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Thursday, January 28, 1999

An Investment Opinion
by Dale Wettlaufer

Bank Analysts Mis-Estimate

It's a "damned if you do, damned if you don't" world for the Charlotte, N.C. banking companies. It's been that way for years, too. First Union (NYSE: FTU) got another big helping of whoopass from the analysts yesterday after the nation's sixth-largest bank holding company announced a couple of tweaks to its discretionary marketing spending and an accounting change dealing with securitization of its subprime mortgage loans. I've also heard that the company commented on the timing of possible mergers, though that isn't reflected in the news reports I've seen.

First, what the heck is with the world's infatuation with calling First Union Chairman Ed Crutchfield "Fast Eddie?" The perception that he's just a dealmaker who is not focused on operations is getting tired. Walter Shipley at Chase Manhattan (NYSE: CMB) is a genius for paying attention to risk management, but Ed Cruthfield is still "Fast Eddie" when the fact is First Union has always run its trading in a conservative manner? Wrong. That the "Fast Eddie" and the "credibility problem" labels come out again after First Union said that it's dialing in some different strategic initiatives is a pretty disappointing comment on the analysts that cover the company.

Chairman Hugh McColl at BankAmerica (NYSE: BAC) suffers the same "deal maker" perceptions, but these guys don't screw around like some of the New York bankers who've had more five-year plans than the Bolsheviks and almost as many restructurings as Cher. Crutchfield and McColl aren't the sort of bank chairmen that can't brush their teeth in the morning without a consultant telling them which brushing style is in vogue that day and which is the best risk adjustment method for assessing flossing results. What you can say about these guys is that they've delivered consistent value creation and have built veritable Death Star companies going into the next century. And this has all happened without these companies blowing up, which is something that a lot of the big banks certainly cannot say for themselves.

Despite the fact that First Union and BankAmerica are much more dynamic than money center banks that run their ships up on shoals every 12 years or so, there's still the "credibility problem." To wit, First Union's announcements about this year's earnings outlook less than two weeks after their earnings announcement gets under the skin of analysts. The thinking goes, "Why didn't they tell us then? They have a credibility problem for not doing so." Does First Union know how to play the game with analysts? Maybe not as well as other bank holding companies. I'll give the analysts that. Would I be upset at First Union for changing course and making me look like I'm not on the ball with my earnings estimates? Maybe. But in the end, a well-run company doesn't live to please the analysts. A well-run company lives to please it shareholders and other constituencies, depending on your view of the balanced-scorecard approach to corporate performance.

So what do we have with First Union's announcement? We've got some good stuff, that's what. Doing away with the ridiculous gain on sale accounting technique for securitizations is a wonderful idea. Let's all say it out loud: It might reduce near-term earnings estimates, but it doesn't hurt near-term cash flow. (It actually could help cash flow, because you have to prime the pump with cash in new securitization pools anyway.) It increases the quality of earnings and it increases the quality of the balance sheet. Boy, how horrible. How First Union's acquisition of Money Store is turned into a negative is a little bizarre. Let's review some of the good things about the Money Store deal.

1. The company was essentially a cash transaction, not a stock-for-stock transaction, because the company bought back the shares that were issued in the deal.

2. The Money Store is one of the best consumer finance franchises around.

3. First Union's funding costs actually increase spreads on these loans and gives the company the flexibility to select among the best funding alternatives when the asset-backeds market isn't doing well.

4. With a better potential spread than other subprime lenders, First Union has flexibility in increasing market share profitably for this segment of the company and in gathering customers.

5. The Money Store's securitizations were never low quality to begin with. Unlike one insurance company I'm thinking of that overpaid for a specialty lender that regularly showed particularly scary differences between GAAP net income and actual cash flow, the price First Union paid for Money Store was not that bad at all.

Banks as Consumer Companies

I'm sure there are Boston bankers that are appalled at First Union's advertisements. There are no old people puttering around in golf slacks talking about their retirement. The advertisements grab you by the brain and shake you around a bit -- they're DIFFERENT. Does that diminish the effectiveness of these commercials? Not at all. Initially I didn't like them, but when you watch these commercials, the brand proposition is clearer than those in other groundbreaking commercials such as the Energizer Bunny campaign. One can't forget the consumer components of these companies -- they're asset managers, consumer lenders, small business lenders, deposit takers, and much more in the future if things go as planned.

If you're a bank that takes yourself seriously as a retail company, you don't just float along and not tend to the brand just to "make estimates" this year. What First Union is doing here is a strategic positive. The extra $100-150 million in Future Bank spending this year and incremental $100 million marketing expense plan to water the brand garden is a positive, not a negative.


The one drawback is the pushback of savings that were expected this year from the CoreStates integration. Due to increased training for outbound marketing personnel, Future Bank initiatives, and getting everyone on the same page in creating a sales-oriented culture, revenues are projected to be $50-100 million lower and cost savings are expected to be $50 million lower this year than were expected. OK, so that's an execution boo-boo. Anyone that's ever done a discounted cash flow on a company can tell you that a dollar not earned today but earned tomorrow is going to lower the price of the company. This is a swing in cash flows, but a $5 billion valuation swing off an already reasonable price is pretty drastic.

The Value

First Union finished last year with a 1.69% return on assets performance (deducting goodwill amortization and merger-related charges from earnings) and came in with a 1.68% return on assets and a 23% return on equity performance (same adjustments as above) in the fourth quarter. If Chase Manhattan or other money center banks did this, the world would be doing backflips. With CoreStates not performing where the bank wants it, where will the results be when it is in gear? My case is this: I think Hugh McColl is the better Chairman in Charlotte, but I think both he and Ed Crutchfield are great bankers. However, this move brings Mr. Crutchfield up a few notches in my book. I love it when the people that run a company are willing to make economically beneficial decisions rather than praying to the altar of earnings estimates. The gain on sale accounting thing is a non-issue. It improves the company's cash flow, actually, and aligns the company's earnings over the long term with its true cash stream of earnings.

Lately, the financial performance at First Union has been better than BankAmerica's, as well, with less leverage. Ed Crutchfield is on a roll and the overall package looks good for First Union. On the estimates, it's cheap, too:

            Multiple on 1999 EPS estimate 
Company + goodwill amortization
First Union 11.6
BankAmerica 12.8
Chase Manhattan 14.4
Wells Fargo 15.2
US Bancorp 15.5
Citigroup 15.7

The thesis here is pretty clear. First Union still has some strategic pieces to add or grow on its own, but its financial performance is good and its management is getting better and better all the time. The view that Ed Crutchfield and Hugh McColl aren't good bankers and are just dealmakers is bull.

Now, I don't believe the market is totally inefficient, but I think a bias exists among analysts that cover these companies. They're not thinking about the investing proposition here as they should. That is, that there are money center bank functions, middle market functions, and retail functions to First Union. All are quality, but the retail and middle market functions particularly stand out. I don't think those are being properly assessed. If they were, the CoreStates news and the strategic moves the company is engineering would be more readily welcomed. I think the company's 8.6% earnings yield on 1999 numbers is too high, and I like what the company is doing. Sometimes the market is wrong, and I think it is here.

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