Old National Bancorp Stock Needs Execute On First Midwest Merger Opportunity (NASDAQ:ONB)

Banks undergoing significant mergers are typically put in the penalty box now due to concerns about regulatory delays and real post-deal synergies, but the close of Old National Bancorp’s (NASDAQ:ONB) merger of equals with First Midwest hasn’t really helped much. These shares have continued to lag peers since my last update, with the shares up about 4% against closer to a 10% positive move in the peer group and a similar 4% move in the S&P 500.

I have decidedly mixed feelings on Old National shares at this point. On one hand, the valuation doesn’t seem ambitious or aggressive to me, even in the context of long-term term earnings growth in the neighborhood of 4%. On the other hand, neither of these two banks stand out on customer service or long-term core growth, and the Chicago-era lending market is getting increasingly competitive.

Now The Real Work Begins

As has been the case with most larger bank deals, it took a little longer for Old National to close its merger of equals with First Midwest. This has nothing to do with any shortcomings on management’s part; bank deals are taking longer in part because of turnover in regulatory agencies and pressure from Congress and the administration to take a closer look at deals.

The deal did close in mid-February, though, and the only real consequence to the delay is a push back in the systems conversion (now targeted for July, most likely around July 4) and the realization of cost synergies. At worst it’s a quarter or two delay relative to prior assumptions and it doesn’t have a particularly meaningful impact on valuation or company performance.

Integrating mergers of equals is typically more difficult than other bank mergers due to greater challenges with integrating the cultures, but both management teams seem aware of that history and began laying the groundwork for a smoother integration. To that end, it doesn’t seem as though there was meaningful attrition leading into the merger, but time will tell. It has been common for bankers to leave merged companies and I have little doubt that there will be several banks in the Chicago area looking to poach productive teams.

Given how heavily First Midwest was focused on the Chicago metro area (about 90% of deposits), I do think this will be a simpler bank to integrate. There will be some adjustments in the underwriting, but Old National may use this as an opportunity to loosen up a bit on its underwriting and target better growth by leveraging some of First Midwest’s capabilities in areas like asset-backed lending, healthcare, structured loans, and online consumer lending.

Old National could use the boost. Loans grew less than 2% qoq in the last quarter, with only 2% sequential growth in commercial lending – well below what many regional banks were able to do in the quarter, with commercial loan growth in the high single-digits to low double-digits.

“Steady As She Goes” May Not Be Enough

Old National has generated lackluster returns over the last five, 10, and 15 years, with total annualized returns (share price appreciation and dividends) of 5% over the last 10 years versus a regional bank average of 7%. I believe there are reasons for this, and they are reasons that management may want to consider addressing as they integrate First Midwest and look to start a new era for the bank.

Put simply, there hasn’t been exceptional or exciting growth here, with revenue growing at an average long-term rate of around 5.7% and tangible book value per share growing 4%. First Midwest is in much the same boat, with respective growth rates of 7% and 4.2%. By comparison, consistently better-performing regional banks have generally produced revenue and TBVPS growth in the high single-digits (or higher), with Fifth Third (FITB) and PNC (PNC), for instance, both growing TBVPS at a rate of more than 7% (on a CAGR basis) over the last decade.

Some of Old National’s more moderate growth can be tied to its operating philosophy. Few banks can surpass this one for long-term credit quality, with charge-offs amounting to a token percentage of loans even including the pandemic.

I wonder, though, about the impact of customer satisfaction on that growth rate. Net promoter scores aren’t perfect reflections of customer satisfaction, but they do seem to correlate with long-term outperformance in the banking sector, both in terms of growth and stock price appreciation (and multiples). Banks like First Republic (FRC), Cullen Frost (CFR), and Pinnacle Financial (PNFP) have conspicuously high scores, with those banks scoring 73, 57, and 48 in a 2021 JD Power survey, while the median bank scored 37%.

Old National and First Midwest? They scored 21 (Old National) and 24 (FMBI), respectively. Moreover, a host of in-region competitors like U.S. Bancorp (USB), PNC (PNC), JPMorgan (JPM), First Citizens (FCNCA) and Huntington (HBAN) scored meaningfully higher, with the latter two coming in at 46 and 47.

While a lot of attention has been given to the cost-savings potential of this merger, as well as opportunities to extend the lending franchise, I think customer service and customer satisfaction may need to be a bigger focus. After all, growth in fee-generating businesses like wealth management and treasury management is supposed to be another post-merger synergy opportunity, but will customers switch over and use those services if they’re unhappy with the bank’s service qualities in other areas?

Likewise, with companies like First Citizens looking to step up their commercial lending activity in markets like Chicago, improvement on this metric may be all but mandatory.

The Outlook

I have no credit concerns with either Old National or First Midwest at this point. I’m also not too concerned about the underlying market health in the bank’s core operating areas. While supply chain pressures are weighing on the economy now, I think the overall environment will remain a healthy one for loan growth for at least a couple more years. Whether or not Old National can outperform its markets and take lending share is a different question, though, and this something well worth watching.

Absent a more concerted effort to drive customer satisfaction and loan growth, I think Old National will hit its marks for post-deal synergies, but I don’t know that the bank will find a new, better, long-term trajectory for growth. The opportunity is there, particularly with Old National having not operated in the Chicago market before, but executing on that opportunity will require management to go at least a little beyond its comfort zone.

My core assumptions post-merger really haven’t changed that much, though I have moved up my capital return assumptions a bit. Given the price of the stock, I don’t think additional buybacks are a bad use of capital. I’m still looking for mid-single-digit core earnings growth over the next 10 years, though on the lower end of the mid-single-digits (around 4%).

The Bottom Line

My three preferred valuation approaches give me an interesting range of valuation outcomes. On a long-term core discounted earnings basis (which carries the risk of accurately modelling earnings far into the future), the shares look modestly undervalued below $18.50. A modified ROTCE-based P/TBV approach gives me a target around $20.50 (with a 16% ROTCE), while 11.5x FY’23 EPS gives me $21.50 target.

Even in the least of those, Old National is at least 10% undervalued and maybe closer to 40% at the high end. Beat and raise quarters would certainly help sentiment here, but I think the real key is investors buying into the idea that Old National will be a different, higher-growth business after this merger. Whether or not management can embrace the necessary strategies and communicate them convincingly to the Street has yet to be seen, and my concern is that the valuation here is counterbalanced with the risk of “the same old same old” performance that keeps the shares in a lackluster return percentile.