This quarter's American Banker Analyst Round Table focused on the problems at Bank One Corp., on whether bank earnings can grow at a 15% annual rate, and on which stocks are the stars and which the dogs. The participants were Ronald Mandle of Sanford C. Bernstein & Co., Katrina Blecher of Brown Brothers Harriman & Co., Sean Ryan of Bear, Stearns & Co., Frank Suozzo of Alliance Capital Management LP, and American Banker staff.
As you know, Bank One Corp.'s stock dropped dramatically a few days ago when the company surprised investors, saying its fourth-quarter and 1999 earnings would fall below expectations. It attributed the problems primarily to its First USA credit card unit. Where does it go from here?RONALD MANDLE: There is some possibility that Bank One will sell First USA, or even the whole company. The company needs to beef up management of First USA because the person who is running it now - Bill Boardman - doesn't have much direct credit card operational experience. At a minimum, they would need to hire people from the outside to run that part of the business.
Who did the pushing, Bank One or First USA?MANDLE: You have to blame both. Richard [Vague, who headed First USA] took his eye off the ball because of the other responsibilities that he had been given. [He was put in charge of Wingspan, Bank One's cyberbank venture.] Also, senior management pushed too hard, seeking 15% earnings growth. The responsibility goes all the way to the top.
SEAN RYAN: Clearly it's a management issue. There is wariness on the part of senior management to make changes and look at avenues to harvest value. When the Bank One/First USA transaction was announced, we heard about the miraculous changes First USA would achieve. But the synergies remained elusive. I agree with Ron that there is high probability that First USA will be sold, or the entire company will be.
How vulnerable is John McCoy [Bank One's CEO]?RYAN: You've got a board with a lot of people from First Chicago [Bank One merged with First Chicago NBD Corp. in October 1998.] Verne Istock [former CEO of First Chicago and now the No. 2 executive at Bank One] has run and sold two very large banks. We are in one of the best economic periods in American history, and Bank One has really stagnated through that entire period. It doesn't take a big leap of the imagination to conclude that there is a substantial increase in pressure from the board.
FRANK SUOZZO: I tend to agree with a lot of the comments that have been made. Yet Bank One stock at current levels is attractive. If someone wanted to make an aggressive bid for Bank One today, it would be put into play and there'd be very low probability that it would maintain its independence.
There was pressure on Dick Vague to deliver earning results, partly because of the promises he made when the First USA deal was put together and partly because of his apparent early success. But it was hard to continue delivering those results. On one hand, Dick Vague felt he had to deliver, and felt he could continue to deliver, and on the other hand it was almost a requirement from management that he deliver 20% earnings.
There is going to be somewhat of a management vacuum as a result of Dick Vague's departure. And I'm sure other First USA people will leave because he really was a leader. At the same time, I think there is a lot of talent on board, and I think they can fix the First USA problems.
What are the problems?SUOZZO: The main problem is they priced themselves out of the market. They got too far ahead of themselves in trying to raise the profitability of the business while the industry yields were tending to come down. My feeling is they became noncompetitive on a price basis. This is a $70 billion portfolio that's completely up for grabs. I think MBNA is going to gain share. I think Capital One and Providian will gain share. And I think that Citi will gain share.
There's a lot of franchise value in the company. The problem is a management struggle.
By management struggle, do you mean between Mr. Istock and Mr. McCoy?SUOZZO: Yes. Basically, it was a merger of equals where John McCoy was clearly running the company, and his baby, First USA - the perceived driver of the company - seems to have imploded. McCoy has been sent to fix it.
The signal of a struggle was when Istock was given all the operating units earlier this month, and McCoy was sent to fix this unit. If it can't be fixed, Istock assumes more and more control. I'm sure Verne Istock does not want to sell the company. I think that's the issue.
MANDLE: Verne doesn't want it or John doesn't want it?
SUOZZO: I don't believe Verne does.
MANDLE: Verne has sold two companies already.
SUOZZO: I know. But I don't believe he wants the company to leave Chicago.
MANDLE: That's a potential problem.
Do you think the company would be better off with Mr. Istock than with Mr. McCoy?SUOZZO: The company needs the operating discipline that Verne has been successful in bringing to the two different companies that he has owned.
KATRINA BLECHER: It appears that I'm more negative on Bank One at this point than my fellow panelists. I don't believe that the operating model for a credit card company is that complicated. You determine underwriting criteria, you drop mail, you build a portfolio. The industry learned years ago that the teaser-rate approach doesn't work because of high attrition rates. Having used teaser rates to grow their portfolio, First USA now had to get their high attrition rates down to manageable levels. That is going to be very difficult.
Now they are trying to correct this by shifting marketing dollars from direct mail to the international marketplace. That makes a lot of sense, I give them credit for that.
But they're also going to do home-equity lending on a nationwide basis. That's just full of pitfalls. What do they know about repossessions and loan value and dealing with appraisals outside of their territory? Their philosophy for getting back on their feet, I don't think is sound. That's why I'm a little more negative going out.
I think, though, that there's a very small probability, though, - less than 5% - that this company will be sold.
Why?BLECHER: Because of personalities. Neither McCoy nor Istock wants to sell. And they do control their destiny. History has shown how difficult it is to force an institution to be sold.
You don't see McCoy losing his job over this?BLECHER: He didn't lose it over the derivatives, he didn't lose it over other problems. He's young, and I don't see him losing his job.
We spoke about Bank One seeking 15% earnings growth each year. It seems many companies are shooting for that rate. Is it possible to achieve?MANDLE: The difficulty of sustaining 15% earnings growth is starting to be recognized. For example, Bank of America, has set its revenue target for 7%-9% growth. Probably for the industry as a whole the low end of that range is realistic. Perhaps Bank of America can do a little better than that because some of its branch-based businesses are in parts of the country that should grow faster than average - Florida, Texas, and California. They can get double-digit earnings per share growth by improving their efficiency ratio and buying up their own stock. For the average bank, I think Bank of America is talking realistically.
If this perception becomes widespread among investors, what will it mean for bank stocks? MANDLE: It will be good for bank stocks if managements start talking that way. Bank stocks are priced right now as if there were less growth than even 10%. Banks now are being valued at minimal growth, zero, 1% or 2%, or a bit more.
SUOZZO: You have to look company by company. In aggregate, financial services earnings won't grow much more than a high single-digit number, or a mid-to-high single-digit number.
Chase talks about 10% revenue growth, or revenue growth accelerating to 10%. Why do they talk about that? Because their business mix is shifting significantly to what has been faster growth businesses: global capital markets activity and the private equity business, where they have invested pretty heavily. Chase is a company that's going to be able to deliver something close to 15% EPS growth because of good revenue growth and capital capacity to buy back several percentage points of their shares every year.
BLECHER: I would be suspect of any company that thought they would have 15% growth in revenue. Yet the banks are an incredibly inexpensive group at this point. I think these stocks deserve a higher valuation. I think people will see that. I think they are going to be beaten down unfairly because of things that don't really relate as much to growth as to things like interest rate expectations.
Do you think the financial modernization bill will make any difference?SUOZZO: Marginally. It will make the financial system a little bit more efficient. We already had financial modernization through loopholes, and looking at J.P. Morgan or Citi, I really think there's not going to be a significant change.
MANDLE: I think we will see a number of acquisitions, particularly of asset managers that are disguised as life insurance companies. That would probably be the most common type of deal. I don't expect to see many acquisitions by banks of property and casualty insurance companies.
RYAN: The act will have only a marginal impact on efficiency, even though the regulatory effect is a repeal of Glass-Steagall. The real winners from this bill are investment bankers. I call it the "Investment Banker Full Employment Act of 1999."
MANDLE: So the investment bankers can double dip.
BLECHER: I don't think we are yet going into the phase of divestiture. But we will definitely get there.
Which banks do you like out there, and which ones belong in the dumpster?MANDLE: Wells Fargo is doing well, approaching their mergers at a very leisurely pace. Investors may be upset about that, but Wells is making sure it does things right when it does them. They seem to be successfully blending two pretty different cultures [following Norwest's takeover of Wells Fargo & Co. last year. The combined company goes under the Wells' name.]. Of course, a lot of its success already has been recognized in the stock.
RYAN: Centura is a bank that's doing the right things. It's a $10 billion bank in Rocky Mount, N.C. They are the first bank in the country that got electronic data interchange. They have a much more sophisticated understanding of profitability and of their product mix and channel usage patterns, and what their products cost to manufacture and distribute. These items are elemental for probably every business on the planet, except banking.
Another is First Tennessee. Because its business mix is so unique, it deflects attention away from how good they are. They've been the alpha bank, going where the rest of industry follows several years later. They built up their fee businesses in the '70s, they built up their data warehouse in the '80s. Over the coming five to 10 years they will distinguish themselves by dramatically elevating the profile of the human resources function inside the bank. While so many of their competitors are out there talking about the need to be big and the need to have the newest, latest technology, they are out there trying to get adequate technology into the hands of well-trained people. So I think they are putting the horse before the cart.
Who has not acted smart?MANDLE: I'm still not sure that PNC has a clear strategy. They are going off in a lot of different directions.
RYAN: I won't single anyone out because I have gotten myself into enough hot water, but there are some large, superregional banks with extensive footprints and a history of technology projects that turn out to be real money pits. A lot of banks, because they have the scale, attempt to buy their way to a competitive advantage through technology. We have yet to see any proof that that produces a lasting competitive advantage.
Bank One has spent billions of dollars on branches and now it seems to be saying the branches are worthless, that everything will be on the Internet.RYAN: If branches are worthless, there are still people out there paying money for them. Why doesn't Bank One sell them?
SUOZZO: I think they have Bank One.com supporting their branch infrastructure as an Internet bank within a traditional bank. Internet Wingspan is their stand-alone Internet bank that is designed to attract new customers. If there's going to be a market for that, they want to be there. So, the two are not mutually exclusive.
Chase, too, is really thinking about where the industry is going, how technology is changing the industry and how they can play off their core strengths.
Do you think Chase needs a big investment bank?MANDLE: They already are a big investment bank.
So you think they don't need more.SUOZZO: I think they would love to have a much bigger equity platform. I don't think they are going to get there with H&Q [Hambrecht & Quist]. But I think they don't feel a sense of urgency, which may be a little bit different mind-set than they would have had a couple of years ago.
As to other companies, Associates First is a company I love, as is MBNA. MBNA has stuck to its knitting, the high-end of the credit card market or the platinum market. They've leveraged the incredible affinity group network that they have. Their earnings should grow 25% this year and 25% next year.
And the ones you don't like?SUOZZO: The regional banks are less appealing from an investment standpoint because they don't have the same kind of growth characteristics. I'm thinking in terms of midsize and small regional banks that are less competitive. KeyCorp has been an abysmal stock. They have not been able to fix on a consistent strategy and they don't seem to believe their core markets can give them the growth they want.
BLECHER: The companies I like very much are Wells Fargo, MBNA, and Mellon. I love MBNA. It's a wonderfully run organization.
I agree that Associates First Capital is a great company, their business model is excellent. They can manage both the consumer and the commercial sides so they can move in and out of markets. Plus they have a true international presence that none of my regional banks have, and they've been able to do that successfully.
What should we look for in the fourth quarter?MANDLE: Y2K will be the first thing that people will look at in terms of what it means for capital markets-related activity, M&A, equity underwriting, and trading.
BLECHER: Is it going to be a yawn?
MANDLE: Six months ago the word was that on Sept. 30 we'd go off a cliff and the capital markets would shut down. Now it's almost the middle of November and I think we're just starting to see reduction in activity. So October apparently was fairly normal. The normal shut down would be Dec. 15th, so we're probably going to shut down two to four weeks earlier than usual.
This is not a fourth-quarter question, but does anybody have any sense that there is going to be any kind of a technology catastrophe related to Y2K or is that completely off the boards at this time?MANDLE: We don't know until the lights come on or don't come on on Jan. 1. But I think the likelihood of catastophe has diminished.
