How Will This Bid Benefit Investors?

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Los Angeles-based business lender PacWest Bancorp (NASDAQ: PACW) recently made a juicy offer for cross-town rival CapitalSource (NYSE: CSE). Valued at around $2.3 billion, the cash-and-stock deal would create a fairly large bank that could immediately challenge regional competitors for dominance in the small and mid-cap lending space. In fact, the combined bank would be among the 10 largest commercial banks in the entire state and could boast combined revenue of more than $650 million. 

Shareholders reacted positively to the deal, but market-watchers' opinions are far from uniform. Given the accelerating speed of California's economic recovery, many pundits believe that PacWest is underpaying for CapitalSource by a fairly wide margin. A few legal challenges have emerged as well. Indeed, this offer's persistent premium suggests that investors are cautious about its terms. This could present a welcome opportunity for arbitrageurs who wish to lock in short-term profits. With an assortment of economic tailwinds at play, this situation might also appeal to long-term investors and value-seekers.

PacWest, CapitalSource, and the competition
PacWest is a small commercial bank that operates primarily in Southern California. Most of its clients are small business owners who need working capital to expand their operations or meet ongoing expenses. Likewise, CapitalSource is regarded as an important source of medium-term capital infusions for businesses that employ fewer than 100 workers. Both exist as stable, reputable alternatives to payday lenders and short-term providers of working capital. They compete with the much larger US Bancorp (NYSE: USB) for market share.

US Bancorp also helps small to mid-sized businesses with capital needs, but in much larger numbers. Large companies also come to US Bancorp for financing. One of the massive advantages that US Bancorp has is its huge capital inflows from retail customers which gives it cheap capital to invest. US Bancorp has over 3,000 bank offices and over 5,000 ATMs to receive these funds from retail customers.

PacWest has a market cap of just under $1.6 billion. This compares to a market capitalization of $2.4 billion for CapitalSource and a massive valuation of about $70 billion for US Bancorp. All three firms have manageable price-to-book ratios that reflect their conservative business models: Whereas US Bancorp and PacWest have nearly identical ratios of 1.98 and 1.93, CapitalSource has a slightly cheaper metric of 1.53.

In 2012, PacWest earned $52.3 million on total revenue of $288 million. While its profit margin of just under 19% fell short of its peers' performances, it was able to console itself with a relatively small debt load of $142 million and an adequate cash reserve of $219 million. Meanwhile, CapitalSource earned $136 million on $396 million in revenue and struggled with roughly $5 in debt for every $1 in cash on hand. With earnings of $5.5 billion on revenue of $17.6 billion, US Bancorp was about as profitable as CapitalSource. Unfortunately, it had an even wider debt-to-cash ratio.

How the deal is structured
The terms of this deal require PacWest to issue cash and stock to CapitalSource's shareholders on a yet-to-be-determined closing date. In addition to making a fixed cash payment of $2.47 per share, PacWest will issue 2.837 of its own shares for every 10 CapitalSource shares that the larger company's shareholders own. At current prices, this equates to a total payment of about $12.44 per share.

Relative to CapitalSource's current share price of $12.02, participants may earn a premium of nearly 4%. While there is no guarantee that this arbitrage premium will persist until the closing date, it currently offers an excellent opportunity for short-term investors.

Legal issues: Worth a worry?
Emerging legal challenges threaten to delay the closing of this merger. Many observers believe that CapitalSource could have held out for a better offer from PacWest or one of its rivals. While it is unclear whether these challenges will result in lawsuits or put enough pressure on PacWest to force it back to the negotiating table, investors would do well to keep them in mind. In the event that they are withdrawn or settled, much of this deal's current premium could be erased.

Synergies and effects on competitors
This merger will produce a company with a market cap of nearly $4 billion and the potential to earn combined revenue of $1 billion or more. It will be well-positioned to expand its lending portfolio to attract larger, more diversified businesses. The combined company may also attempt to expand its geographical footprint and expand in lucrative markets in Northern California and elsewhere.

The firms' management teams expect the merger to produce cost savings of nearly $50 million per year. This would be equivalent to 7% or 8% of the combined firm's total revenue. Moreover, scale-related synergies are also expected: With better pricing power, the combined company will attract additional customers with more attractive loan rates and terms. Barring a faster-than-expected economic recovery that benefits all local lenders, PacWest-CapitalSource could grab market share from weaker competitors.

Long-term outlook and investment opportunities
In the long run, a stronger Californian economy will benefit most of the commercial banks that operate in the state. However, PacWest-CapitalSource may be positioned more favorably than most. Although PacWest's recent quarterly earnings drop should give long-term investors pause, most market-watchers expect this merger to bear fruit. Only a prolonged economic decline could seriously challenge this outlook. 

In sum, this situation offers a significant, relatively low-risk arbitrage premium as well as the potential for long-term value creation. Investors who are not averse to the sometimes volatile banking space should take a closer look at these two names. Since this merger is not expected to close until early 2014, there is still time to take advantage.

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Mike Thiessen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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