Facing pressure to make acquisitions pay off quickly, bankers have grown skilled at targeting cost savings to offset premiums paid in mergers. But as acquirers increasingly focus on out-of-market targets, experts say that expense reductions may become less important than forecasting and delivering revenue growth.
At First Manhattan Consulting Group, merger integration experts warn that banks risk cannibalizing revenue opportunities if they are too aggressive in cutting costs. At the same time, they say that banks which understand how to use technology to segment their customers will have greater skill in accurately forecasting revenue potential for mergers.
This is something that Lawrence A. Willis, an executive vice president, and Robert Zizka, managing vice president, know very well. Their New York- based firm has handled some of the industry's biggest integration assignments, including the marriage of Chemical Banking Corp. and Manufacturers Hanover Corp.
The two spoke about the progress of the industry toward delivering the results that shareholders demand. They also talked about the next phase in mergers, in which more emphasis would be placed on revenue growth.
Here is what they had to say:
Q.: What are the most common mistakes that bankers can make in the integration process?
ZIZKA: The biggest mistake is not defining, as quickly as possible, the organization structure of the new entity and the principles according to which decisions will be made.
A lack of clarity can temporarily paralyze an organization's decision- making process. The other major mistake is losing sight of "business as usual" and possible revenue growth opportunities by focusing exclusively on the expense side.
WILLIS: I think that comment carries over to the technology side. Some institutions focus too much on the totality of their technological options.
The cost of that extended analysis and the complexity of the resulting technology architecture delay the ability to move forward with actual operational integration. You end up giving up a lot in cost savings and also delaying your ability to pull things together so you can focus on the market.
Those institutions that have created an acquisition-integration infrastructure before going into the merger end up winning because of the time saved. If you can speed up the assimilation of a $15 billion acquiree by two months, the increment to the net present value of the merger runs about $28 million; if you can save six months, the net present value gain comes to $85 million.
Q.: Is it safe to assume that the post-merger integration is planned today even before a deal is announced?
ZIZKA: Successful acquirers have reasonably detailed integration plans before the deals are finalized. They have to in order to identify feasible savings and thus compute realistic acquisition premiums.
In the case of Chemical-Manny Hanny, there was a very detailed understanding of what was going to happen before the deal was ever consummated.
WILLIS: For most mergers of equals or large acquisitions, both parties will have their own views on where shareholder value is going to be created. They understand, with reasonable clarity, which branches they will be able to close. They understand how much cost they will be able to take out and where there is an opportunity to create revenue.
Q.: Are banks delivering the kind of expense reductions investors and analysts expect?
ZIZKA: Expense savings are always an important part of a deal, particularly an in-market one, because every dollar of expense savings yields an infinite ROE, meaning there is no capital required to cut expenses. By contrast, you still need capital to grow revenue.
Unfortunately, banks have at times gotten themselves into a difficult box. They will say the key piece of the deal is cost savings, and that they are going to save x-hundreds of millions of dollars.
But as they bring the two institutions together, they may find that they are able to reinvigorate revenue growth in some businesses.
In the case of Chemical-MHT, the ability to achieve a stronger debt rating created new strengths in rating-dependent businesses, and that led to new revenue opportunities.
In other words, banks can start out concentrating on specific savings targets and then find that their new revenue opportunities require increased spending, which interferes with the attainment of the aggregate target. As a result, they are now becoming more careful about articulating overall targets for both expense savings and revenue growth. Instead, some will carefully define revenue and expense tradeoffs by line of business.
Q.: Are you implying that banks have been too focused on cost savings at the expense of revenue growth?
WILLIS: Expense savings, properly analyzed, are more accurately predictable than revenue gains. You can control how much fat you pare. Revenue enhancement opportunities are a little more problematic. You can't control customers. You can't force them to buy. You can certainly try to take advantage of product synergies and capabilities. But it is much riskier to base an acquisition bid on something not totally under your control.
Q.: Does that have to change?
WILLIS: Clearly, as we move forward, the revenue opportunity will become the driving factor in the acquisition analysis. We are going to see more out-of-market acquisitions.
These are motivated much less by cost savings and much more by revenue gains, including the ability to cross-sell when one merger partner is active in product lines not being featured by the other.
ZIZKA: In an in-market deal, one can normally cut about 35% of the smaller institution's expense base, so the expense piece is clearly the dominant factor. In a contiguous-market deal, you might find yourself saving only 25%, and an out-of-market deal might save only 10%-15%. In some out-of-market deals, the revenue benefits can exceed the expense savings. If you have unique skills in middle market lending or in credit card origination, you can transport those skills, leveraging the franchise.
Also, mergers can transform two subscale activities into one that has the scale to attract new revenues.
For example, if two banks with subscale mortgage servicing operations combine, the new entity may have sufficiently lower unit costs to bid more for servicing rights and thus expand revenues.
Q.: Nevertheless, it does seem that the push for cost savings can risk cannibalizing the potential for revenues. Is that right?
ZIZKA: Deals that were done five years ago for just the cost savings often cannibalized revenue growth because of that single-minded focus.
Today, banks will generally have a more disciplined planning and merger tracking process in place. It facilitates expense saving, but also lets management keep an eye on what's happening to both "business as usual" and new revenue opportunities. Banks that are doing well are focusing on all the lines on their P&Ls.
Q.: Is the balance between cost savings and new revenue as much an issue in smaller bank acquisitions?
ZIZKA: The relative size of the institution does have an impact on the cost savings you can get. We've seen deals where a large bank acquiring a very small bank can cut the latter's expense base by as much as 75%.
Q.: Are you suggesting that it is easier to justify a large premium on small deals?
ZIZKA: All else being equal, on a smaller acquisition you can create more shareholder value through merger synergies. For a typical in-market deal, you can create value equal to about 1.3 times the book value of the acquiree just from cost reductions. If you also begin picking up revenue gains, it may be feasible to pay a premium of as much as 1.5 to 2 times the book value of the acquiree. These premiums can be even larger for big banks buying small ones.
Q.: What will the drivers be on the larger, out-of-market deals you see?
WILLIS: There are two. First, national banking and national branching will cause many more to focus on out-of-market mergers, where revenue enhancements are key to success. The second fundamental factor changing the way banks are looking at acquisitions, particularly from the revenue side, is the new focus on customer segmentation and profitability.
Q.: Can you describe this new focus?
WILLIS: Banks are getting much more sophisticated at understanding what their customers buy, how they use the bank, and what they need. As banks become more marketing oriented and develop the information bases to allow them to better understand product usage and customer behavior, they will become better able to accurately predict revenue opportunities through acquisition.
Q.: In your view, have many banks arrived at this level of expertise?
WILLIS: Banks are really just getting into this. Institutions that are good at this must develop a data warehousing facility that pulls together all of the necessary information to allow them to analyze the drivers of profitability at the customer level. And they also must have a segmentation process in place that allows them to develop a strategy for marketing to and serving the customer based on what the data warehouse reveals about his or her product usage, balance levels, transaction behavior, and price sensitivities.
Let us remember that most individuals have five basic financial needs: transactions, credit, investment products, protection products (insurance), and financial planning (to tie the other four together in an optimized package). Banks currently serve the customer largely in only the first two areas, transactions and credit.
With new legislative authority, the capacity to create alliances, and with better data and decision-support tools, banks can serve all five needs. Doing so will greatly increase the revenue potential, enabling the better consolidators to earn two and three times what they now earn per customer.
