2023-04-28 13:30:42 ET
Summary
- Washington Federal is acquiring Luther Burbank Corporation, a small market cap bank.
- The recent global banking crisis might make regulators more open to the merger, as it would combine a small Californian bank with a larger, more diversified entity.
- The tight merger spread and upcoming shareholder meetings on May 4 suggest the deal could close sooner than anticipated.
- Equity mergers carry inherent risks, the solid financial performance and discounted book value of Luther Burbank provide a level of security for investors considering this opportunity.
I tend to like small mergers that fly under the radar. The acquisition of Luther Burbank Corporation ( LBC ) is theoretically one of these situations. A $450 million market cap bank is being acquired by Washington Federal ( WAFD ), a $1.8 billion market cap bank, for 0.3353 shares of WFD per share of LBC. The transaction was announced on November 14, 2022, and the share prices have closely tracked each other since then:
Awkwardly, Washington Federal pays a dividend and raised it in February to $0.25 per quarter. This was recently paid on March 10; for shareholders of record Feb. 24; ex-div Feb. 23.
Back in November, S&P Global Intelligence ran a very bearish story on this merger. The publication basically contended the deal may face delays (and not meet the Q2 2023 target) due to recent increased regulatory scrutiny and an unusual stipulation in the merger agreement. SPI included interesting data on the bank's recent deals:
Among 25 U.S. bank deals announced since Jan. 1, 2020, with deal values between $250 million and $1 billion, the median days to close was 184. Washington Federal and Luther Burbank's second-quarter 2023 close estimate puts the anticipated days to close to between 139 if it were to close on the first day of the second quarter, or less than five months, and 229 if it were to close on the last day of the quarter, or less than eight months.
and a sweet graphic:
They also cited experts believing the timeline was too aggressive. The unusual provision they refer to allows one party to extend the deal close until Feb. 29, 2024, unilaterally. This would indicate that the banks may lack confidence in their ability to close the deal without regulatory delays.
I'm not sure if that's an entirely fair characterization. It could also be the case that the banks believe they should and are likely to get it through by Q2 2023, but in case regulators do go hard at them, they'll need the extra time. Often, mergers are quite binary in this way. Either you don't get regulatory scrutiny and a merger may close very smoothly, or you get the full treatment and this tends to put a lot of time on the clock. Merger closing dates do not scatter neatly around the average time to close. They close a bit sooner, or they close much later.
The story also mentioned one factor that could work in Washington Federal's favor, which is a terminated consent order with the Office of the Comptroller of the Currency. The order was terminated in December 2021 and related to deficiencies in the bank's Bank Secrecy Act/anti-money laundering compliance program. That sounds bad but because the order was lifted, the bank's BSA/AML controls are probably in good shape (as they just improved them) and this is an important area of concern to bank regulators that thus likely won't raise any red flags during regulatory review.
Other positives are the lack of overlap in the territory in the bank's service and Luther Burbank's outstanding Community Reinvestment Act rating and proven track record in lending to low- and moderate-income areas.
Importantly, we've just seen the global banking sector go through a precarious moment. Recent bank failures caused uncertainty and unrest. The collapse of Silicon Valley Bank (SIVBQ), the second-largest bank failure in U.S. history, initially sent shockwaves throughout the financial world, prompting central banks to take action to proactively stabilize things. But not before the world-famous Credit Suisse Group AG (CS) was toppled as well. Currently, there's still uncertainty around the path forward for First Republic (FRC). A disappointing event on that front could easily resurface banking angst. Luther Burbank is a Californian bank, the epicenter of the recent crisis, and it wouldn't surprise if regulators don't mind if a small bank in that area becomes part of a larger, more diversified entity.
During the banking turmoil, many merger spreads increased, some of which I wrote up in the Special Situations Report . The spread on this deal blew out some as well, and in hindsight, it would have been a good play. I was wondering why the spread on this merger was so tight. After looking more closely, I realized both banks have a special meeting on May 4 for their respective shareholder bases to approve the merger. Closing soon thereafter wouldn't be that unusual for a banking merger this small in size. I think it is interesting to hold the bank at this time, as the $8.93 share price implies a 3.47% upside to the consideration, with WAFD's share price at $27.57.
A good bit over 3% is an excellent return if it materializes over the next month. However, in an equity merger, you sell the acquirer's shares short. In this case, an arbitrageur would sell 3353 shares of WAFD for every 10k shares of Luther Burbank long.
The challenge with that position is you pay borrowing fees on the short side, dividends on the short side and if there's a bid on the acquirer you can get hit at both sides. The acquirer's price will jump, and sometimes a deal would break the deal that you are betting on, and those shares can plummet. That seems very unlikely in this case.
When the merger breaks, I wouldn't expect true carnage anyway because, at its current price, Luther Burbank is trading at a solid discount to its $13.64 book value. Its latest report indicated a net interest margin of 1.72%, deposits of $5.6 billion (marginally declined), only 17.9% of deposits are uninsured (much less than at the banks that got into trouble) and the bank has virtually no nonperforming assets. It generated a return on equity of 7.78% which isn't great, but that's often the case with tiny banks (hence why they trade at a discount to book).
Another risk to be mindful of is that Washington Federal is likely to declare and pay another $0.25 dividend in June. Holding through a dividend would quickly wipe out the profits on a hedged position.
At the end of the day, the acquisition of Luther Burbank Corporation by Washington Federal looks like an interesting opportunity for arbs. While the merger may face regulatory scrutiny and potential delays, there are several factors that could make it work in the short term. The lifting of Washington Federal's consent order, the lack of territorial overlap, and Luther Burbank's excellent Community Reinvestment Act rating are all positive signs for the deal's success.
In the wake of recent banking crises and instability, the merger of a small California bank with a larger, more diversified entity may be welcomed by regulators. The tight merger spread and upcoming special shareholder meetings on May 4 further indicate that the deal could close sooner than anticipated. Despite potential risks associated with equity mergers and the need to pay borrowing fees and dividends on the short side, the solid financial performance and the discounted book value of Luther Burbank help to set a floor in case of a break. If the Washington Federal acquisition closes somewhere in the next month, a 3%+ return for Luther Burbank Corporation stock would be somewhere between great and sublime.
For further details see:
Luther Burbank Acquisition Potentially Offers 3.47% Upside In A Month