital restraints will force banks to partner up. Fairly Illiquid Trading – Most smaller cap banks tend to have fairly illiquid shares. Theboards of such institutions will consider this as they deliberate on ways to increase shareholdervalue. Most institutional investors will not invest in companies they deem illiquid, tending toshy away from market caps under $500 million. This excludes most of the public banks andthrifts from receiving direct investments by institutional investors. www.fjcapital.com 15
    •  Management/Board Fatigue – Sophisticated management and boards understand that abank must have a valid business plan in place, one that includes either organic growth or growthvia acquisition. We suspect many leaders find it difficult to execute their original businessplans in the current economic environment. This recession has been particularly tough onbanks focused on real estate lending. Therefore, we believe many banking leaders currently areweighing their M&A options. Regulatory Reform – One recent factor is the Dodd-Frank legislation. The potential forchange is yet to be fully processed by management teams and boards. It is clear the regulationwill greatly increase operating costs and will reduce shareholder returns. In fact, new capitalstandards alone will make it much harder for companies to earn an acceptable return on equityto justify independence. Additionally, uncertainty surrounds the implementation of the newreform and the potential impact on generating acceptable returns.Impediments to M&A Evolving Accounting Standards – The accounting for bank M&A has evolved from thefavorable pooling of interest method (prior to 2001) to purchase accounting with newpronouncements, such as SFAS 141R, and other bulletins along the way. Pooling wasfavorable as it allowed the combination of assets and liabilities and did not create materialgoodwill. Under the current scheme, all transactions are now completed under purchaseaccounting. To complicate matters (or increase transparency, depending on your view) FASBintroduced SFAS 141R along with several bulletins that, among other things, restricttransferring reserves over to the acquirer. These accounting rules, coupled with the creditmarks assumed by the buyers, create issues for both buyers and sellers. The higher the creditmark (more conservative) the greater the goodwill, thus reducing the potential price a buyercan/will pay. We suspect the accounting treatment and the credit marks have had the effect ofslowing consolidation. As the economy improves and loan books are more easily valued, thecredit marks should moderate, paving the way for lower goodwill charges and higher multiples. Regulatory and Legal Uncertainty - The process of approving transactions has appeared toslow somewhat as the agencies consolidate their base and turn their attention to writing newrules mandated by Dodd-Frank legislation. For companies with thin capital bases or creditquality issues, winning the approval of regulators will be more challenging than in the past. Itis not to say that regulators have failed to look at these variables in the past, but rather moreattention is given today as capital rules are yet to be written. On the legal front, it seems everytransaction has some type of legal/investigation attached to it. While most of these suits are notgrounded in strong logic, nonetheless it is one more consideration to pulling the trigger on anM&A transaction. Bank Stock Valuations – Arguably one of the most important factors in bank M&A ispricing. One of the factors that limit the potential valuation a buyer can pay is its own currency.Bank stocks have been under considerable pressure over the last several years, reacting both tothe financial crisis and the ensuing great recession, events that historically have been especiallyhard on bank stock valuations. For the most part, valuations have not recovered – since the start www.fjcapital.com 16
    • of the economic downturn, the SNL Bank and Thrift index is down 62.3%, while the smallerbanks are down 60%. The largest banks in the country, with market caps greater than $10billion, are down 81% from their peak. In addition, the industry median price-to-book valuehas declined from approximately 174% at the end of 2006 to 75% at present. Conversely,sellers may be holding out for better times when they could fetch 2.5 to 3 times book value.You can see with the value destruction caused in the market that seller expectations are toohigh. The bid/ask spread needs to adjust as equities have adjusted over the last several years. Establishing the Right Credit Mark – The wide bid/ask spread between buyers and sellersis in part driven by what the credit mark should be. While sellers have put aside reserves(which now cannot be transferred under FASB 141r), buyers take a fresh look and re-mark theportfolio based on their own set of assumptions. Buyers will take a conservative approach tomake sure they identified all the impairments and mark them accordingly. Sellers either believetheir marks are appropriate for the risk or they are in denial about the real mark to mark value oftheir loan books. We believe the answer falls somewhere in the middle. Nonetheless, this is amajor impediment when delivering a price that the seller can accept. Social Issues – The social issues are an important consideration when discussing potentialmergers and acquisitions. The phrase most often used in this sector is “banks are sold notbought,” which refers to the fact that boards and managements make the decision to sell ratherthan reacting to either a hostile situation or overtures from other banks. That is not to say thatgood bank managers are not talking all the time to potential sellers, rather that the ultimatedecision to pull the trigger resides with the board and/or management. It is difficult to handicapthis, as many management teams are entrenched and happy to have a job even as theirinstitutions are producing an insufficient ROE for shareholders. In fact, there are manyundercapitalized and underperforming banks that clearly are not acting in the best interests oftheir shareholders. Most bank board members are successful business people in their ownrights, yet are often guided by managers that are not always aligned with shareholders. Westrongly suspect that as more bank boards realize that the industry will not move back to peakprofitability or peak pricing, more will decide to find a partner. www.fjcapital.com 17
    • The Banking Landscape # of Institutions Assets ($ Billions) Total Industry Banks & Thrifts 7,040 100% 18,460 100% Private 5,799 82% 2,512 14% Public 1,241 18% 15,948 86% # of Institutions Assets ($ Billions) Public Banks & Thrifts 1,241 100% 15,948 100% Public Banks 992 80% 15,317 96% Public Thrifts 249 20% 632 4% # of Institutions Assets ($ Billions) Public Thrifts 249 100% 632 100% Fully Public 196 79% 593 94% MHCs 53 21% 39 6% Sources: SNL Financial LC & FJ Capital Research Data as of January 2, 2012The above chart illustrates the landscape of private and public U.S. banking institutions. Areview of the opportunity set shows that the majority of banks are small community banks withassets of less than $500 million. Of that, roughly 1,100 are publicly traded companies withmarket caps below $250 million, and a combined $85 billion capitalization (table on p. 19). U.S. Banking System Composition Number of Banks by Asset Size 6,000 5,714 4,000 2,000 646 400 76 154 0 $0 to $500 Mil $500 Mil to $1 Bil $1 Bil to $3 Bil $3 Bil to 5 Bil $5+ Bil Sources: SNL Financial LC & FJ Capital Research Data as of January 2, 2012 www.fjcapital.com 18
    • Summary of Potential Market OpportunitySNL Micro-Cap Bank & Thrift Index 993 Companies with: --A Median Market Cap of $ 20.6 Million --An Average Market Cap of $ 39.3 Million --For a Total Index Market Cap of $ 39.0 BillionSNL Small-Cap Bank & Thrift Index 98 Companies with: --A Median Market Cap of $ 426.2 Million --An Average Market Cap of $ 474.0 Million --For a Total Index Market Cap of $ 46.5 BillionSNL Micro-Cap and Small Cap Bank & Thrift Indices 1,091 Companies with: --A Median Market Cap of $ 25.0 Million --An Average Market Cap of $ 78.3 Million --For a Total Index Market Cap of $ 85.5 Billion Sources: SNL Financial LC & FJ Capital Research Data as of February 3, 2012As noted below, nearly 764 companies are trading at less than book value, reflecting investorappetite for liquidity coupled with the current economic environment and company-specificissues. As previously stated, new capital requirements and banks’ lack of access to the publicmarkets, will contribute significantly to the increase in consolidation. As the below chartshows, 413 companies or 54% of the public banks trading below tangible book value, areexperiencing substandard capital levels and/or elevated asset quality issues. Public Banks: Current Valuation and Credit Summary Public Banks 1,180 100.0% P/TBV >= 100% as of close on 2/3/2012 352 29.8% P/TBV < 100% as of close on 2/3/2012 764 64.7% P/TBV is not available or not meaningful 64 5.4% P/TBV < 100% 764 100.0% TCE > 6% AND NPAs/Assets < or = 4% 472 61.8% TCE > 6% 990 129.6% NPAs <= 4% 747 97.8% TCE < 6% AND NPAs/Assets > or = 4% 122 16.0% TCE < 6% 179 23.4% NPAs >= 4% 413 54.1% No TCE data available 11 1.4% No NPA data available 20 2.6% Sources: SNL Financial LC & FJ Capital Research Data as of February 3, 2012 www.fjcapital.com 19
    • Update on FDIC-Assisted TransactionsThe financial crisis of late 2007 sparked a resurgence in bank failures. As shown below, thereal estate bust led to an unprecedented number of failures in the early 1990s. The trough phaseof the most recent cycle has seen some very large institutions fail, yet the absolute number offailures remains well below the peak created in the prior real estate crash.Companies with strong balance sheets have taken advantage of this cycle to prudently growtheir franchises. Often, multiple bidders try to grow their franchises with the help ofgovernment stop-loss guarantees. The below chart shows that while the U.S. economicrecovery still has a long way to go, the pace of FDIC-assisted transactions has slowed, coupledwith much more competitive pricing. Number of FDIC Assisted Deals (1990-2011) 555 485 279 194 147 118 115 90 22 25 9 2 3 8 8 5 7 3 3 3 0 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sources: SNL Financial LC & FJ Capital Research Data as of January 13, 2012In the second half of 2010, Sheila Bair, former head of the FDIC, highlighted that there were829 banks on the FDIC’s “Problem List” at June 30, 2010. She also declared the market near apeak in failures and said that this cycle will produce far less bank failures than the mid 1990scycle. At September 30, 2011, the number of problem banks was 844, down 5% from therecent high of 888 banks at March 31, 2011.Based on FJ Capital’s research and SNL Financial LC data, we count 415 banks with Texasratios [nonperforming assets/(tangible common equity + loan loss reserves)] greater than 100percent, a typical sign of potential failure. The five states with the highest numbers of bankswith Texas ratios above 100% are: Georgia (63 banks), Florida (43 banks), Illinois (42 banks),Minnesota (29 banks) and Missouri (23 banks). www.fjcapital.com 20
    • About FJ Capital Management, LLCThis paper was written by FJ Capital Management Co-Founder, Managing Member and CIO,Martin Friedman, and FJ Capital Management Managing Director, Scott Cottrell, who have acombined 35-plus years of capital markets experience, much of this time spent following andanalyzing small- and mid- capitalization financial institutions. A special thanks goes out toMutian Yang, who helped significantly in data collection and presentation.Prior to founding FJ Capital in 2007, Mr. Friedman served nine years as director of research atFriedman, Billings, Ramsey Group, a major financial services firm publicly traded on the NewYork Stock Exchange, where he built the 13th largest U.S. sell side research organization, with140 professionals encompassing eight industry sectors. Previously, Mr. Friedman was a seniorresearch analyst focused on the financial services industry covering small- and mid- cap banksand thrifts. Mr. Friedman has been analyzing and investing in this sector for over 20 years. Mr.Friedman currently serves on the board of Access National Bank (ANCX), an $800 million assetcommunity bank headquartered in Reston, VA.Prior to joining FJ Capital, Mr. Cottrell served as a research analyst at FBR covering small-and mid- cap banks and thrifts. Mr. Cottrell has approximately 15 years of banking industryexperience for firms that include Wells Fargo, National City Bank and Servus Financial Corp.He is a CPA and earned his MBA from Georgetown University.FJ Capital Management is a fundamentally driven investment management firm founded in2007 that analyzes and invests in publicly traded U.S. community and regional banks throughalternative strategies. The firm utilizes proprietary fundamental research to uncover valuedisparities in the small- and mid-cap bank sector and seeks to take advantage of these disparitiesby building core positions with longer term holding periods. The firm also seeks to generateattractive, risk-adjusted investment returns by uncovering opportunities with identifiable, near-term catalysts. For more on FJ Capital or to further explore opportunities in the bank sector,please visit www.fjcapital.com or contact:Andrew Jose FJ Capital ManagementO: 703.875.8378 1313 Dolley Madison Blvd.,M: 703.408.0394 Suite 306ajose@fjcapital.com McLean, VA 22101www.fjcapital.comImportant Disclosures:This White Paper is provided for informational purposes only, does not constitute investmentadvice and should not be relied upon as such. It is neither an advertisement for investmentadvisory services nor an offer to sell or solicitation of an offer to buy securities.The information presented in this White Paper has been developed internally and/or obtainedfrom resources believed to be reliable; however, FJ Capital Management does not guarantee theaccuracy, adequacy or completeness of such information. References to securities or asset classesdo not constitute recommendations to purchase or sell any specific securities or asset classes. www.fjcapital.com 21