Through the Investors Eyes

Perceptions mean everything on the Street. The way a bank communicates its strategy often can be as important as the strategy itselfu00e2u20ac”as analysts carefully watch and wait for signs that a bank is on the right or wrong track. And a nod from this group, one way or the other, can pack a wallop when a bank needs investor support to enhance growth, develop a new business, or court a merger target. At our Bank Analyst Forum held this spring, Bank Director brought together four top analysts to shed light upon how analysts and investors view the decisions that bank managements and boards make and the strategies they pursue. Participating were David Berry, Keefe Bruyette & Woods; Sally Pope Davis, Goldman Sachs; Susan Roth, Donaldson, Lufkin & Jenrette; Sean Ryan, Bear Stearns.

Bank Director: Describe the relationship between the analyst community and the banks they cover. In terms of communications, what can directors, either individually or as a group, do to enhance and positively affect that relationship?

Sally Pope Davis: One of the things that I look for is how well the bank markets to the analytical and investment community, because as far as I’m concerned, we are another important constituencyu00e2u20ac”as is the community, as is their customers. Some companies view dealing with the investment community as a necessary evilu00e2u20ac”as opposed to an opportunity. To me, when companies are that defensive, it perhaps reflects how they treat their customers as well. Analysts are a group that requires as much proactive marketing and focus as other constituents, and sometimes bank managements ignore this fact. The analyst’s perspective should be considered in all methods of communication: from the annual report to conference calls. Having accessibility to management sends a signal that the investment community, the company’s stock price and performance, are important to the bank.

David Berry: It is also important for companies to think about their own goals and intentions, to express them clearly, and to be willing to own up if there are problems. Recently, a company I follow had a ton of bad news and yet it was, if anything, more accessible than it had been before. That ultimately builds a certain degree of trust such that, even if there are difficulties in the business, the analyst believes he can rely on these people. Ultimately, it gives the company the benefit of the doubt, which can be very important. There are companies that clam up when they have problems or whose communications simply reflect what they think the Street wants to hear. Unfortunately, the Street is fairly schizophrenic. One day we love value, one day we love growth, one day it’s the Netu00e2u20ac”you never know.

Susan Roth: I find vast differences among companies in terms of making themselves accessible and having great investor relations (IR) staffs who make it easy for you to get into the numbers and understand what’s going on. I have had an accessibility problem with a number of banks that are in the midst of mergers. Some of them have wide-open doors, making it easy to understand the process and how smoothly it is, or is not, going. Others shut their doors, which makes it difficult if the bank has an integration problem down the road and no one’s been given the heads up. Generally, though, I have found managements to be accessible.

What’s more frustrating to me is to find differences in the quality of the IR staffs. I think senior management needs to be aware that the IR staff is the institution’s first line of communication with the Street, and if they are not ready, willing, and accessible, that stock does not get priority in terms of coverage. If you don’t have access, you can’t be as strong an advocate.

Sean Ryan: I’ve also encountered a tremendous disparity in banks’ abilities to communicate their stories effectively. It’s really striking. Some banks have a professional IR staff that is clearly plugged in to what’s going on. Others just as clearly use it as a dumping ground. It’s astonishing to see people with a very limited understanding of what’s going on at their institution trying to interact with investors and analysts.

Davis: Banks should seize opportunities to interact with the Street, because it hones their ability to state their strategy clearly and succinctly. Sometimes you wonder if banks that aren’t visible with the Street perhaps don’t even know their own story well. It is a good exercise to continually sit down with investors or analysts and talk about your business. Also it’s a great source of information for managements to hear about what other companies are doing. Interestingly, I don’t think enough managements ask us questions. I think they should, because we know a lot about the competition and we’re always willing to share our thoughts.

BD: Let’s shift the focus a bit. From your perspective, what is the most important force changing the banking landscape today?

Berry: Consolidation is certainly changing the lives of many bankers and will continue to do so. In a lot of respects, the industry is still

massively underconsolidated compared to other consumer financial businesses, so I think there is more to come.

Then there’s technology. We are really in a world whereu00e2u20ac”this is not exactly new newsu00e2u20ac”banking has changed from a personal, high-touch, open-ended, nonscaleable business to a somewhat impersonal, product-driven, high-tech, 24-by-seven kind of business. This new business model is massively scaleable. So banks now have toll-free call centers and customers using ATM machines, going on the Internet or whatever else. Banking is now a business that almost requires size to succeed. This has driven banks to change their business models, merge, or get larger.

Having said that, there are parts of the business that I don’t think lend themselves to scale at all. Small-market commercial banking is one of them. There is a reason we see lots of new banks springing up in the wake of all the giant mergersu00e2u20ac”because there are customers out there who want more intimate relationships with their banks.

A few things that bank directors have to think about are: What kind of institution do they have? How does it compare against competitors on things such as technology and scalability? Is it appropriately set up to do what you want to do? Should you change? And if you need to change, should you consider consolidation? These are critical issues.

Davis: Managements across many industries are struggling with the issue of technology. Technology is, of course, not foreign to banks. If you scratch a bank, you have technology. But then there’s the Internet. In terms of something new, this is itu00e2u20ac”and excuse this trite phrase, but this is such an important paradigm shift. It’s not clear to me yet how many managements are really focused on it. I think all of them are in some ways, but there aren’t many that are leading with it as a front-and-center issue with the investment community. Of course, banking on the Internet has been one of the slower things to catch onu00e2u20ac”it’s not fun, like buying a book or a CD from Amazon.com. But it can creep up on bankers if they are not ready.

In terms of retail, the strategy becomes very important when you think about branding and how you want to be positioned on the Internet. Technologyu00e2u20ac”particularly the Internetu00e2u20ac”strikes me as a sort of an amorphous, but highly important, issue that bankers and investors have to struggle with. If I were a director, I would encourage my management to give me a clear view of the bank’s Internet strategy and where it is positioned relative to the competition.

Roth: Bigger banks typically enjoy the benefit of a bigger technology budget. And while more is better when it comes to technology and marketing dollars, the process of creating scale, i.e., integrating acquisitions, can interrupt important technology-based strategic initiatives, if resources are taken away and reallocated to integration. To prevent strategic stagnation, banks must establish some sacred cows so that the organization can move forward strategically, even if it comes at the expense of short-term-oriented cost savings. This is increasingly important in terms of Internet strategies. In my view, banks must develop their Internet strategy nowu00e2u20ac”not tomorrow, and certainly not after they’ve integrated their latest acquisition.

BD: Has anyone seen banks that have great Internet strategies?

Roth: I think Wells Fargo has by far one of the best products. Management has taken the Internet unit and made it a sacred cow within the organization. The resources dedicated to that unit have not been touched by the integration of the old Wells Fargo and the old Norwest. So those resources are intact, the strategy is developing, and the customer base is growing.

Berry: Citicorp has handled it the same way. It put it to one side, and e-Citi basically has carte blanche to do whatever it needs to do.

Roth: That’s great. I do wonder, though, if that same forward momentum would be created in the midst of a major integration. This is something that bank managements and directors need to consider.

Berry: I’m not sure this is front and center for the banks that we follow. A lot of what’s in our coverage universe includes smaller, middle-market commercial banks, and while I’m in favor of using technology, at the end of the day, a lot of this business is relationship-drivenu00e2u20ac”the Internet doesn’t play a major role in the relationship.

The Net is a scaleable retail model. I marvel at the lofty valuations that some of the pure-play Internet banks have, and I believe that some very large banks, like Wells Fargo, Citibank, and probably Bank One, have very large Internet banks living inside of them. These companies have the scale, the brand identity, and the customer trust to really scale up a business that, ultimately, boils down to an impersonal “point and click.” There is the view that Internet banks will steal deposits from the traditional banking system, but I think the yield-hungry money in the banking system probably went into mutual funds a long time ago.

Looking at this another way, for years I have felt that bankers who have focused on new distribution strategies, such as call centers, ATMs, or, now, PC and Internet banking, have mistakenly viewed these things as expense-saving measures. I don’t think they appreciated that these developments start to change the whole dynamic of the business. From the consumer’s perspective, the nature of convenience is different. If we fast-forward five years from now and I’m comfortable doing my banking on the computer, I can live in New York City and comfortably bank with Wells Fargo, which doesn’t have a branch within 2,000 miles. Thus, the nature of competition is going to change dramatically.

Ryan: I want to make a point regarding consolidation and technology. I think the single-biggest problem is a destructive infatuation on the part of bank management with consolidation and technology to the detriment of the deal’s execution. Much of consolidation rests on vastly overestimated promises of economies of scale in banking. And while there are some elements of commercial banking that are quite scaleable, on an aggregate basis, there is a mountain of evidence to suggest that most economies of scale are exhausted by the time you get to a few billion dollars in assets.

We often hear that technology is going to spur consolidation. We’ll say that a bank “is just too far behind the technology curve.” But technology is only the symptom. Twenty years ago, being large enough to afford mainframe computing power may have separated the haves from the have-nots in technology. Now we’ve had 20 more years and plummeting costs in computer pricing, such that computer power is effectively free in the sense that banks of every size can afford much more computer power than they know how to use. What they need is the management skill to deploy it.

And though I hold this somewhat cynical view, I think it is borne out in that a lot of consolidation is not driven by economies, or scale, or technological issues, or overcapacity, or any of the other fig leaves that we hear about so often. These are peripheral to what is really driving this activity: the economic incentives offered to buying and selling CEOs. Executive compensation correlates more to asset size than any financial performance metricu00e2u20ac”that’s the incentive for empire builders in this industry. Being a selling bank CEO has been a great gig in the ’90s. People aren’t in line to give that up. You don’t have to work too hard, and there’s lots of money, power, and influence, but the payoff has gone up by a huge magnitude. When you can take home $100 million for selling your bank, there are a lot of hard-charging, type-A personalities who will begrudgingly accept a life of leisure.

Berry: I guess I would quarrel a bit about the issue of whether there are scale economies to be had or not. There are different businesses within banking: Some scale and some don’t. But somehow Chase Manhattan, through a couple of big mergers, has taken its efficiency measures down and, more important, profitability up, pretty dramatically. The merger that Chemical did with Manny Hanny and the one Chase did with Chemical have had a lot to do with that. The entire industry has improved its efficiency over the last several years. I think mergers have had something to do with that. The issue that is frustrating from an investor’s perspective is when deals get done in auction-like situations. Sometimes, as the ultimate winner is putting the final touches on his bid at two o’clock in the morning, he may be persuaded to pay whatever price it takes to win the deal and then justify it with unrealistic cost-cutting promises.

In general, deals that look fully priced when they are announced and whose underlying assumptions seem pretty aggressive are promises that banks live to regret. I think negotiated situations that give rise to smaller premiums or no premium on the day of the announcement have a better chance of succeeding.

Davis: One of the benefits of scale has been the ability to attract outside talent to deepen your management bench and to make acquisitions that enable you to get into the mutual fund business or the investment banking business. Of course a lot of these deals have happened at high prices in auction scenarios at the near-term cost of the shareholders. Frankly, I don’t think we ask ourselves enough about the cost of sitting still. The large and superregional banks that I remember covering 10 years ago that just said, “No, we are not going to make acquisitions,” later found themselves making acquisitions at higher prices than they would have liked, and they are still playing catch-up. Their long-term viability is still somewhat in question because they stood still. I don’t think there has ever been an easy solution.

Berry: I recall a comment in a conversation I had with Frank Cohouet of Mellon Bank about a year after he had done the Dreyfus deal, for which Mellon was severely criticized for overpaying. We were talking about how long it takes to earn back dilution. Frank said, “Sometimes if it’s really strategic, you might take permanent dilution,” which was heresy to Wall Street analysts. But looking at Mellon Bank today and the business mix it has and the valuation the company has achieved, I’d say he made the right move. There’s more to mergers and acquisitions than financial ratios. Ultimately, it’s about strategy.

Ryan: I don’t deny that there are some economies of scale in banking and that they have been a big driver of the efficiency gains in this decade. But I think it’s overblown. If you rank the top 10 banks by asset size and look at their returns on equity, they are exceedingly average. If you rank the top 10 banks by return on equity, none of those banks is terribly large. The trouble is that many banks have put the cart before the horse. Some have grown very large by acquisition, but while they have been doing that, they haven’t taken the time to go back and build a sales culture. Other banks, like Firstar, were quite small and did some heavy lifting to change from a regulatory mentality to a sales-and-service mentality. Once Firstar had that model up and running, it began expanding and doing larger acquisitions. I think this model bodes well for the future. Consolidations could become far more rational, because instead of there being bidding situations being won by the suitor that can spread dilution over the largest base, banks would be empowered with premium multiples that could help them win bidding situations on an accretive basis.

Berry: Size is not a strategy, but size can support a strategy.

BD: What about the elimination of pooling and its effect on consolidation for the next 12 to 24 months?

Roth: The elimination of pooling treatment is likely to create a sense of urgency and, hence, a heightened level of M&A activity. However, a number of those banks that rush to do deals before the pooling window closes will be those banks that investors don’t want to own to begin with. In other words, we prefer to invest in companies where cash-flow-based economic returns, coupled with strategic rationale, dictates the desire to acquire, not accounting treatment.

Ryan: Bingo.

Roth: This goes back to David’s example of Mellon and the dilution that came with its acquisition of Dreyfus. The numbers that we look atu00e2u20ac”reported earnings per shareu00e2u20ac”and the way we value banks is probably wrong. The right way to look at value creation is to examine how cash flow is generated over the long term and how it can be reinvested in the bank and ultimately made available to shareholders over time.

Berry: Exactly.

Roth: Unfortunately, the stock market is used to looking at P/E ratios, and that’s not going to change overnight. But doing away with pooling accounting will force investors to look at real value creation. Some mergers have made sense economically, but a lot of them have not. And the market has been far too willing to look past one-time charges, where banks have blown away shareholders’ capital in billion-dollar chunks at a time, not realizing that were that capital not thrown away on a restructuring charge, it could be reinvested in a productive way. Productive capital deployment drives value; this should be the most critical imperative for bank management today.

Berry: There are sharp distinctions that could be drawn among different bank managers and their understanding of capital and the factors driving shareholder value. Those that act, on the one hand, like “serial diluters,” probably don’t understand what Susan was just talking about. A company like Bank of New York manifestly does. Probably every bank director would do well to go out and buy a basic book on corporate finance.

Davis: To an extent, managements have sold the investment community short with respect to how we look at cash flow. I’ve had a number of managements say that if the investment community would look at cash flow and not just P/E, then this wouldn’t be an issue. But if you go back and look at the Wells Fargo/First Interstate merger, which was done as a purchase and had a huge amount of goodwill, analysts did look at cash earnings. And it wasn’t until the merger didn’t go well that they threw it out the window, but it wasn’t because of earnings.

Berry: In that example, the financial concept was tarnished by the poor operational execution of the merger.

Davis: Exactly. The investment community looks at cash flow for most other sectors. That being said, I think the elimination of pooling will have an impact on behavior, because I’m sure some investment bankers are probably telling managements today that if they sell now, they will get a higher price. And in fact, they might. But overall, I don’t think the accounting change will cause people to enter into transactions that don’t make economic sense or to do transactions that they wouldn’t otherwise do, although they won’t always pay with the discipline that we would like to see.

Berry: One of the funniest things I heard recentlyu00e2u20ac”it was just so honestu00e2u20ac”was during the Fleet/BankBoston merger presentation. A question came from the audience about whether this merger was, in part, driven by the pending changes in the accounting rules regarding pooling. You could tell that [Fleet CEO] Terry Murray hadn’t thought about this at all. He responded, “What deal would have gotten done over the last few years [without pooling of interests accounting]?”

Ryan: I think the change can’t come soon enough. Ultimately, though, I think it won’t have much effect on consolidation; it will just produce more goodwill. However, there will be a number of salutary effects: First, there will be more rational pricing, because purchase accounting makes it more difficult to overpay and to mask the dilutive impact on earnings. Second, banks will no longer have to make the explicit tradeoff between their preference for the accounting treatment of their mergers and repurchasing shares. So you could get more rational capital managment. Finally, it makes earnings more transparent.

Roth: Could we switch gears to talk about an issue that is increasingly importantu00e2u20ac”for better in some cases, for worse in others. That is, bank managments’ absolute fixation on fee incomeu00e2u20ac”as if fee income is the Holy Grail.

Davis: I agree, that’s one of my pet peeves, too.

Roth: Not all fee income is necessarily equal. So-called “fee income” is being created through things like securitization gainsu00e2u20ac”which is not fee income, it’s spread income. Quite honestly, I care a lot more about how a bank is building its revenue-generating capacity rather than whether the revenue is from fee income or spread income. There are only a few components of fee income that are truly more valuable, and they are more valuable than spread revenues because of their sustainability.

Berry: There is the annuity-like nature of fee income and also the lower capital intensity.

Roth: Yes, there are fee components that are valuable. I’m willing to place a higher valuation on Bank of New York because of its fee-generating securities-processing businesses. By that same token, I am not willing to pay for KeyCorp’s securitization gains. Banks’ credit management difficulties in the ’80s and early ’90s have convinced bank managements that fee income is better than spread income. But they are missing the point that generating sustainable revenue growth should be at the top of a bank’s priority list.

Davis: This all points to the importance of the chief financial officer being a frequent spokesman for the company about its position on accounting issues, acquisition pricing, and capital allocations. And this even circles back to your first question about how companies can improve their investor communications: Banks sometimes underestimate how important the CFO is in articulating the company’s position. In terms of communication, bank directors should make having a professional, high-quality CFO a high priority.

Roth: One of the biggest benefits of consolidation is that banks have an opportunity to upgrade their management talent. The scarce resource in the banking industry is intellectual capital. I don’t think all banks are poorly managed, but look at Chase and what has come out of the two megamergers that it has entered into. Today that organization is as good as it is because it pruned its management and ended up with the best of breed from all three banks that were combined.

Ryan: And it’s not necessarily that one person is so much better than another. In some respects, it’s just addition by subtraction. Consolidation has culled a disproportionate share of the idiots in this industry. There are still plenty of weaker managements around, but in aggregate, it’s gotten better just by taking out the less qualified.

Berry: One caution: When Wall Street anoints a company as having “one of the best management teams in banking,” you probably should sell the stock. No one is as good as we say they are. It may be possible that people are as bad as we say they are, but we are all human.

Ryan: If I could say one thing to any management, going back to what we were saying about communication, it is that it should not try to tell the Street what it wants to hear. So many times we hear a banker say, “We are going to buy back shares, because that’s what you all want, right?” They shouldn’t do it just because they think that’s what analysts are clamoring for at the moment. Banks should have their own strategy to add value to the corporation. If they are going to conduct management by plebiscite, then they don’t need to pay the CEO millions of dollars a year. By the same token, I respect managements that are willing to tell investors and analysts: “We don’t care what you want to hear. We are not going to do everything you’d like us to do this quarter, next quarter, or maybe for the next year. Why? Because we are willing to let our short-term results suffer to ensure the long-run prosperity of the institution.” That philosophy is really at cross currents with the standard quarterly focus on making the numbers, whereby if 79 cents is the estimate, you better put up 79 centsu00e2u20ac”78 cents isn’t good enough. Managements have to be brave enough to risk that.

Berry: At times the phrase “capital management” becomes code for “buying back stock.” On one hand, this is a marvelous development in bankingu00e2u20ac”that we actually give the capital back. But I think it’s become reduced to “buybacks are good.” In the same way, there are companies that have legitimate growth opportunities in their businesses and that are properly deploying their capital, yet some analysts and investors will complain because they are not buying back stock. In some ways I think the fault lies with us who reduce it down to very simple levels because buybacks are in vogue.

To reinforce what Sean said, companies must think through their strategy. They need to do that before they communicate with us so they won’t be pushed around by our fads and fashions. Walter Shipley at Chase is a good example. He got a lot of criticism a few years ago because his costs were running up faster than people wanted them to. In plain English he said, “What are you complaining about? If I were not making the investments today, then you would be complaining about where the growth is in a few years.” Today, those investors are not complaining.

Davis: One thing to remember about capital and its usage is that banks don’t deploy the balance sheets the same way they used to. The capital markets have disintermediated away from them, and it is not economic for banks to hold the same type of assets on the balance sheet as they did 20 years ago. It all goes back to the bank’s capital allocation. But everything else being equal, especially with banks doing more and more securitizations and moving into new businesses that don’t require as much capital, if they can’t come up with something better to invest in, then why not return the capital to the shareholder? There is still too much capital supporting the slower growth prospects in the banking industry relative to what’s available in the capital markets. Thus, there is going to be a long-term return of capital to shareholders, which is a positive. But it will only last as long as the economy holds up and the excess capital is there. Of course it’s up to each management to determine its strategy and seize its opportunities.

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