| Feature Story |
Participating, via conference call, in this second annual ABA Banking Journal M&A Roundtable were the following people: Mark Anderson, executive vice-president and chief financial officer, Community First Bankshares, Fargo, N.D. (total assets, $3.1 billion; 79 locations in seven midwestern states; 22 acquisitions since its founding in 1987; 2 acquisitions last year; one pending acquisition would add $1 billion in assets). Anderson was a co-founder of the company along with Donald Mengedoth. Both had been with First Bank System. H.B. Conlon, chairman and CEO, Associated Banc-Corp., Green Bay, Wis. (total assets $4.4 billion; 96 banking locations mostly in Wisconsin, with some in Illinois; 21 acquisitions since 1975; 4 acquisitions last year; 1 closed this year). Conlon has been CEO since 1975. Ben Crabtree, managing director, research analyst, Dain Bosworth, Inc., Minneapolis, Minn. He covers 17 banks ranging from superregional like First Bank System to mid-size players like Associated and Community First. Crabtree has been a sell-side analyst for 21 years, covering banks and thrifts in particular for the last 11 years. Charles Miller, managing director, Alex Sheshunoff & Co. Investment Banking, Austin, Texas. Miller has been helping advise banks on M&A decisions for 4 years with Sheshunoff, but has 30 years experience in financial services. In his current work he primarily represents the selling institution, and primarily works with banks of $1 billion or less in assets. Kenneth Neilson, chairman, president, and CEO, HUBCO, Inc., Mahwah, N.J. (total assets $3.1 billion; 85 locations in New Jersey and Connecticut; 17 acquisitions since 1990; 6 last year; none pending). Neilson has been CEO since 1989. Prior to that he had been the bank's senior lending officer. He joined the bank (Hudson United Bank) in 1983. |
The inevitable link-up of two or three banking giants into one nationwide banking company will be a historic milestone and will stir up a huge buzz in the industry. But in terms of the impact on most banks, the action below the top 25 players is far more significant to the destinies of bankers and their shareholders.
With that in mind we gathered representatives of three aggressive mid-size acquirers, to explore their M&A strategies and insights. To complement the bankers' views, we included a regional bank stock analyst and an investment banker familiar with this market segment. (See "Stats" box, right.)
Editor-in-Chief Bill Streeter moderated the discussion and prepared the report below. Comments were edited for length and, in places, for clarity.
Value of Branches
ABABJ: The banks represented here have plenty of branches. Considering all the talk about alternative delivery systems, what is the value of branches?
Neilson (HUBCO): That's like asking whether stores are relevant any more, given that catalog sales and TV shopping have taken off. Obviously, customers have preferences for both alternative delivery systems as well as branches.
The interesting thing is that as an industry we keep saying we want to instill a sales culture. We call our branches "stores," and diversify into products such as insurance that we sell through our locations--yet we keep buying technology that keeps customers out of branches. That's something we need to come to grips with, because some things need to be sold in person.
Anderson (Community First): The branch is far from dead. We believe it remains an extremely viable delivery option in many markets and will continue to be so for years. It will be more of a challenge for community banks than for large banks to strike a balance between alternative delivery channels and the traditional branch.
As we look at acquisitions, I wouldn't suggest that it's the physical facility that we focus on--it's really the customer base. The business of acquisitions is very much cash-flow-driven and it's the customer base that drives the bulk of the cash-flow. The facilities are part of the delivery mechanism that supports that customer base.
Crabtree (Dain Bosworth): There are some markets--specifically the smaller, less-urban ones--where there's a clear preference for visiting the branch. However, even within the larger markets there are some customer segments--including some very profitable ones, such as small business--that want to be able to visit a branch. And almost every segment, with the exception of the pure techies, wants to have the branch there in case they want to visit. So it seems like bank customers want a variety of delivery channels and the branch is one of them.
Also, there are unrecognized or underrecognized marketing advantages created by branches. If you talk to bankers who do mass-marketing, they'll tell you that in markets where they have physical branches the response to telemarketing is 50% to 100% higher than in markets where they don't. Clearly there's a valuable image created by that branch. If it weren't so, I don't think we'd see people like Fidelity and Schwab opening branches around the country.
Conlon (Associated): You've got to develop that alternative delivery strategy, but not overinvest in it. We figure about 95% of our customers are using our traditional systems, and although we see an increasing number of people using our call centers and ATMs, the time when the alternative system passes the traditional system is sometime out in the future. Once that happens it's going to be very difficult to add value to the transaction and get paid for it if you can't have contact with your customer.
Miller (Sheshunoff): The role for the physical plant--the branch--is changing, which probably extends the life of it, as we look at more of a sales orientation, broader product lines, etc.
As I travel around the country, [I] see most of the majors out there, not only expanding by acquisition, but by new construction of brick-and-mortar particularly in markets that are growing rapidly.
Acquisition Strategies
ABABJ: For the three bankers, what's the key strategy driving your acquisition activity?
Conlon (Associated): In Wisconsin it was obvious to us that we were not a Florida, and that we were going to get 5-7% internal growth. So if we wanted to grow earnings by 11% to 12%, acquisitions would have to provide that. About 65% of our growth from about $500 million to the present $4.5 billion has been created by acquisitions, mostly of banks, but also some nonbank financial companies.
Neilson (HUBCO): Our industry has become dramatically more efficient over the last five years. And when you look at the standards in efficiency ratios for the top-performing institutions the ratios have moved down from maybe 60% to now where maybe you've got to be at 45% to be considered good. That's a 25% increase in efficiency--a difficult thing to achieve without acquisition.
Anderson (Community First): One of the most significant issues in the industry is the present and growing oversupply of capital. Acquisitions, whether they be cash or stock accounted for as purchases, are extremely heavy users of cash and capital and can be extremely accretive to earnings if they're not too excessively priced.
Our other acquisition strategy is growth in terms of earnings, customer base, and, ultimately, franchise value. Our strategy isn't geography-driven, it's market driven and presence-oriented. We do like this general geographic region very well [upper Midwest to Colorado] but our focus is on community banks in markets with populations that are typically less than 100,000 and may range down to 1,000.
Miller (Sheshunoff): The primary goal should be to create a rational market franchise. That market can be based on, geography, product line, customer segmentation, or whatever. Regrettably--present company excepted--too many transactions are done based on availability of a target without it being necessarily something that creates this cohesive market franchise.
Crabtree (Dain Bosworth): We don't always see a shareholder-or owner-oriented attitude to acquisitions. For a long time the banking industry has been driven by goals of size rather than return to shareholders. The M&A business in the '80s was a shining example of this. That has changed to a certain extent lately, but we're still not sure that we see some of these deals being done with an eye to what it does to the interest of the current shareholder.
Conlon (Associated): We all see [acquisitions] that seem to be without purpose or for ego purposes. We've been giving our shareholders about a 22% total return for a bunch of years and we don't think that can come unless we can grow at a greater rate than the market. We're very careful; we track as long as we can whether there's any dilution and how each acquisition's going and hold people accountable for that.
Crabtree (Dain Bosworth): One of the positive developments in the industry over the last five years is many more managers have significant equity ownerships in the banks that they run and are behaving more like owners and less like people who are trying to protect their W2. That leads to a much more rigorous and objective examination of whether a deal is accretive or whether it just makes me bigger and therefore higher on the salary scale.
Conlon (Associated): This is our net worth, for most of us. But more importantly, 70% of our 2,000 associates also own stock. That's great news as long as the stock's going up. If it ever goes down,, it might be a long year.
Anderson (Community First): Ownership interest is very important. About 92% of our people have ownership in the organization. Through various structures we have effectively a phantom stock plan in which every single president participates in the performance of his unit, which ties back to individual performance.
M&A outlook for '97
ABABJ: Do you think the rest of '97 will be active for mergers and acquisitions?
Miller (Sheshunoff): We started '97 with more situations than last year and I'm getting more phone calls than in recent recollection. All the phone calls start the same way: "Charlie, do you think the prices are going to get a lot higher?" I say, no. Then they ask, "Charlie, do you think these prices are going to be available for a long time?" My answer to that also is no. There are a couple of reasons why: One is that the currency for a lot of these transactions [stock prices] is at awfully elevated levels. Two, there's the perception among the buyers we talk with that the supply might be moving up to where they can be a little more selective.
Frankly it seems that many bankers are concerned about whether the acquisition window will be closing sometime in the near term. For the first time many smaller banks who were sitting on the fence are sellers today.
Crabtree (Dain Bosworth): More and more of the larger banks that have invested a lot of money in alternative delivery, enhanced data management, predictive modeling, and things like that are saying to us that their appetite for acquisitions is becoming much more selective. They've gotten enough scale to be able to afford to do what they want. And they believe that the incremental cost of acquiring additional revenue through doing a much better job of cross-selling is dropping to the point where they don't have to go out and make acquisitions in order to get revenue. I don't know that that's a provable number--and you have to wonder if they're telling you want they hope to be true or what they want you to hear--but I'm certainly hearing it consistently. What that tells me is that the window in fact may very well be closing, at least in some markets.
At the same time, we're hearing more comments from smaller banks that are beginning to say, "If my ultimate game plan is to be acquired, aren't we getting pretty close to the time?" They're getting quite alarmed by the deep pockets and the increasingly broad product lines and the more aggressive marketing of some of the big banks.
Neilson (HUBCO): While I think that's true [large banks not needing to acquire], I'm not sure anybody who says it really believes it. That's exactly what NationsBank had been saying before they acquired Boatmen's, for example.
From my view, '97 is going to be a more active year than even '96 or '95 on the acquisition side, primarily because the stock prices of the acquirers it make it easier to justify economically some of the acquisitions that are available. The only factor that really works against that are that a lot of the underperforming institutions have also seen big rises in their stock prices based on takeover speculation.
ABABJ: Ken, you did six deals last year; are you suggesting you will do more than that this year?
Neilson (HUBCO): We don't want to do more in number, although we might be willing to do more in size. Six kind of maxxed us out.
Miller (Sheshunoff): The Boatmen's transaction motivated a lot of people. There were an awful lot of Midwestern bankers who had gone to sleep at night dreaming of selling to Boatmen's. We've gotten phone calls saying, who's left and who do we need to go see?
Crabtree (Dain Bosworth): And they'd better hurry because the other Missouri buyers will be gone before long, too.
Conlon (Associated): There's a bigger gap appearing between ourselves and the $300 million banks in regard to technology. A lot of banks have waited too long and when you look at those situations, it's very hard to turn some of those banks around quickly. We did five transactions for about $700 million the last 12 months, but they were all market fillers. This year we've also had lots of calls. But we look at 10-12 transactions and maybe make one.
Anderson (Community First): In 1996 we went through more evaluations than probably the three previous years combined. Thus far in 1997 we have a significant backlog of interested sellers as well. Many of the people we've talked to have not yet sold, even though they've made the decision to sell, because there's still some rational pricing expectations on the part of buyers out there for community banks under $200 million.
If buyers had met sellers' expectations, we probably would have seen, in the under $500 million asset size range, at least twice the number of transactions during 1996 as we saw.
ABABJ: Do you see any change in reasons why banks sell?
Crabtree (Dain Bosworth): In the larger markets where community banks have to compete against the really large banks and do so across a fairly wide spectrum of business lines, we're starting to see more of those bankers recognize that their franchise value isn't growing anymore and that the window may be closing and that there is a little more urgency on their part to sell simply because they may not be worth more next year. Up until now they always were.
Miller (Sheshunoff): Another reason we hear very frequently is concern about technology. The question has come up about how the millennium issue affects bank valuations. [Also called the Year 2000 problem, this issue refers to the fact that most computer programs were not written to recognize two-digit dates after 99 and will not function properly.] We've done some quick surveys and what we're finding is a very high percentage of the institutions are operating on the assumption that their vendors are taking care of this issue. But often there's not just one vendor.
A great many banks feel threatened. There's a threat to their franchise value in the foreseeable future from a variety of circumstances. Conversely there are others who will be very aggressive and will prosper in this environment.
Cost and Revenue Reality
ABABJ: What's realistic in terms of cost reduction and revenue generation resulting from an acquisition?
Conlon (Associated): The savings really come from a leveraging of size--purchasing and all the other things you do--but not really from the transaction per se because you have to invest more into the company than you really save. That's not true in all circumstances, obviously.
Also, I'm always surprised when people who announce 25% savings are never held accountable as to whether they achieve them.
Crabtree (Dain Bosworth): The problem is when a company says, yes, we got it, as an analyst I don't have any way of finding out whether it's true. You can look at numbers over a period of time, and if a year later the employment numbers are what they said it would be before the merger you can back into the cost numbers.
The other part of the equation that is never checked is what are the implications for revenue from those cost cuts. All I can do is ask the companies and they answer, but it is interesting that I've never had a company tell me that the revenue loss was greater than they thought.
In the aggregate I believe there are a few companies that achieve their cost and revenue numbers even though they may be high. Companies that are set up on a functional organization basis essentially are acquiring sales offices instead of full banks and therefore don't have the technology issues Harry's talking about, so it's easier to achieve cost savings there. But if you go back and talk to companies that did acquisitions three or four years ago, what they found out is that the transition was much more difficult than they thought. The cross-training requirements were higher, the number of employees that needed to be replaced were higher.
Neilson (HUBCO): Banks are doing a much better job now than they did three or four years ago at achieving the cost reduction side of the equation. I do agree also, though, that it's difficult to measure the revenue side, and we probably aren't doing as well there as we hoped.
Miller (Sheshunoff): We just ran an analysis on the companies that thought they would have the cost savings we've been talking about. We ran it from January 1994 to February 1997 on acquisitions between $100 and $400 million. The average savings was 30%. Ken, one of your acquisitions was in that study and came in at a 45% savings. Could you comment on that?
Neilson (HUBCO): We put four acquisitions together in an overlapping market in Connecticut in a six-month period last year and the expected cost savings on the first acquisition was 32%, while on the third one we were out there with a 60% expected cost savings. It really was just a matter of keeping a couple of branches open on that one because all the infrastructure was already in place.
Anderson (Community First): You can post 40%, 50%, 60%, or even 70% expense reductions, but the real test is, are you cutting bone when you're doing it? Have you gotten to the point where you're not only losing revenue but you're losing a large base of customers and any goodwill in the marketplace? That's obviously a key factor for the long term success of that franchise.
ABABJ: Some banks have been quite willing to make such predictions.
Crabtree (Dain Bosworth): You would find, however, that most investors wouldn't put much credibility in them.
Neilson (HUBCO): And revenue doesn't always equate to profits. There can be more expenses involved in generating those revenues than the revenues themselves. We don't worry about keeping every last customer when we make an acquisition, but what we have done over a period of five years is bring our demand deposits as a percentage of deposits from 18% to 45% of our deposits.
How Much Autonomy?
ABABJ: To what degree do you consolidate an acquisition into the parent company, and how much autonomy is left in place?
Neilson (HUBCO): We've done 17 acquisitions and we're currently running two banks. We've consolidated absolutely everything that we can. All the retail, small business, and mortgage lending from both banks funnels up to the holding company. We've pulled most back-office functions out of both banks and put them in the holding company.
What we're trying to do is give ourselves a competitive advantage with loan turnaround time on retail loans. We guarantee a half-hour turnaround time, which we'd like to get down to 15 minutes. We guarantee a 24-hour turnaround time on a small business loan, which we define as anything up to $250,000, and a two-day turnaround on a residential mortgage. We expect to have mortgages down to a couple of hours within a year.
We keep lending staff out in the field at both banks and have regionalized the banks to keep the touch and feel of a smaller organization.
Conlon (Associated): What Ken just described is what you're going to have to do to be competitive in the next year or so.
We are consolidating all our back rooms and in a very short period of time we'll be underwriting centrally most of the loans Ken mentioned, and be able to produce the loan documentation at the customer contact point.
Anderson (Community First): We've also moved aggressively to consolidate back offices. As a result of our most recent acquisitions we've looked at couple of different models of centralizing some of the loan functions. Our strategy has long been to keep those processes local that involve customer-contact We're looking for efficiencies on the loan origination side, but the heart of community banking is really the lending relationship. Moving some of the autonomy is viewed as a major give-up, and is something we've been extremely reluctant to do.
Miller (Sheshunoff): You can have both worlds. On the business side and on the delivery side, you can retain many of the characteristics of the community bank, but you consolidate all the operational redundancies. When you collapse the back office, the public doesn't necessarily know that. More people are accepting that those types of changes will occur.
Is There A Size Advantage?
ABABJ: Some superregionals have a similar strategy to consolidate the back office and keep the customer contact local. Do you feel there is an inherent advantage to those very large organizations compared to banks of between, say, $3 and $10 billion, or is it the other way around?
Conlon (Associated): The recent consolidations of big organizations have been very good for our business. They've closed local boards and consolidated down to one bank. That may be a very short term advantage, though.
Neilson (HUBCO): We've also picked up a lot of relationships when the megabanks came into our markets, but I do feel the larger banks will pose a threat to the smaller banks because they can decide to buy market share in a geographic region through pricing. The effect on a large diversified institution when they do that is going to be far less than on an institution operating only in that geographic area. That is part of the reason we decided to expand geographically.
Anderson (Community First): As you look at larger banks and try to evaluate their competitive advantage or disadvantage, it really depends on the competitor.
Miller (Sheshunoff): Someone coined a phrase that I like: "refugee customers." Most of the major acquirers, when they move into a market, create these refugee customers. Community banks often pick them up and can take some hope from this. But they shouldn't be complacent, because, as Harry [Conlon] said, some of this advantage may be short lived.
We're moving into an era when scale is creating an advantage.
Large institutions may have advantages in a couple of key areas. One is technology-based systems such as home banking, credit cards, etc. Another comes from the fact that the market capitalization of the ten largest institutions is approaching half of the market capitalization of the industry--which represents the huge [acquisition] power of the major institutions. When you segment the industry into the money center banks, regional banks, etc., the money center banks' stocks, at least since '91, have outdistanced the other segments.
Crabtree (Dain Bosworth): That was particularly true in 1996. We don't really watch the money center banks, but if you just look at the regional group--the biggest 15 of those have clearly outperformed the smaller ones in '96 and are trading at higher p/e multiples than the smaller regionals.
In the 1990s up till now, smaller banks tended to trade at premiums because it was always assumed that they were going to be acquired by the bigger banks. That premium seems to have disappeared. One reason is that money managers have been trying to put money to work in the banking industry because it performs so well. But it's awfully hard to put a lot of money to work in the Community Firsts and Associateds of the world. It's a whole lot easier to buy a million shares of BankAmerica and the price doesn't even move an eighth.
Neilson (HUBCO): It's clear the larger banks have benefitted in the past year in stock price and that is part of the reason acquisition activity is going to increase. We'll see how it all plays out.
Conlon (Associated): Another major factor is going to be the consolidation of the entire financial services industry [with the insurance, and securities industries], for example. That's going to happen a lot faster than people think. That will create both opportunities and challenges.
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