Prosperity Bancshares Is Set to Acquire Stellar Bank. Here's What Investors Need to Know.

The wave of bank mergers and acquisitions continued today. Prosperity Bancshares (NYSE: PB) announced an agreement to acquire Stellar Bancorp (NYSE: STEL), creating a $54 billion-asset bank with a strong presence in the fast-growing Houston, Texas market.

Prosperity Bancshares will pay roughly $2 billion to acquire Stellar in a part-cash, part-stock transaction, with 70% of the value in stock. The total purchase has an implied value of $39.08 per Stellar share. Stellar shares traded roughly 12% higher, as of this writing. Two directors from Stellar's board of directors will also be added to Prosperity's board, and key Stellar executives will be retained.

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The pro forma bank will have the number one deposit market share in Beaumont County and the number five deposit market share in Houston. Stellar also brings a significant amount of commercial real estate and commercial and industrial loans to Prosperity, which has a large residential mortgage portfolio.

Is the acquisition a smart financial decision for Prosperity?

In today's banking landscape, many banks believe they need to grow to better compete with the largest banks in terms of technology and regulatory compliance.

The deal certainly has merit, given the strong overlap in Houston and the pro forma bank's projected return metrics. The acquisition of Stellar is projected to be over 9% accretive to Prosperity's earnings in 2027, and Prosperity will be able to cut 35% of Stellar's non-interest expense base.

In 2027, management projects the combined entity to generate a return on average assets of 1.58% and a return on average tangible common equity of 17.1%. The combined entity is also expected to have an efficiency ratio of 44%, which measures expenses as a percentage of revenue. A lower ratio is better, and a sub-50% efficiency ratio is superb.

However, Prosperity had to pay up for Stellar. The deal valued Stellar at slightly over 180% of its tangible book value (TBV), or net worth, which is a strong multiple, but not entirely unexpected in a market with high bank stock valuations.

The real kicker, however, and the reason Prosperity's stock is down about 8% today, is that the acquisition is projected to dilute Prosperity's TBV by nearly 8%. It will take Prosperity approximately 4.5 years to earn that back. Typically, bank investors don't want to see an acquisition result in more than a 3-year earn-back, so it doesn't surprise me that Prosperity's stock is struggling.

Now, this doesn't mean the deal can't be successful, but investors are typically wary of dilutive acquisitions, so Prosperity's management team will have to prove they can integrate Stellar in a timely manner, achieve all projected cost savings, and even identify potential revenue synergies.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.