Wall Street has a hard time believing that merger-related cost savings can overcome earnings dilution. But a quick fix may come from changing the way banks measure efficiency.
The near-term benefits of mergers are typically evaluated on the basis of absolute reductions in recurring noninterest expenses, such as wages and rent.
But studying such reductions in isolation distorts the cost savings analysis, since changes in overhead often are accompanied by changes in fee revenues, and by changes in total assets.
For example, branch closings can drive customers -- and fee income -- into the arms of a competitor. In this case, expense reductions are offset to some degree by revenue reductions.
In the other direction, fee gains from an acquisition may well lead to increased noninterest expenses.
A More Accurate Gauge
For example, merging companies can often market products to each other's customers, but only after incurring marketing and operational expenses. The benefits of increased fee income do not show up in a straightforward analysis of merger-related cost savings. However, they do show up in transition costs.
A more-accurate way of gauging mergers is to look at net operating expenses, or outlays not offset by accompanying fee revenues. Net operating expense -- defined as recurring non-interest expense less noninterest income -- takes into account a merger's effect on both noninterest expense and noninterest income levels.
This figure can be expressed as a percentage of average total assets, giving a clearer picture of overall efficiency.
Good News for 1991 Acquires
Employing this diagnostic technique, a recent study by SNL Securities reveals that sizable in-market acquisitions can produce significant cost savings, even in the short term.
That's good news for the parade of institutions that launched major in-market mergers in 1991. The list includes BankAmerica Corp.'s takeover of Security Pacific Corp.; Chemical Banking Corp.'s acquisition of Manufacturers Hanover Trust; Comerica Inc.'s merger with Manufacturers National Corp., and Security Corp.'s gobbling up of Ameritrust Corp.
Those transactions rank among the largest in banking history.
Skepticism Hurts Stock
But they have been viewed skeptically. Episodes of delayed cost savings have undermined the perception that acquirers can realize substantial cost savings through an in-market merger.
And that skepticism has taken its toll. Since July 1991, the SNL Bank Stock Index has outperformed three of the four institutions created by those megamergers. Only Chemical bucked the trend.
Compared with a 63% rise in the SNL Index between July 1, 1991, and Dec. 2, 1993, Comerica's stock rose 46%, Society's 39%, and BankAmerica's 24%. Chemical's stock climbed 83%.
If the market exacted these penalties based on prior merger results, then it may have gone overboard. There are two precedents suggesting that's the case.
Noticeable Cost Savings
When examined in the proper light, the most prominent in-market acquisitions of the 1980s yielded noticeable cost savings for the acquirers. Those deals are Wells Fargo & Co.s merger with Crocker National Corp.; and Bank of New York Co.'s acquisition of Irving Bank Corp.
In each instance, the acquirer's ratio of net operating expenses to average assets declined from the period spanning the calendar year before deal completion to the calendar year after completion.
Bank of New York slashed its net operating expenses to 1.06% of average assets, a reduction of 42 basis points. Wells Fargo cut its ratio by 25 basis points to 2.14% of average assets.
The results aren't s lustrous when measured by traditional methods.
Treading Water So Far
Excluding fee revenues from the calculations, Bank of New York reduced its noninterest expense by a lesser 34 basis points, to 2.69% of average assets, and Wells Fargo cut its ratio by a lesser 15 basis points, to 3.21%.
The measurement disparity may well be part of the problem affecting the 1991 in-market megamergers.
A quick look at the pre-merger and post-merger noninterest expense levels of those acquirers shows that most have either treaded water or seen an increase in their noninterest expense levels.
Not until yearend can these four transactions be measured in the same way as the two 1980s deals, whose results were based on the last full calendar year before mergers and the first full calendar year following mergers.
More Favorable Light
But it appears likely that the four 1991 mergers will appear in a more favorable light once results become available.
In the SNL study of the Bank of New York and Wells Fargo takeovers, results were stripped of nonrecurring items such as gains on sales of securities and subsidiaries, restructuring charges, and expenses on foreclose properties.
Net operating expenses were expressed as a percentage of average assets. This adjusts results for changes in the merged entities' pro-forma size.
Wells and Bank of New York took different routes to early success in the consolidation game. The Wells Fargo merger exemplifies the savings bonanza most often associated with in-market megamergers, where the acquirer promises to purge overlapping branches and consolidate back-office functions.
Operating Expenses Dropped
Wells Fargo reduced its proforma noninterest expense base by about $240 million (once restructuring, other real estate owned, and amortization expenses are backed out), while holding its noninterest income steady at about $480 million.
The result was a drop in the company's net operating expenses, from almost $1.2 billion in 1985 to just under $950 million in 1987, producing a 42 basis point improvement in its ratio of net operating expenses to average assets.
While Bank of New York enjoyed reductions in its expense base after the Irving acquisition, it also saw an increase in noninterest income.
The company boosted its noninterest income by $83 million, thanks to Irving's strong trust operation, and it trimmed noninterest expense by almost $84 million. That generated a whopping 42 basis point improvement in its ratio of net operating expenses to average assets.
A major caveat on this analysis is that cost savings don't guarantee a merger's success. An acquirer may save substantially and still come out behind if the purchase price was too high.
Questions of deal pricing aside, the megamergers that stole the spotlight in 1991 appear, at least in the early stages, to take after Bank of New York. For the most part, these mergers brought together in-market competitors with expertise in different areas, allowing for the possibility of both cost savings and revenue enhancements.
Challenge of Demystification
If investors look at noninterest expense levels alone, however, they are unlikely to recognize the overall benefits of a merger, as reflected in net operating expenses.
Only transactions like Wells Fargo's -- producing sizable cuts in noninterest expenses while holding fee revenues fairly constant -- would enjoy market support.
Bank managers not similarly positioned are left with the challenge of demystifying the cost-savings process.
Mr. Dillon is senior editor of Bank Mergers & Acquisitions, a publication of SNL Securities, Charlottesville, Va.
