First in a two-part BankThink series debating whether bank mergers are worthwhile. Coming next: bank investor Philip Timyan makes the case that bank mergers benefit all parties.
I'm skeptical that bank M&A creates much value.
In theory, even a large deal that is conservatively priced and then skillfully integrated provides only modest financial benefits to the acquirer. In practice, few acquirers consistently accomplish both goals. As a result, shareholders of serial acquirers often end up no better off from all those deals, and sometimes worse off.
When one bank acquires another, what does the acquirer's management team hope to accomplish? Very simply, if they are rational they hope to buy the target for less than it is worth. If they succeed, their shareholders will be better off. What can make this possible? Synergies make the target worth more to the acquirer than it is on a stand-alone basis. So an acquirer can pay a premium for a target and still come out ahead. As long as it doesn't pay too much.
How much ahead? Let's say Bank A, worth $1,000, decides to buy Bank B, currently worth $200, which Bank A believes is worth $280 with synergies. If Bank A pays $240 to Bank B, that leaves Bank A shareholders richer by about $40. If the deal is stock for stock, as most are, the new Bank A is worth $1,280: $1,000 for Bank A, $200 for Bank B and $80 for the presumed synergies. Bank A's value increased by 28%. But Bank A shareholders end up only about 3 % better off (their $40 gain divided by the new $1,280 valuation). That's not all that great when you consider that banks hope to grow EPS by 8% or more per year. To do better, the acquirer must close bigger deals (which are riskier) or buy cheaper (a challenge when a primary goal of the seller is to maximize price ).
According to SNL Financial, more than 5,800 bank and thrift deals valued at $1.3 trillion have been completed since the beginning of 1991. The 24 deals valued at over $10 billion each make up just under half of this value. No surprise, the largest banks have done the biggest deals. How happy have their shareholders been?
Wells Fargo (WFC)? It has produced great operating and shareholder returns, while infrequently pursuing megadeals. It paid a low premium in its $35 billion merger of equals with Norwest in November 1998 and didn't do another megadeal until the opportunistic $15 billion acquisition of distressed Wachovia in December 2008.
JPMorgan Chase (JPM)? Its large acquisitions proved to be a disappointment until it acquired Bank One for $59 billion in July 2004. This deal brought Jamie Dimon, who transformed the institution. But Dimon was willing to do a "no premium" deal if he could share the chief executive job with JPMorgan CEO William Harrison. Harrison refused, and JPMorgan paid a $7 billion premium for Bank One. How much did this decision hurt JPMorgan shareholders?
Citigroup (NYSE:C)? Its sizable problems appear to have been homegrown. But remember that it was irate over losing Wachovia to Wells Fargo, in a quarter in which Citigroup posted an $18 billion loss.
Bank of America (BAC)? A serial acquirer of banks and nonbank financial institutions, it made deals for Merrill Lynch ($47 billion) and Countrywide ($4 billion) that have proven to be especially problematic. Bank of America's market cap reached its quarter-end peak of $241 billion at Sept. 30, 2006. As of Monday night's close, it was $159 billion, and that's with a 133% increase in shares outstanding in the interim.
U.S. Bancorp (USB)? Great operating and shareholder returns, no large deals in a very long time. It completed three large deals between November 1998 and February 2001. The last one, also the largest, was the $21 billion Firstar deal.
Space prevents me from going through the list of all banks, so I'll comment briefly on a few others:
Regions Financial (RF)? Through two large acquisitions between July 2004 and November 2006, Regions tripled its asset size. But then it needed to raise equity and was forced to double its shares outstanding. Its peak market cap was $27 billion; even with nearly twice as many shares outstanding, its current market cap is only $14 billion. I'd say this was a failed experiment.
And don't forget about other large acquisitive institutions whose operating problems forced them to sell, such as Wachovia, National City and Marshall & Ilsley, or fail, like Washington Mutual.
Bank M&A activity has been depressed since early 2008, and many traditionally acquisitive institutions have sat on the sidelines. I think there are several reasons for this. Some have simply gotten too big to care about most targets. Others are working through their own problems or are scared by the macro environment. But I suspect many are put off by unreasonable price expectations on the part of potential sellers.
But a new crop of serial acquirers is appearing. They're willing to pay full prices in a quest for "growth," and to use cash consideration in order to manage the "problem" of excess capital. Time will tell if these new acquirers fare better than the old ones. I'm starting to miss the days when banks preferred to use so-called pooling-of-interests accounting. Pooling let buyers and sellers simply add their balance sheets together, avoiding the creation of goodwill. Goodwill-inflated book value and also had to be amortized. Both were bad for return on equity. When pooling was eliminated, new merger accounting rules obligated banks to test goodwill for impairment but didn't force them to amortize it.
While securing the use of pooling sometimes made banks jump through irrational hoops, such deals had to be stock for stock. And that kept acquirers out of trouble. If an overcapitalized acquirer uses excess cash to partially fund a deal, and it uses accretion in earnings per share to assess the deal's merit, it could easily overpay, trashing its tangible book value per share in the process. Of course, stated book value per share grows because intangible assets grow, even as the deal price ratchets up! An acquirer could never "manufacture" book value under pooling.
I'll end with two random thoughts. First, when advisors model transactions, they assume that the acquirer's stand-alone earnings remain the same after the deal. Is this fair? In reality, acquirers sometimes get distracted by deal integration, competitors use this distraction to their advantage, and earnings suffer. If you're a target shareholder, this can lower your long-term return. If the acquirer share price moves sideways for a year or two, that eats up a good portion of the deal premium.
Second, assuming I'm right about a typical deal making the buyer's shareholders 3% richer, if the target pays his investment banker a 1% fee, and the buyer pays his banker a 1% fee, don't fees eat up a meaningful portion of the upside to the buyer?
I think M&A is sort of like a scalpel. It can do wonders in the hands of a gifted surgeon. But how many gifted surgeons are out there? Shouldn't some version of the Hippocratic oath's central tenet do no harm apply?
Harvard Winters, a former investment banker, writes research on banks.