5 Bank Stocks That Could Jump on 2012 M&A (Update 1)

Bank M&A story updated with additional information on likely buyers, sellers.

NEW YORK (TheStreet) -- The case for consolidation in the banking sector remains strong in 2012 as heightened regulatory costs, demands for greater capital, revenue pressures and mounting expenses will force smaller banks to re-evaluate their ability to stay independent.

However, few analysts expect the pace of M&A to really pick up in 2012, as volatility in the markets and macroeconomic uncertainty gives buyers pause, while depressed valuations have made reluctant sellers.

Still, a few deals might be all it takes to get the chatter going and get the market to start attaching higher valuations to likely targets.

Deal activity slowed down in 2011 as the number of FDIC- assisted transactions declined, according to KBW analyst Chris McGratty. On the one hand, bank failures declined with the problem shifting from one of liquidity to one of earnings. Two, as banks have become healthier, there has been more competition for deals, which has meant that the terms of such deals aren't as attractive as they used to be.

Meanwhile, traditional deal activity has not picked up as sellers still pine for the valuations of the old days, which is little more than a "fantasy" on their part, the analyst says.

Instead what the market has seen is banks becoming more creative in the structure of the deals, McGratty says. Banks are picking up only certain assets, for instance.

KBW regularly screens for potential buyers and sellers in the banking space as it believes a "multi-year" consolidation cycle has been set in motion. "Banks are under increasing amount of earnings pressure, regulatory pressure, they are facing higher capital requirements and expenses are going in the wrong direction. The case for consolidation is still strong." he said.

In some markets, consolidation is almost inevitable. "In markets like the MidWest- that is the third largest market but it is still really fragmented. Margins are tighter as competition is cut-throat. That market should consolidate over time," he added.

Sellers are typically likely to be banks with weak capital positions or weak competitive advantages but it could also include those with attractive franchises that could still command a premium. But investors should be careful when it comes to buying into targets with the expectation of upside upon an acquisition.

Small and mid-cap banks are likely to be more active in deals than the large players. Banks like Bank of America (BAC) are busy shedding assets, not buying them. Even banks with strong capital like JPMorgan Chase (JPM) are unlikely to participate in acquisitions as they look to build capital in accordance with new regulatory targets.

"Not all sellers will be selling from a place of strength," McGratty cautions. " Some might have severely impacted franchises, might have to go through a forced sale."

He adds that there are targets that could still command a premium but investors need to be more selective,.

McGratty recommends a "barbell" investment strategy to play the M&A opportunity in banking. Investors should buy a handful of likely buyers- those that have the flexibility to deploy capital- and a handful of likely sellers which have a franchise value that can command a premium.

TheStreet pared down KBW's list of about 20 potential targets to five actively stocks with an average 3-month trading volume of more than 500,000. Note that not all these stocks are necessarily on the buy list of KBW. Some potential sellers that have an outperform rating from KBW include Citizens South Banking (CSBC), Metrocorp Bancshares (MCBI) and West Coast Bancorp (WCBO). Trading volumes on these stocks however tend to be thin and hence did not make our list.

Here are five likely regional bank M&A targets, listed in alphabetical order.

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