End of An Era

When the merger between Mercantile Bank Corp. of Dallas and Southwest Bancshares Corp. of Houston took place in 1984, both companies were looking for a way to overcome the woes of the energy patch. Each had grown to about $10 billion in assets through numerous acquisitions of smaller Texas banks, and the deal sought to bring their complementary operations together-Mercantile`s presence was focused in Dallas, Austin, El Paso, and Corpus Christi, while Southwest loomed large in Fort Worth and Houston.In the face of dire economic problems, both banks sought to take advantage of an accounting method that allowed the surviving institution, MCorp, to put a positive spin on the combination of their assets. Because Southwest`s shares were trading at a discount to book value, Mercantile used purchase accounting to create negative goodwill by writing down some of Southwest`s assets. Says Jim Gardner, former president of Mercantile and now a managing director in mergers and acquisitions with SAMCO Capital Markets, a Dallas-based investment bank: We were able to amortize them back into earnings in the following years.In the end, the earnings boost from the merger`s negative amortization was not enough to help MCorp overcome the credit-quality problems that multiplied in its loan portfolio. But nearly two decades later, and after years of consolidation at historic pricing multiples, the structure of MCorp`s transaction may prove instructive if the Financial Accounting Standards Board (FASB) follows through on its plan to eliminate pooling-of-interests accounting by yearend. While pooling-of-interests accounting is not responsible for the euphoria of consolidation in recent years, its mechanisms helped create the high pricing multiples that have become prevalent. Under pooling provisions, buyers and sellers are able to combine their balance sheets without demonstrating the full effect of the prices paid-with no amortization of goodwill. As a result, when premiums of as much as three or four times the net asset value of the seller are paid, these amounts are not reflected on the surviving institution`s income statements. In the view of FASB Chairman Edmund Jenkins, not accounting for inflated pricing lets the board and management off the hook for their decisions. Because you do not have to disclose the value you gave a seller in pooling, you feel more comfortable in not being as diligent in pricing the deal, Jenkins says. You need to face up to the value of the investment you are making. For the past several years, FASB has taken this stance in its hearings and with its proposals on the elimination of pooling of interests and is expected to rule that buyers must exclusively use purchase accounting for their transactions beginning in 2001. Under purchase accounting rules, buyers must appraise all assets and apply any differences between book value and fair market value against the net equity of the seller. Any differences between the price paid and the newly appraised net equity creates the intangible asset known as goodwill. Though FASB hasn`t made many friends by pursuing its controversial position, the rule changeover needn`t cause palpitations for bankers. In one sense, the pending elimination of pooling of interests couldn`t come at a better time for banks. After years of strong earnings, good credit quality, low and-until recently-falling interest rates, institutions are flush with capital. So much capital have they accumulated, in fact, that many are returning the excess to their shareholders in the form of stock repurchases. Moreover, after nearly seven years of a strong economy and more liberal banking regulations, the industry is considerably more consolidated than it was at the beginning of the 1990s. Since the end of 1992, one in every four banking and thrift companies has disappeared. While there are still plenty of institutions out there-approximately 8,350 as of December 30-most are small and located in a few states. Nonetheless, while no one seriously believes that the proposed change will halt the forces of consolidation, it is likely to have some negative effects upon acquirers going forward. Not only will banks have to record goodwill when they pay a premium over book value for a seller, they will likely have a shorter period over which to amortize that intangible asset. Current proposals reduce the maximum amortization period to 20 years from 40 years. There is a view that in today`s economy, where companies are reorganizing faster than they used to, the life of a company is much shorter than it was when the 40-year rule was put in place, Jenkins says. The prospect of having to record a large amount of goodwill likely will persuade buyers to avoid high premiums in the future. Then result: an expected cooling off in pricing multiples, not only for acquisitions but for day-to-day market valuations as a reflection of lower potential takeout values. That expectation is reinforced by a review of deals announced since the beginning of 1997. While the number of banking and thrift deals announced during that period are roughly even-out of 1,123 deals announced since the beginning of 1997, 560 used pooling and 563 used purchase accounting-pooling deals carried higher valuations, according to Charlottesville, Virginia-based SNL Securities. On a price-to-book-value basis, the average multiple in pooling deals during that period was 43.5% higher than for purchase deals. On a price-to-earnings basis, the premium was lower, though still significant at 13.7% . Lower pricing multiples for purchase deals have come about partly because of concern over capital, says Gardner of SAMCO. The problem is that banks have to have a certain amount of tangible net worth for regulatory purposes, he says. The goodwill created in a purchase transaction, however, reduces the amount of accounting equity in the calculation of tangible equity. So goodwill not only affects a company`s earnings, it also affects the amount of capital an institution must have. Charlie Crowley, a managing director with McDonald Investments, a Cleveland-based investment banking subsidiary of KeyCorp, says capital constraints again may become an issue for certain acquirers. Boards will have to focus on their capital structure and what effect internal growth and acquisitions will have on those capital levels as well as on return on equity and earnings-per-share growth. He says, these considerations could limit the potential universe of buyers for community banks. Institutions in the $10 billion to $20 billion range may no longer have the impetus to acquire small banks. And the $1 billion to $5 billion banks may have trouble accounting for acquisitions of institutions in the $500 million range, since the tangible net worth of the combined company after subtracting goodwill could put the acquirer below regulatory requirements. Therefore, banks that are ready to buy may turn up the heat to accomplish deals before the pooling window closes. Of immediate concern, however, is the depressed state of bank stock prices. Some people may prefer to be acquirers, still, but may not have the purchasing power in terms of the value of their stock to effectively continue as successful acquirers, Crowley says. Those companies will have to assess whether they can achieve their goals through internal growth and find other ways to deliver acceptable returns to their shareholders. Even though prices are depressed, some investment bankers are advising their clients that now may be their best shot to sell for a number of years. Robert Ulrey, a managing director with Stephens Inc. in Little Rock, Arkansas, says that while such recommendations are made on a case-by-case basis, I think if someone were going to sell their bank within two years, I would have them seriously think about doing it now. Crowley agrees that bank boards are taking this advice to heart. Of those that see themselves as potential sellers and were inclined to sell in the next three years, many are wondering whether they should accelerate their plans, he says. Even if the bid is lower than expected, They still may want to sell now because they may get stock with better upside potential than the stock they currently own. So while the heat is on banks that want to sell, things are not any easier for potential buyers. They, too, are suffering from low stock market multiples and are, therefore, reluctant to use shares as their currency in one final pooling-of-interests deal. Nonetheless, Crowley says he expects activity to increase later this year. We think the window will be a catalyst to getting a number of transactions done in the second half of the year. Still, he concedes, it would be more robust if the share prices of acquirers were higher. When we get a break in the interest rate increases and share prices rebound, we will see a new wave of consolidation. SAMCO`s Gardner says if banks don`t sell now, they should be prepared to stay independent for another two to three years. But such strategic considerations are not likely to affect all banks. While banks in large or growing markets have understandable concerns about selling before the pooling window closes, those in rural regions will continue to deal on a cash basis, regardless of the accounting rule change. When it comes to selling the bank, though, shareholders often have their own ideas. Some investors believe it is already too late to sell. Price-to-book ratios reached their peak in 1998, when the multiples for pooling deals reached an average 295.4%, according to SNL Securities. Even purchase deals peaked that year, with an average price-to-book value multiple of 201.3%. By 1999, the multiples for both accounting methods had fallen, to 269.5% for pooling transactions and to 190.1% for purchase deals, leaving little for bank investors to celebrate. The average management on the landscape today is less shareholder-oriented than those that were around in 1996, says David Harvey with Everest Managers, a Gardenville, Nevada-based hedge fund. They could have checked out at a higher price then. Therefore, as for those companies that ought to be sold and are not [sold] before the pooling window expires, we as investors will draw some dramatically negative conclusions about management. Jerry Shearer with MidAtlantic Investors in Columbia, South Carolina says even small investors will likely be disgruntled with management that they feel missed the boat. Those shareholders are going to wake up one day and say to themselves that [management] did them a great disservice.The mandate to use purchase accounting is viewed by many as a return to rationality. To Jeff Bronchick with investment manager Reed, Conner & Birdwell in Los Angeles, the end of pooling cannot come soon enough. Maybe [eliminating the use of pooling] will stop the `serial diluters` from making silly acquisitions that destroy shareholder value but can be made to be accretive to earnings per share, he says. Despite the grumbling of some shareholders, the end of pooling will create new strategic challenges for buyers and sellers alike. On one hand, the expected reduction in pricing could be a boon for buyers. On the other hand, exchanging shares in a purchase-accounting transaction makes some acquirers nervous, because the buyer`s shareholders must take the attendant goodwill as well as endure the dilution that comes from issuing large numbers of shares. But those fears are somewhat overblown. The biggest and best-known purchase transaction to date was Wells Fargo & Co.`s 1996 purchase of First Interstate Corp., a $11.3 billion deal that created $7.2 billion in goodwill for the San Francisco-based bank. Though Wells Fargo ultimately fell prey to Minneapolis-based Norwest Corp., the competing bidder for First Interstate, the deal provides some guidance on how to get investors and analysts to look beyond the harmful effects of goodwill. Ultimately, Wells Fargo reported cash earnings per share and cash returns on equity and assets in conjunction with GAAP earnings per share-a model that analysts have started to apply elsewhere in the financial services world. Bank boards should understand how to take advantage of the flexibility of purchase accounting. Huntington Bancshares of Columbus, Ohio used purchase accounting for its $138 million acquisition of Empire Banc Corp. of Traverse City, Ohio, announced last February. The deal was structured as an exchange of shares and carried a price-to-book value ratio of nearly 300% and 19.8 times latest 12 months` earnings. Milt Baughman, a senior vice president in mergers and acquisitions with Huntington, says purchase accounting made more sense in a deal like this. The pooling rules that keep you out of the market for stock buybacks are a heavy penalty to pay for a small transaction, he says. We felt our balance sheet could support a transaction of that size, and [the use of purchase accounting] was an advantage at this time. Still, Huntington, like most, historically has used pooling-of-interests accounting for its largest acquisitions. Of the four deals the bank has announced since the beginning of 1997, only its $893.2 million acquisition of First Michigan Bank Corp. was accounted for under pooling of interests. The pricing multiples in that transaction amounted to 323.1% on a price-to-book value basis, and 20.6 times latest 12 months` earnings. Only the recent acquisition of Empire comes close to those multiples. Cash deals offer other advantages. On a much smaller scale, Whitney Bank of New Orleans recently paid $58 million in cash for Bank of Houston in Texas, an institution with $184 million in assets. The purchase price amounted to 32.7 times latest 12 months` earnings at completion and nearly 286% of book value. Yet despite the use of purchase accounting, management had very little trouble paying a price that high. They viewed it as their entry into Texas, says SAMCO`s Gardner, who advised the Bank of Houston`s board. They decided to do whatever was necessary to get the deal done. Strategic implications are what matter most, says John Ennest, vice chairman and chief financial officer with Citizens Banking Corp. in Flint, Michigan. Citizens has grown to $7.9 billion in assets largely as a result of four acquisitions, the most recent of which was last year`s $822.2 million purchase of F&M Bancorp. of Kaukauna, Michigan. Citizens used pooling in that deal, though purchase accounting was used in the first two deals, which had a combined valuation of $137.5 million. Regardless of the accounting method, a deal must stand on its own merits. Strategic opportunities, such as expansion into different markets or different products, or the ability to consolidate an institution`s position in a market, are the relevant considerations. The fact that an accounting convention is changing doesn`t change the economics of a transaction, Ennest says. If you`re going to buy or sell a company, there are more strategic things in the process than how it is going to be accounted for. As a small midwestern bank, we price deals strategically based on the markets or institutions we are acquiring and select which accounting convention we use secondary to that. Still, the use of purchase accounting, particularly in cash deals, are sure to create shareholder relations headaches. By their very nature, pooling transactions involve an exchange of stock between buyers and sellers. As a result, sellers` shareholders do not immediately incur tax liability from the deal-the tax is deferred until the investor sells the shares. The same holds true for purchase transactions using stock. In cash transactions, selling shareholders incur immediate tax liability. Investor Shearer says explaining this downside to shareholders will require some finesse. How are [boards] going to explain to somebody who has owned stock in a company for 20 years that this is the best deal they are going to get, and then say, `Oh, by the way, you are now going to have to pay a 20% tax on the sale of those shares`? he asks. Such explanations could lead shareholders to vote against a merger. There is also the matter of earnings. Cash earnings per share subtracts from net income the amounts related to noncash expenses such as goodwill amortization and depreciation. The number is the rough equivalent to a pretax operating cash flow number for an industrial or service company and defines how efficiently the company is operating. While reporting cash earnings per share is considered a reasonable option for banks with a significant following among Wall Street firms, institutions without that kind of following could find investors focused squarely on GAAP earnings. Opinion is mixed about whether the market will ever accept such alternative earnings measures. I think the market will value these companies based on cash EPS, says Stephens` Ulrey. But that doesn`t mean that bank directors and CEOs won`t be focused on GAAP EPS, as well. Eventually, bank investors will come to understand and trust those numbers, just as investors have in other industries, says Gardner. Telephone companies have recorded a lot of goodwill in recent years as a result of buying divisions of big companies for cash, he says. Nonetheless, the market now looks at those companies on a cash-flow basis. Huntington`s Baughman is less optimistic. We, like other people, have tried to thread [cash earnings reports] into our earnings announcements. But, he adds, I`m not sure equity analysts and investors in general are ready to look at cash earnings. To investors like Everest Managers` Harvey, it won`t make much difference whether it is cash or GAAP earnings per share. Prices, he says, are going lower across the board and earnings don`t matter because this is an industry that America wants to liquidate. I think of banks [that are still independent] as liquidation targets, because that`s how the market looks at them. The bottom line on the pooling/purchase debate is this: While pooling gets much of the credit for giving buyers the means to avoid showing the true costs of an expensive transaction, purchase accounting has its share of advantages. For one thing, buyers doing stock-for-stock deals can avoid diluting existing share value by repurchasing stock without the restrictions imposed on companies that do pooling transactions. Under pooling rules, a company cannot launch a stock buyback program within a two-year window before and after a pooling transaction. While in reality, that two-year restriction can be reduced to around six months if management and directors have not planned the repurchases before or during the six-month period, there is still a waiting period that limits a bank`s growth options. The primary restriction on stock repurchases under purchase accounting is to prevent insider trading by buying shares before a deal is announced. Other than that, an acquirer can start buying its own shares the day a deal is announced. For the Empire transaction, says Baughman, we will go out into the open market and purchase the shares we will issue in the acquisition. We will not be issuing any new shares. While stock repurchases may not be a viable option for smaller banks, there are other solutions that are unique to such institutions. Says Everest Managers` Harvey: They could go private and become a subchapter S corporation. Under the Internal Revenue Code, subchapter S corporations can have no more than 35 shareholders. But the company`s earnings avoid taxation at the corporate level and are, instead, paid by the individual shareholders. It`s the tax advantage that excites Harvey. I`d like to own some companies as a subchapter S corporation for about 20 years, paying no taxes and getting a high yield, he says. So while the prospect of only having purchase accounting for future acquisitions will certainly make consolidation a more difficult task, banks will still have plenty of flexibility to get deals done. And though the public relations burdens may rise, most acquirers will likely find the effort worth it for a deal that gives an institution a strategic boost. Boards of directors will eventually get used to the idea of accounting for their acquisitions under the purchase method, just as MCorp did some 17 years ago. The big question is whether buyers will find prices as low in this market as they were in Texas in the early 1980s. Only time will tell. |BD|