In the aftermath of Wells Fargo & Co.'s successful bid to buy First Interstate Bancorp, banks are moving toward a new way of presenting themselves to investors: cash-flow analysis.
In presenting its plan to Wall Street, Wells urged investors evaluating the deal to look at cash flow rather than reported earnings. The latter don't reflect the income available for dividends and stock repurchases, because of the way merger expenses are accounted for.
Although Wells' argument was controversial among analysts, its share price soared, and the value of its bid rose accordingly.
"It was a watershed event," said Arthur Loomis, president of Northeast Capital and Advisory Inc., Albany, N.Y. "Wells Fargo said goodwill amortization, which is a noncash event, would not be damaging for their franchise."
Now signs of cash-flow analysis have turned up in the first-quarter earning reports of several banks involved in recent mergers, including First Union Corp., Mellon Bank Corp., and BankAmerica Corp.
"First Union mentioned net income per common share before merger and amortization expenses in their press release," said Carole S. Berger, a Salomon Brothers bank analyst who has written a report on the cash-flow phenomenon. "You would not have seen that in their last year's first- quarter earnings."
As the name suggests, cash-flow analysis is a method of accounting for the amount of cash flowing through a company. Traditionally, this analysis was used by industrial companies with balance sheets heavy in noncash items and goodwill, which are not included in cash flow.
But as mergers and acquisitions flourished in the banking community, the method has taken on new significance. Indeed, the market appears to be focusing more on cash flow than on reported earnings.
When Ms. Berger studied the price-earnings ratios and price-to-cash-flow ratios of the 50 banks Salomon follows, she found that cash flow correlated better to their stock prices.
"It really appears that the market equates companies on a cash-flow basis," said Ms. Berger. "Cash flow is a much better tool to valuation than price-earnings ratios in respect to the overall marketplace."
Last fall, Wells argued that its cash flow would be $17.65 per share in 1996, after the merger with First Interstate. Reported earnings would be only $16.90, it said.
Cash flow tends to be higher because this accounting treatment allows amortization of chargeoffs and merger expenses, explained Ms. Berger.
"When you amortize this expense, it becomes available to grow your business," said Ms. Berger. "And you can pay your dividends and do share repurchases."
However, Richard Bove, analyst at Raymond James & Associates Inc., said he finds little merit in cash-flow analysis. Banks are simply using it "to clean up problems," he said.
"Investors hate acquisitions because it adds goodwill and a tremendous amount of dilution, which causes the price of the acquiring bank's stock to go down," said Mr. Bove. "So banks must convince investors that they are still doing well."
Mr. Bove added that some banks may be trying to make earnings look better than they really are, using an overly liberal version of cash-flow analysis.
In disclosing their cash flow, Wells and the other banks have not accounted for loan-loss provisions, agreed Ms. Berger. "They want to add back the amortization of goodwill without right-sizing for reserves provisions," she said. "And that is not cash flow; that number is cash earnings."
