The pace of bank consolidation was the focus of the American Banker quarterly roundtable discussion among Wall Street's bank analysts. Industry consolidation is far from over, but some players are assuming different roles, analysts said, with some that were once considered acquirers now viewed as takeout targets.
Participants in the session last month were Carole S. Berger of Berger Jackson Capital Management, New York; Sean J. Ryan of Bear, Stearns & Co., New York; Thomas Finucane, John Hancock Advisers, Boston; and Ronald I. Mandle, Sanford C. Bernstein & Co., New York.
What did you think of HSBC Holdings' plans to acquire Republic New York Corp?
BERGER: The fact that Republic's stock fell was not really relevant, considering that the stock had been up over the previous couple of weeks. There was huge anticipation that there would be a deal. There's been rumors for months. The stock reacted negatively to the news because it had reached the takeover price, plain and simple.
RYAN: This deal also shows that consolidation is alive and well, and so are merger premiums. We've seen three of the 25 biggest U.S. banks agree to be acquired: Fleet Financial Group Inc. is buying BankBoston Corp. for a negligible premium, but (St. Louis-based) Mercantile Bancorp would be paid a 30% premium by Firstar Corp.
These deals are not as headline-grabbing as the acquisitions of the second quarter of '98, to be sure, but it's just one more sign that the merger market is heating up.
FINUCANE: The HSBC share price didn't react too negatively in the London market, which is a good sign.
Some European banks have not been very successful in the United States. National Westminster Bancorp, for example, was a dismal failure. Some foreign acquirers tend to take a pretty dim view of expansion within the United States. But perhaps the HSBC-Republic deal will make the ABN-Amros of the world less gun-shy about acquisitions.
Is domestic merger activity going to pick up?
MANDLE: It has already started to pick up as banks are getting over the Y2K hump. We'll probably see a bit of a rush to get deals done in 2000 in advance of the end of pooling accounting. Banks like pooling accounting, even though investors like cash earnings.
Still, over three to five years we probably will have gotten the same amount of consolidation anyway.
A lot of consolidation is going to occur because of the 10-percent limit on domestic deposits. That is the (regulatory) ceiling, given human nature, but it has in some ways become the target for acquisition-minded bankers.
The consolidation wave has quite a ways to go.
BERGER: The environment today is ripe for mergers. When you have a huge valuation gap between the large acquirers and the acquirees, it gives buyers the ability to pay a premium without too much dilution. So the pricing environment is pretty good.
Other underlying trends remain intact. Revenue growth in the industry is still decelerating, so there is the need to either acquire businesses that are faster-growing or business combinations with significant synergies. The object is to do deals which improve profitability and/or earnings growth prospects.
Do you think banks are paying too much for their acquisitions?
BERGER: Most of the deals over the last year were disappointing. With the exception of (the new) Wells Fargo & Co., almost every other earnings estimate has been cut from what management originally projected on their deals.
That was a huge disappointment to the Street. Going forward, managements need to be a lot more careful about what they project.
Firstar took an extremely conservative approach in its proposed acquisition of Mercantile. They should have absolutely no problems hitting their target on earnings.
Banks should now be able to structure transactions that are accretive to the buyer and create value to the shareholders of both companies, as opposed to a year ago, where people stretched in order to pay the premiums.
Do you think premiums will go down?
RYAN: I don't think so. It's all well and good for the heads of the very large traditional acquirers to say they're no longer interested in buying banks or paying high premium for banks, but the empirical evidence says that when mid-cap bank A decides to listen to offers, these guys drop whatever they're doing and work overtime to put a deal on the table without bothering with such extraneous issues as due diligence.
MANDLE: And then they reverse-engineer it to make sure that the numbers come out in a way so that Wall Street is happy.
RYAN: Right. Bankers say "we need the deal to be nondilutive." That means we need what level of cost savings.
FINUCANE: Forty-eight percent?
RYAN: Done!
John McCoy, the head of Bank One Corp., said his bank may never have to buy another because of the Internet. Is technology moving that fast?
MANDLE: It's very unlikely that they're going to do a major acquisition in the near term-certainly not this year and probably not next year.
They're going to make a bigger and faster push than most major banks into the Internet domain to see if the strategy really works. Although to make it work, they'll need some type of physical presence beyond the fourteen states that they're in. This presence might come by way of a tie- in with a national retailer. The importance of a physical presence is shown by the fact that Schwab signs up 60% to 70% of its new accounts in its offices, not on-line. Only if the Internet strategy fails will Bank One consider another major merger.
Was Compass Bancshares right to reject Amsouth Bancorp's bid?
FINUCANE: I think that deal makes a lot of sense. There are a lot of possible cost saves in Alabama and then there also is overlap in Florida. And then you have these other growth states, Texas and Arizona. You could leverage the bigger combined franchise in those higher growth states.
Can Compass return shareholder value independently?
FINUCANE: It isn't that they can't do it, but I have my doubts.
They now have a very far-flung franchise after going into Arizona with the 1998 acquisition in Tucson and then buying the divestitures from Norwest and Wells Fargo. That's a new market for them.
They've been in Texas for a couple of years and they bought on the cheap. But I don't see that being as strong an operation as it could be. So therefore, I will watch Arizona carefully to see how quickly it adds meaningfully to earnings.
BERGER: An important question is whether the landscape is changing so quickly that some companies will find it hard to compete.
There are some plain-vanilla franchises that really risk becoming wasting assets, because they don't have engines of revenue and earnings growth, and may therefore not even be attractive to an acquirer.
I look at Summit Bancorp and I don't know who the buyer is. PNC Bank Corp. might take a swing at them, but PNC's chairman, Thomas O'Brien, said he's not going to buy a plain-vanilla bank.
That's a big issue. Compass fits into the plain-vanilla bank category.
RYAN: Technology, however, is the great equalizer. And as the cost of computing power continues to plummet, it levels the industry and allows the Compasses of the world to do what a Bank of America can do. Certainly a lot of franchises will stagnate and become wasted assets, but not because of any systemic flaw or hurdle.
If anything it's because there are not that many competent managements around.
Are we going to have even bigger financial firms stalking around five years from now? What does that do for, say, Centura and Compass and those banks?
RYAN: From a competitive standpoint, it will do them a lot of good, because we're probably on the 10th round of trying to build successful financial services conglomerates. It means full employment for investment bankers, who make a lot of fees putting these beasts together. And then, as with American Express and Shearson, and as with Sears and Dean Witter, we'll make a lot of money taking them apart eight or 10 years hence.
What do you think of Federal Reserve Chairman Alan Greenspan's comments about the market being overvalued and the prospect of inflation?
RYAN: I was really surprised by the reaction to the speech. I happened to be there in the room, and it didn't seem nearly as sensational as what I heard on the news that night. Yes, he talked about inflation, but really in a very long-term sense. I didn't perceive any short-term warning or sense of alarm in his comments.
MANDLE: Inflation is the enemy of high price-earnings ratios. But the likelihood that we're going to see rapid acceleration of inflation in the near term is low.
Were there any trends that you picked up in first-quarter results?
BERGER: There has been a significant increase in junk bond defaults. And yet we're not seeing any material increases in credit problems on the commercial side or the credit portfolio. Historically, they were much more closely related. I view this divergence positively. It shows that banks have dramatically improved their risk management.
Back for a moment to the question of future banking, how would a bank go about building an Internet business?
MANDLE: Well, if you're John McCoy of Bank One, you start with First USA, which last year added 300,000 accounts on the Internet, and hopes to do much better than that this year.
Citibank has spent hundreds of millions of dollars trying to answer that same question, probably with less success than McCoy has had. And Wells Fargo has over a million on-line customers that are not really primarily Internet-they weren't primarily gained through the Internet.
I think it's still a very open question, but banks are certainly trying. They really have to try to push ahead with this because there are a lot of other nonbanks who are active and likely to be more successful, starting with Charles Schwab Corp.
BERGER: Every manager of a large bank has to seriously consider what the Internet means for his delivery mechanisms-on the corporate side as well as on the consumer side.
Most of the time when you hear about on-line banking, you're talking about the consumer side, but there's a lot of areas of cash management and a lot of back-office stuff that can be easily transferred to the Internet at a much lower cost.
When you look at the amount of retail sales that are done on-line and the growth of the Internet, chief executives must try to develop some Internet strategy. I read that half of everybody who goes out and buys a car goes to the Internet to do research. This is no longer just sort of a toy of a few people. This is rapidly becoming a viable delivery channel.
Is Schwab a major competitor of banks?
MANDLE: Yes, because they're committed to the Internet strategy.
They've already shown that they're willing to accept cannibalization. They went through such a period 18 months ago, as they completely reinvented themselves, moving from a discount broker to an Internet broker. And they had a decline in revenues, earnings, and the stock price for a period.
The new Schwab company model has since gone into the stratosphere. And adding banking functions to their existing investing functions would not be all that difficult. But there are not that many in banking who are willing or even thinking about cannibalizing and reinventing themselves that way.
RYAN: That's really the key hurdle banks have to overcome, and they've historically always failed. Maybe this time it will be different. But as the co-CEO of Schwab said at a conference last year, if you don't cannibalize yourself, somebody else will do it for you.
Is margin compression the biggest challenge facing banks right now?
MANDLE: Margin compression will be less this year than we thought originally. Cost control will be a bigger challenge, while margin pressure will be less this year than we thought originally because of the steeper yield curve. The biggest challenge will be keeping the balance between revenue and growth rates and making sure that you have a positive operating leverage.
FINUCANE: There is loan pricing and credit quality. We're seeing a degradation in both pricing terms and conditions in commercial and industrial (loans) and commercial real estate lending.
Banks benefited somewhat in the fall from the closure of the capital markets-things improved for them in terms of pricing and structure.
Still, loan quality is the function of the business cycle and I feel that this is headed back the other way now. You don't find out who's been swimming naked until the tide goes out, but at some point we'll find out that there are some skinny-dippers out there.
BERGER: One thing that's been bothering me is falling loss- reserve ratios of banks.
The further we go into this extended recovery and the further reserve ratios go on the downside, the worse the earnings impact is going to be when the economy does turn down.
I'm not a believer of the theory that there aren't economic cycles anymore. The lower the reserve ratios are at the start of a credit cycle, (that is, the end of the expansion), the worse the cycle. It creates the credit crunch. It makes a whole economic environment worse, not just earnings at the banks, but their willingness to lend.
MANDLE: Reserves are down compared to where they were at the beginning of the decade. Still, they're not that low from a long-term perspective.
BERGER: But there's a barbell distribution within the group. You have a bunch of guys who are at one end and a whole bunch at the other. Even though the average looks O.K., I'm not sure that it's fairly representative.
Let's hear everyone's favorite and least favorite stock picks.
BERGER: My favorites are Mellon Bank Corp. and Bank of New York. They're high-multiple stocks and represent significant values.
Mellon has reallocated capital to faster-growing, higher-return businesses. Bank of New York has good growth and lower risk. They've exited from the high-risk businesses. They're one of the better revenue-generators in the industry and they've also kept their operating leverage in a positive mode. They've never done a dilutive acquisition.
My least favorite bank stock is Union Planters. Their earnings have repeatedly disappointed and they are not too responsive to the Street.
RYAN: The only large-cap bank I can get really excited about right now is Wells Fargo, even though it's had a good run here. It's the only very large bank that really does have a very strong sales culture, and so is positioned to be a long-run winner in the industry.
The Wells Fargo-Norwest merger is the one deal from 1998 in which the market is actually overestimating the execution risk.
First Union is my favorite takeover pick because it is a great franchise whose management has destroyed its credibility.
My favorite midcap bank is Centura Banks in North Carolina. Pound for pound it is one of the best-managed banks in the industry. It trades at a substantial premium to the group, which is justified by the performance of management. Hibernia Corp. is also a favorite, but it is down because of their well-publicized asset-quality problems. The market's reaction has been very disproportionate to the magnitude of the problem.
FINUCANE: Commerce Bancshares, Kansas City, has strong fundamentals. It can raise revenues and has good credit discipline. They have heavy inside ownership and lots of excess capital. No one ever names Commerce as a takeover candidate, but you can never tell.
Among stocks that are ahead of themselves, I pick PNC. It's had more than its fair share of a good run.
MANDLE: I like three of the merger stocks-Bank of America Corp., Bank One, and Wells Fargo. They all look as if their steep quarterly ramp-up in earnings per share this year will set the stage for superior growth next year as well. I would much prefer Bank of New York and Mellon to Northern Trust Corp. and State Street on a price basis.
