Quick Pitch: First Horizon Corporation (FHN)

Merger Arbitrage – Upside TBD

The merger spread of TD and First Horizon Corporation blew up and now stands at 54%, almost a triple from the 20% just several days ago. FHN shares dropped down this week following the collapse of SVB. FHN is more or less a standard commercial bank with solid capital ratios and it’s unlikely that the SVB debacle might’ve impacted either the regulatory review or FHN’s attractiveness to TD in any meaningful way. The key thing that has changed, is that with all the banking shares down significantly over the last week, TD has much more leverage to negotiate the merger price lower. As already noted above, this is a large-cap transaction with a wide following among investors/analysts, and therefore FHN’s market price is very likely to correctly reflect the situation. The merger itself entails some serious risks, which I am detailing a bit more below.

The largest Canadian bank TD Bank Group ($107bn market cap) is buying FHN at $25/share in cash (plus a small monthly uptick). The merger was announced in February last year and would allow TD to significantly expand its presence in the US, particularly in the Southeast region. TD’s US franchise would become the 6th largest bank in the US. Shareholder approval has already been received and the remaining risks are twofold – pending regulatory approvals (US and Canada) and a likely cut in merger consideration price. Till this week, the market used to price both of these risks at a c. 20% spread.

Initially, the market considered the regulatory risk to be minor and the spread hovered around 2% till the beginning of March. The spread widened to 15-20% after the announcement that the regulatory approvals won’t happen by the merger’s outside date of May 27. The reason behind the delay wasn’t detailed and the overall visibility into the regulatory review process has been opaque so far. Furthermore, on TD’s conference call (March 2) the CEO noted that both parties have already started negotiating a potential price cut. This is not really that surprising as the offer valued FHN at 2.3x TBV at the time of announcement. This seemed quite expensive for a 10-13% ROE-generating bank. Since then, the US bank indices are down 35% (e.g. Regional Banking ETF KRE). Another concerning issue is that FHN has recently started bleeding deposits with a 10% decline over the last two quarters. This significantly outpaces the average deposits outflow in US commercial banks (around 1%). The reason for the decline in FHN’s deposits hasn’t been detailed.

I do not think TD will drop this merger altogether when the outside date passes. So far, TD’s CEO has been continuously praising the transaction and again reaffirmed the buyer’s commitment multiple times in the conference call at the beginning of March. However, lower bank valuations across the board (KRE is down 25% over the last week), obviously help TD to negotiate the acquisition price lower and maybe that accounts for the bulk of a widened spread in this merger arb. A reduced acquisition offer seems to be the most likely outcome.

In case the merger breaks, the downside is probably at around $11/share assuming a similar decline in FHN share price from merger pre-announcement levels as for KRE.