Mellon Bank Corp. is facing higher hurdles than Wall Street expected in the acquisition of Dreyfus Corp., which has been hit by asset shrinkage and fee revenue declines. But officers insist the deal will work.
Shareholders of the two companies are scheduled to vote today on the proposed merger, which is the largest of its kind ever seen in the banking industry.
Mellon, a $37 billion-asset banking company based in Pittsburgh, last December agreed to buy New York-based Dreyfus, the nation's sixth-largest mutual fund company. The stock swap deal is valued at $1.8 billion.
At year end, Dreyfus was either managing or administering $77.6 billion of mutual fund assets. But Dreyfus has lost muscle since the merger pact was inked.
Hit by investor withdrawals and market declines, Dreyfus suffered a $6.8 billion -- or nearly 9% -- decline in fund assets through midyear. First-half operating income fell 13.5% from the prior year.
Analysts say the slowdown further clouds the near-term performance outlook for Mellon. They say the deal initially will dilute Mellon's earnings per share by roughly 19% -- more than twice original estimates.
To be sure, Dreyfus is containing the damage and stands to regain some lost ground.
Mellon vice chairman W. Keith Smith said, "We do not see any change in the value of the deal."
While Mellon still enjoys support from many quarters on Wall Street, even advocates acknowledge that the situation with Dreyfus sends a message about fee-based businesses.
Enterprises such as mutual funds, credit card operations, and mortgage banking often were portrayed as inherently stable by the many banks chasing fee revenues in recent years. But the downturn at Dreyfus illustrates that such activities are not immune from volatility.
"Acquirers have to understand that the trend lines don't always go straight up," said Chicago Corp. analyst James M. Schutz, who counts himself among the staunch supporters of the Mellon-Dreyfus transaction.
Mellon has obtained required regulatory clearances and hopes to close the deal within weeks. As part of the merger, Mellon will take an after-tax restructuring charge of $85 million.
Supporters such as Mr. Schutz contend that Mellon, which already manages or administers $750 billion of trust and mutual fund assets, possesses the expertise and technological infrastructure needed to tweak performance at Dreyfus.
Most importantly, advocates say, the Dreyfus deal moves Mellon into the position of deriving more than 50% of revenues from nonlending sources.
With the propulsion of mighty fee engines, they say, Mellon can lessen dependence on risky loans and enhance consistency of earnings.
"For patient investors, Mellon remains an appealing special story in banking," said Dean Wilier banking analyst Anthony R. Davis, who maintains a buy rating on the company.
At the same time, uncertainties about near-term results at Dreyfus are prompting some analysts to trim earnings estimates for Mellon, leaving the company's stock vulnerable to further weakness.
At about 130% of book value, or 8.7 times earnings over the past four quarters, Mellon's stock already trades at a pronounced discount to the issues of some other superregional banking companies.
"The terms of the Dreyfus merger are painful for current shareholders because Mellon will give away a third of the ownership in order to acquire a company that will contribute only 15% to net income," said Frank DeSantis, an analyst with Donaldson, Lufkin & Jenrette, in a recent report.
Dreyfus lugged competitors in developing equity funds, forfeiting some growth opportunities.
And when the Federal Reserve System began hiking rates this year, institutional investors stampeded out of certain of its money market and fixed-income funds.
First-half operating income, which excludes securities gains, interest expense, and taxes, totaled $63.2 million at Dreyfus, down $9.9 million from the year-ago period.
Mellon's Mr. Smith conceded that some of the payoff on the Dreyfus acquisition "may be delayed" until investors fully regain appetites for money market and bond funds. But he expressed confidence that demand will resurface. And he said Mellon won't sit idle in the meantime.
Saying additional equity products "clearly are needed" at Dreyfus, Mr. Smith said Mellon would draw on its own expertise, and that of newly acquired Boston Co., to round out the product menu. "We have to make sure Dreyfus has competitive offerings in each major investment category," he said.
Although some analysts predict Mellon will expand and accelerate expense cuts at Dreyfus, Mr. Smith all but ruled that out, saying Mellon "won't resort to wholesale layoffs."
Mellon is standing by projections calling for a $30 million annual expense reduction in the first 12 months following the merger, Mr. Smith said, with the total rising to $60 million in the second year.
Respectively, these reductions equal 13.4% and 26.8% of annualized operating expenses at Dreyfus in the first six months of 1994.
In Securities and Exchange Commission filings, however,. Mellon said the savings would be partially offset by expenditures needed to support anticipated growth.
A case can be made that the terms of the Dreyfus purchase are exaggerated because the mutual fund company is overcapitalized.
Deducting short-term investments from the purchase price, and deducting corresponding after-tax interest and dividend income from earnings, Mellon told analysts, the deal's value falls from more than 18 times earnings to roughly 15 times earnings.
But Mellon apparently lacks a quick way to return any excess capital held by Dreyfus to shareholders, at least temporarily limiting its ability to exploit balance sheet restructuring opportunities.
Contradicting the whispers of some analysts, Mr. Smith said accounting conventions will bar Mellon from repurchasing shares until two years after the Dreyfus acquisition.
Frank V. Cahouet, Mellon's chairman, chief executive and president, has publicly stated that the company will work off some excess capital by raising its dividend.
But this is a slow process. And Mr. Smith cautioned that Mellon could not go overboard with pay-out hikes.
Facing limits on overhead cuts and short-term balance sheet restructuring, Mellon will have to ratchet up product development and marketing at Dreyfus, experts say, while waiting for more favorable market conditions.
In the short hm, that puts analysts in the position of explaining to investors why Mellon's earnings are veering south of projections.
But Mr. Smith says Wall Street should lengthen its time horizon when evaluating a deal of this magnitude.
"We are here to create value over the long term," said Mr. Smith. "Dreyfus is almost unsurpassed in name recognition within the mutual fund industry, and we continue to have real confidence in what we are buying."
That view is not without support on Wall Street, especially among analysts who believe potential damage from the Dreyfus transaction is already factored into Mellon's trading value.
"The deal is dilutive to shareholders, but that is already reflected in the stock price," said George A. Bicher, a Kidder Peabody analyst who maintains a "strong buy" rating on Mellon. "Longer term, the Dreyfus merger will prove valuable in diversifying Mellon's revenue mix."
But even Mellon's cheerleaders say the company has bitten off as much as it can chew.
After leaping from the May 1993 acquisition of Boston Co., to the December 1993 acquisition of AFCO Credit Corp., to the planned third-quarter 1994 purchase of Dreyfus Corp., "Mellon should be focused on developing the properties already on its plate," said Mr. Bicher.
Barring "some highly unusual circumstance," said Mr. Bicher, "I would be very surprised to see Mellon pursuing further acquisitions anytime soon."