Cohen Bros. & Company

Present Value: Essays on Community Banking, Spring, 2005

If you have focused on investing in community and regional banks, there is a good chance that you’ve become rich. This holds true whether you’ve been investing passively as an individual or an institution or more aggressively as a hands-on mergers and acquisitions investor, or perhaps even a bank founder.

Part of this windfall has to do with your investment acumen. The other part of your new wealth has to do with being in the right place at the right time.

Over the last 50 years, a constellation of economic events has aligned itself in such a way as to produce a staggering increase in wealth. The United States economy, when measured by the total value of goods and services produced, is now six times larger than it was 50 years ago. In fact, between 1949 and 2002, the nation’s economy grew from $1.5 trillion to more than $9 trillion, measured in 1996 dollars. Talk about a bull run!

Growth in the U.S. GDP 1949-2002
1996 Dollars

Today, the U.S. economy is nearly twice as large as its closest competitor, Japan, and almost nine times larger than its fastest-growing competitor, China.

With a span of 50 years under consideration, it didn’t take much luck to get the timing right. It was being in the right place that really mattered, and that took vision.

For many investors, it wasn’t so easy to see that such a pedestrian business as banking -– arbitrage happening at the speed of cold tar –- could produce such spectacular and superior long-term returns. But the 10-year return on the PHLX/KBW Bank Index shows that this was indeed the case.

Index 10-year Return to 2004
Russell 1000 12.16%
Russell 3000 12.01%
S&P 500 12.07%
Dow Jones Industrial Average 10.72%
PHLX / KBW Bank Index 14.03%

Here is the meteoric rise in banking stocks presented graphically.

SIDETRACKED BY OTHER SECTORS
Over the past 50 years, a number of more glamorous investment opportunities have obscured banking’s prospects. In the ’60s and early ’70s, conglomerates were the rage. And why not? They offered the opportunity to diversify an investor’s holdings within a single equity.

From 1982 to 2000, investors could be easily distracted by several thousand initial public offerings with enticing “ground-floor” opportunities, some of which were indeed ground floor. Microsoft went public in 1985. Silicon Graphics and Sun Micro Systems were also graduates of the class of 1985 — companies whose track records illustrate that investing in technology can be potentially lucrative or lethal. While technology companies offered meteoric growth, they also offered above-average risk: Many of the markets in which they competed were either not fully rationalized or not fully developed; they didn’t have a proven pool of customers, viable trade credit, or a proven demand cycle.

It’s true that many investors did quite well in technology investments, but the sex appeal of this industry and several well-publicized success stories obscured the fact that many other investors lost all or almost all of their principal in technology investments. Even a proven tech company such as Lucent, with a vaunted Bell Labs pedigree, saw 95 percent of shareholder value disappear at one point.

For an analogy, consider automobiles. If you invested in automobile companies at the beginning of the 20th century — when they were at the cutting edge of technology –- you had more than 100 choices. Remember the Duryea Motor Wagon Company? How about the Hudson Motor Car Company? Pierce Arrow? John Lambert? Fifty years later, only four companies were left standing. In other words, investors made the wrong bet 96 percent of the time.

Decades later, the same scenario unfolded in Silicon Valley. In a world dominated by Microsoft and Intel, several hardware and software companies simply vanished, taking their investors’ capital down the drain with them.

THE PROMISE OF BANKING
In the face of all this progress, it wasn’t necessarily easy to see that empires could be built on a spread of 3 percent. There are several reasons for banking’s promise: regulation and deregulation, an entrepreneurial culture that drives bank profitability, and a vibrant merger and acquisition market that provides liquidity to buyers and sellers. Entrepreneurship and regulation and deregulation are covered in more detail in other chapters. Here, we’ll examine more closely the role that mergers and acquisitions play in generating wealth for investors. We’ll also examine, with a skeptic’s eye, the strategic underpinning of mergers and acquisitions in the banking industry.

Because of the unit banking heritage of American banking and the number of banks in the United States, consolidation is occurring on a vast scale.

LEFT SIDE: Number of Mergers

LEFT SIDE: Numbers of Transactions

The consolidations have consistently offered wealth-generation opportunities for investors. In short, when banks merge, investors win. At least that’s the prevailing trend. Figure #XXX shows the difference between the price-to-book ratios for companies that were publicly trading versus those that were targeted for a merger or acquisition over the past 10 years. In every year except 1997, bank investors were awarded a bonus for their participation in the sector in the form of a takeover premium that averaged 20.4 percent.

Thrift investors, who perhaps had to employ more patience, enjoyed an average takeover premium of 34.3 percent.

There is nothing remarkable per se about these takeover multiples. Obviously, buyers need to entice would-be sellers, and other industries offer higher takeover multiples. What’s truly remarkable is the scale and pace at which the transactions are occurring. This brings to light one of the unique factors that enables the banking industry to create wealth for its investors more efficiently than many other industries: The merger and acquisition market in banking is highly liquid and highly efficient.

Any why shouldn’t it be? With steadily rising stock prices for the industry at large, almost every institution has a viable currency to do deals. Furthermore, with balance sheets and capital requirements that are regulated to ensure conservative capital structures, almost every bank is a target. Likewise, almost every bank has the opportunity to be a buyer. Thus, beneath the staid and conservative veneer of the banking industry boils a veritable wanderlust for transactions and, in most instances, an imperative to merge or acquire.

It’s worth noting that despite ongoing consolidation, there is a healthy level of de novo banking in the United States. Since 1975, more than 4,400 new banking charters have been granted. To some degree, consolidation begets de novo banking. All across America, acquisitions of smaller and midsize banks give rise to the formation of a new bank by local, high-flying entrepreneurs who need a “bank for us and our deals.” While this is a striking trend, it is de minimis with respect to the overall and perhaps inexorable trend of consolidation in banking.

THE IMPETUS FOR CONSOLIDATION
There are other subtle and not so subtle factors that drive transactions. On the regulatory front, when the Financial Accounting Standards Board adopted its Statement of Financial Accounting Standards #142 — Goodwill and Other Intangible Assets — it eliminated the amortization of goodwill for merger transactions and certainly quickened the pulse of many would-be dealmakers. The elimination of annual charges to earnings in favor of an impairment test meant that there was less earnings dilution from acquisitions. Therefore, a larger universe of deals became viable. While there is no conclusive evidence that the adoption of Statement #142 unlocked the floodgates for bank consolidation, it certainly didn’t hurt. At the least, it added momentum to a host of other factors.

One of these factors was the regulation of all products bearing FDIC insurance. The regulatory chapter and verse that went with products such as CDs, NOW accounts, demand deposit accounts, money market accounts, and even holiday accounts meant that banks could acquire other banks with very little product risk. On the retail side, nearly all banks have the same products.

The risk that product integration poses to mergers and acquisitions cannot be underestimated. Remember when Quaker Oats bought Snapple for $1.7 billion in 1994? Quaker’s plan was simple: exploit the seemingly straightforward “synergies” between New Age leader Snapple and Quaker’s own sport beverage, Gatorade. After all, weren’t both products sold through almost the same distribution systems?

Unfortunately, the devil is in the details. Distributors balked at the changes called for by Quaker’s new distribution plan -– even though the distribution channels were “similar.” Next, inventory and raw materials problems arose, which in turn led to the delay of needed marketing, operational and organizational changes. By the time the dust had settled in 1997, Quaker had sold Snapple for $300 million and took charges of up to $1.5 billion. Quaker Chief Executive Officer William D. Smithburg, architect of the deal, resigned soon afterward, and Quaker itself was sold to PepsiCo in December 2000 for $13.5 billion in stock. Ah, synergy.

Banks are susceptible to bad mergers as well. However, the uniformity of retail products takes some of the risk out of the equation. In the minds of many bankers, the uniformity of retail products takes a lot of risk out of the equation and emboldens them –- ill-advisedly or otherwise -– to pursue transactions.

Bank consolidation is also driven by decidedly human – or emotional — factors. They are, from most to least logical, as follows.

First, because interest rates and the economic environment are cyclical, bank revenue and earnings growth can be cyclical, too. When growth is stalled, bank management is motivated to consider acquisitions to stimulate growth. This phenomenon is the first hint of an agency issue that has a dramatic impact on the fate of many community and regional banks. Through acquisitions, management is attempting to present the picture of manufactured growth until such time as real growth can be demonstrated, with little motivation other than job security.

Second, banking is less regulated today than it was a generation ago. As a result, the industry has attracted more dynamic managers and entrepreneurs. This cuts two ways. Historically, high levels of regulation have left a legacy of bankers who are relatively staid and not innovative. At the same time, contemporary bankers see a wider array of opportunities in the franchises of their more conservative brethren and relish opportunities to “shake things up.”

This was clearly the case between Newark, N.J.-based First Fidelity and Charlotte, N.C.-based First Union, now Wachovia, in which the latter acquired the former in 1995 for nearly $6 billion. At the time, First Union was considered the arbiter of a new hegemony in banking, while First Fidelity was a vestige of another era. Here’s how the contrast was characterized in the Charlotte Business Journal on January 27, 1997, 18 months after the deal, when First Union was declaring victory:

“No one denies that First Fidelity had badly neglected its aging branches. Walking inside First Unionzzs Broad Street branch in downtown Newark, N.J., is like a return to the 1960s. The linoleum floor and brown wood paneling are pedestrian compared with the bankzzs glistening uptown Charlotte digs. Itzzs not a slum neighborhood either; world headquarters of giant Prudential Insurance Co. are next door.”

It wasn’t just the branches. First Fidelity seemed to have lost the will to market or provide customer service in a newer, more competitive environment. The Charlotte Business Journal article continued: “In fact, community bankers often threw parties celebrating a First Fidelity acquisition in their market in the early 1990s because they counted on the bigger bankzzs poor service pushing customers out the door.”

While hubris may have befallen First Union, its then dynamic and well-respected management team — encouraged by a track record of deals that seemed to demonstrate the viability of their banking model — continued its buying spree unabated. They completed more than 60 deals during the high-flying decade of the ’90s.

Bank consolidation is also driven by the real and perceived reductions in cost that can be achieved by merging banking operations. The rise of technology has given banking institutions a tremendous transaction-processing capacity, and it’s easy for the acquiring company to appreciate that one centralized back office can easily do the work of two. Similarly, technology has improved the productivity of the financial accounting staff, which suggests that combined entities can meaningfully reduce the head count. The presumed metric in banking is that a combination will yield a 25 percent reduction in noninterest expense.

Cost reduction would seem to be a strange factor to place among the emotional driving forces of bank consolidation. However, very few studies will unequivocally confirm that mergers result in cost savings, leaving little other explanation than emotion.

A casual glance at the aggregate income statements of banks maintained by the FDIC between 1992 and 2002 –- a period in which the entire banking industry consolidated by 31 percent –- seems to confirm this. During this period, and on an aggregate basis, the efficiency ratio of the industry fell from 65.8 percent to 57 percent. While a fall is better than an increase, the percentage drop in the aggregate is less than the projected percentage drop used to justify mergers and acquisitions. Obviously there’s a lot of noise in aggregate statistics, but these numbers nonetheless provide insight about the elusiveness of costs savings. Clearly, if there are some dramatic costs savings occurring as the industry consolidates, they should be evident – somewhere — in these aggregate numbers.

Even more academic and rigorous analyses of bank mergers and acquisitions have not produced conclusive results that mergers reduce cost and increase efficiency. Federal Reserve economists Simon Kwan and Robert Eisenbeis conducted a landmark study of 3,844 mergers between 1989 and 1999. They concluded, “Consistent with the results of earlier studies, the efficiency and performance effects were mixed [in our study]. Evidence suggests that the better-performing institutions tended to target the higher-performing targets, but the resulting mergers did not significantly improve profit performance or efficiency. There were marginal declines in leverage and increases in loan-portfolio composition. … The overall conclusion is that the widely touted earnings and efficiency … of mergers are still in doubt.”

What may ultimately drive consolidation is the compensation of bank CEOs. In their study “CEO Compensation and Bank Mergers,” published in The Journal of Financial Economics, Babson College and Indiana University professors Richard Bliss and Richard Rosen found that the growth in CEO compensation over their study period, 1986 to 1995, was positively correlated to merger and acquisition activity. Specifically, the growth of compensation for chief executives at so-called high-merger banks outstripped the growth of chief executives at low-merger banks by 82 percentage points. Bliss and Rosen conclude “. . . acquisitions significantly increase CEO compensation even after accounting for the typical announcement-date stock price decline. While the decline in existing wealth partially offsets some of the subsequent gains, the vast majority of mergers still increase the overall wealth of the CEO, often at the expense of shareholders.”

So how does all the evidence stack up? The $9.4 trillion U.S. economy produces a wide range of opportunities that are actively seized upon by an entrepreneurial American culture. Bank and, to a lesser degree, thrifts, are poised to capitalize on this growth. Because of heavy regulation, they do so in ways that often result in profitable operations and, over time, above-average returns to shareholders. These above-average returns may be further enhanced by wholesale consolidation, which in many instances provides an additional premium for investors.