Eyes on the Market

arlier this year, just as Wall Street was hinting at the market’s subsequent downward spiral, Bank Director probed three leading analysts about the banking industry’s strengths and weaknesses in the near future and the state of industry consolidation. Sitting in on our annual Bank Analyst Forum were Nancy A. Bush, senior vice president, Ryan, Beck & Co.; Joseph C. Duwan, senior vice president, Keefe, Bruyette & Woods; and Kenneth F. Puglisi, principal, equity research, Sandler O’Neill & Partners, L.P.

Bank Director: Can you all comment on the recent market declines and their effect on bank valuations?

NANCY BUSH: Well, it’s hard to see how the economy gets better than it has been. I think there is going to be a worsening for the banks I follow. But it’s not going to be dramatic. It’s just going to be one of those slow erosions, but it’s going to scare investors nonetheless.

KENNETH PUGLISI: Of course, one factor that’s held up bank stock prices over the last several years has been consolidation. When you think back on some of the largest deals this year, there wasn’t much excitement from the viewpoint of the speculators, because the deals were MOEs where no premium was paid.

BD: If we do move into a recession, as some are predicting, are banks in general stronger this time around since they have gotten into more diversified businesses that aren’t as dependent on loan performance?

BUSH: Yes, but a lot of those sources are tied to the financial markets, such as venture capital, brokerage, and asset management. Banks have a lot of market-sensitive revenue sources today. What we’ll find when markets start going down is exactly where those sensitivities are embedded.

PUGLISI: I don’t think there’s any question that there is more of an emphasis today than 10 years ago on fee revenues. Banks are less susceptible to net interest income erosion than they were 10 years agou00e2u20ac”not just because more of their income comes from fees, but also because asset liability management has gotten so much better. Very few banks take large interest rate risks. So, they’re better insulated from that standpoint as well.

BUSH: They are fundamentally different this time than they were during the last down cycle. Of course, they will make mistakes, and there will be a downturn in earnings, but we are not going to see banks going out of business. We are not looking at solvency issues now, we are looking at earnings issues.

PUGLISI: And the capital ratios are quite high. Banks have the opposite kind of capital problem today, they’ve got too much capital. That provides quite a cushion as well.

Joseph DUWAN: Banks can manage their balance sheets more effectively today. They realize they don’t necessarily have to portfolio all of their loans. They can securitize; they can look at other financing mechanisms. However, core deposit growth is a challenge for the industry. Many smaller banks have not made the transition to other business lines quite as well as the larger banks have in terms of diversification of revenue sources. For many banks, a high percentage of earnings continues to be driven by the core deposit base, which is not growing (partly because of the changing demographics of depositors, in that they are becoming more investor oriented). Those that make the transition to other revenue sources will compete much more effectively.

PUGLISI: On the other hand, although the deposit pie isn’t growing, some smaller banks seem to be having very little trouble taking market share away from the bigger banks. I hear it time and time again when I visit these smaller banks. They are eating the lunch of companies like KeyCorp and First Union. The customer is fed up with the impersonal service they are getting. So smaller banks are able to grow the deposit base. Some of them actually have done a good job of getting fee revenue, too. For example, Commerce Bancorp in Cherry Hill, N.J. is the largest insurance agent in metropolitan Philadelphiau00e2u20ac”and the largest insurance agent in the State of Delaware. So you don’t have to be huge to generate fee revenue.

BD: Your example seems to uphold the general notion that there will be two distinct classes of profitable banks going forward: the very large and very small.

PUGLISI: We were talking earlier about the fact that there is no large bank left in Philadelphia. There’s a prime example of a market where the smaller banks have been able to pick up market share. Look at what’s happened to the larger competitors. A middle-market bank like Progress Financial in Blue Bell, Pa. is doing a good job picking up loans and building market share.

BD: Turning to the merger market, everything we’ve seen during the last couple of years has been driven by great performance and high stock values, fueled by a strong economy. What does the recent volatility in stocks portend for M&A? Will we see panic selling?

BUSH: I think that’s a good question, because I think there are some very large banks that are having revenue difficulties and, at some point, they may decide to give up the ghost. The very small banks are going to be fine. Their fortunes are not going to change that much. It’s the guys stuck in the middle, some of the mid-caps, that are going to have to make up their mindsu00e2u20ac”fastu00e2u20ac”about whether to sell now. Probably Richard Tilghman selling out Crestar to SunTrust was one of those examples. They were one of the great holdouts. I think there will be more of those.

DUWAN: High stock prices drive acquisition activity. Frequently, the board or CEO looks at the pricing of the last deal in deciding the bank’s sale price. We are generally talking about stock swaps, and if the buyer’s currency is depressed, there is more earnings dilution for a given price, which makes it more difficult to do a deal. With a decrease in valuations, there’s an adjustment period that needs to take place as sellers’ adjust to the maketplace. We could be in for an adjustment period in the near term. However, in the long run, the consolidation pressures are intense. Buyers have a business model that is scalable in terms of realizing cost savings, and, clearly, one of the primary reasons for consolidation is to take costs out of the system, and these buyers have honed their acquisition and integration skills.

PUGLISI: As for price declines that we’ve seen recently, even though the large cap stocks are down, small caps are down much more, and if that situation continues, I think it might actually foster some deals. Whenever the spread widens between the P/Es of the buyers and sellers, buyers can easily offer a premium over the market.

I think it’s kind of ironic that we talk about takeover multiples being so high at 23x earnings, but really it’s all an exchange ratio game. For years, deal multiples hovered right around 14x-15x for an acquisition. Now they are up around 23x, but overall market multiples expanded even farther. Consequently, a deal that looks expensive today, might actually be transacted for fewer shares than had it happened two or three years ago.

I don’t know how many directors think about that when they consider the price they are getting, but they really ought to be focused on it. They should be asking: How much of this surviving company are we going to own at the end of the deal? That’s what’s important. Stock prices are going to go up and downu00e2u20ac”unless all of the seller’s shareholders sell their stock on day one, and they’re probably notu00e2u20ac”what they should be interested in is percentage of ownership. I don’t know how many directors think in those terms. I suspect most just think about absolute price.

BD: Which banks might you choose as good potential merger partners in this more cautious market?

BUSH: One that would make sense is Fleet/PNC, but if PNC thinks it can continue to exist, then it will. While it may lose market share and revenues may drag, they continue to exist. That’s the deal I keep hoping I’ll wake up on a Monday morning and hear about.

DUWAN: Would that one be well received?

BUSH: Well, it would solve a lot of Terry Murray’s problems, so I think it would be well received on that end. I’m not too sure about PNC’s shareholder base. PNC had a mortgage company for ages, but they’ve not been a great grower. However, PNC’s growing asset management business would be very attractive for Fleet. So I believe that deal makes a lot of sense. Will it happen? Probably not.

DUWAN: The types of companies that become sellers, frequently, are those that stall in terms of revenue growth. Also there’s still a high degree of correlation between the CEO’s age and his pending retirement and a sale. Succession issues are an important factor, something the board of directors needs to pay attention to. These are probably the two most common factors leading to a sale, along with not performing up to par. Essentially it’s a relative gameu00e2u20ac”are you going to outgrow the potential buyer’s earnings per share? Directors don’t always see that. Absolute performance has been at record levels for most companies, but there is likely to be a higher degree of relative earnings growth separation among banks these days.

BUSH: I think bank CEOs and directors have a remarkable ability to tell themselves that everything is fine, even when the world is telling them it’s not.

PUGLISI: Any company that’s developed a good market share within a heavily consolidated market has a certain scarcity value to their stock. There are simply fewer and fewer of them. As for trying to pick who is going to be taken out, I’ve pretty much come to the conclusion that the best approach is to just own a basket of them, because trying to figure out who specifically is going to go next is a low percentage bet. The companies that are going to be attractive are companies with good deposit market share because, as Joe mentioned, deposit growth is a real challenge, and sometimes you have to buy it.

BD: Joe brought up management succession as a factor driving some deals. Obviously, only one CEO can really rise to the top, and rarely does a true partnership exist. Can you comment on some of the deals where management succession played a key role in the deal’s overall success?

BUSH: In most cases, I don’t think there are any surprises. You pretty much know who’s going to come out on top. As for the MOEs, they seem to have mostly evolved with a non-executive chairman and a CEO and no president. They’ve all been generally structured one way.

BD: Is that an effective structure, or just a necessary one?

BUSH: A necessary structure. You have to give the CEO a couple of years to play a part in the integration, so he can go out with some honor.

DUWAN: It’s true there’s a lot more than just the exchange ratio in a deal. These are the so-called “social issues” in terms of management positions. You can even see other factors entering into the package, such as headquarters location and board composition. And there is, as Nancy mentioned, the figurehead position of the chairman, which is frequently a role for the non-CEO executive.

BUSH: Sometimes that may turn out to be significant. If you look at the BankBoston/BayBanks deal in 1996, [BayBanks Chairman] Bill Crozier was ready to retire. He stayed there and he had very helpful suggestions… he had a real role. I think we never know in some of these, whether their role is going to be real or not.

PUGLISI: But clearly, management succession, from the analyst’s standpoint, is very important to these deals, because execution risk is so high. It’s very difficult after the deal is done to determine how successful the integration was because you can’t unscramble the omelet to figure out what really happened. We need to have a lot of confidence in the person who is going to make sure that that transaction is completed successfully. Sometimes it’s not the CEO, frequently another senior executive is responsible for making sure that that integration takes place properly.

BUSH: I think one thing that the world is waiting for is Norwest/Wells Fargo. I mean the Wells Fargo/First Interstate model is pretty definitively discredited at this point, but there has been no signal about what is going to happen with the combined Wells/Norwest management, and there’s a lot of concern.

DUWAN: Management credibility in terms of integration is critical to Wall Street’s reaction to a merger. There are only a handful of companies where the management has this credibility: U.S. Bancorp, First Union, National City, and Fifth Third are a few.

PUGLISI: On the smaller scale we’ve got North Fork Bancorp., right here in New York, with one of the lowest efficiency ratios in the industry, and they’ve done a wonderful integration job with just about every one of their transactions. The thing that’s kind of unique about them is, not only do they drive down costs, but they actually spend some money to make sure that they don’t lose customers, so the revenue side actually grows. Another example, is the merger of equals between MidAm and Citizens Bancshares. Citizens has one of the lowest efficiency ratios in the industry and Marty Adams, who runs that company, is going to be in charge of making sure that the integration goes according to plan. So, in situations like that, you have to have a lot of confidence that it’s going to be done appropriately.

DUWAN: And that’s one of the problems with having mergers of equals. Many investors assume the worst: that the tough decisions won’t be made, which is one of the reasons that many of these MOE transactions haven’t been as well received as the companies would have liked.

BD: Do you almost feel like you need to wait until the time when the “real” CEO takes over completely to give your nod to a merger’s success?

BUSH: I think you know, going in, the personality of the two top guys and how it’s going to go.

DUWAN: There needs to be a clear leader in place at the beginning. What you are not seeing anymore, which is good news, is a lame-duck CEO, where he would agree to relinquish the CEO role after a period of time. KeyCorp comes to mind.

BUSH: The poster child on how not to do a deal!

PUGLISI: The Comerica/Manufactures National MOE is probably another example of a deal where no one was clearly in charge of getting that integration done. It was too much of a team effort. They’ve learned some real lessons over the last couple of years.

BUSH: That’s one of the concerns about Banc One’s deal right now. I mean the First Chicago NBD deal should be a lay-up, but there are a lot of concerns about whether Banc One can do all they say they will do.

BD: Why is that?

BUSH: Well, they haven’t managed their own franchise so well up to this point, so there is a legitimate concern about whether the biggest deal they’ve ever done is going to go smoothly.

BD: If you were talking to a board of directors right now that wanted to build its franchise by acquisition, what would be on your analyst’s checklist for that board to discuss before jumping into the fray?

DUWAN: One thing that comes to mind is operational risk and systems integration. You cannot underestimate the potential problems that could result just in terms of the back-office systems and customer disruptions, which was essentially the Wells Fargo/First Interstate problem. This would be fairly high on my list, along with credit quality.

PUGLISI: Also Year 2000 issues.

BD: Do you think we’ll see an M&A slowdown because of year 2000 concerns?

BUSH: I don’t think it will be an impediment to a deal where both sides really want to make it happen. Unless the regulators say they’re in such poor shape…and [the regulators] may scotch a deal, somewhere along the line, for that reason.

PUGLISI: We’re hearing some managements say they don’t want to deal with the year 2000 issue and a consolidation at the same time. On the other hand, a lot of small banks outsource their data processing, or most of it anyway, so I don’t know how big of an issue it really is. And it may cause an acceleration if there are small banks that don’t outsource and they face a very expensive software upgrade. That may very well lead them over the edge, and into the arms of a bigger bank.

BD: Changing course for a moment, a lot of companies are scurrying to tap into the Internet channel. On the banking side it’s been mostly a defensive strategy so far, but are there some banks using the Web that you think will make a real splash?

PUGLISI: I think it’s just evolving technology at this point, another distribution method, and one that’s in its infancy. I think the expectations for it right now are just a little too high.

BUSH: And the security issue is still there. And whether it’s actually licked or not, it’s not solved in the minds of consumers.

DUWAN: But retail banking is changing. I can certainly see the convenience of not necessarily having to walk into a branch and deal with a teller. Being able to bank when you would like to is my definition of convenience. I use a bill paying service and find that to be convenient.

BUSH: There are a lot of people that use BankBoston’s Internet PC product. Their Homelink is a simple system and very well regarded. Of course, it’s not that big a deal for me to sit down and write a check. Plus, you have that feeling of greater control if you are writing the check and putting it in the mailbox.

DUWAN: Few banks are making money on their online banking at this point. It’s really a customer retention strategy.

PUGLISI: It could also level the playing field somewhat. I’m not a technology expert, but my sense of it is that it’s not that expensive for a bank to set up an Internet facility so they can compete against Citicorp or First Union or whomever their competition may be.

DUWAN: So this could be the great equalizer between smaller banks where they can access off-the-shelf technology. There’s still quite a debate out there whether size and technology are linked.

BUSH: That’s been one of the great arguments for doing these huge deals.

PUGLISI: I think what you really find is that those banks that have kept up with technology all along, almost regardless of their size, that have invested in technology every year to make sure that they aren’t getting too far behind the curve, are in very good shape, competitively.

BD: One more question in closing. From the board of director’s perspective, what’s the most insidious threat to banking today?

DUWAN: Complacency.

BUSH: Yes, I agree. Also, though, these megadeals are not always healthy from a customer-retention standpoint. I think one of the questions boards of directors have to ask is: How many customers have we lost? Is this an ongoing trend? How do we get them back? Can we get them back? We could end up with a consolidated industry that everybody hates. It will be very interesting to watch the customers’ reaction to NationsBank/Barnett when the name of the bank finally changes. How many people are actually going to leave? I’m worried that banks are becoming less relevant to the lives of their customers, even as they are getting bigger.

PUGLISI: I think another threat might be banks not being adequately compensated for the credit risk they are taking. You know, we’ve been through eight years of economic expansion, and anybody can look like a brilliant underwriter at this stage of the economic cycle. At the same time, I keep hearing bank after bank cry the blues about how thin spreads have gotten. They are not getting enough spread and eventually it’s going to come back to haunt them, because we are going to have loan losses and thin spreads at the same time.

DUWAN: I agree with Nancy, keeping the customer focus is critical. Many of these companies are going through a lot of organizational changes. Many large banks have changed their structure to a line-of-business focus, and that’s one of the reasons many smaller banks have been successful in being able to steal customers away from larger banks. Sometimes the customer focus is lost. There is a risk that companies can become too product-focused or technology focused, and lose focus on the customer’s needs.

BUSH: I think it’s going to be very interesting to see if Norwest can, in acquiring Wells Fargo’s disaffected customer base, actually be able to bring customers back by taking the Wells Fargo name, to convince them that “things are different.” Probably nobody has a greater customer-service focus and product focus than does Norwest. Are they going to be able to transfer that to a franchise that’s already pretty much been stripped out? That will be a great experiment.