
Tom Brown Tackles M&A
Ed Crutchfield once dismissed him as that “little red-haired boy” after he had panned several of the former First Union Corp. CEO’s acquisitions, and went so far as to call Crutchfield a “serial diluter.” When other bank analysts were jumping on the consolidation bandwagon and even criticizing certain CEOs for not pursuing mergers aggressively enough, Tom Brown was hopping off the wagon and saying the likes of Crutchfield and former BankAmerica Corp. CEO Hugh McColl were doing too many. He is, simply, the most controversial bank analyst of the past decade and a card-carrying cynic when it comes to the mergers and acquisitions tsunami that swept over the banking industry in the late 1990s. Time has proven Brown correct in his dislike for big, splashy, transformational mergers. Many large bank deals in recent years have actually destroyed shareholder value because their success was predicated on wildly optimistic economic assumptions and highly aggressive integration schedules. Wall Street is wiser for the experience and Brown has earned the right to say, “I told you so.”
With his disarming mop of reddish-brown hair and easygoing manner, Brown’s personality seems at odds with his candid, shoot-from-the-lip style. Talking with him one-on-one, Brown doesn’t seem like the kind of guy who would take on two of the country’s most powerful bank CEOs with the ferocity of a pit bull. That fearlessness seems to have cost Brown his job as a stock analyst with Donaldson, Lufkin & Jenrette in 1998. According to his version of events, Brown was fired the same day that DLJ hired a new team of investment bankersu00e2u20ac”and the bankers made it clear that having him around would be bad for business. He later spent a year at the now defunct Tiger Management in New York, working for famed investor Julian Robertson, and then started a hedge fund of his own called Second Curve Capital LLC.
In addition to overseeing the fund with a team of ex-DLJ analysts, Brown maintains a popular website at bankstocks.com that serves as a delivery vehicle for his opinionsu00e2u20ac”which still count judging by the hefty, six-figure income he earns just from giving speeches. Brown is still critical of First Union and BankAmerica and still cool on most mergers, at least between large banks. Merger activity last year was off more than 50% from the record 504 dealsu00e2u20ac”for a total value of $289 billionu00e2u20ac”the market saw as recently as 1998. But Brown does not say a eulogy for consolidationu00e2u20ac”as much as he might like to. To find out why, read on.
Bank Director:
Merger activity last year was off sharply from what it was just three years ago. Is the consolidation boom over, or are there economic factors that account for the downturn?
Tom Brown:
Consolidation has not peaked, that I feel very comfortable saying. There’s a number of reasons why M&A was down so much last year. The first is that the largest acquirers are suffering a massive hangover from the deals they did in ’98 and ’99, and they’re still not feeling well. The second reason is that the stock prices of the likely acquirers are down, and that always makes it tougher to do deals. The expectations of the sellers never decline as fast as the currencies of the buyers. And the third reason is the soft economy. There’s more trepidation about acquiring somebody else’s book of business in a deteriorating economic environment.
BD:
So you don’t feel that consolidation has run out of steam.
Brown:
You and I are reasonably young people and for the rest of our lifetimes there will be consolidation within the financial services sector, because it’s such an unconsolidated marketplace. There will be an inevitable march toward greater consolidation.
BD:
Do you expect to see more cross-sector mergers?
Brown:
We’ll see cross-sector mergers, we’ll see in-sector mergersu00e2u20ac”and while this is going on there will also be a continuation of the start-up trend that has been taking place. We’ll see new entrants come in and take massive market share, although the existing players for as far out as we can see will be going through a period of consolidation.
BD:
What kind of new entrants?
Brown:
Here’s an example: Barnett Banks is acquired by NationsBank and some executives from Barnett leave and start a new bank. That new bank grows organically and grows through acquisition and becomes a reasonably sized player in the Florida market. Many of the largest banking companies that have grown through acquisition have terrible customer service, and that has created an opportunity for new entrants.
BD:
It seems that the integrations of many mergers were so badly handled and caused such service nightmares that they’ve created an environment in which it would be hard for a community bank to fail.
Brown:
The biggest change I saw between 2000 and 2001 was the recognition by some of the largest banks that their service quality was so poor that it had to be addressed. I just attended a BankAmerica Corp. investors meeting and it was interesting that many of their employees came up to meu00e2u20ac”a frequent a critic of theirsu00e2u20ac”and basically acknowledged that some of the things I have written about them are accurate. Now they say, “This is a new company. We’re focused on improving service quality.”
BD:
In conversations I’ve had with bankers over the past two years or so, there seems to have been a dramatic shift in how acquirers view the post-merger integration process and the speed with which they now try to do things. The old model called for slamming the banks together as quickly as you could; perhaps because you were an aggressive acquirer and knew you were going to do another deal soon, or because you had committed to an aggressive post-merger earnings forecast and needed to get the cost saves as quickly as possible. That approach caused a lot of problems; now it seems that banks are more likely to take their time putting these deals together.
Brown:
Yes, and I think that has been a positive trend. However that is only a small part of the cause of their performance problems. It’s so difficult for an existing management team to manage a much larger organization. It doesn’t matter whether you’re $2 billion going to $4 billion or $10 billion going to $20 billion. You’re used to managing, and have the systems to manage, a company of a certain size. I call it discontinuous growth, and I think discontinuous growth leads to management problems, which then translate into customer service problems. Finally, some companies are realizing there is a strong correlation between employee satisfaction and customer satisfaction. Any time Bank A buys Bank B, you get employees who become uncomfortable because of the uncertainty. They don’t like the new system, and that discomfort translates into poor customer service.
BD:
What are some of the other reasons deals don’t work out?
Brown:
You can’t go into a merger assuming that you’re immediately going to improve the revenue stream of the acquired company. No matter how good you are at integration, no matter how long you take, inevitably there are going to be customers whom you’re going to upset during the initial periodu00e2u20ac”the initial period being a couple of years. In very few deals does the acquirer improve the revenue stream of the acquired company. A merger usually results in a loss of customers and revenue.
BD:
The largest deal this year was the merger of First Union Corp. and Wachovia Corp. What’s your opinion of that one?
Brown:
Unfortunate. It’s unfortunate because I thought First Union under new leadership was really headed in the right direction, but no matter how good the new leadership is, this is a huge deal. All the progress that they were making on internal improvement is going to be put on hold as they go through a difficult integrationu00e2u20ac”difficult because of the size of the two banks.
BD:
Do you think SunTrust Corp. would have made a better merger partner for Wachovia than First Union?
Brown:
No, I think they were the right partners. I’ve said two things: One is that I wish it hadn’t happened at allu00e2u20ac”that Wachovia didn’t elect to merge with either partneru00e2u20ac”but if it was going to merge, it was a better fit with First Union than with SunTrust.
BD:
What’s your view of BankAmerica these days?
Brown:
I’m real disappointed. I owned the stock most of last year on the basis that it was suffering from the flu and was going to recover. And I think that recovery did take place. The flu was poor credit problems and net-interest margin pressure. Last year management demonstrated better expense control and got its hands around the credit issues. And the net-interest margin benefited greatly from the fall in interest rates. However, [right now] I happen to be in California and I can tell you that management has not fixedu00e2u20ac”nor do I see any signs of it fixingu00e2u20ac”the operating problems, or the problems in corporate middle-market lending or retail banking.
In middle-market banking, [BankAmerica’s] focus is so driven on trying to turn this into a capital markets business that it’s losing customers to players who aren’t asking middle-market borrowers for M&A business. On the retail side, customers feel like it’s a big bank, and when they have a problem, they go into the BankAmerica customer service hole and never get out of it. That’s the difference between the mid-size players like a Commerce Bancorp. and the biggest players like BankAmerica. When customers go to Commerce, they get their issues solved. When they go to BankAmerica, they get handed off and can’t get their issues solved.
BD:
Were there any deals this year that you liked?
Brown:
Well, I actually like the fact that a number of companies, whether we’re talking about BankAmerica, National City Corp., or FleetBoston Financial Corp., have come to the realization that as they were pursuing a growth-through-acquisitions strategy, their basic operating performance deteriorated. I like the fact that there’s a recognition that they need to improve customer service if they’re going to win. M&A is not a bad thing per se; I just think CEOs should remember that the vast majority of deals inside the financial services sector have failed to provide value to shareholders. The burden of proof should be that most deals fail, so banks should be really conservative in their assumptions. And until most deals succeed, I would like to see CEOs be much more conservative in evaluating acquirees.
BD:
Do you believe the stock market has taken a more critical view of bank mergers in recent years and has that been a deterrent to doing deals?
Brown:
Yes, and it surprised me how long it took for people to see through the unrealistic assumptions that managements were giving in ’98 and ’99 to justify the prices they were paying. We now have had enough time to know that most of those deals didn’t work outu00e2u20ac”in fact they destroyed huge amounts of shareholder value. For instance, BankAmerica was expected to earn around $5 a share in 2001. When [the old BankAmerica and NationsBank] merged, the new bank was supposed to earn over $7 a share in 2001. The difference is not recession-related; it’s mostly operating-related.
The deals that were done in ’98 and ’99 were a disaster for shareholders, so the market has become more skeptical of any mergers being beneficial.
BD:
What about deals like SunTrust’s acquisition of the Huntington Bancshares branch network in Florida, or the purchase by Citizens Financial Group of Buck Consultants (formerly Mellon Financial Corp.’s) branch business, both of which occurred last year? Do those kinds of deals make more sense then going out and buying an entire bank?
Brown:
Yes, again because they don’t result in discontinuous growth. A fill-in deal for SunTrust in Florida is very manageable, while Wachovia and First Union is a transformational merger. I think your point is a good one and I don’t know what the right number is, but [former Bank One Corp. CEO] John McCoy had it right in the ’80s and early ’90s when he said [Bank One] didn’t want to acquire a bank that was more than half its size in terms of assets.
BD:
What’s your forecast for M&A next year?
Brown:
I expect to see an improvement because I’m anticipating stock prices will be higher and a number of companies that wanted to sell this year and couldn’t are going to be willing to take offers next year. Now, that outlook is somewhat back-end loaded. Credit quality at a bank lags that of the economy. But stock prices lead the economy. So acquirers will get the benefit of having a higher currency, but they’ll have the negative of seeing that the banks they want to buy will be experiencing deteriorating asset quality. So it wouldn’t surprise me if the big M&A boom were in the third and fourth quarters of next year.
BD:
Why haven’t we seen banks acquire insurance underwriters now that they have the legal authority to do so?
Brown:
Banks have been drooling over the ability to get into the insurance business, but once they had that ability, they took a closer look and said, “Wow, these guys actually have lower returns than we do!” And so the appetite to pay a big premium to acquire a company that has a lower return and lower growth rate hasn’t been there. However, there has been a huge turn in the insurance underwriting cycle, and it’s quite possible that banks may get more excited as they see the earnings growth of some insurance companies explode in 2002 and 2003.
BD:
Doesn’t this kind of acquisition require the bank to find synergies and cross-selling opportunities at the insurance company? And isn’t that a potential problem for these deals?
Brown:
Yes, that’s exactly right. When you pay a 30% or 40% premium for a company, you have to justify that premium somehow, and the way you justify it in a cross-sector merger between banking and insurance would be through cross sells. That has been difficult for banks to accomplish profitably.
BD:
How will the elimination of the pooling-of-interest accounting treatment for mergers, which took effect Jan. 1, affect M&A activity?
Brown:
It’s going be a lot more fun. Under the old rules, when most bank deals were accounted for as poolings, you couldn’t sell a large part of the acquired company for two years, otherwise you would queer the pooling. Under the new accounting rules, you’re going to see much more creative transactions. Let’s say you were going to acquire PNC Bank Corp. Under the new accounting rules, you could acquire PNC and say, “I’m going to keep these attractive businesses, like asset management, but get rid of its retail bank.” Investment bankers are going to become more creative and actually earn part of the huge fees they get paid.
BD:
That’s actually how M&A is done outside of financial services, isn’t it? It’s not unusual for a large industrial company to buy another industrial company that has certain pieces it’s not particularly interested in. So it keeps what it wants and divests the rest.
Brown:
That’s one of the reasons why so many bank deals have worked out so poorly. Banks ended up getting into businesses that they didn’t know and became more diversified and less focusedu00e2u20ac”and, of course, I’m a big fan of focus as opposed to diversification. So I think this change in the accounting rules has a real opportunity to lead to better M&A transactions.
BD:
Most of the M&A activity this year has been in the small-bank market where there doesn’t seem to be the same disinclination to do a deal because of a concern about economic factors. Does that surprise you?
Brown:
Smaller banks actually do better due diligence, and the reason why is because they’re not worried about the news leaking out. They seem to have more time to do it. The other thing that small bank deals often have is a more motivated seller. Usually there’s a liquidity event for the smaller banks, and they actually need to sell the company. So, no, it doesn’t surprise me.
BD:
Put yourself in the shoes of a director of a small bank. The subject of doing an acquisition comes up. What are some of the questions that director should be asking of his or her management team?
Brown:
Well, the first thing is, if the management team uses the word “scale,” I would immediately walk away. Economies of scale in banking are achieved at pretty low asset levels. History shows there are more diseconomies of scale than economies of scale. So be careful with that.
The second thing is, I would try to get behind the motivation of the seller. Why do they want to sell at this time? Typically you can sell your company at roughly a 30% premium. And if that’s the case, then there must be some reason why they’re choosing to sell now.
And the third thing is, make sure that the merger plan doesn’t call for a melding of the two companies’ management teams. There really has to be one company in charge.
BD:
That’s tough, because sometimes you may have to make those kinds of promises during negotiations to get the deal done.
Brown:
That’s exactly right. But it just delays the inevitable, because not everyone can be part of the new company. With the Wachovia/First Union transaction, they made their management announcements soon after the deal was announced, but it won’t be until two years from now that we’ll get the real management team. All they’re doing is a kind of dance for two years until they realize they don’t have the strongest players on the field.
BD:
When a bank embarks on an acquisition, how should it handle guys like you? Institutional investors and analysts ultimately have a big say in whether a transaction is perceived to be a success or a failure.
Brown:
The first thing is, don’t make up numbers. In ’98 and ’99, everybody came to New York to announce their deals using presentations written for them by their investment bankers, and none of them could achieve those numbers. That hurts you two ways. It certainly hurts that your earnings are less than what you would have achieved if you hadn’t done the deal. But it also hurts your creditability as a management team.
The second thing is, if you really believe in the deal and you really believe you’re being conservative in forecasting the numbers, don’t worry what Wall Street’s first-day reaction is. Wall Street has a great record of being wrong on the first day when it comes to what’s a good deal and what’s a bad deal. Most management teams are too hung up on how much the stock went up or down after they announced the transaction. I wouldn’t view that as a very good proxy.

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