Ockham Reseach - the Razor's Edge

Banks Shopping for National City

Regional bank, National City Corporation ( NCC) appears to be in discussions to either sell all or a portion of itself and the most likely suitor is NCC’s cross-town (Cleveland) rival KeyCorp. ( KEY). Other potential buyers include larger banks Wells Fargo, JP Morgan/Chase or PNC. NCC has been in a tailspin of late, losing more than 70% in the last year. Much of this loss is because of NCC’s mortgage industry exposure. Mortgage losses were a key contributor to NCC’s very disappointing results for the fourth quarter–net income was only 6 cents per share compared to 36 cents the year before. NCC’s exposure to bad debt makes this acquisition far from certain but the bank does have substantial assets and could be an attractively-priced growth opportunity for KeyCorp.

In January, National City slashed its dividend almost in half to 21 cents from 41 in an effort to deal with its burgeoning credit troubles. In addition to cutting the dividend, NCC raised $1.6b in capital through the issuance of debt and preferred stock as a means to shore up the balance sheet after incurring subprime mortgage losses of $333 million in the 4^th quarter. Further contributing to its problem is the fact that NCC is primarily located in the struggling economic regions of Ohio and Michigan. Even so, there may be enough appeal for regional banks such as NCC to attract attention from either rival banks or private equity firms because of the stock’s greatly depressed valuation. National City is a relatively large bank and its $2.7b deposit base is a compelling asset. NCC also has a $1b stake in Visa, which is an attractive asset, but with a catch as NCC is not yet able to sell those shares in the secondary market.

A possible merger with smaller KeyCorp would allow massive cost savings, as the combined entity would likely cut many redundant jobs and be able to reduce overhead at its Cleveland headquarters. KeyCorp covets NCC’s local deposit base, which is three times the size of its own. Clearly, the sell-off in NCC shares over the last year has them priced attractively based on historical norms. For example, price-to-cash flow is 57% below NCC’s historical average, and price-to-sales is 76% below the average. Assuming normalized valuations, we would rationally expect NCC to trade between $16.60 and $22.60 a share. So, the question for KeyCorp is: has the market adequately priced-in the extent of the dangers related to NCC? If KeyCorp and their strategic advisors at Goldman Sachs believe the market has, then this would be a very opportune chance to acquire a rival.

However, KeyCorp has to this point steered clear of the mortgage crisis and that could be a deal breaker because National City continues to have mortgage related problems. At least NCC has taken some initiative to strength its balance sheet, which is certainly not the case for all regional banks with credit problems. Regional banks are about to start feeling squeezed in the next quarter or two. Look for more of these types of “shot-gun marriages” between struggling regional banks in coming quarters.

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