Sterling’s Shine

George Martinez saw the writing on the wall about seven years ago. The chairman and co-founder of Sterling Bancshares in Houston has overseen the company’s strong growth with a strategy that blends basic tools, such as equity incentives for employees, with an unconventional roster of business development boards, preferred stock for customers, and a single-minded focus on small-business borrowers.

The board of directors, all 21 of them, has been heavily involved in the process, rotating shifts on no less than eight separate committees in a constant effort to keep current with, and oversee, the company’s latest initiatives.

Shareholders have done well by a strategy that walks a tightwire between tradition and innovation. During the first three quarters of 2001, Sterling reported net income of $22.4 million, up 10% from the previous year. Return on average common equity was 16.81%, while return on assets was 1.26%. Last July the company completed a 3-for-2 stock splitu00e2u20ac”its fifth in 10 years, and a rarity in the past year’s down market.

Since it went public in 1992, Sterling has registered compounded earnings-per-share growth of 19%, according to Joseph Stieven, director of financial institutions research for Stifel, Nicolaus & Co. in St. Louis, while a $100,000 investment made by its original investors in 1974 is now worth more than $4.5 million. “This is easily one of the most successful banks in the country,” Stieven says.

Over the past decade, Sterling has grown its asset base tenfold, from $265 million to $2.65 billion. While strong internal growth and de novo expansion, powered by a group of well-paid lending officers, has fueled the push, acquisitions have played a key role as well. In total, Sterling has purchased eight banks in the Houston area and one in San Antonio during the past decade, including three in the past year.

Sitting on the buyer’s side of transactions afforded Martinez, 59, a chance to think about the question that eventually faces most community bank leaders: Acquire or be acquired? Like Sterling, the acquirees were well-run banks. The region’s financial institutions were decimated by a banking crisis in the mid-1980s, rooted in falling oil and real estate prices, that left only the best-managed institutions standing. Yet, all of them were, in essence, forced to sell.

“There are really two reasons why good banks sell,” explains Martinez, a genial, energetic man, as he sits in Sterling’s headquarters in a modest office tower overlooking a suburban Houston freeway. “The investorsu00e2u20ac”which usually means the board of directorsu00e2u20ac”want an exit. Or the CEO wants to retire, and they don’t have anyone they trust to turn it over to.”

Martinez realized that a similar fate could befall Sterling, and concluded that he had put too much of his own sweat into building the franchise to see it swallowed up by a rivalu00e2u20ac”or worse, by one of the big out-of-state players that dominate Texas’s retail banking scene.

“One of my goals has been to see the company endure beyond me. But I’ve seen these banks that can’t endure because the CEO wants tou00e2u20ac”or has tou00e2u20ac”retire, and there’s no one qualified to replace him,” says Martinez. So on
Jan. 1, he formally handed over the CEO title he’s held for nearly 22 years to J. Downey Bridgwater, a 43-year-old Houston banker with some 23 years of experience.

Martinez isn’t totally out the door just yet. He’s slated to remain Sterling’s chairman until at least 2006. His biggest comfort is that he’s been able to retain the company’s independence. Still, he concedes, it won’t be quite the same. “There’s a sense of loss in leaving,” he says. “But I knew I’d eventually have to reduce my involvement, and I’ve spent the past seven years preparing for that day.”

Sterling’s history and growth tell the tale of both Texas’s and the banking industry’s evolution from a highly regulated business to one that is expected to produce returns that are competitive with the rest of corporate America. When Sterling was founded in 1974, Texas was a unit banking state, meaning banks that wanted to expand geographically were required to charter entire new organizations.

Martinez, then a chief financial officer for a chemical manufacturing company, was recruited by a group of directors for a bank on Houston’s south side to help launch an institution in the northern part of town.

The then-privately held bank grew in fits and starts, aided by regulatory changes. In the early 1980s, for instance, interest rates were deregulated. The real turning point came in 1986, when scores of banks in the Lone Star state collapsed under the weight of heavy loan defaults. Out-of-state giants, including predecessors to today’s Bank of America Corp., J.P. Morgan Chase & Co., and Bank One Corp., swooped in and bought both struggling institutions, and, from the Federal Deposit Insurance Corp., those that had failed outright.

While the arrival of deep-pocketed competitors initially made him cringe, Martinez now says it was a “second birth” for Sterling. Concurrent with the out-of-state invasion, Texas revoked its unit banking laws. Large acquirers set to work wringing inefficiencies out of the old system, merging different banks and charters, consolidating departments, and centralizing decision-making authority. They saved a lot of money, but also laid off a lot of people and made the banking experience less intimate for customers.

Small-business owners, who place a high value on relationships with bankers who know their businesses, felt the burden of those changes more than most. “It was the marketplace opportunity that helped make us who we are today,” Martinez says.

That was only the beginning, however. Texas is home to nearly 750 banks, according to the Texas Bankers Association, and many are focused on the same small-business niche as Martinez’s operation. To rise above the pack, Sterling, under the watchful eye of a highly involved board, implemented a wide-ranging set of organizational and incentive structures designed to capitalize on those competitive conditions by giving customers what they want: individual branches, each with their own CEOs, senior lenders, and business development boards, that look and feel like separate independent banks, with levels of service to match.

“In a mature industry like banking, the question is, ‘How do we distinguish ourselves?’” Bridgwater explains. “Our competitive advantage is personal service.”

Larger banks have struggled mightily to provide good serviceu00e2u20ac”a fact reflected in a recent study by First Manhattan Consulting Group, which found that half of the 30 largest banks in the country registered a net loss of core deposits between 1993 and 2000, when adjusted for mergers.

Now, confronted with tighter lending and profit margins, many of those banks, including some in Texas, such as Wells Fargo & Co., have begun emphasizing customer service as a way to retain consumer customers and their deposits.

They’ve also continued to do a relatively good job of serving larger corporations, which are perceived as being worth the cost and effort of greater hand holding. The hole in such strategies continues to be small businesses, which are seen as too labor-intensive and costly to service for scale-oriented large banks.

Sterling has sought to capitalize on that deficiency with a variant of the supercomunity banking strategy that has found growing popularity among larger and mid-sized banks.

The key behind all successful supercommunity strategies is an ability to blend the efficiencies of a larger institution with the personal touch of a smaller, community bank. The key difference with Sterling is that its emphasis lies almost exclusively with small businesses, rather than consumers.

Sterling’s typical small-business customer has good ideas and sound business models, but lacks a CFO or in-house counsel. Bankers in each of Sterling’s local offices specialize in getting to know each client’s business intimately, offering advice on financial matters and reacting quickly to their requests.

“If they come in with an opportunity to buy a new pump or the lot next door for expansion, they want to talk with someone who’s already familiar with what they’re doing and is empowered to make a decision,” Bridgwater says. “These are customers who want a relationship, not just a cheap loan.”

The strategy is not for everyone. The model will only work in larger metropolitan areas that boast a critical mass of small-business clients. It also costs more to do business Sterling’s way.

Martinez argues that the benefits outweigh any additional expense. Small-business customers tend to keep a lot of deposits in the banku00e2u20ac”Sterling’s tally of noninterest deposits is a healthy 35% of total depositsu00e2u20ac”lowering overall funding costs. At the same time, those clients are willing to pay higher interest rates on loans. Fully 80% of Sterling’s loan portfolio is in commercial loans, which average a scant $100,000 in size, while 70% of its deposits come from those same clients.

At the end of the third quarter, as most other banks were experiencing severe margin compression, Sterling’s net interest margin was an eye-popping 5.78%. “[Because our] margins are so much higher, we can afford to pay for the extra staffing that provides the good service,” Martinez explains.

Martinez says it’s crucial that Sterling’s board, charged with overseeing the company’s growth, understand in detail what distinguishes the company from its rivals. “Corporate governance is the most important function of the board,” he explains. “To do it right, [directors] need to understand how the strategies we’re employing comply with the broader mission of the bank and differentiate us.”

Given the board’s size, the task can be difficult. A group of 21 local business leaders, the directors include lawyers, engineers, software executives, and the heads of several manufacturing companies. Martinez and Bridgwater are the only insiders, though a couple of directors are former CEOs of acquired banks.

To reflect the priorities of the institution, Sterling’s board boasts no less than eight committees, including the usual suspectsu00e2u20ac”compensation, audit, and assets and liabilityu00e2u20ac”as well as those that grapple with issues such as human resources, information technology, and service quality.

The latter committee meets eight times a year, reviewing the results of “secret shopper” programs and other in-house service measurements to watch for signs of deterioration or other changes. They also read correspondence, both positive and negative, from customers and review new service offerings. “Service quality is so important to our strategy, we decided to create a committee to oversee it,” Martinez says.

Having so many committees gives the directors added assurance that they’re not just rubber-stamping management’s agenda. “I feel comforted that directors have been close by when key issues are being considered,” says Bruce Harper, a certified public accountant and director since 1995. “There’s a sense of more thorough oversight, rather than management making all the calls.”

Committee involvement serves another important role: educating outside directors on the finer points of Sterling’s operations. To that end, all directorsu00e2u20ac”with the notable exceptions of the chairmen of the audit and technology committeesu00e2u20ac”rotate committee assignments annually.

John Buck, a Houston trial lawyer and director since 1996, is presently serving a stint on an executive committee that includes five directors and three operating officers, but has also done time on the human resources and audit committees. Harper, now chairman of the human resources committee, also has served on the executive, audit, and service quality committees.

Directors say they love the variety, challenge, and insight provided by regularly rotating committee assignments. “It opens the eyes of a lot of directors to the different initiatives the bank has going on,” Harper explains. “If you just sat on the board, you’d never get the same perspective.”

The board also gets a full slate of educational supplements, designed by Bridgwater, at its quarterly meetings. Sterling’s typical board meeting begins at about 8:30 a.m. with a continental breakfast, then moves quickly to several “breakout sessions,” run by key executives, on issues management believes are important for directors to better grasp. Recent topics have ranged from a detailed report on the bank’s 80%-owned mortgage origination subsidiary (its biggest deviation from the small-business emphasis), to primers on credit scoring and M&A strategies.

Directors each attend two such morning sessions, getting an opportunity in the smaller group setting to ask more-detailed questions. Lunch follows, with an outside expert, such as an institutional investor or chamber of commerce chairman, as the guest speaker. In the afternoon, the full board meets for up to four hours, listening to reports from various committee chairmen and management, voting on motions, and discussing strategic initiatives.

Directors walk away from it all with a clearer understanding of how they can best support a strategy that aims to rally both employees and customers around the bank.

Martinez argues, for instance, that workers won’t give the kind of service he demands if they’re unhappy with their own compensation. With that in mind, employees receive regular option grants and quarterly cash bonuses.

Cheap it ain’t. According to figures from the FDIC, Sterling paid $47.1 million in salaries and benefits during 2000u00e2u20ac”18.5% more than the average commercial bank with between $1 billion and $10 billion in assets, even though it’s on the low end of that size range.

Directors, however, have little trouble balancing such incentives with shareholder demands for greater returns. Indeed, they argue better pay is a big part of what fuels those returns. The quarterly bonuses are paid only if Sterling’s ROE surpasses 12%, and Buck says it takes talented bankers to manage a portfolio of small-business loans.

“A good loan officer is like a good baseball pitcher. They’re free agents, and people are always trying to steal them from you,” Buck says. “So whatever we spend on their compensation comes back to shareholders many times over.”

Similarly, Sterling often seeks to win over choice customers in the pocketbook. Over the past decade Sterling has opened 11 de novo branches, employing the same formula time and again. Beginning with demographic studies, the bank looks for areas with high concentrations of small-business owners, and a relative dearth of good community banks.

Prospective branches must be assured of gaining support from the local business community, and having the person running the branch is considered crucial. Bank CEOs almost always come from another bank, not Sterling, and are well connected to the local community. “They need to have a network of referral sources to help us build the business,” says Bridgwater, who himself was hired to run a local Sterling branch when his former employer, Charter Bank, was acquired by the former NationsBank.

The lead-up to a new bank opening can take more than a year. One of the CEO’s initial tasks is to line up local business leaders who are willing to invest in preferred stock issued by the company and generate referrals.

The idea of getting local leaders to provide start-up capitalu00e2u20ac”and supportu00e2u20ac”is common with private community bank launches. A publicly traded bank like Sterling, however, can’t lock investors into its common stock. To solidify the relationship, and give business leaders an added incentive to steer customers the bank’s way, Martinez in 1994 devised the strategy of selling convertible preferred shares.

The shares, sold in blocks of no more than 2,000, are offered to roughly two dozen movers and shakers, hand picked by that branch’s CEO. If, as has happened in seven of the eight times the preferred strategy has been employed, the branch hits its core deposit targetsu00e2u20ac”usually around $25 millionu00e2u20ac”within two years, the shares can be traded in for 1.25 common shares. In the other case, the goal was hit within three years, and the preferred shares were converted for 1.1 shares of common. If the goal isn’t reached within three years, the conversion rate is 1-to-1.

Some directors say it can be difficult to measure the exact payout of the preferred stock offerings. “It’s not always a roaring success,” Harper says. “But it does provide us with extra visibility in the community.” And while Martinez admits to a little concern about shareholder dilution, he says that the sales typically help Sterling hit deposit goals in about half the normal time. “It saves us a lot of money and benefits the shareholders.”

Another Sterling support-building tactic is its extensive use of business development boards. Many banks today have such boards, but few use them as aggressively as does Sterling. Most of its 36 branches boast one, meaning that at any given time, there are about 200 Sterling development directors on the job.

These aren’t true director jobs, by any stretch of the imagination. There are no responsibilities, aside from alerting bank officials to service problems and steering business Sterling’s way. Each member is paid $100 per monthly meeting and is given bank business cards to pass out to prospective customers. They serve one-year stints, during which time they are given an inside look at the bank’s operations and products, and are treated a bit like royalty, with invitations to special bank functions and seminars, such as the board of directors’ morning breakout sessions.

The whole operation is something of a cross between a chamber of commerce and a college fraternity. When their terms are finished each November, development directors are feted with an appreciation event for family and friends. From then on, they’re considered “alumni,” receiving invites to special bank functions in an effort to maintain their strong ties to the bank. Some branches have more than 200 alumni who remain intimately involved with the bank. “They’re VIPs from that point forward,” Martinez says.

The de novo openings, equity programs, and development boards, all centered around a core of well-connected bankers providing top-flight service, are viewed as crucial to Sterling’s success. Stieven says Sterling’s ability to execute a seemingly simple strategy on a tightly focused niche, and drive internal growth, are what makes the company attractive to investors.

But M&A activity is an equally important factor in that growth formula, and one that the board of directors pays special attention to. “Internal growth comes naturally if you’re doing your job well,” says Buck. “But if you want to make quantum leaps in your growth, it has to be done through judicious acquisitions.”

In 2001, the banking industry’s appetite for M&A deals continued its general decline. Through mid-December just 168 deals were completed, according to SNL Securities in Charlottesville, Va., compared to 191 deals for all of 2000, and a whopping 411 mergers during the high-water days of 1998.

The total value of last year’s deals was also meek, at about $31.5 billion, compared to $89.9 billion in 2000 and a record $265.3 billion in 1998. With lower demand, pricing slumped as well. Bank deals in 2001 averaged 1.87 times book value, and 17.56 times earnings, according to SNL. In 1998, banks fetched an average 2.11 times book value, and 18.95 times earnings.

None of this has hindered Sterling. Indeed, the company has grown more voracious amid the downturn, closing on three acquisitions in 2001 alone. The deals for Lone Star Bancorp., Community Bancsharesu00e2u20ac”both in the Houston areau00e2u20ac”and San Antonio-based CaminoReal Bancshares of Texas boosted Sterling’s asset size by about $560 million, or 25%, and deposits by $507 million.

In comparison to the national averages, those deals didn’t come cheap. According to SNL, Lone Star sold for nearly 4 times book value, while CaminoReal went for 2.4 times book and 16.89 times earnings. Indeed, the Lone Star purchase was the most expensive, on a book value basis, of 23 deals announced in Texas during 2001.

But Martinez asserts that Sterling is a “disciplined” acquirer that gets the price it wants. He says the company has purchased only about 20% of the banks sold in recent years in Houston, and regularly loses bidding wars against larger holding companies. “If a bank hires an investment banker and puts out a package to 10 or 20 banks, it’s looking for the highest price,” he says. “We’ve never won one of those.”

While the boards of selling banks are obviously interested in price, he says, many are equally concerned about retaining the character of their operations and stability for employees. That, Sterling officials boast, gives the bank a leg up on the latest wave of out-of-state regionals, including Regions Financial Corp. and Colonial BancGroup, both based in Alabamau00e2u20ac”and New Orleans-based Whitney Holding Corp., that have recently bought banks in the Houston market.

Sterling looks for banks that share its desire to serve small-business clients. Consumer-oriented banks, or ones that serve niches like municipalities, are nixed immediately. So, too, are banks that have asset-quality problems. All deals must be accretive within a year to be considered. “It has to be a good strategic fit,” Martinez says. “To buy a bank that’s mostly consumer, and try to convert it to our way of thinking, would be too difficult.”

To keep the pipeline full, Martinez and Bridgwater stay in regular contact with independents that might be contemplating a sale. When the time comes, those informal contacts become more formalized negotiations.

In the negotiations, Sterling demands that the organization’s leaders stay on to help build the business, often getting such agreements in writing. That’s important, says Stieven, because the company’s goal isn’t cost savings, but revenue growth. “When Sterling buys a bank, they don’t try to cut 40% of its overhead,” Stieven says. “They invest in it. They understand that to make money, you’ve got to spend some money.”

While management does most of the legwork on deals, directors are kept abreast of potential developments. “We have pretty candid discussions about deals that are nowhere near made,” Buck says. Those talks include various “what-if” scenarios, and a weighing of the pros and cons of specific managements and locations.

When a preliminary deal is struck, the executive committee, which is legally empowered to act on the board’s behalf, gives its approval. But Sterling officials like to get everyone behind a deal, and usually will hold a full-board conference calls to get formal approval and address any director concerns.

In those discussions, Buck says he and his comrades are most concerned with pricing. He also wants to ensure that management is approaching an acquisition rationally. “It’s easy for an acquirer to want a deal so badu00e2u20ac”to have such an emotional investment in itu00e2u20ac”that it’ll sweeten the price just to get it done,” he says. “My chief concern is to make sure it doesn’t create too much dilution.”

Will this formula allow Sterling to continue achieving growth in assets and earnings? The economy is a wild card. Small businesses are notoriously more susceptible to the kind of recessionary pressures now being experienced. If loan growth starts to slow, or if chargeoffs increase, directors say they’d at least entertain the possibility of moving up market to larger clients. “If we felt that we were going to experience a significantly stagnant earnings potential, then we might look at branching out,” Harper says.

Analysts say that would be a mistake. While small-business customers are rightly perceived as riskier credits, the fact that Sterling boasts 23,000 loans, spread across various industries, mitigates much of the risk. The bigger risk, they say, would be for the company to tinker with a proven success formula.

“It’s very tempting for a bank that does something as well as Sterling does to try to become everything to everyone,” says Ken Puglisi, a Chicago-based analyst with Sandler O’Neill & Partners. “Sterling’s strength is that it hasn’t deviated from its core strategy so far, … and it shouldn’t in the future.”

Bridgwater, now the man in charge, seems to agree. Noting that there are only so many small businesses in Houston, he’s begun pursuing geographicu00e2u20ac”not business lineu00e2u20ac”expansion. “For us to stay in the game, we have to continue growing our earning assets at the rate our shareholders demand,” Bridgwater says. “But I don’t want to abandon the strategy that has brought us to the dance.”

In 2001, the company launched its first de novo bank in Dallas and, in December, announced plans to supplement the CaminoReal acquisition with a de novo opening in San Antonio. More acquisitions are in the company’s future, directors and management agree, and Bridgwater won’t rule out moving into neighboring states as the business grows.
Maintaining that keen sense of focus on a niche it knows well should allow Sterling to remain independent for the foreseeable future, and keep Martinez’s dream in tact.

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