After five or six years of strong bank M&A activity, 2020 slowed drastically following the onset of COVID-19. Eventually, we expect M&A activity will rebound once buyers have more confidence in the economy and the COVID-19 medical outlook. In that case, there will be greater certainty around seller’s earnings outlook and credit quality, particularly for those loan segments more exposed in the post-COVID-19 economic environment.
The factors that drive consolidation such as buyers’ needs to obtain scale,
improve profitability, and support growth will remain as will seller desires to exit due to shareholder needs for liquidity and management succession among others.
One emerging trend prior to the bank M&A slowdown in March 2020 was credit unions (“CUs”) acquiring small community banks. Since January 1, 2015, there have been 36 acquisitions of banks by CUs of which 15 were announced in 2019.
In addition to the factors favoring consolidation noted above, credit unions can benefit from diversifying their loan portfolio away from a heavy reliance on consumers and into new geographic markets. In addition to diversification benefits, bank acquisitions can also enhance the growth profile of the acquiring CU.
From the first quarter of 2015 through the second quarter of 2019, CU bank buyers grew their membership by ~23% compared to ~15% for other CUs according to S&P Global Market Intelligence. A positive for community bank sellers is that CUs pay cash and often acquire small community banks located in small communities or even rural areas, that do not interest most large community and regional bank acquirers.
There are, of course, unique valuation issues to consider when a credit union buys (or is bidding for) a commercial bank.
Based upon our experience of working as the financial advisor to credit unions that are contemplating an acquisition of a bank, we see three broad factors CUs should consider.
Developing a reasonable valuation for a bank target is important in any economic environment but particularly so in the post-COVID-19 environment. Generally, the guideline M&A comparable transactions and discounted cash flow (“DCF”) valuation methods are relied upon.
In the pre-COVID-19 environment, transaction data was more readily available so that one could tailor one or more M&A comp groups that closely reflected the target’s geographic location, asset size, financial performance, and the like. Until sufficient M&A activity resumes, timely and relevant market data is limited. Even when M&A activity resumes, inferences from historical data for CU deals should be made with caution because it is a small sample set of ~35 pre-COVID-19 deals where only 75% of announced deals since 2015 included pricing data with a wide P/TBV range of ~0.5x to ~1.7x (with a median of ~1.3x).
While deal values are often reported and compared based upon multiples of tangible book value, CU acquirers are like most bank acquirers in which value is a function of projected cash flow estimates that they believe the bank target can produce in the future once merged with their CU.
A key question to consider is: What factors drive the cash flow forecast and ultimately value? No two valuations or cash flow estimates are alike and determining the value for a bank or its branches requires evaluating both qualitative and quantitative factors bearing on the target bank’s current performance, outlook, growth potential, and risk attributes.
The primary factors driving value in our experience include considering both qualitative and quantitative factors. In a post-COVID-19 valuation, a CU may have a high degree of confidence in expense savings, but less so in other aspects of the forecast—especially related to growth potential, credit losses, and the net interest margin (“NIM”).
It is important for CUs to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma net worth of the CU at closing as well as their future earnings and net worth. In the initial accounting for a bank acquisition by a CU, acquired assets and liabilities are marked to their fair values, with the most significant marks typically for the loan portfolio followed by depositor customer relationship (core deposit) intangible assets.
Once a valuation range is determined and the pro forma balance sheet is prepared, the CU can then begin to model certain deal metrics to assess the strength and weaknesses of the transaction. Many of the traditional metrics that banks utilize when assessing bank targets are also commonplace for CUs to evaluate and consider, including net worth (or book value) dilution and the earnback period, earnings accretion/dilution, and an IRR analysis. These and other measures usually are meaningfully impacted by the opportunity cost of cash allocated to the purchase and retention estimates for accounts and lines of business that may have an uncertain future as part of a CU.
One deal metric that often gets a lot of focus from CUs is the estimated internal rate of return (“IRR”) for the transaction based upon the following key items: the cash price for the acquisitions, the opportunity cost of the cash, and the forecast cash flows/valuation for the target inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the CU’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the CU and its members. In our experience, an IRR estimate 200-500 basis points (2-5%) above the CUs historical return on equity (net worth) implies an attractive acquisition candidate.
Mercer Capital has significant experience providing valuation, due diligence, and advisory services to credit unions and community banks across each phase of a potential transaction. Our services for CUs include providing initial valuation ranges to CUs for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the CU’s management and/or Board, and providing valuations for fair value estimates of loans and core deposit prior to or at closing.
We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit by including a credit union in the transaction process. Feel free to reach out to us to discuss your community bank or credit union’s unique situation in confidence.
Originally published in Bank Watch, May 2020.
The National Restaurant Association’s Restaurant Performance Index for March dropped to its lowest level since the Index began in 2002. The 95.0 reading was down from 101.9 in February, with 100 being the separator between expansion and contraction. The RPI is equally weighted between the Current Situation Index (93.1) and the Expectations Index (97.0). The Expectations Index is usually the higher of the two and measures operators 6-month outlook, but it is telling that this figure is still below 100 looking out to September.
Coming into 2020, there was a growing chasm between the valuations of many restaurant brands that get significant franchise royalty revenues and their franchisee operating counterparts. Franchisee valuations have lagged as margins have been squeezed by factors including costly third-party delivery services. Perhaps these costs will be abated once this subindustry experiences some consolidation like Uber’s recently announced attempted takeover of Grubhub. Or maybe this will further squeeze the bottom line for restaurant operators as these delivery companies compete less. Either way, franchisors clipping royalties off the top of revenues have been protected, and their asset lite approach has streamlined operations. However, the success of this business model is premised on the idea that operator margins may be squeezed but their revenues will not materially decline. The demand shock created by COVID has burst the bubble on this investment thesis, which has brought down valuations for franchisors and operators alike. It will be interesting to see going forward how this impacts the separation between brand and operator as franchisees have long bemoaned expensive capex requirements that are a use of cash and may increase revenues and profits in unequal measure.
Restaurants with significant leverage (debt or other fixed costs such as rent not tied to a % of sales) are likely to fare worse than others. Brand may also play an increased role as consumers seek to “support local.” Stay-at-home orders have seen grocery bills increase and restaurant trips confined to takeout. In certain areas, restrictions have been eased including Nashville, where retail and restaurant businesses are allowed to open at 50% capacity as part of Phase One of the city’s reopening plan. While government’s allowing restaurants to reopen is the first step to returning to normalcy, there are many more steps to go. First, restaurants must be willing to reopen amidst concerns about staffing and profitability. For restaurants to be willing to open, they must believe customers will be willing to return as well.
Despite now being allowed to open, not all restaurants will opt to flip the switch and open their doors. There is a myriad of potential reasons, but we will highlight a couple key issues. First is labor. In April, 20.5 million jobs were lost, and 5.5 million of these were in food services. Rehiring at this scale doesn’t happen overnight. Also, the CARES Act signed on March 27th increased unemployment benefits by $600 per week through the end of July. For an employee making $10/hour in Tennessee, they would be eligible for a total of $800/week in benefits from unemployment between state and federal. While unemployment originally would have only replaced half of the worker’s $400/week wage, they would now be receiving double. This significantly impairs the ability of restaurant owners to compel staff to return.
This presents a problem for employers who are required to restore employment under the terms of the PPP to make loans forgivable. On May 3rd, the Treasury Department issued guidance that if businesses could document a rejected written offer, this employee will be excluded from the forgiveness calculation. Receiving unemployment benefits requires people to be “actively searching” for a job. While this has historically been only minimally enforceable, the PPP loans will cause written documentation to be provided to the government that people are ineligible for unemployment, which may increase compliance. But this will strain labor relations as many will view themselves as underpaid.
An effective pay cut is not the only thing that would keep staff away from work. Even management-level employees are not necessarily eager to return to work with the potential health and safety risks. While staying below full capacity is likely safer than reopening all at once, the risk is certainly not eliminated. People have been strongly encouraged or required to wear masks in public, but masks will be decidedly less prevalent in between bites of a meal.
Finally, restaurant owners have to perform their own cost benefit analysis as to whether it makes sense to reopen, just like they had to determine whether or not to offer takeout or close entirely. Certain overhead expenses like rent are considered a cost of doing business, except for some companies who opted to forego rent payments. Many expenses, however, are variable such as food costs. If restaurant owners decide to reopen their doors, they will have to pay for inventory, bring back workers, and incur the majority of their typical expenses. Incorrectly projecting consumer behavior can lead to spoilage. On the other hand, people returning to their favorite restaurants expecting their favorite menu item may deal a blow to reputation if items aren’t properly stocked. For many, reopening will not make sense if revenues are only 25-50%.
In the March 2020 Bank Watch, we provided our first impressions of the “reshaping landscape” created by the COVID-19 pandemic and its unfolding economic consequences. This month, we expand upon the potential asset quality implications of the current environment.
One word that aptly describes the credit risk environment is inchoate, which is defined as “imperfectly formed or formulated” or “undeveloped.” We can satiate our analytical curiosity daily by observing trends in positive COVID-19 cases, but credit quality concerns created by the pandemic and its economic shocks lurk, barely perceptible in March 31, 2020 asset quality metrics such as delinquencies or criticized loans. However, the pandemic’s effect on bank stock prices has been quite perceptible, with publicly-traded bank stocks underperforming broad-market benchmarks due to concerns arising from both asset quality issues and an indefinite low interest rate environment. Bridging this gap between market perceptions and current asset quality metrics is the focus of this article.
At the outset, we should recognize the limitations on our oracular abilities. Forward-looking credit quality estimates now involve too many variables than can comfortably fit within an Excel spreadsheet—case rates, future waves of positive diagnoses, treatment and vaccine development, and governmental responses. The duration of the downturn, however, likely will have the most significant implications for banks’ credit quality.
We neither wish to overstate our forecasting capacity nor exaggerate the ultimate loss exposure. We recognize that transactions are occurring in the debt capital markets involving issuers highly exposed to the pandemic’s effects on travel and consumption—airlines, cruise operators, hotel companies, and automobile manufacturers. Investors in these offerings exhibit an ability to peer beyond the next one or two quarters or perhaps have faith that the Fed may purchase the issue too.
To assess the nascent credit risk, our loan portfolio analyses augment traditional asset quality metrics with the following:
A Farewell to Arms (1929) by Ernest Hemingway, which provides the preceding quotation, speaks to a longing for normality as the protagonist escapes the front lines of World War I. While perhaps a metaphor for our time, the quotation—with apologies to Hemingway—also fits the 2008 to 2009 financial crisis (“the world breaks everyone”) and uncertainties regarding banks’ preparedness for the current crisis (will the industry prove “strong in the [formerly] broken places”?).
To simulate credit losses in an environment marked by a rapid increase in unemployment and an abrupt drop in GDP, analysts are using the Great Financial Crisis as a reference point. Is this reasonable? Guardedly, yes; in part because no preferable alternatives exist. But how may the current crisis develop differently, though, in terms of future loan losses?
Table 1 presents aggregate loan balances for community banks at June 30, 2002 and June 30, 2007, the final period prior to the Great Financial Crisis’ onset. One evident trend during this five year period is the grossly unbalanced growth in construction and development lending, which led to outsized losses in subsequent years. Have similar imbalances emerged more recently?
We can observe in Table 2 that loans have not increased as quickly over the past five years as over the period leading up to the Global Financial Crisis (67% for the most recent five year period, versus 90% for the historical period). Further, the growth rates between the various loan categories remained relatively consistent, unlike in the 2002 to 2007 period. The needle looking to pop the proverbial bubble has no obvious target.
Using the same data set, we also calculated in Table 3 the cumulative loss rates realized between June 30, 2008 and June 30, 2012 relative to loans existing at June 30, 2008.
This analysis indicates that banks realized cumulative charge-offs of 5.1% of June 30, 2008 loans, although this calculation may be understated by the survivorship bias created by failed banks. The misplaced optimism regarding construction loans resulted in losses that significantly exceeded other real estate loan categories. Consumer loan losses are exaggerated by certain niche consumer lenders targeting a lower credit score clientele.
Are these historical loss rates applicable to the current environment? Table 4 compares charge-off rates for banks in Uniform Bank Performance Report peer group 4 (banks with assets between $1 and $3 billion). Loss rates entering the Great Financial Crisis and the COVID-19 pandemic are remarkably similar.
We would not expect the disparity in loss rates between construction and development lending versus other real estate loan categories to arise again (or at least to the same degree). Community banks generally eschew consumer lending; thus, consumer loan losses likely will not comprise a substantial share of charge-offs for most community banks. For consumer lending, the credit union industry likely will experience greater fall-out if unemployment rates reach the teens.
Regarding community banks, we have greater concern regarding the following:
In the Great Financial Crisis, banks located in more rural areas often outperformed, from a credit standpoint, their metropolitan peers, especially if they avoided purchasing out-of-market loan participations. This often reflected a tailwind from the agricultural sector. It would not be surprising if this occurs again. Agriculture has struggled for several years, weeding out weaker, overleveraged borrowers.
Additionally, to the extent that the inherent geographic dispersion of more rural areas limits the spread of the coronavirus, along with less dependence on the hospitality and tourism sectors, rural banks may again experience better credit performance.
The Plague (1947) by Albert Camus describes an epidemic sweeping an Algerian city but often is read as an allegorical tale regarding the French resistance in World War II. Sales of The Plague reportedly have tripled in Italy since the COVID-19 pandemic began, while its English publisher is rushing a reprint as quarantined readers seek perspective from Camus’ account of a village quarantined due to the ravaging bubonic plague.
As Camus observed for his Algerian city, we also suspect that banks will not be free of asset quality concerns so long as COVID-19 persists. Another source of perspective regarding the credit quality outlook comes from the rating agencies and SEC filings by publicly-traded banks:
Banks tend to be senior lenders in borrowers’ capital structure; thus, the rating agency data has somewhat limited applicability. Shadow lenders like business development companies and private credit lenders likely are more exposed than banks. Nevertheless, the data indicate that the rating agencies are expecting default and delinquency rates similar to the Great Financial Crisis. As for Camus’ narrator, the ultimate duration of the pandemic will determine when normality resumes. Lingering credit issues may persist, though, until well after the threat from COVID-19 recedes.
Community banks rightfully pride themselves as the lenders to America’s small business sector. These small businesses, though, often are more exposed to COVID-19 countermeasures and possess smaller buffers to absorb unexpected deterioration in business conditions relative to larger companies. Permanent changes in how businesses conduct operations and consumers behave will occur as new habits congeal. This leaves the community bank sector at risk. However, other factors support the industry’s ability to survive the turmoil:
Nonetheless, credit losses tend to be episodic for the industry, occurring between long stretches of low credit losses. The immediate issue remains how high this cycle’s losses go before returning to the normality that ensues in Hemingway and Camus’ work after war and pestilence.
1 Emmanuel Louis Bacani, “US Speculative-Grade Default Rate to Jump Toward Financial Crisis Peak – Moody’s,” S&P Global Market Intelligence, April 24, 2020
2 Fitch Ratings, U.S. LF/CLO Weekly, April 24, 2020.
3 Fitch Ratings, North American CMBS Market Trends, April 24, 2020.
4 Fitch Ratings, U.S. CMBS Delinquencies Projected to Approach Great Recession Peak Due to Coronavirus, April 9, 2020.
5 Fitch Ratings, Update on Response on Coronavirus Related Reviews for North American CMBS, April 13, 2020.
6 Jake Mooney and Robert Clark, “US Banks Detail Exposure to Reeling Hotel Industry in Q1 Filings,” S&P Global Market Intelligence, April 24, 2020
7 Tom Yeatts and Robert Clark, “First Financial, Pinnacle Rank Among Banks with Most Retail Exposure,” S&P Global Market Intelligence, April 27, 2020
Originally published in Bank Watch, April 2020.
March 2020 probably will prove to be among the most dramatic months for financial markets in US history. Likewise, the fallout for banks may take a year or so to fully appreciate. Nonetheless, in this issue of BankWatch, we offer our initial thoughts as it relates to the industry.
U.S. equity markets have entered a bear market, the definition of which is a drop of at least 20%. As of March 27, 2020, the S&P 500 had declined 21% year-to-date and the Russell 2000 was down 32%. Not surprisingly banks have fared worse with the SNL Large Cap Bank Index falling 39% given the implications for credit because of the government’s mandated shutdown of broad swaths of the economy due to COVID-19.
Bear markets vary in length and depend upon the severity of the economic downturn, the value of assets before the downturn started, and policy responses among other factors. The 2001 recession, which was shallow, started in March and ended in November according to government statisticians; however, the bear market for equities as measured by the S&P 500 was brutal (-49%) that ran from March 2000 to November 2002. Banks trended modestly higher during 2000-2002 because they entered the downturn cheap to their late 1990s valuations and because real estate values did not fall.
The Great Financial Crisis (“GFC1”) that ran from August 2007, when the Bear Stearns hedge funds failed, through year-end 2009 entailed a bear market that saw a 57% reduction in the S&P 500 between October 2007 and the bottom on March 9, 2009. Economists tell us the recession occurred from year-end 2007 through June 30, 2009. Unlike 2000-2002, banks were a disaster for investors because credit losses were high, and many had to raise equity at low prices to survive.
We do not know how much further bank stocks may fall if at all from late March in what we are taking liberty to define as GFC2. Figure 1 provides perspective on how banks—here defined as SNL’s Small Cap US Bank Index—performed in the two-year period ended March 9, 2009, and March 27, 2020. During GFC1 the bank index fell almost 70% to when the bear market ended. (March 9 was near the date when FASB eased mark-to-market rules and the Obama Administration signaled it would not nationalize the banks.)
By contrast the bank index traded sideways between March 2018 and early 2020 before plummeting about 40% at the lowest point in March as investors rushed for the exits as economic activity crashed. Massive intervention in the markets by the Fed has arrested the decline in financial assets for now, but in doing so the important market function of price discovery and therefore capital allocation has been distorted.
Relative to history banks are cheap, but that does not mean they cannot get cheaper. Alternatively, valuation multiples may rise because EPS and TBVPS fall more than share prices fall or even trade sideways or higher from here. Presumably GFC2 will be like GFC1 and most bear markets in which prices fall in anticipation of earnings that will decline later as the market discounts fundamentals that are expected to prevail 6-18 months in the future.
As of late March, bank stocks were cheap to long-term average multiples with small cap banks trading for 9.4x trailing 12-month earnings and 105% of TBV compared to 7.9x and 122% for the large cap bank index. Dividend yields around 4% are enticing, too, but the downturn could be sufficiently severe to force widescale dividend cuts. We do not know and will not know until the future arrives.
Interestingly, small cap banks as of March 27 were trading below the March 9, 2009, bottom at 105% of TBV vs. 118% nine years ago.
Perhaps one of the more depressing expectations for banks is not that credit losses will increase but the Fed promise that short-term rates will remain anchored near zero for the foreseeable future. As shown in Figure 3, the market expects 30/90 day LIBOR to fall from current distressed levels in excess of 1.0% to around 0.3% within a few months and remain anchored there for a couple of years.
Those who follow the forward curves know that forward rate expectations can change quickly. Nonetheless, the market today expects LIBOR benchmark rates (and SOFR) to fall toward the Fed Funds target range.
Our expectation is that NIMs may fall below the last cycle low of ~3.5% recorded in 1H09 because asset yields are much lower today than in 2008 when the GFC1 was gathering steam. Likewise, deposit rates can be cut somewhat but they, too, are much lower now than was the case in 2008. By way of comparison the NIM for banks with $1 billion to $10 billion of assets in 4Q06 was 3.74% according to the FDIC. By 1H09 the NIM for the group had declined to less than 3.4%. As of 4Q19 the NIM was 3.67%.
We do not know how high credit costs will go. According to the FDIC, losses approximated 2% of loans in 2009 for banks with $1 billion to $10 billion of assets and 3% for banks with $10 billion to $250 billion of assets. Losses were especially high in C&D portfolios because residential mortgage was the epicenter of the last downturn.
This time more asset classes look to be at risk because a deflationary shock has been unleashed on the global economy.
The hardest hit sectors within most bank loan portfolios will be hotels and restaurants as part of the travel and leisure industry that has been impacted the most by COVID-19. Among a subset of banks in the Southwest, Dakotas and Appalachia potentially will be sizable losses in energy-related credits as oil and gas are at the epicenter of this deflationary shock. Retail CRE will see more problem assets, too, as the shutdown accelerates the shift to digital commerce.
An unknown element is how shifts in consumer and business behaviors may impact credit losses. One surprise from the last recession was the move by consumers to pay auto and credit card loans while defaulting on mortgages in order to commute to work and maintain access to revolving credit. Previously consumers would default on other borrowings to save the home. The behavior was an admission by many consumers that they overpaid for houses and were willing to return to renting.
In this downturn maybe consumers will let auto loans go because the average auto loan is much larger and has a longer duration than a decade ago, and ride sharing lessens the need for a car. Businesses may decide that much less office space is needed as employees become more adept at working remotely.
In short, it is easy to construct a scenario in which credit losses are higher than those experienced during 2008-2010, but it is too early to know for certain. One interesting market data point arguing perhaps not is high yield bonds. The option-adjusted spread (“OAS”) on the ICE BofA High Yield Index peaked on March 23 at 1087bps versus 1988bps in November 2008.
If credit losses are notably higher than what was experienced in 2008 then an informal form of regulatory forbearance may be allowed in which losses are slowly recognized to protect capital. Past precedence includes the Lesser Developed Country (“LDC”) crisis of the early and mid-1980s in which money center banks took 5-6 years to write-off large exposures to LDCs as a result of a collapse in oil and commodity prices.
As shown in Figure 5, US banks are much better capitalized today than at year-end 2006 immediately before GFC1 began. Ironically, the severely adverse scenario in the DFAST-mandated stress tests will be tested given the magnitude of the economic shut-down. All 18 large-cap banks that were subjected to the Fed’s 2019 test passed with leverage ratios bottoming over an eight-quarter period in the vicinity of 6-7%. Results can be found at the following link http://mer.cr/2JswW1d.
A secondary issue is the outlook for common and preferred dividends. We expect first quarter and perhaps second quarter dividends to be paid; however, beginning in the third quarter dividend reductions and omissions are possible if not probable once a better estimate of losses is developed. Aside from written agreements with regulators that preclude payments we assume sub debt coupon payments will continue to be made because a missed coupon payment is an event of default unlike trust preferred securities that provided issuers 20 quarters to miss a payment without tripping a default.
Finally, M&A will become more imperative among commercial banks as NIMs go much lower. Executives of Truist Financial Corporation likely are relieved that the respective boards of directors of SunTrust and BB&T had the courage to combine to extract significant cost savings on what will be a lower run-rate of revenues than originally envisioned.
As for investors and M&A participants, the challenge as always will be first to think about earning power rather than next year’s estimate and what is a reasonable valuation in terms of earning power. That, of course, is easier said than done when markets are rapidly repricing for a new order.
Originally published in Bank Watch, March 2020.
We recognize what matters today for many funds is helping portfolio companies survive a sharp drop in revenues rather than discerning how much first quarter marks may fall from the last valuation.
Scooter rental firm Lime reportedly is trying to raise capital at a valuation that is 80% below its last raise. Dilution and a valuation mark-down may be a bitter pill for existing investors, but for many money losing enterprises with dwindling cash such as Lime, it is unavoidable if the firm is to survive.
Our focus is on valuing illiquid securities, not sourcing capital. One of our colleagues once said that valuing private equity and credit portfolios is about marking as close to market as possible; it is not marking to a price target predicated on an investment thesis. The accountants provide perspective and guidance, but not precision beyond the preference hierarchy of Level 1 vs. Level 2 vs. Level 3 valuation inputs. ASC 820-10-20 defines fair value as, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value from the accountant’s perspective represents the exit price of the subject asset for a market participant in the principal or most advantageous market. Exit multiples are a theoretical concept today in which private equity and credit markets are frozen, but that will not always be the case. One never knows how much price dislocation is due to illiquidity vs. the market’s reassessment of fundamentals. Time will tell, but the impact of the governments response to COVID-19 on the economy is unlikely to be transitory. As it relates to marking private equity and credit to market or some semblance thereof, we offer these initial thoughts:
So how does one value private equity and credit in a developing recession or depression that may be very deep and of an unknown duration? Our view is that investors will be more focused than ever on cash flow and earning power because the era of ridiculous valuations on flimsy pro-forma EBITDA is over.
Table 1 provides a sample overview of the template we use at Mercer Capital. The process is not intended to create an alternate reality; rather, it is designed to shed light on core trends about where the company has been and where it may be headed. Adjustments are intended to strip-out non-recurring items and items that are not related to the operations of the business.
In addition, EBITDA is but one measure to be examined because EBITDA is a good base earnings measure, but it does not measure cash flow. Capex, working capital and debt service requirements are to be considered, too.
The adjusted earnings history should create a bridge to next year’s budget, and the budget a bridge to multi-year projections. The basic question to be addressed: Does the historical trend in adjusted earnings lead one to conclude that the budget and multi-year projections are reasonable with the underlying premise that the adjustments applied are reasonable?
The analysis also is to be used to derive earning power. Earning power represents a base earning measure that is representative through the firm’s (or industry’s) business cycle and therefore requires examination of earnings over an entire business cycle. If the company has grown such that adjusted earnings several years ago are less relevant, then earning power can be derived from the product of a representative revenue measure such as the latest 12 months or even the budget and an average EBITDA margin over the business cycle.
Terminal values like cash flow will be subjected to more scrutiny, too. As noted previously, guideline transaction data is not as informative today given the change to the economy that has occurred. That is not to say guideline company and transaction data is not relevant, but probably requires a larger than normal haircut for fundamental adjustment.
Alternatively, the build-up method in which current earning power and the terminal value cash flow in a DCF model are capitalized may provide a better estimate of fair value than pre-COVID transaction data.
Table 2 presents a perspective on why market participants may often times conclude the multiple applicable to a given company should be lower in the post-COVID-19 world. The process will lead to lower values than would have been derived prior to February 2020 because earning power and cash flow projections will be lower; risk premium applied to develop a weighted average cost of capital will be greater; and the expected long-term growth rate in earning power will be lower. That may change over time as risk premia recede and business cash flows rebound, but that is not the world that exists today as it relates to marking-to-market (or model).
Originally published in Mercer Capital’s Portfolio Valuation | Private Equity and Credit Newsletter
Originally presented at the Deposit Mastery Summit, sponsored by The Institute for Extraordinary Banking, in this session, Jeff K. Davis, CFA addresses the following objectives:
Jeff K. Davis, CFA and Jay D. Wilson, Jr., CFA, ASA, CBA along with DeVan Ard Jr. (Reliant Bank) originally presented the session “Evaluating the Buyer’s Shares” at the 2020 Acquire or be Acquired (AOBA) Conference in Phoenix, Arizona. A short description of the session can be found below.
Although M&A is usually focused on the price (and valuation) sellers realize in a transaction, consideration paid to sellers that consists of the buyer’s common shares raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.
SAAR1 came in at 16.70 million for December 2019, as a shortened holiday season led to volume declines of 5.8%. However, total volume was 17,047,725 for 2019, the fifth straight year above 17 million. While volumes did decline, the drop was not as much as proffered at the beginning of the year as fears of a recession failed to materialize and the Fed cut interest rates three times to buoy affordability.2 As seen in the graph above, SAAR generally lagged its 5-year average in 2019.
NADA is forecasting U.S. light-vehicle sales of 16.8 million, which would represent a 1.2% decline and the second consecutive year-over- year decline. This would also be the first year under 17 million units sold since 2014.
In the past decade, trucks have also taken over a significant portion of the market, from about a 50/50 split in 2010 to about 70/30 in 2019. This includes the increasingly popular crossover segment which makes up about 40% of the new vehicle market. Sedans have historically been the more fuel-efficient option, but lower gas prices and improved fuel efficiency have made roomier mid-sized cars more attractive.
While sales volume has declined for new vehicles, this tends to be the lowest margin business for dealerships who typically earn more gross profit per vehicle on used vehicles and significantly higher margins on its parts and service departments. Used car sales may continue to increase as many consumers are priced out of increasingly expensive new cars, particularly if interest rates creep back up. Additionally, a record 4.3 million leases are set to end in 2019, which could increase fleet and used sales as consumers ponder next options. This would stand to compound the trend of slipping retail volumes, which was offset by higher discounts and more fleet sales.
While not frequently quoted for valuation purposes in the industry, all six of the public new vehicle auto dealers increased in value in 2019 in a bull market that saw the S&P 500 increase over 27%. Only AutoNation, Inc. grew by less (19%) while Sonic Automotive, Inc. more than doubled its market cap.
1 A Seasonally Adjusted Annual Rate (SAAR) is defined as a rate adjustment used for economic or business data, such as sales or employment figures, that attempts to remove seasonal variations in the data. In the automotive space, it is understood to mean the number of light-weight vehicles (autos and light trucks) sold in a given month, adjusted for seasonal factors and scaled up to a year’s worth of sales based on that month.
2 Declining interest rates also aided dealers on inventory carrying costs by lowering floorplan interest.
SAAR came in at 16.844 million for January 2020, up about 1% from both the prior month and the prior year. Actual sales of 1.13 million units was slightly down from January 2019. Similarly, while SAAR was up from last month, sales volume was down 25% from December. However, this is the reason the auto industry seasonally adjusts, as dealers offer significant discounts (e.g. Toyota-thon and Happy Honda-Days) at year-end. In each of the past ten years, the month of December has had higher than average sales volume, whereas January and February have each had below average. October and November are also below average, as consumers anticipate falling prices. Incentives reached all-time highs in December at $4,600 per vehicle, while January’s figure dropped to $4,000 as dealers clear out 2019 model year inventory. As seen above, SAAR has been below 17 million more often than not in the past year.
NADA maintained their 2020 sales expectation of 16.8 million units. This was higher than forecasts provided by Asbury Automotive Group and Group 1 Automotive of 16.5 million and 16.7 million, respectively. As unit volume is expected to drop below the 17 million threshold for the first time since 2014, public company executives are distancing their companies from this metric. We listened to Q4 earnings calls for three of the public auto dealers (Group 1, Penske, and Asbury) within the past two weeks, and all three highlighted common themes to increased profitability.
“Our Service and Parts operation throughout the organization provide recurring revenue which generates 46% of our company gross profit. We continue to demonstrate that PAG’s business model is much more than monthly new vehicles sales or the SAAR.” – Roger Penske, Chairman and CEO of Penske Automotive Group
“We were able to achieve record adjusted net income […] by concentrating on areas of the business where we exert greater control: used vehicles, parts and service, F&I, and cost.” – Earl Hesterberg, President and CEO of Group 1 Automotive
The valuation of stock options is a complex issue that divorcing parties may face during the determination and division of property. Designed to both reward performance and retain employees, these benefits can be difficult to value, particularly at a random moment for the purpose of marital dissolution.
The American Institute of Certified Public Accountants (“AICPA”) Forensic and Valuation Services Section provides a quick reference guide on valuing stock options, Valuing Stock Options: AICPA’s Financial Instrument Quick Reference Guide (section membership required). We excerpt from the Guide below in order to provide a few highlights.
A stock option is a contract that allows the owner of the right, but not the obligation, to buy equity in the company that issued the option at a certain price for a certain period of time. In its most basic structure, an option contract consists of:
Valuation models can be as simple or as complex as the derivative they are valuing. Each step in the process requires a thorough technical understanding, as well as professional judgment to identify the model that works best for the particular valuation and ultimately be able to explain and support the resultant conclusions.
Lattice models are used to value derivatives when discrete, or distinct, points in time need to be part of the model (e.g., days, months). Common lattice models are binomial and trinomial models that are easy to use and highly adaptable to different types of options since it allows for changing assumptions between discrete measurements (e.g., volatility). These are structured by discounting a series of cash flows from the time of maturity to the beginning date of the option contract.
The Black-Scholes model is classified as a “close-form” model because it assumes the option is only exercised at the end of the contract term and the underlying assumptions remain constant over the term of the option. This model is useful when trying to value options such as the European options that only have one exercise date. The Black-Scholes model is based on six inputs:
The Monte Carlo Model (MC) is considered a stochastic model because this method generates a large number of time-dependent scenarios and estimates the value of the option as a statistical expectation of the outcomes of those simulations. Compared to the Black-Scholes formula, MC allows for much more flexibility, including large changes in the interest rates, volatility and the possibility of major events, such as mergers and acquisitions. Statistics are used to quantify the error in the estimates.
There are three main ways to account for stock options. The way these are accounted for depends largely on why and how the options are being issued.
Due to the complexity of valuing stock options, it is critical to consult a financial expert. As we can glean from the AICPA Quick Reference Guide (section membership required), not only must the financial expert apply professional judgment and technical understanding during the process, but he/she must be able to communicate the process and result conclusion(s). If the divorce case includes stock options, hire a financial expert to value these complex financial instruments. The professionals of Mercer Capital can assist in the process. For more information or to discuss an engagement in confidence, please contact us.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Volume 3, No. 1, 2020.
This divorce involved issues of property division and alimony, among others. Husband worked for his father’s railroad construction business (the “Company”) since turning 18 years old and eventually was named Vice President, a position which he held for the duration of the marriage. Wife was employed in the health insurance industry, however, stopped employment in 2009 and did not work outside of the home over the remainder of the marriage. Wife filed a complaint for divorce in January 2014, and the trial court entered an amended final divorce decree in July 2017.
A key issue in the appeal involved Husband’s salary and payments received from the Company. For background, in 2006, Husband’s Grandfather purchased several unimproved parcels of land for a new business location. Grandfather titled these properties in his name and Husband’s name as joint tenants with rights of survivorship. In 2010, the Company began operating the new location from this property and began paying rent to Husband and Grandfather. Husband received a salary from the Company in addition to the rent payment income. The Company also covered several personal expenses for Husband and his family such as property taxes on the marital residence, uncovered medical expenses, family dining expenses, groceries, clothing, furniture, and travel expenses. After the divorce complaint was filed, Grandfather reduced annual rent payment from the Company to Husband from $180,000 per year to $2,400 per year. Grandfather also stopped paying for Husband’s health insurance policy and other expenses.
During the trial, Wife retained a forensic accountant and economist to calculate Husband’s income for purposes of alimony and child support. Wife’s expert calculated Husband’s total annual income as either $285,993 or $216,958, dependent upon if rent was received at historical levels or a reduced rate based on fair market rental value. In the trial court determination, Husband’s income was set at $188,488 per year based on the fair market rental value calculated by Husband’s appraiser and value of personal expenses covered by the Company as calculated by Wife’s expert witness. The trial court ordered Husband to pay $1,332 in monthly child support and the children’s private school tuition. Wife was awarded alimony in futuro of $1,500 per month until the parties’ twins graduate from high school at which time the alimony would increase to $2,832 per month for ten additional years. As for the business interest valuation, the court was unable to conclusively determine whether Husband had any ownership interest in the Company. There was (potential) evidence that suggested a 10% ownership interest in the Company, but the weight of the evidence suggested that he did not in fact own any interest in the business.
On appeal, Husband raised the issue of whether the trial court erred in determining Husband’s income for purposes of alimony and child support and in setting the amount of alimony, among other issues. According to the opinion, Husband did not present any analysis of the statutory factors to be considered when awarding alimony or include any discussion of the types of alimony. He did not provide any indication of what he thought an appropriate amount for his income would be. Husband rather argues that the trial court erred in “imputing to him the rental and other forms of income.” In its determination of Husband’s income and ability to pay, the trial court found it appropriate to consider Husband’s base salary of $78,500 in addition to the fair rental value of the property and the amount of personal expenses the Company paid for Husband. The Court notes that this is reasonable given that Husband received a salary of over $250,000 in the three years prior to the divorce. Ultimately, the Court found no error in the trial court’s determination of Husband’s monthly income.
As shown in this case, the testimony of an expert witness can significantly assist in the court’s determination of need and ability to pay, as well as historical earnings and “true income” in its decisions regarding spousal support. An experienced forensic accountant can provide a detailed analysis of income that accounts for all relevant sources of income.
Click here for the opinion.
Statements on Standards for Forensic Services (“SSFS No. 1”) are issued by the AICPA’s Forensic and Valuation Services Executive Committee. SSFS No. 1 provides guidance and establishes enforceable standards for members performing certain forensic and valuation services, specifically, for litigation and investigation engagements. These engagements are defined by SSFS No. 1 as follows:
Prior to the issuance of these standards, litigation and investigation engagements were covered by the AICPA Statement on Standards for Consulting Services No. 1 and the AICPA Code of Professional Conduct. As the need for forensic services has grown and evolved, SSFS No. 1 serves to protect the public interest and increase the level of consistency across the profession.
The issuance of SSFS No. 1 reflects a consolidation of relevant forensic services standards into one single standard. These forensic standards are effective for engagements accepted on or after January 1, 2020. Ensure that your hired expert, if applicable, is aware of these new requirements and is aware of the applicable standards for the engagement.
To download the Statement on Standards for Forensic Services click here.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Volume 3, No. 1, 2020.
Most family law cases settle at mediation or prior to trial. For example, Tennessee requires that parties must attempt to settle their cases at mediation prior to granting a trial date. Considering both of these facts, when should a family law attorney involve a financial expert in divorce mediations?
Most family law cases that require the use of a financial expert share some combination of the following: a high-dollar marital estate, complex financial issues present, business valuation(s) performed, and/or the need for tracing/classification of certain types of marital and separate assets. Of the family law cases that settle at mediation, most include motivated parties with experienced attorneys that have entered the mediation process properly organized and prepared to negotiate the various financial and parental aspects of the case.
Depending on numerous factors, attorneys require attendance of their financial expert for either the full mediation or for a particular session of the mediation. In addition, sometimes financial advisors are required to be available by telephone should issues arise. While having your financial advisor involved in the mediation in this way can be costly, a talented financial expert provides benefits to the client and the overall process to aid in its success. This author has participated in divorce mediations as a financial expert many times over the years and, as a result, has identified five ways a financial expert can be helpful to a family law attorney and client during mediations.
Your financial expert may have performed a business valuation that resulted in a report or some communication of value conclusions. An experienced financial expert that can communicate those conclusions and other complex financial issues in a clear and understandable manner to the client and the mediator is a priceless asset for your team. Because of this, often during mediation, that expert’s role evolves from a valuation vendor to a trusted advisor. The mediation process can be lengthy and includes significant down time where the attorney, client, and financial expert sit around the table together. It is during this time that the financial expert truly becomes a trusted advisor to the client and their attorney by providing data and expertise to assist in the decision-making process.
If a case involves a business valuation, there is usually contention around the value of the business. Often, valuation experts from each side are present at mediation and have the opportunity to speak to each other regarding their assumptions and disagreements on conclusions. A good financial expert helps quantify and elaborate on the key issues or differences in the valuations to the mediator to help bridge the gap in negotiations.
Property division is one of the crucial issues that must be solved for a mediation to be successful. Property division is often thought of as a puzzle, putting pieces together based on value, transferability, and the motivations/desires of each party to own certain assets. While the attorneys have compiled the marital estate, a competent financial expert assists with real-time decision-making and changing variables through the use of a dynamic model of the marital estate. The flexibility of a dynamic model allows for shifting assets/liabilities from one party’s column to the other or calculating an equalization payment due to the illiquidity and lack of transferability of certain items.
While financial experts don’t generally determine actual alimony amounts, they can assist clients and attorneys in understanding the amount, structure, and time value of the proposed alternatives. Often clients look for clarity in the amount either from the viewpoint of the payor (Can I afford to pay this monthly amount?) or from the viewpoint of the payee (Can I survive on this monthly amount?). Some structures of alimony also include accelerated amounts or prepayments of the entire amount. A financial expert aids in the decision-making by providing time value of money calculations to assist in the psychology of those financial decisions.
Financial experts often assist attorneys by performing tracing analyses and calculations to determine and/or quantify the separate and marital portion of certain assets. Assets often subject to dispute are retirement accounts that were owned prior to marriage. Some states, like Tennessee, recognize not only the balance of such accounts at the date of marriage, but also the appreciation of that amount during the marriage as separate assets. Financial experts are often asked to perform and explain these calculations at mediation to protect the integrity of the separate portion of those assets.
While the costs of mediation may be high, they pale in comparison to the costs of going to trial. Some states, including Tennessee, already require that cases attempt mediation, so why not head into mediation organized, prepared, and ready to do business? Consider involving a financial expert directly or indirectly to assist in that process and chances of settlement will certainly increase.
The economic impact from the COVID-19 pandemic has been swift and unexpected. Just a few short weeks ago, the S&P 500 was at an all-time high and goodwill impairments were not a serious concern for most companies. However, between mid-February and the end of March, the S&P 500 declined by 25%. The Russell 2000 fell nearly 32% over the same period, and the negative shock to certain companies and sectors has been much worse.
Most financial professionals understand that goodwill impairment testing is typically performed annually, usually near the end of a Company’s fiscal year. In fact, many companies just completed an impairment test as of year-end 2019. But the unprecedented events precipitated by the COVID-19 pandemic now raise questions about whether an interim goodwill impairment test is warranted.
The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.
For interim goodwill impairment tests, ASC 350 notes that entities should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, including the following:
The examples above are not all-inclusive and entities should consider other relevant events and circumstances that might affect the fair value or carrying amount of a reporting unit. An entity should place more weight on the events and circumstances that most affect a reporting unit’s fair value or the carrying amount of its net assets. The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.
Once an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”
For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount. Under the old framework, an additional “Step 2” analysis was performed and the impairment charge was based on the amount by which carrying amount exceeded the implied value of goodwill.
ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most commonly used in goodwill impairment testing. In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.
At a minimum, we anticipate that additional analyses and support will be necessary to address these questions. The documentation from an impairment test at December 31, 2019 might provide a starting point, but the reality is that the economic landscape has changed significantly in the last three months.
Not all industries have been impacted in the same way and there will certainly be differences between companies. For public companies, it can be difficult to ignore the significant drop in stock prices and the implications that this might have on fair value. For private businesses, even if a triggering event has not arisen yet, the deteriorating economic environment may just push the triggering factors into the second or third quarter of the year.
At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Statement Reporting Group.
To close our series on community bank valuation, we focus on concepts that arise when evaluating a controlling interest in another bank, such as arises in an acquisition scenario. While the methodologies we described with respect to the valuation of minority interests in banks have some applicability, the M&A marketplace has developed a host of other techniques to evaluate the price to be paid, or received, in a bank acquisition.
In the Valuing Minority Interests segment of this series, we discussed that valuation is a function of three variables: a financial metric, risk, and growth. From a buyer’s standpoint, the ultimate goal of a transaction, of course, is to enhance shareholder value, which would occur if the target entity can, on balance, enhance (or at least not detract from) the buyer’s financial metrics, risk, and growth. This can be achieved in several ways:
These benefits are not without risks, though. Some of the more significant acquisition risks include:
The previous installment of this series introduced the comparable company and discounted cash flow methods to bank valuations. Both of these methods remain relevant in assessing a controlling interest in a bank, meaning an interest of sufficient size to dictate the direction of the bank. Most often, controlling interest valuations arise in the context of an acquisition.
In a controlling interest valuation, the comparable company method can be used. However, the resulting values often would be adjusted by a “control premium”, which is measured by reference to the value of historical M&A transactions relative to a publicly-traded seller’s pre-deal announcement stock price. This approach has the advantage of synchronizing the controlling interest valuation to current market conditions, which can be a drawback of the comparable transactions approach.
More often, though, the comparable company method morphs into the comparable transactions method in an M&A setting. Comparable M&A transactions can be identified by reference to geography, asset size, performance, time period, and the like. Ideally, the transactions would be announced close in proximity to the date of the analysis; however, narrowly defining the financial or geographic criteria may mean accepting transactions announced over a longer time period. The computation of pricing multiples, such as price/earnings or price/tangible book value, is facilitated by the widespread data availability regarding targets and the straightforward deal structures that usually allow analysts to identify the consideration paid to the sellers. That is, contingent consideration, like earn-outs, is rare. However, deal values are not always publicly reported for transactions involving privately-held institutions.
While the comparable transactions approach is intuitive – by measuring what another buyer paid for another entity in an industry with thousands of relatively homogeneous participants – the most significant limitation of the comparable transactions method is created by market volatility. Buyers’ ability to pay is correlated with their stock prices, and most bank M&A transactions include a stock component. Deals struck at a certain price when bank stocks traded at 16x earnings would not occur at that same price if bank stocks trade at 12x earnings without crushing dilution to the buyer. Thus, prices observed in bank M&A transactions need to be viewed in light of the market environment existing at the time of the transaction announcement data relative to the valuation date.
We introduced the discounted cash flow method as a forward-looking approach to valuation reliant upon a projection of future performance. In an M&A scenario, buyers usually start with the target’s stand-alone forecast, unaffected by the merger. Acquirers then add layers to the forecast reflecting the impact of the transaction, such as:
While buyers may expect a certain level of expense savings, it is not clear that buyers “credit” the seller with all of the expense savings the buyer takes the risk of achieving. That is, the risk of achieving the expense savings effectively is split between the buyer and seller, with the favorability of the split in one direction or the other dictated by the negotiating power of the buyer and seller.
One advantage of a discounted cash flow approach is that it allows the buyer to evaluate, for a given price, the level of earnings contribution needed from the target to justify that price. While if you torture the numbers long enough they will confess to anything, as a statistics professor of mine was fond of saying, buyers should not lose sight of the reality of implementing the modeled business strategies.
While the comparable transactions and discounted cash flow models crossover – no pun intended with another valuation approach we describe below – from a minority interest valuation environment, several valuation techniques are unique to M&A scenarios.
After the financial crisis, investors became focused on the tangible book value per share earn-back period, sometimes to the point of seemingly ignoring other valuation metrics. There are several ways to compute this, but the most common is the “crossover” method. This requires two forecasts:
The analyst then calculates the number of periods between (a) the current date and (b) the date in the future when pro forma tangible book value per share exceeds stand-alone tangible book value per share. Ultimately, the earn-back period is driven by factors like:
The tangible book value earn-back method also exacts a penalty for deal-related charges, as a higher level of deal charges extends the earn-back period. From an income statement standpoint these charges often are treated as non-recurring and, in a sense, neutral to value. However, these charges represent a real use of capital, which the TBV earn-back approach explicitly captures.
Investors often look favorably upon transactions with earn-back periods of fewer than three years, while deals with earn-back periods exceeding five years often face a chilly reception in the market. The earn-back period often is the real governor of deal pricing in the marketplace, which investors often like because it overcomes some limitations posed by EPS accretion analyses.
As for the tangible book value per share earn-back period analysis, an EPS accretion analysis requires that the buyer forecast its EPS with and without the acquired entity. EPS accretion simply is the change in EPS resulting from the transaction. The attraction of this analysis lies in the correlation between EPS and value. For a buyer trading at 12x earnings, a deal that is $0.10 accretive to EPS should enhance shareholder value by $1.20 per share, holding other factors constant.
But how much accretion is appropriate? Should a deal be 1% accretive to be a “good” deal, or 10% accretive? It is difficult to answer this question in isolation. This is especially true for a deal comprised largely of cash, where the buyer is forgoing the use of its capital for shareholder dividends or share repurchases in favor of an M&A transaction. Recent deal announcements often indicate EPS accretion in the mid to high single digits with fully phased-in expense savings.
A contribution analysis is most useful in transactions involving primarily stock consideration. It compares the buyer and seller’s ownership of the pro forma company with their relative contribution of earnings, loans, deposits, tangible equity, etc. In a merger of equals transaction, where the two merger parties are roughly similar in size, this type of analysis is important in setting the final ownership percentages of the two banks.
A valuation of a controlling interest may take many forms; fortunately, the strengths of certain valuation methods described here offset the weaknesses of others (and vice versa). Value ultimately is a range concept, meaning that there seldom is a single value at which a deal fails to make economic sense. There are good deals, reasonable deals, and dumb deals. Evaluating a number of valuation indications puts a buyer in the best position to slot a transaction into one of these three categories and to negotiate a deal that accomplishes its objective of enhancing financial performance, controlling risk, and developing new growth opportunities. It is crucial to remember, though, that deals are tougher to execute in reality than in a spreadsheet.
This concludes our multi-part series examining the analysis and valuation of financial institutions. While approximately 5,000 banks exist, the industry is not monolithic. Instead, significant differences exist in financial performance, risk appetite, and growth trajectory. No valuation is complete without understanding the common issues faced by all banks – such as the interest rate environment or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.
A new year brings new opportunities and challenges in the world of fair value accounting. The Wall Street Journal’s recent coverage of the potential changes coming to goodwill impairment testing and the increased scrutiny around private equity portfolio company valuations signals that fair value issues continue to be top of mind for investors, companies, and regulators. Here are four key areas worth watching in 2020.
The FASB convened a roundtable in late 2019 to hear comments from registrants, investors, and the practitioner community about whether to continue the current system of annual goodwill impairment tests or shift to an amortization model over a set period of time. The responses have been mixed thus far, with some advocating instead for a trigger-based approach, perhaps over an initial period of time following an acquisition. The FASB has indicated that it will continue to discuss the comments during 2020 and no timeline for any changes has been set.
Read our latest thoughts on technical issues surrounding goodwill impairment testing.
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The AICPA issued final guidance in 2019 for the valuation of portfolio company investments held by venture capital and private equity funds and other investment companies. The new accounting and valuation guidance lays out best practices for preparers, independent auditors, and valuation specialists, and we anticipate that firms and their stakeholders will increasingly expect that their fair value measurements will be done in compliance with the guide.
Read more about some of the new concepts.
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Another robust year for M&A transactions in 2019 meant an increased need for purchase price allocations and contingent consideration valuations. What may have been overlooked is that The Appraisal Foundation has now issued final guidance on the valuation of contingent consideration (earn-outs). One message from the new guidance: scenario-based methods are now being discouraged in favor of more complex, alternative approaches.
Find out more in our recent whitepaper.
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The increased scrutiny on PE/VC portfolio company investments inevitably spills over into the realm of valuing private company shares for equity-based compensation purposes. Indeed, the AICPA is in the process of drafting an update to its 2013 accounting and valuation guide on the topic. Another trend we’ve noticed is the increasing prevalence of equity grants with market condition vesting (such as performance of the issuer’s stock relative to a benchmark index) and issuances of incentive units / profit interests. These frequently require specialized fair value measurements.
Read our latest whitepaper on equity-based compensation here.
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Mercer Capital provides a full range of fair value measurement services and opinions that satisfy the scrutiny of auditors, the SEC, and other regulatory bodies. We have broad experience with fair value issues related to public and private companies, financial institutions, private equity firms, start-ups, and other closely held businesses. We also offer corporate finance consulting, financial due diligence, and quality of earnings analyses. National audit firms regularly refer financial reporting valuation assignments to Mercer Capital.
Estate of Aaron U. Jones v. Commissioner, T.C. Memo 2019-101
(August 19, 2019)
In May 2009, Aaron U. Jones made gifts to his three daughters, as well as to trusts for their benefit, of interests (voting and non-voting) from two family owned companies, Seneca Jones Timber Co. (SJTC), an S corporation, and Seneca Sawmill Co. (SSC), a limited partnership. These gifts were reported on his gift tax return with a total value of approximately $21 million. The IRS asserted a gift tax deficiency of approximately $45 million on a valuation of approximately $120 million. The Tax Court ruled that value was approximately $24 million, agreeing with the taxpayer’s appraiser.
In this case, the Tax Court again concluded that “tax-affecting” earnings of an S corporation was appropriate in determining value under the income method (see also Mercer Capital’s review of the Kress decision). However, there are several other issues of interest in this case which we discuss further in this article.
SSC was established in 1954 in Oregon as a lumber manufacturer. SSC operated two saw mills – its dimension and stud mill – delivering high quality products that were technologically advanced, allowing SSC to demand a higher price for its products than its competitors. Early in its history, SSC acquired most of its lumber from Federal timberlands. As environmental regulations increased, SSC’s access to Federal timberlands became at risk. Mr. Jones began purchasing timberland in the late 1980s and early 1990s when he became convinced that SSC could no longer rely on timber from Federal lands.
SJTC was formed as an Oregon limited partnership in 1992 by the contribution of those timberlands purchased by Mr. Jones. SJTC’s timberlands were intended to be SSC’s inventory. Further, both SSC and SJTC maintained similar ownership groups, with SSC serving as the 10% general partner of SJTC. As of the date of valuation, SJTC held approximately 1.45 million board feet of timber over 165,000 acres in western Oregon, most of which was acquired in those initial purchases between 1989 and 1992. In 2008, approximately 89% of SJTC’s harvested logs were sold directly or indirectly to SSC and SJTC charged SSC the highest price that SSC paid for logs on the open market.
In May 2009, Mr. Jones formed seven family trusts and made gifts to those trusts of SSC voting and nonvoting stock. He also made gifts to his three daughters of SJTC limited partner interests. Mr. Jones filed a timely gift tax return reporting values based upon appraisals prepared by Columbia Financial Advisors as shown in Figure 1 on the next page (Petitioner’s Value). The IRS notice of deficiency asserted values much higher.
A petition was filed in the Tax Court by Mr. Jones in November 2013. Mr. Jones died in September 2014 and was replaced in the Tax Court proceeding by his estate and personal representatives. His estate then engaged another appraiser, Robert Reilly of Willamette Management Associates. Mr. Reilly was noted by the Court to have “performed approximately 100 business valuations of sawmills and timber product companies.”
The original appraiser for the IRS was not noted in the case decision. At trial, the IRS’ valuation expert was Phillip Schwab who, per the Court, has “performed several privately held business valuations.” Additionally, the IRS was noted as having “previously reviewed and completed several business valuations, including several sawmills.”
Their conclusions are presented in Figure 2.
Ultimately, the Court sided with Mr. Reilly’s conclusions of values for SSC and SJTC, along with his reported discount for lack of marketability (DLOM). The only distinction the Court made with Mr. Reilly’s DLOM was to correct a typo wherein the Appendix in Mr. Reilly’s report referred to a 30% DLOM, when in actuality, he had applied a 35% DLOM. A summary of the Court’s conclusions are shown in Figure 3.
The most critical issue surrounding the large difference in the valuation conclusions of SJTC for both experts centered on the valuation approach. The Court noted that “when valuing an operating company that sells products or services to the public, the company’s income receives the most weight.” Contrarily, the Court noted “when valuing a holding or investment company, which receives most of its income from holding debt securities, or other property, the value of the company’s assets will receive the most weight.”
A question in this matter: is SJTC an Asset Holding Company or is it an Operating Company? Petitioners’ experts concluded that SJTC was an operating company and relied on an income approach utilizing projections from management. Conversely, one respondent’s experts concluded that SJTC is a natural resource holding company and relied on the asset approach utilizing real estate appraisal on the underlying timberlands.
One of the critical factors the Court relied upon in determining its conclusion of the nature of SJTC’s operations centered on the Company’s operating philosophy. SJTC relied on a practice called “sustained yield harvesting” which didn’t harvest trees until they were 50 to 55 years old. As such, SJTC limited the harvest to the growth of its tree farms, even if selling the land or harvesting all of the trees would be the most profitable in the short-term. As discussed earlier, Mr. Jones began purchasing the timberlands and formed SJTC to supply the lumber to SSC for its long-term operations.
The other argument the Court considered when determining how to treat SJTC was the limited partner units in question. Specifically, the subject blocks of limited partner units could not force the sale or liquidation of the underlying timberlands. Recall, SSC maintained the 10% general partner or controlling interest in SJTC and its focus remained on SSC’s continued operations as a sawmill company dependent on SJTC for supplying the majority of its lumber.
Based on these factors, the Court concluded that SSC and SJTC “were so closely aligned and interdependent” that SJTC had to be valued based on its ongoing relationship with SSC, and thus, an income-based approach is more appropriate to value SJTC than a net asset value method. With this distinction, SJTC was more comparable to an operating company and less comparable to a traditional Timber Investment Management Organization (TIMO), Real Estate Investment Trust (REIT), or other holding or investment company.
Both of Petitioner’s experts relied on management projections in the underlying assumptions of their discounted cash flow (DCF) analyses to value SJTC. The original appraisal utilized management projections that were included in the prior annual report. For trial, Mr. Reilly utilized revised projections from April 2009 in his DCF analysis.
Respondent challenged the use of the revised projections, despite the fact that their own second expert, Mr. Schwab, also used the revised projections in his guideline publicly traded company method. He chose to average the revised projections with those from the most recent annual report.
The Court specifically noted the economic conditions at the date of valuation, highlighting the volatility during the recession years. As such, the Court determined the revised projections were the most current as of the date of valuation and included management’s opinion on the climate of their market and operations. The impact of the current economic conditions is also referenced by the Court in another key takeaway that we will discuss later.
Mr. Reilly computed after-tax earnings based on a 38% combined proxy for federal and state taxes. He further computed the benefit of the dividend tax avoided by the partners of SJTC, by estimating a 22% premium based on a study of S Corporation acquisitions. Respondent argued that since SJTC is a partnership, the partners would not be liable for tax at the entity level and there is no evidence that SJTC would become a C corporation. Therefore, respondent argued that the entity level tax rate should be zero.
The Court concluded that Mr. Reilly’s tax-affecting “may not be exact, but is more complete and convincing than respondent’s zero tax rate.” The Court also noted that the contention from respondent on this tax-affecting issue seems to be more of a “fight between lawyers” as the criticism appeared more in trial briefs than in expert reports. In fact, respondent’s expert, Mr. Schwab, argued that tax-affecting was improper because SJTC is a natural resources holding company and therefore its “rate of return is closer to the property rates of return” rather than challenging the lack of an actual entity level tax.
The Court and respondent’s expert agreed with Mr. Reilly’s market approach for the valuation of SJTC. With little to no disagreement, the key takeaway here is on Mr. Reilly’s analysis. The Court detailed the analysis by mentioning that Mr. Reilly selected six guideline companies. The Court also cited the analysis and reasoning behind Mr. Reilly’s selection of pricing multiples slightly above the minimum indications of the guideline companies. Specifically, Mr. Reilly noted that SJTC’s revenue and profitability for the most recent twelve months before the valuation date were below those of the guideline companies. Thus, he accounted for these differences in financial fundamentals in his selection of the guideline pricing multiples.
Respondent argued that Mr. Reilly erred by excluding the receivable held by SSC and the corresponding liability of SJTC. Further, respondent contended that Mr. Reilly’s treatment of SSC’s receivable from SJTC as an operating asset, rather than a non-operating asset, reduced the value of SSC under his income approach since a non-operating asset was not added to that value.
On this issue, the Court weaved in earlier themes regarding the symbiotic relationship of the two companies and also the present economic conditions on the date of valuation to make its conclusion. The Court agreed with Mr. Reilly that the intercompany debt could be removed as a clearing account based on the idea that both companies operate as “simply two pockets of the same pair of pants.” The Court rejected respondent’s theories that this treatment of intercompany debt was only to avoid a negative asset valuation of SJTC and to reduce the value of SSC by not including the receivable as a non-operating asset.
The Court referenced the relationship of the two companies and how the joint credit agreements of the two companies were secured by SJTC’s timberlands. The Court recognized that SSC could not have obtained separate third-party loans without the assistance of SJTC’s underlying timberlands as collateral. A further detail of the two companies’ relationship was revealed earlier in this decision. 2009 economic conditions also included subprime mortgage lending crises, particularly in the housing market. Around this time, SSC was anticipating a shift in the market from green lumber to dry lumber. Dry lumber production required SSC to build dry kilns and a boiler in a larger renewable energy plant project. Because of economic conditions, SSC was not able to obtain the construction loans to finance the renewable energy plant for itself or with another planned related entity. Instead, SSC was forced to borrow against the timberlands of SJTC.
Ultimately, the Court viewed the two companies (SSC and SJTC) as a single business enterprise and concluded that Mr. Reilly’s treatment of the intercompany debt captured their relationship.
Respondent’s criticisms of Mr. Reilly consisted of three items:
Mr. Reilly captured the value of SSC’s general partner interest in SJTC by projecting a portion of the expected partnership income in his projections. Specifically, Mr. Reilly projected $350,000 annually for SSC’s general partner interest based on an analysis of the 5-year and 10-year historical distributions from SJTC.
Respondent claimed that this approach undervalued SSC’s general partner interest by not considering its control over SJTC and treating it as a non-operating asset to be valued by the net asset value method.
The Court concluded that SSC’s general partner interest in SJTC is an operating asset again citing the single business enterprise relationship between the two companies. Further, the value of SSC’s general partner interest is best estimated by the expected distributions that it would expect to receive.
Although not directly discussed and cited in any of the Court’s factors that we have discussed so far, the decision did highlight certain elements from SSC’s and SJTC’s buy-sell agreements as we noted. Both buy-sell agreements contained language that prohibited the sale of the entity or transfers within the units/shares that would jeopardize the current tax status of the Companies as an S Corporation (SSC) and Limited Partnership (SJTC), respectively. Both agreements called for discounts for lack of control, lack of marketability, and lack of voting rights of an assignee (where applicable) to be considered. Finally, both agreements stated that the valuations of the entities should consider the anticipated cash distributions allocable to the units/shares.
While the Court’s decision to allow the tax-affecting of earnings (like in the Kress case) in the valuations of SSC and SJTC will dominate the headlines, there are additional takeaways from the case that impact the valuations. Of note, the disparity in experience of the appraisers involved, consideration of the current economic conditions, and the purpose and nature of the business relationship of the two companies seemed to influence the Court’s conclusions. Finally, the distinction and eventual valuation treatment of SJTC as an operating company rather than a holding company was of particular interest to us.
Many people believe that the win/loss ratio doesn’t have much effect on revenues and attendance. They believe the local team has loyal fans who will attend games despite their performance. We investigate that assumption in this article focusing on Major League Baseball (MLB) by sampling a top tier, middle tier, and lowest tier team.
We analyze average season attendance of the league over the last five years and then track the three-team sample’s attendance and on-field performance.
We have selected three teams to review their attendance vs. winning percentage, along with their playoff and World Series performance. Our sample consists of the Los Angeles Dodgers, the Texas Rangers and the Miami Marlins.
As a reference point, average season attendance for the MLB reached a peak in recent years at 2.5 million in 2007 for the American League and 2.8 million for the National League. The MLB averages dropped in the subsequent years and were finally steady around 2.3 million for the A.L. and 2.5 million for the N.L. during the next ten years. League attendance average declined, however, by 140,000 to 2,161,376 in 2018 and 2,039,521 in 2019.
The Dodgers attendance in 2007 was 3.9 million and stayed above 3.4 million for three years. This figure dropped to 2.9 million in 2011 yet returned to 3.7 million by 2013. Recently, season attendance has slowly climbed to approximately 4 million in 2019, marking an all-time team high.
This growth was greatly influenced by the Dodgers being in the World Series in 2017 and 2018, which helped push 2019 to a record high attendance. (See Table 1 for details)
The Texas Rangers have experienced a different attendance history. They peaked in 2012 at 3.5 million after playing in the World Series in 2011 and the playoffs in 2012. The team didn’t make the playoffs in 2013 and 2014 and attendance dropped to 3.2 million and 2.7 million, respectively. The win/loss record dropped significantly from about 59% in 2011 to 41% in 2014.
Attendance followed the same trend by dropping 450,000 to 2.7 million in 2014. Even when the team made the playoffs in 2015, attendance fell to 2.5 million as a result of their poor record in 2014. The team’s 2015 win/loss ratio was near 59% and they made the playoffs, but not the World Series. In the following year, attendance increased to 2.7 million. The win/loss ratio dropped below 50% in 2017 to 2019 and they missed the playoffs each year. As a result, attendance dropped steadily to 2.1 million in 2019, a decrease of over 1.3 million people, or 38% from their peak in 2012. (SeeTable 2 for details)
The Miami Marlins clearly represent the bottom tier of the MLB in many categories. They built a brand-new state of the art ballpark in 2012 and attendance averaged about 1.7 million from 2014 to 2017. In the fall of 2017, the Derek Jeter group bought the team. and the new owners quickly traded notable high-priced players to other teams, including the NY Yankees, in order to reduce their losses. The new ownership group was hoping to stabilize attendance near the 1.7 million mark, but instead dropped to 811,000 in both 2018 and 2019; 367,000 less than the next worst attendance in MLB, which was Tampa Bay, and about 500,000 less than the third worst team, the Baltimore Orioles. (SeeTable 3 for details)
Without attempting to do a statistical analysis, what does the data mean? Yes, the quality of the players counts – especially if the win/loss record corresponds, however, winning percentage also impacts the ability to get into the playoffs and ultimately the World Series. It is clear from our experience and from the three-team sample that win/loss ratios have a major effect on MLB home stadium attendance.
The In Game Leaders (IGL) Winter Summit took place January 3, 2020 at the esports Stadium Arlington. IGL originated as a capstone project for summer interns at esports Stadium Arlington. The primary purpose of the Summit was to “[provide] the opportunity to learn from industry professionals and collegiate leaders as they speak about the various career paths in esports. IGL strives to teach parents and students how to develop a sustainable career in the rapidly-growing esports field.”
This second event (the first Summit was held on August 19, 2019) consisted of several panels that addressed collegiate esports, professional esports, as well as marketing and event management. The event drew approximately 150 people. We recap a few key panels below.
Alex Rocha (UT Arlington), Eric Aaberg (UT Dallas), Austin Espinoza (UT), Dylan Wray (UNT)
Traditional sports and esports at the collegiate level share some similarities. For example, not only do the teams practice and compete, but they workout and train in order to play to their potential. The players are one piece of the team, as there are also managers, coaches, and streamers that add value to the organization. Several universities across the country offer partial and full scholarships. As of December 2019, there were over 125 schools around the United States with esports programs.
Collegiate esports programs generally fall into two categories: club or varsity. Varsity esports programs enjoy the administrative and financial support of their educational institution while club esports organizations are student-run and have limited financial backing from their educational institution. The primary goal of most collegiate esports clubs is to become a varsity sport at their school.
A distinction between esports and traditional sports stems from the recruiting platform. In collegiate esports, recruiting currently consists of attracting students who are already on campus as opposed to recruiting from high schools. Although the recruiting landscape is less structured than in traditional sports, esports teams have had success in gaining interest from active students.
The main games played in collegiate esports include: Overwatch, League of Legends, Rocket League, Hearthstone, Super Smash Brothers, and Call of Duty. The teams encourage the gaming community on campus to join the organization, whether it be as an analyst, coach, or player. The teams emphasize that there is a position for everyone and that a student does not have to be the best at every game to bring value and compete.
Kyle Bautista (COO, Complexity), Hector Rodriguez (CEO, NRG/Huntsmen), Mike Rufail (Founder/CEO, Envy)
The esports industry is turning heads and opening eyes as it becomes compared to the traditional sports leagues. The panelists, often recognized as leaders in the industry, emphasized their passion for the rapidly growing esports space. They highlighted that because esports is relatively new, and because games have shorter shelf lives, it is harder to gain significant experience.
esports is categorized as a sector in the media and entertainment industry because it is able to capitalize on the vast audience that is watching or streaming. The panelists each recalled their favorite esports events, and all described those events as having the same euphoric feel as a traditional sports game. The crowd erupts for clutch play in a Call of Duty World Championship the same as a huge play in a Super Bowl. Each panelists has been a part of the evolution of the space and all see it heading in the right direction with time.
The franchise model that has developed in traditional sports has made its way to the esports platform. The industry is attempting to follow the blueprint of the major professional sports leagues. The industry leaders agreed that the structure is beneficial, but also emphasized that time, competition, and the willingness to learn and collaborate will take esports to the next level.
Simon Bennett and Markel Lee (AOE Creative)
As the esports industry experiences rapid growth, it is important for teams and companies to consider their brand identity. Bennett and Lee illustrated the struggles that companies within the industry often face when attempting to establish a brand or marketing initiative. Rather than simply making a brand logo that looks “cool,” Bennett and Lee challenge players in the industry to create a brand that captures the message they are attempting to create.
Simply put, “Do not build a brand, build a legacy.” – Markel Lee
Bennett and Lee were excited about the power of community marketing. Community marketing enables a vast audience to connect and establish a relationship with the message or objective that is being conveyed. The example given was the Marshmello Fortnite concert – the most attended concert in history. The concert was able to be seen by the virtual community that was playing Fortnite at the time of the event. This brilliant marketing scheme was able to capture over 10 million players at once.
Kyle Stephenson (Gearbox), John Davidson (PRG), Justin Varghese (Dreamhack)
Stephenson, Davidson, and Varghese explained the challenges and satisfactions of creating events in the esports space. With sponsorships providing the biggest source of revenue in the industry, events are extremely important to execute well. Creating a debut event or launching a new destination is a complicated process that takes exceptional diligence both before and after it occurs. In order to measure the success of the event, it is important to first set expectations. The three panelists agreed that expectations must be accurate going into an event.
Attracting a digitally native audience can be difficult, but it requires creating a “fear of missing out” (FOMO) in order to capture as many people as possible. For those unable to attend the first event, attracting them to the second event is also important.
A specific industry challenge is that most esports do not have a defined end. With no set run-time for most games, event managers must be prepared for every scenario. There can also be challenges that arise at an event such as power outages, which causes a delay in the audience’s experience. Putting the challenges aside, the key to executing a successful event is creating a fair and pure playing environment and enjoyable fan experience by providing an exceptional experience to as many people as possible.
The second IGL Summit built upon the success of the first. There was increased attendance and intriguing panel discussions. The overarching theme communicated by the panelists was that as an industry, esports is still developing. Due to the relative immaturity of the industry, best practices are not concrete and player movement mechanisms are nebulous. However, there was a general sense of optimism for the industry. esports has made great strides over the past few years but still has plenty of room to grow. According to an article by Syracuse University, the number of projected esports viewers in the U.S. will reach 84 million in 2021, second only to the NFL. There has been an increase in transactions within the industry as well with one esports organization acquiring another for approximately $100 million.
As we find ourselves at the end of the decade, many pundits are considering what sector will be most heavily influenced by the disruptive impact of technology in the 2020s. Financial services and the potential impact of FinTech is often top of mind in those discussions. As I consider the potential impact of FinTech in the coming decade, I am reminded of the Mark Twain quote that “History doesn’t repeat itself but it often rhymes.”
A historical example of technological progress that comes to mind for me is the combine, a machine designed to efficiently harvest a variety of grain crops. The combine derived its name from being able to combine a number of steps in the harvesting process. Combines were one of the most economically important innovations as they saved a tremendous amount of time and significantly reduced the amount of the population that was engaged in agriculture while still allowing a growing population to be fed adequately. For perspective, the impact on American society from the combine’s invention was tremendous as roughly half of the U.S. population was involved in agriculture in the 1850s and today that number stands at less than 1%.
As I ponder the parallels between the combine’s historical impact and FinTech’s potential, I consider that our now service based economy is dependent upon financial services, and FinTech offers the potential to radically change the landscape. From my perspective, the coming “combine” for financial services will be not from one source or solution, but from a wide range of FinTech companies and traditional financial institutions that are enhancing efficiency and lowering costs across a wide range of financial services (payments, lending, deposit gathering, wealth management, and insurance). While this can be viewed as a negative by some traditional incumbents in the space, it may be a saving grace as we start the decade with the lingering effects of a prolonged historically low and difficult interest rate environment, and many traditional players are still laden with their margin dependent revenue streams and higher cost, inefficient legacy systems. Similar to the farmers adopting higher tech planting and harvesting methods through innovations like the combine, traditional incumbents like bankers, RIAs, and insurance companies will have to determine how to selectively build, partner, or acquire FinTech talent and companies to enhance their profitability and efficiency. Private equity and venture capital investors will also continue to be attracted to the FinTech sector given its potential.
As the years in the 2020s march on, FinTech acquirers and traditional incumbents face a daunting task to evaluate the FinTech sector. Reports vary but generally indicate that over 10,000 FinTechs have sprouted up across the globe in the last decade and separating the highly valued, high potential business models (i.e, the wheat) from the lower valued, low potential ones (i.e., the chaff) will be challenging. Factor in the complicated nature of the regulatory/compliance overlay and investors, acquirers, and traditional incumbents face the daunting task of analyzing the FinTech sector and the companies within it.
As a solution to this potential problem, the efficient operations and historical lessons learned in the agricultural sector from the combine may again provide insights for buyers of FinTech companies to learn from. For example, the major professional sports leagues in the U.S. all have events called combines where they put prospective players through drills and tests to more accurately assess their potential. In these situations, the team is ultimately the buyer or investor and the player is the seller. Pro scouts are most interested in trying to project how that player might perform in the future for their team. While a player may have strong statistics in college, this may not translate to their future performance at the next level so it’s important to dig deeper and analyze more thoroughly. For the casual fan and the players themselves, it can be frustrating to see a productive college player go undrafted while less productive players go highly drafted because of their stronger performance at the combine.
While not quite as highly covered by the fans and media, a similar due diligence and analysis process should take place when acquirers examine a FinTech acquisition target. This due diligence process can be particularly important in a sector like FinTech where the historical financial statements may provide little insight into future growth and earnings potential for the underlying company. One way that acquirers are able to better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE). In this article, we give a general overview of what a QoE is as well as some important factors to consider.
What is a Quality of Earnings Study? A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer in order to assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors. Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long term growth can be expected. This estimate of earning power typically considers trying to assess the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.
Analysis performed in a QoE study can include the following:
These areas are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:
For high growth technology companies where the analysis and valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:
This article discusses a number of considerations that buyers may want to assess when performing due diligence on a potential FinTech target. While the ultimate goal is to derive a sound analysis of the target’s earning power and potential, there can be a number of different avenues to focus on, and the QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.
Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers. Leveraging our valuation and advisory experience, our quality of earnings analyses identify and focus on the cash flow, growth, and risk factors that impact value. Collaborating with clients, our senior staff identifies the most important areas for analysis, allowing us to provide cost-effective support and deliver qualified, objective, and supportable findings. Our goal is to understand the drivers of historical performance, unit economics of the target, and the key risk and growth factors supporting future expectations. Our methods and experience provide our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows.
Our methodologies and procedures are standard practices executed by some of the most experienced analysts in the FinTech industry. Our desire is to provide clients with timely and actionable information to assist in capital budgeting decisions. Combined with our industry expertise, risk assessment, and balanced return focus, our due diligence and deal advisory services are uniquely positioned to provide focused and valued information on potential targets.
Originally published in Mercer Capital’s Value Focus: FinTech Industry Newsletter, Year-End 2019.
Bank fundamentals, which are discussed in more detail below, did not change a lot between 2018 and 2019; however, bank stock prices and the broader market posted strong gains as shown in Table 1 following a short but intense bear market that bottomed on Christmas Eve 2018. Our expectation is that 2020 will not see much change in fundamentals either, while bank stocks will require multiples to expand to produce meaningful gains given our outlook for flattish earnings.
The primary culprit for the 4Q18 plunge and subsequent 2019 rebound in equity prices was the Fed, which has a propensity to hike until something breaks according to a long standing market saw. A year-ago the Fed had implemented its ninth hike in short-term policy rates that it controls despite the vocal protests of the President and, more importantly, the credit markets as reflected in widening credit spreads and falling yields on Treasury bonds and forward LIBOR rates.
One can debate how much weight the Fed places on equity markets, but it has always appeared to us that they pay close attention to credit market conditions. When the high yield bond and leverage loan markets shutdown in December 2018, the Fed was forced to pivot in January and back away from rate hikes after forecasting several for 2019 just a few months earlier. Eventually, the Fed was forced to reduce short rates three times and resume expansion of its balance sheet in the fourth quarter after halting the reduction (“quantitative tightening”) in mid-year.
Markets lead fundamentals. Among industry groups bank stocks are “early cyclicals,” meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom. One take from the price action in banks is that the economy in 2020 will be good enough that credit costs will not rise dramatically. Otherwise, banks would not have staged as strong a rebound as occurred.
Likewise, somewhat tighter spreads on B- and BB-rated high yield bonds relative to U.S. Treasuries (option adjusted spread, “OAS”) since the Fed eased is another data point that credit in 2020 will not see material weakening. The stable-to-tighter spreads in the high yield market today can be contrasted with 2007 when OAS began to widen sharply even after the Fed began to cut rates and the U.S. Treasury curve steepened as measured by the spread between the yield on the two-year and 10-year notes.
Bank fundamentals are in good shape even though industry net income for the first three quarters of 2019 increased nominally to $181 billion from $178 billion in the comparable period in 2018. On a quarterly basis, third quarter earnings of $57 billion were below the prior ($63 billion) and year ago ($62 billion) quarters. Not surprisingly, earnings pressure emerged during the year as what had been expanding NIMs during 2017 and 2018 began to contract due the emergence of a flat-to-inverted yield curve, a reduction in 30/90-day LIBOR which serves as a base rate for many loans, and continuation of a highly competitive market for deposits. Also, loan growth slowed in 2019—especially for larger institutions.
As shown in Table 2, core metrics such as asset quality and capital are in good shape, while profitability remains high. Our outlook for 2020 is for profitability to ease slightly due to incrementally higher credit costs and a lower full year NIM although stabilization seems likely during 2H20. Nonetheless, ROCE in the vicinity of 10- 11% and ROTCE of 13-14% for large community and regional banks seems a reasonable expectation.
EPS growth will be lacking, however. Wall Street consensus EPS estimates project essentially no change for large community and regional banks, while super regional banks are projected to be slightly higher at 3%. Money center banks (BAC, C, GS, JPM, MS, and WFC) reflect about 6% EPS growth, which seems high to us even though the largest banks tend to be more active in repurchasing shares relative to smaller institutions where excess capital is allocated to acquisitions, too.
In the December 2018 issue of Bank Watch we opined it was hard to envision the Fed continuing to raise short-term rates even though the Fed forecasted further hikes. We further cited the potential for rate cuts. Our reason for saying so was derived from the market rather than economists because intermediate- and long-term rates had decidedly broken an uptrend and were heading lower.
As the calendar turns to 2020, the Fed has indicated no changes are likely for the time being. The market reflects a modest probability that one more cut will be forthcoming, but to do so in an election year probably would require long rates to fall enough to meaningfully invert the Treasury curve unlike the nominal inversion which occurred in mid-2019.
As it relates to bank fundamentals, the impact on NIMs will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies NIMs should stabilize in 2H20 as higher cost CDs and wholesale borrowings rollover at lower rates. Also, if the Fed continues to expand its balance sheet (presently it is doing so through only purchasing T-bills through support of the repo market) then assets may remain well bid. All else equal, stable to rising prices in the capital markets usually are supportive of credit quality within the banking system.
A synopsis of bank valuations is presented in Table 3 in which current valuations for the market cap indices are compared to year-end 2018 and year-end 2017 as well as multi-year medians based upon daily observations over the past 20 years.
The table illustrates the important concept of reversion to the mean. Valuations were above average as of year-end 2017 due to policy changes that occurred with the November 2016 national elections that culminated with the enactment of corporate tax reform in late 2017. One year later valuations were “cheap” as a result of the then bear market that reflected concerns the Fed would hike the U.S. into a recession.
Despite the rebound in prices and valuation multiples during 2019, bank stocks enter 2020 with moderate valuations provided the market (and us) have not miscalculated and earnings are poised to fall sharply. Money center and super-regional banks are trading for median multiples of about 10x and 11x consensus 2020 earnings. Regional and large community banks, which include many acquisitive banks, trade for respective median multiples of 12x and 13x.
An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over-time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract. Looking back to last year one might surmise the rebound in valuations reflects the market’s view that the Fed avoided hiking the U.S. into recession.
M&A activity has been robust with bank and thrift acquisitions since 2014 exceeding 4% of the industry charters at the beginning of each year. It appears once the final tally is made, upwards of 275 institutions will have been acquired in 2019, which would represent almost 5% of the industry. With only a handful of new charters granted since the financial crisis the industry is shrinking fast. As of Sept. 30, there were 5,256 U.S. banks and thrifts, down from about 18,000 in 1985.
While activity was steady at a high level in 2019, the most notable development was market support for four merger-of-equals (“MOE”) in which the transaction value exceeded $1.0 billion. The largest transaction closed Dec. 9 when BB&T Corp. and SunTrust merged to form Truist Financial Corp. Others announced this year include tie-ups between TCF Financial Corp./Chemical Financial Corp., First Horizon National Corp./IBERIABANK Corp., and Texas Capital Bancshares Inc./Independent Bank Group Inc. Although not often pursued, we believe MOEs are a logical transaction that if well executed provide significant benefits to community bank shareholders.
The national average price/tangible book multiple eased to 157% from 173% in 2018, while the median price/earnings (trailing 12 months as reported) declined to 16.8x from 25.4x (~21x adjusted for the impact of corporate tax reform). The reduction was not surprising given low public market valuations that existed at the beginning of 2019 because acquisition multiples track public market multiples with a lag.
We see 2020 shaping up as a potentially great year for bank M&A. The backdrop is an M&A trifecta: buyer and seller earnings will likely be flattish primarily due to sluggish loan growth and lower NIMs; asset quality is stable; and stock prices are higher, meaning buyers can offer better prices (but less value) to would-be sellers. Also, the capital markets remain wide open for banks to issue subordinated debt and preferred equity at very low rates to fund cash consideration not covered by existing excess capital.
This year appears to be the opposite of late 2018 in which a strong market for bank stocks is predicting continuation of solid fundamentals and possibly better than expected earnings. Nonetheless, an environment in which earnings growth is expected to be modest at best likely will result in limited gains in bank stocks given the rebound in valuations that occurred in 2019.
Originally published in Bank Watch, December 2019.
In our family law practice, we serve as valuation and financial forensic expert witnesses. There is typically another valuation expert on “the other side.” In several recent engagements, the following topics, posed as questions here, were raised as points of contention. We present them here to help the reader, whether you are a family law attorney or a party to a divorce, understand certain valuation-related issues that may be raised in your matter.
The financial and business valuation portion of a litigation is often referred to as a “battle of the experts” because you have at least two valuation experts, one for the plaintiff and one for the defendant. Hopefully your valuation expert has both valuation expertise and industry expertise. While industry expertise is not necessary in every engagement, it can be helpful in understanding the subtleties of the business in question.
Most businesses are dependent on the climate of the national economy as well as the local economy. For businesses who have a national client base, the health of the national economy trumps any local or regional economy. However, many of the businesses we value in divorce engagements are more affected by changes in their local and regional economy. It’s important for a business appraiser to understand the difference and to be able to understand the effects of the local/regional economy on the subject business. There is also a fine balance between understanding and acknowledging the impact of that local economy without overstating it. Often some of the risks of the local economy are already reflected in the historical operating results of the business.
Many of the corporate entities involved in litigation have sophisticated governance documents that include Operating Agreements, Buy-Sell Agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process. Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigated matters, focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value.
Two common questions that arise concerning these agreements are:
These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document. In divorce matters, the out-spouse is often not bound by the value indicated by the governance document since they were not a signatory to that particular agreement. It is always important to discuss this issue with your attorney.
Similar to governance documents, internal transactions are a possible valuation data point. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation.
An important consideration in internal transactions is the motivation of the buyer and seller. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and of the specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation.
Most business owners have to submit personal financial statements as part of any guarantee on financing. The personal financial statement includes a listing of all of the assets and liabilities of the business, typically including some value assigned to the value of the business. In divorce matters, these documents are important as yet another valuation data point.
One view of the value placed on a business in an owner’s personal financial statement is that no formal valuation process was used to determine that number; so, at best, it’s a thumb in the air, blind estimate of value. The opposing view is the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in document under penalty of perjury. Further, some would say that the value assigned to the business has merit because the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.
For an appraiser, it’s not a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them. The business value indicated in a personal financial statement should be viewed in light of value indications under other methodologies and sources of information. At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as the national and local economy, to explain any difference in values over time.
Normalizing adjustments are adjustments made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask if the business has non-recurring or discretionary expenses and are personal expenses of the owner being paid by the business? Comparing the business to industry profitability data can help the appraiser understand the degree to which the business may be underperforming.
An example of how normalizing adjustments work is helpful. If a business has historically reported 2% EBITDA (earnings before interest, taxes, depreciation, and amortization) and the industry data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point. For a business with revenue of $25 million, historical profitability at 2% would suggest EBITDA of $500,000. At 5%, expected EBITDA would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the business to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the business without non-recurring or personal owner expenses.
There are many other issues a valuation expert faces in divorce matters; however, the issues presented here were top of mind for us because they were present in recent engagements. Valuation can be complex. Serving as an expert witness can be challenging as well. However, having an expert with valuation expertise and experience is an advantageous combination in divorce matters. In future articles, we’ll discuss other issues of importance to hopefully help you become a more knowledgeable user of valuation services. In the meantime, if you have a valuation or financial forensics issue, feel free to contact us to discuss it in confidence.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2019.
In the June 2019 BankWatch we began a multi-part series exploring the valuation of community banks. The first segment introduced key valuation drivers: various financial metrics, growth, and risk. The second and third editions described the analysis of bank and bank holding company financial data with an emphasis on gleaning insights that affect the valuation drivers. We now conclude our series by assembling these pieces into the final product, a valuation of a specific bank.
While it would streamline the valuation process, there is no single value for a bank that is applicable to every conceivable scenario giving rise to the need for a valuation. Instead, valuation is context dependent. This edition of the series focuses on the valuation of minority interests in banks, which do not provide the ability to dictate control over the bank’s operations. The next edition focuses on valuation considerations applicable to controlling interests in banks that arise in acquisition scenarios.
Valuation specialists identify three broad valuation approaches within which several valuation methods exist:
The following discussion focuses on the valuation methodologies used most commonly for banks, the comparable company method and the discounted cash flow method.
Bank analysts are awash in data, both regarding banks’ financial performance but also market data regarding publicly traded banks’ valuation. Table 1 presents a breakdown by trading market of the number of listed banks in November 2019.
To narrow this surfeit of comparable company data, analysts often screen the publicly traded bank universe based on characteristics such as the following:
Even after applying screens similar to the preceding, it remains doubtful that the publicly traded banks will exactly mirror the subject bank’s characteristics. This is especially true when valuing smaller community banks, as a relatively limited number of publicly traded banks exist with assets of less than $500 million that trade in more liquid markets. Ultimately, the analyst must determine an appropriate valuation multiple based on the subject bank’s perceived growth opportunities and risk attributes relative to the public companies. For example, analysts can compare the subject bank’s historical and projected EPS growth rates against the public companies’ EPS growth rates, with a materially lower growth outlook for the subject bank suggesting a lower pricing multiple.
Part 1 of this community bank valuation series described various valuation metrics applicable to banks, most prominently earnings and tangible book value. It is important to reiterate that while bankers and analysts often reference price/tangible book value multiples, the earning power of the institution drives its value. Chart 1 illustrates this point, showing that price/tangible book value multiples rise along with the core return on tangible common equity. This chart includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion.
Since banking is a more mature industry, bank price/earnings multiples tend to vary within a relatively tight range. Chart 2 provides some perspective on historical price/earnings and price/tangible book value multiples, which includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion and a return on core tangible common equity between 5% and 15%. Trading multiples in the first several years of the analysis may be distorted by recessionary conditions, while the multiples reported for 2016 and 2017 were exaggerated by optimism regarding the potential, at that time, for tax and regulatory reform. The diminished multiples at yearend 2018 and September 30, 2019 reflect a challenging interest rate environment, marked by a flat to inverted yield curve, and the possibility for rising credit losses in a cooling economy.
The discounted cash flow (DCF) method relies upon three primary inputs:
First, a few suggestions regarding projections:
In preparing a DCF analysis for a bank, the most meaningful cash flow measure is distributable tangible equity. The analyst sets a threshold ratio of tangible common equity/tangible assets or another regulatory capital ratio based on management’s expectations, regulatory requirements, and/or peer and publicly traded comparable company levels. Equity generated by the bank above this target level is assumed to be distributed to the holding company. After determining the holding company’s expenses and debt service requirements, the remaining amount represents shareholder cash flow, which then is captured in the DCF valuation analysis.
For a financial institution, the discount rate represents the entity’s cost of equity. Outside the financial services industry, analysts most commonly employ a weighted average cost of capital (WACC) as the discount rate, which blends the cost of the company’s debt and equity funding. However, banks are unique in that most of their funding comes from deposits, and the cost of deposits does not rise along with the entity’s risk of financial distress (because of FDIC insurance). Therefore, a significant theoretical underpinning for using a WACC – that the cost of debt increases along with the entity’s risk of default – is undermined for a bank. Analytical consistency is created in a DCF analysis by matching a cash flow to equity investors (i.e., dividends) with a cost of equity.
A bank’s cost of equity can be estimated based on the historical excess returns generated by equity investments over Treasury rates, as adjusted by a “beta” metric that captures the volatility of bank stocks relative to the broader market. Analysts may also consider entity-specific risk factors – such as a concentration in a limited geographic market, elevated credit quality concerns, and the like – that serve to distinguish the risk faced by investors in the subject institution relative to the norm for publicly traded banks from which cost of equity data is derived.
The terminal value is a function of a financial metric at the end of the forecast period, such as net income or tangible book value, and an appropriate valuation multiple. Two techniques exist to determine a terminal value multiple. First, the Gordon Growth Model develops an earnings multiple using (a) the discount rate and (b) a long-term, sustainable growth rate. Second, as illustrated in Chart 2, bank pricing multiples tend to vary within a relatively tight range, and a historical average trading multiple can inform the terminal value multiple selection.
In most analyses, the values derived using the market and income approaches will differ. Given a range, an analyst must consider the strengths and weaknesses of each indicated value to arrive at a final concluded value. For example, earnings based indications of value derived using the market approach may be more relevant in “normal” times, as the values are consistent with investors’ orientation towards earnings as the ultimate source of returns (either dividends or capital appreciation). However, in more distressed times when earnings are depressed, indications of value using book value assume more relevance. If a bank has completed a recent acquisition or is in the midst of a strategic overhaul, then the discounted cash flow method may deserve greater emphasis. We prefer to assign quantitative weights to each indication of value, which provide transparency into the process by which value is determined.
The analysis is not complete, however, when a correlated value is obtained. It is crucial to compare the valuation multiples implied by the concluded value, such as the effective price/earnings and price/tangible book value multiples, against those reported by publicly traded banks. Any divergences should be explainable. For example, if the bank operates in a market with constrained growth prospects, then a lower than average price/earnings multiple may be appropriate. A higher return on equity for a subject bank, relative to the comparable companies, often results in a higher price/tangible book value multiple. As another reference point, the effective pricing multiples may be benchmarked against bank merger and acquisition pricing to ensure that an appropriate relationship exists between the subject minority interest value and a possible merger value.
There are many valuation issues that remain untouched by this article in the interest of brevity, such as the valuation treatment of S corporations and the discount for lack of marketability applicable to minority interests in banks with no active trading market. Instead, this article addresses issues commonly faced in valuing minority interests in any community bank. A well-reasoned valuation of a community bank requires understanding the valuation conventions applicable to banks, such as pricing multiples commonly employed or the appropriate source of cash flow in a DCF analysis, but within a risk and growth framework that underlies the valuation of all equity instruments. Relating these valuation parameters to a comprehensive analysis of a bank’s financial performance, risk factors, and strategic outlook results in a rigorous and convincing determination of value. In the next edition, we will move beyond the valuation of minority interests in banks, focusing on specific valuation nuances that arise when engaging in a valuation for merger purposes.
Originally published in Bank Watch, November 2019.
