Analysts at American Banker's quarterly roundtable said they expect consolidation in the financial services industry to continue in new and exciting directions, but they expressed concern that buyers may not be doing their homework. Bank stock prices have reached unprecedented heights, they agreed, but they disagreed on whether they are likely to go higher still. The participants were David Berry of Keefe, Bruyette & Woods Inc., Richard X. Bove of Raymond James & Associates, Nancy A. Bush of Ryan, Beck & Co., and Yun Jae Chung of Bessemer Trust Co.
Do you think consolidation will continue at the pace of the first half?
YUN JAE CHUNG: I don't think that the pace of the first half of this year can continue. But while I thought the year-2000 issue was going to ease the level of activity, I'm not so sure anymore. I think most banks are in a position that if there is a deal that is strategically important enough, I don't think they'd let that stand in the way.
I also think there will be some very major cross-border deals in the not-too-distant future. And I think you'll see more intra-industry deals with financial services. It could be a European insurance company buying a major broker in the U.S.
RICHARD BOVE: I think banks buying other banks in the United States will continue to occur. But that's not where the real excitement is. It's intra- industry - between banks, insurance companies, securities firms. Also, I think as the euro becomes accepted in Europe-as you know it starts Jan. 1 and will be phased in over a two-year period-you're going to see consolidation occurring in European banks. And I think European and American banks are going to merge.
Of greatest interest to me is what the insurance companies are going to do, because basically the insurance companies, for the first time since the Depression, have more capital than revenue. I'm not aware of any industry in that position. They're going to have to spend that capital somewhere. And I think they're going to spend it buying banks and brokerages.
DAVID BERRY: I guess it depends on your definition of "exciting," but if you were a Firstar shareholder, it was very exciting to get a 40% premium for your stock recently. I think there is still room for deal activity this year. There are some major players who haven't moved yet. I don't know that they're all going to be mergers of equals, like so many lately. But it's easy to forget that we've seen an awful lot of old-fashioned premium takeouts at the same time: Charter One-Albank, Roslyn-T R Financial.
As for year-2000, that's very hard to judge. It hasn't stopped deals from happening yet.
We see people like First Union chief Edward Crutchfield and Washington Mutual chief Kerry Killinger saying they aren't willing to make deals at a premium these days. How much credibility do you give this?
NANCY BUSH: I think Ed Crutchfield is looking for a national presence, so of course he's going to look for a large merger of equals. We can't foresee right now any smaller deal that would offer what he wants.
I also think something interesting is going on. As quarters roll on, we see the banks that are clearly behind others on earnings becoming more distinct each quarter. For example, PNC and KeyCorp. It's getting harder for some of these clearly lagging big institutions to continue making the argument that they're better off by themselves. I don't think year-2000 is an impediment at all.
I do think Crutchfield is sincere in saying he'd like to do a big (merger of equals). But if the right premium deal presents itself, then who knows?
Is the due diligence adequate in all these mergers?
BOVE: Basically what happens is a trophy franchise comes onto the market and the buyer says, "I must have that franchise." And the guy who has the greatest amount of financial resources generally gets it. I doubt that any serious due diligence is being done on these mergers.
CHUNG: Given the economic backdrop, you really don't worry about trying to find every issue at the bank. I do think there is less rigorous focus on it.
BOVE: The fact that we as investors let them get away with what they're doing amazes me. For example, you have Republic Security (Financial Corp., West Palm Beach, Fla.), selling at 20 times earnings, buying First Palm Beach (Bancorp., West Palm Beach), which sells at 33 times. And First Palm Beach is double Republic Security's size.
Now they hold a conference call and say this is going to be an accretive merger. How, mathematically, is that possible? It's because they write off enough book value to make it accretive.
So, the investor says, they just wrote off two dollars in book value and they get 3 cents more in earnings per share. It may take 66 years to get that book value back, but great, this is an accretive merger.
The same thing happens at the First Union-CoreStates level, at the NationsBank level. As long as investors let these banks chew up book value, banks will get away with just incredibly bad deals from a shareholder's standpoint.
BUSH: If you look at Norwest-Wells Fargo, you have to ask if they did enough due diligence to really know the depth of customer disaffection with Wells.
BOVE: Mergers are exciting, but the fact is bank stocks are not performing well. They have not been all year. Investors have started to look beyond saying, "This company should be sold out and at such-and-such a multiple," and say, "Gee, this company might not generate higher earnings."
BERRY: A lot of small banks were run up right at the end of last year on the wake of the takeover speculation surrounding the Barnett and CoreStates deals, to probably just silly levels.
What about cross-selling of products and services after these mergers? Is there evidence this will really work in the future for banks?
BERRY: The notion is: "They've got a lot of customers, we've got a lot of customers, and we can sell a lot of each other's stuff, can't we?" I think that is certainly worthy of skepticism.
Citigroup is the obvious best case, since cross-selling is largely what they have talked about. And yet, I think the number of opportunities in this mega-organization is almost endless. It should be just a layup to do it. Travelers actually has gotten Smith Barney mutual funds through as annuity products to Travelers Life.
BOVE: First Union is showing that you can cross-sell too. But I think you want to develop internally a product strategy rather than just agglomerate.
BUSH: Well, the great rationale behind buying mortgage servicing portfolios was you could cross-sell all these other things and it's never worked yet.
To switch topics, are credit risks rising? And is the industry ready for this?
BOVE: They are rising and the industry is making itself vulnerable because of pricing strategies.
You know that a certain amount of loans will go bad-historically it's been 1%. You're supposed to price against potential risks, and right now banks are not doing that.
They're pricing too aggressively. And there will be another recession. I would think it's going to be sooner rather than later. By 1999, I think the economy is going to be wheezing. Whether it drops into a soft landing or drops into a recession, I'm not sure.
BERRY: Richard Tilghman, the CEO of Crestar, commented this year that when a problem comes around again, it will have a real estate flavor. Which, given what's happened to real estate values over the last couple of years, sounds right. It's not to say there's a problem today, but it just sounds right.
You're talking about an asset class that, given the long lead times involved, is subject to boom-bust pricing and where a lot of lending is done against collateral values, which are based on cash flows, which may or may not materialize.
BOVE: I expect the losses to come from subprime financing companies. People know about the losses some of these companies have taken, but what they haven't focused on is that most lending to subprime companies comes from banks.
And you've got to look at these mortgage REITs. They're a real pressure point, particularly if the yield curve continues to flatten, particularly if we run into a recession. If that occurs, the residual value in these things will go away, and there will be a lot of banks holding the bag.
There's a lot of talk now that Chase Manhattan Corp. has to do a merger or acquisition. Do you agree?
BERRY: To do what they want in corporate banking, they need a full range of capabilities. And they're nowhere near that in equity capability today.
At some point they'll have to buy that capability, because it's inconceivable that you just could build it. My view is, at some time they'll do a deal with some major investment banking firm, but Chase has to go through a couple of years of evolution to be perceived by that investment banking firm as an attractive partner.
How many years more?
BERRY: Well, it's not like things are going badly at Chase. I don't think it's super-urgent.
BOVE: I see no pressing need why Chase has to do anything but build out its franchise. My complaint with First Union is those guys never built out their franchise, they keep running around trying to do additional mergers.
BERRY: The fact is that you made more money on Chase stock over the last couple of years than with First Union. I think with Chase the (circle of) partners we're talking about is very small-Merrill Lynch, Morgan Stanley, and Goldman Sachs. None of those companies is likely to go away real soon, so I don't think there's risk you're going to lose a partner. There've been press accounts that (Chase chief) Walter Shipley has had talks - and I'm sure he has. But I don't think if it takes another year or two to pull it off that Chase is somehow damaged.
BUSH: There are banks that are going to survive as they are, at least for a while. Look at BankBoston. People say, what are they going to do? Probably nothing for a while.
BOVE: There is this notion that banks have to merge immediately. But companies like Fleet or BankBoston don't really have to merge. Why do they have to? They're running businesses that are profitable, growing. And even with my growing view of where things are going the next 12 or 18 months, they're still going to make huge amounts of money. Their business is not going away. They don't have to do anything at this point.
Give us your favorite stocks.
CHUNG: I still like Chase. They do have earnings volatility, but I accept that as I would from a broker. And Chase, I think, is more stable than a Merrill Lynch or J.P. Morgan.
And I like the NationsBank-BankAmerica combination. I think that has terrific synergies ahead. I don't think we have to look for revenue enhancements, because I think there are plenty of opportunities in one or two years for cost savings in the back office.
BOVE: We've been progressively downgrading the sector since last October or November. The only two stocks left I'm willing to buy are NationsBank and First Union. And that is because these companies are leading the changes in the industry and will benefit by them. But we're down on the sector because we think the cyclical economic circumstances will wear down earnings.
The only reason we don't say "sell" is that we're adding $2.5 trillion in financial assets to U.S. household wealth every year. And if you think money is going to pour into the stock market and interest rates continue to fall, it is really hard to sell anything.
We've been very aggressive on Countrywide, Fannie Mae, Freddie Mac, and a company called Resource Bancshares Mortgage Group (in Columbia, S.C.). These stocks are flying because there's a strong fundamental driver-the refinancing boom.
BERRY: We like Cullen/Frost Bankers in San Antonio. Solid double-digit revenue growth story, still massively underloaned for a bank these days. Imperial Bank of California is another. They traded at 15 times earnings last year, have enjoyed explosive growth.
Also Colonial Bank in Alabama, trading for less than 14 times cash earnings for next year. TCF Financial in Minneapolis, trading for 13 times next year earnings.
Just to mention one big name that hasn't been mentioned: The Banc One- First Chicago (merger of equals) is trading at 13 times next year's numbers. It should enjoy superior growth beyond 1999 as they get the deal together. It's one of the better values among the large caps.
BUSH: I still recommend BankBoston, which I think is one of the few banks that has been relentlessly driven to become better. I like the management team, among the most honest in the industry.
I agree about Banc One. I think we're about to see a low quarter due to the First Commerce acquisition. But I think if you buy a stock based on fundamentals, then this is just an incredibly cheap, beaten up, neglected, and doubted stock. I think it would help if CEO John McCoy stops making noises about the next deal, and he may have finally gotten the message.
We're also recommending Bank of New York. We think they'll come back for Mellon later in the year, probably at a lower price. And Bankers Trust's acquisitions of Alex. Brown and Natwest have worked out phenomenally well. Among the small caps, we like Hubco and Commerce Bancorp in New Jersey-the bank that really invented customer service.