Description

Eastern Bankshares is a $21.1B asset bank headquartered in Boston that got knocked about after announcing its merger with Cambridge Bancorp in late September. From an investor’s point-of-view, here is the timeline for EBC:

• Demutualized at $10 per share via an IPO in October 2020
• Within a year had effectively doubled and stayed that way for the subsequent year:

• Sold off in the general sell-off of bank stocks, due in no small part to their being upside down on a large bond portfolio that was purchased with the excess capital from their IPO.
• Took their medicine by selling off their underwater bond portfolio.
• Rallied in July towards $15 on the expectation that EBC’s anticipated sale of their insurance division would provide a nice offsetting gain toward their taking a loss on their bond portfolio.
• Surprised the market by instead merging with nearby Cambridge Bancorp (CATC), handing the reins to the Cambridge CEO while effectively doubling down on their commitment to the asset management side (couched as “gaining scale”).
• Cratered back to $11 on the subsequent lack of love but now bouncing back in line with the recent bank stock recovery. Despite this rally, the stocks of both EBC and CATC are simply back to where they were on the eve of their merger announcement.

What was it about the Cambridge merger that proved such a disappointment to investors? While we are putting this writeup in bullet list form, or dot points as the Australians say, let’s count the disappointments:

• Demutualized banks cannot be sold (with rare exceptions) until after the third year anniversary of their IPO. Investors look for signs that the bank is looking to accelerate a sale towards that first window of opportunity.
• The anticipated sale of the insurance division was closely aligned with the expectation that M&T Bancorp (MTB) was the natural suitor as MTB had similarly exited the insurance business.
• The actual sale went great—Arthur J. Gallagher & Co. paid $510M for Eastern insurance. This was a valuation of 5x revenues and 35x earnings. The proceeds also matched nicely with the merger consideration of $528M for Cambridge.
• While the merger was announced as being ~7.5% dilutive with a 2.75 years earnback, that wasn’t really the full story as the insurance co sale brought TBV/share up to $13.06 and then the merger brought it back down to $10.16.
• Some investors had anticipated as far back as the IPO that Eastern’s CEO had a bright political future whose interests beyond banking would be helpful in putting EBC on a path toward a sale. The Eastern CEO moving out of an operational role via the merger (he remains as Chairman of the merged entity) supported one part of that thesis but not the part that mattered most to investors.
• Meanwhile, Cambridge has been a publicly traded company since before the millennium, so investor IRR calculations about an exit multiple had to stretch from possibly imminent to maybe never.
• Further clouding the merger’s reception was that Cambridge was in bad need of something to shore up its balance sheet. On its surface, the deal looked more favorable to a stressed (but not distressed) Cambridge rather than favoring an opportunistic Eastern. Here are some of the details:
  • The merger presentation describes CATC as being acquired for 14.7x earnings and 1.14x TBV. It was trading around its lows of 0.86x TBV at the time of the announcement.
    • While Eastern did pay $528M in stock for Cambridge’s TBV of $463M, which does calculate as 1.14x, the purchase accounting effectively wiped out CATC’s TBV.
    • Had Eastern simply sold its insurance division, EBC would have had $2.3B in TBV, which would have increased it to $13.06/share.
    • With all the write-downs from marking Cambridge’s assets now yielding current market interest rates, the combined TBV is $10.16/share.
  • 2024 estimated fully synergized net income includes a gain of $63M attributable to the fair value marks for the CATC balance sheet being marked to current market yields.
• Cost savings of 34% of 2024e Cambridge cash expenses. The significant cost savings is due to the low execution risk of having the same in-market footprint as Eastern. While not outside the range of what is season for in-market acquisitions, it is definitely on the favorable side for that size of an acquisition.

What we are looking at now is a very attractive banking franchise centered around Boston and Cambridge. It trades at an attractive discount to the valuation of its possible acquirers. It also is very clean and puts up compelling ROAs and ROEs so is very far from a value trap as it should accrue a double-digit earnings yield post-merger expenses of 11.7% ($1.50 2024e EPS versus $12.86 stock price).

Let’s review some of the positives:

• Eastern is now the #1 mid-sized bank in the Boston MSA (and second largest in New England) with $27B in pro forma assets
• Run-rate earnings of $290M translates into a 13.5% run-rate ROATCE
• Cambridge Trust’s $4.4B in total AUM/A brings the combined total to $7.6B AUM/A
• Low balance sheet risk with 14.5% pro forma CET1 and 80% loans to deposits
• While Cambridge was undoubtedly a very happy seller, it is debatable whether this combination would have occurred without the significant mark-to-market pressures that Cambridge was facing. CATC’s unrealized security losses were approaching $200M and their tangible equity had become dangerously low (near 2%)
• Eastern used its cash-rich balance sheet in one swoop while minimizing the tax effects of the profitable sale of its insurance subsidiary
• Still, after full synergies, EBC paid $528M for a net $105M in earnings. Paying 5x net earnings is a very attractive move. Digging in the weeds a bit further, the actual CATC contribution to earnings will be $128M (against $23M in lost income from the insurance sub sale). That calculates as 4.1x earnings. And perhaps that first sentence should read as EBC paid a net $18M for a net $105M in earnings.
  • Do I look at it that way? Not really, the fair value mark accretion accounts for $63M or approximately half the CATC contribution of $128M. The remaining $65M of CATC consensus plus cost saves would represent 8.1x earnings.
  • But add back to that what the $63M in fair value mark accretion means. Would it have taken five years to accrete naturally? If so, that means the earnings power was still there. So somewhere between 4.1x and 8.1x is a better way to think about the acquired earnings multiple.
  • From an earnings power perspective, there seems to be nothing to complain about here.

Here is the combined footprint:

Here are the headline pro forma financials:

Here are the 2024 estimated projected earnings and multiples:

• Fully synergized net income of $290M to $295M
• EPS of $1.44 to $1.46
• ROATCE of ~13.5%, ROAA of ~1.05%
• Net Interest Margin of ~3.05%
• Efficiency Ratio of ~50%

In the end, Eastern sold a lower operating margin business at an eye-popping earnings multiple (35x) and bought one from which they can extract a very significant 34% cost savings. From another perspective, they sold a business that accounted for 7% of net income and gained one that will increase net income by more than 50%.

While this looks quite dilutive due to the purchase accounting, the combination is a real powerhouse and as a more mature banking stock will eventually be priced on its earnings multiple anyway. The wealth management business has doubled. While some investors regard banking and wealth management as becoming increasingly commoditized, the combination under one roof does suggest a certain stickiness to client business.

Coupling all that with Eastern-Cambridge’s scarcity value as an eventual acquisition target means that Eastern is in good shape going forward. In the meantime, with capital strong at 14.5% versus a target of 12%, EBC is in excellent shape to return capital to shareholders via buybacks.

Catalyst

Investors begin to look at banks again and want a relatively clean story from an attractive mid-sized bank.

A strong capital position encourages the eventual return of capital to shareholders via buybacks.