KBRA Places Ratings for Heartland Financial USA, Inc. on Watch Upgrade Following Merger Announcement

KBRA places the long-term ratings of Denver, Colorado-based Heartland Financial USA, Inc. (NASDAQ: HTLF) ("Heartland" or "the company") on Watch Upgrade, including the senior unsecured debt rating of BBB+, the subordinated debt rating of BBB, and the preferred shares rating of BBB- following the recently proposed merger announcement with UMB Financial Corporation (NASDAQ: UMBF) ("UMB Financial"). In addition, KBRA affirms HTLF's short-term debt rating of K2. KBRA also places the ratings of HTLF's lead subsidiary, HTLF Bank, on Watch Upgrade, including the deposit and senior unsecured debt ratings of A- and the short-term deposit and debt ratings of K2.

Key Credit Considerations

On April 29, 2024, UMB Financial Corporation (NASDAQ: UMBF) and Heartland Financial USA, Inc. announced the signing of a definitive merger agreement, in which the companies would combine in an all-stock transaction that is expected to close in 1Q25. Heartland is expected to merge with and into UMB Financial, and HTLF’s subsidiary, HTLF Bank, would merge with and into UMBF’s subsidiary, UMB Bank, N.A. The transaction was valued at $2.0 billion or 1.53x P/TBV at merger announcement. In conjunction with the deal, UMB Financial announced the pricing of a forward sale common equity raise (2.8 million shares for ~$202 million of net proceeds), in which UMBF’s management team has the option to exercise at any time over the next 18 months, though will likely utilize at the closing of the merger. The offering included participation from Wellington Management and other institutional investors. No change to the executive leadership team is anticipated following the close of the merger, though the Board of Directors is expected to expand to 16 members, with HTLF reflecting 5 members on the Board.

Despite the fact that it has been a difficult environment for bank M&A given the regulatory scrutiny, significant impact on capital due to assets being marked-to-market, and credit uncertainties starting to emerge, KBRA continues to believe that well-executed transactions, with compelling financial targets, and that are complementary from a business model standpoint, can still make strategic sense and provide meaningful benefits to the pro forma institution. Moreover, we believe this will likely be the case for the UMBF-HTLF merger, which is expected to create a $65 billion-asset banking franchise that will be very diversified from geographic (nearly 200 branches across a thirteen state footprint), revenue (~30% fee income), and lending (below average investor CRE concentration and high emphasis on relationship-based C&I lending) perspectives. The combined institution would also reflect increased density in attractive markets (Denver, Phoenix, and Kansas City) and respectable market share, with a top 10 market share positioning for 85% of the deposit base. Moreover, the balance sheet is projected to be in an enviable position for future growth, which will be less levered than most similarly sized banks, including a pro forma loan-to-deposit ratio of 67%. As such, the UMBF management team is confident in its ability to find loan portfolio synergies, including the food & agribusiness segment (~$1 billion of loans on a pro forma basis) and other specialty lending verticals, and achieve strong growth following the close of the deal, which has been demonstrated by both banks in recent years (UMBF’s 15-year CAGR for average loans is 12%; HTLF’s 5-year CAGR for loans is 10%). Despite more robust loan growth in recent years, both UMBF and HTLF have maintained favorable core deposit bases. UMBF’s more commercially oriented deposit base, which is well-entrenched in some favorable verticals, including capital markets & corporate trust, investor services, healthcare services (1.5 million HSA accounts, including 4.8 million cards in circulation), and fund services, is projected to benefit from HTLF’s granular and lower-cost retail deposit base ($5.6 billion of consumer deposits, with an average account size of ~$20k). As such, the pro forma deposit base of ~$52 billion is expected to remain solid, including a favorable level of noninterest-bearing component (32% of total), and reasonable costs (average cost of 2.51% during 1Q24). Additionally, the loan portfolios appear to be complementary, which would aggregate to ~$35 billion, and maintain a higher level of C&I (52% of total loans including owner-occupied CRE) and a modest exposure to investor CRE (18% of total including multifamily; 186% of total risk-based capital), notably a minimal amount of office loans (~4% of total loans).

Both companies reflected strong earnings performance during 1Q24 (core ROA of 1.13% and 1.16% for UMBF and HTLF, respectively) and we acknowledge that the profitability of the pro forma institution is projected to be favorable when considering the 28% cost-savings on Heartland’s expense base, the potential for revenue synergies in certain business lines (treasury services, SBA, etc.), and HTLF executing on its “3.0 strategy”, which was anticipated to improve earnings via balance sheet repositioning from loan growth and optimization of the branch footprint being re-invested into talent additions and building the infrastructure to support middle market capabilities, enhanced treasury management, small business digital banking, and private banking. Moreover, as noted, the noninterest income levels are expected to be healthy at approximately 30% of total revenues and will be primarily consisted of durable line items that are non-credit related and not generally affected by volatility with interest rates. This will be reinforced by UMBF’s diversified business lines, including its private wealth management and trust services, which will increase to $21 billion of AUM/AUA at merger close, and institutional banking services that encompasses corporate trust, institutional custody, fund services, specialty trust & agency solutions, capital markets, investor solutions, and healthcare services. Altogether, the institutional assets under administration were $483 billion at the end of 1Q24. Moreover, due to its well-established healthcare services division (primarily HSA & FSA accounts), UMB Financial ranked #24 in card purchase volume in the U.S., with $4.6 billion of card spend during 1Q24. With regard to credit quality, UMBF reflected a very low NPA ratio as of 1Q24 (0.08%), and while HTLF’s NPA ratio (0.82%) is slightly elevated, when excluding a recent borrower that was added to nonaccrual that is well-collateralized and does not have any specific reserves and should be resolved over the next couple of quarters, is closer in line with similarly rated peers. Moreover, NCO trends have been nominal in recent years for both institutions, and over a longer time horizon, both UMBF and HTLF have outperformed peers from a credit perspective. Specifically, UMB Financial's performance during the global financial crisis was impressive, with a peak NCO ratio of 0.58%. Additionally, with the headwinds facing the industry, specifically in the investor CRE space, KBRA believes that the pro forma company is well insulated given the aforementioned below average exposure to investor CRE and office properties. Moreover, the credit mark of 1.3% for HTLF’s loan portfolio is considered conservative in our view given the strong performance in recent years. The pro forma capital position is expected to decrease, with a CET1 ratio of 10.1% at closing, though the management team noted that they plan to grow back to above 11.0% over the 18 months following the closing of the transaction. We view this as achievable given that the combined company is projected to have the capacity to add 115 bps annually toward the CET1 ratio with the enhanced earnings capacity (includes dividends, excludes one-time costs from the merger, and assumes no further RWA growth). As such, we believe the management team's approach to capital management will be adequate in the context of the overall risk profile of the institution. Lastly, as noted, the funding and liquidity profile of the combined company is projected to be favorable, notably less leverage from a loan to earning asset and loan to core deposit perspective. Moreover, the strong core deposit base and excess liquidity provides UMB Financial the ability to take advantage of lending opportunities and dislocation in the market to further improve its earnings profile prospectively. We acknowledge that there are inherent risks with regard to transactions of this size, though we positively view the track-records of both institutions, and their ability to effectively integrate prior deals historically.

Rating Sensitivities

The Watch Upgrade for HTLF’s ratings assumes that the transaction receives the required regulatory, shareholder, and other approvals to close in a timely manner, and recognizes that Heartland will be merging with and into a larger and more diversified institution. Moreover, the basis for the Watch Upgrade stems from the fact that UMB Financial, while not rated by KBRA, would potentially be rated higher than Heartland given their strong key financial metrics. Moreover, the Watch Upgrade also assumes effective integration of the combined company and achievement of earnings and capital targets, which we believe to be highly likely given the strong track-records at both institutions. As such, once the merger closes, HTLF’s ratings would likely be upgraded one notch from current levels. Conversely, if the transaction were to be terminated, Heartland’s ratings would likely be maintained at current levels with a Stable Outlook assuming the transaction did not present any undue burden on overall financial performance.

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