FOOL ON THE HILL
Today's surprising announcement by First Union that it will merge with Wachovia in a $13.4 billion deal confused some and hearkens back to last decade's free-wheeling banking consolidation days. Many investors got burned during that spree, and it could happen again if First Union reverts to "empire-building" rather than basic banking fundamentals. Investors should tread cautiously.
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By
The Easter Bunny deposited a rather large surprise basket on bank investors' doorsteps this morning as North Carolina banks First Union Corp. (NYSE: FTU) and Wachovia Corp. (NYSE: WB) announced a business combination initially valued at $13.4 billion. As has been the case in the banking world over the past few years, however, the unexpected deal left investors and observers with more questions than answers. First, the agreement is being billed as a merger of equals, even though First Union's total assets outweigh Wachovia's assets by a margin of greater than three-to-one. No matter: The old Wachovia will get just as many seats on the combined board of directors as First Union, and naming rights to the new company to boot -- although the official corporate digs will remain in First Union's hometown of Charlotte. Those concessions will have to suffice for the fairly weak purchase price Wachovia was able to garner for itself, which amounted to about a 6% premium based on Friday's closing prices. On the First Union side of things, the deal is also a bit curious. The company doesn't exactly have a high-powered merger currency at present, considering its stock is just a few months removed from a five-and-a-half year low reached late last year. Still, First Union is doing a stock deal anyway. Furthermore, both companies are in the midst of restructurings and large-scale efforts to right their once well-respected and seemingly predictable businesses. Wachovia's earnings suffered last year as the company jacked up reserves for its commercial loan exposure. First Union, meanwhile, became an earnings warning machine in 1999 and into 2000, creating a streak of bad news that culminated last June in a jumbo write-off as part of large-scale effort to refocus the company. The prospect of two battered banking companies hooking up is a major departure from the merger activity that typified the regional bank empire-building heydays of the mid-1990s. First Union was a major participant in the consolidation trend back then, gobbling up deposits and other business lines like boiled peanuts and lining the pockets of its favored lawyers and merger advisors with a steady stream of fees along the way. Shortly after he was installed as CEO last year, First Union's Ken Thompson swore off any more acquisitions for the foreseeable future. Apparently, as the Bob Dylan song goes, "Things have changed." The interesting thing about last decade's consolidation craze is that it worked for awhile. First Union and crosstown rival NationsBank -- the present-day Bank of America (NYSE: BAC) -- were held up on Wall Street as poster boys for shareholder value creation in a new age of deregulated super-regional banking. But that vision has taken a major pounding over the past few years, thanks to First Union's over-reaching through its CoreStates and Money Store acquisitions and subsequent meltdown, and Bank of America's steady retreat from its mid-1998 stock market high. Banking investors who are trying to figure out what the next decade holds in store no longer have a ready thesis to grab onto for easy investment returns in bank stocks. Determining the correct weight one should place on perceived competitive advantages in the banking world is a burdensome task. The "bigger is better" perception has largely been discredited, and earlier merger justifications such as "strategic positioning" and "expanded distribution systems" now seem like so much consultant happy-talk. It's taken some time, but the banking business is starting to get back to the fundamental business premise that profitability matters, both in the here and now and down the road. That's a major reason why investor attention in the past year or so has shifted away from the mega-cap companies that dominated the 1990s and toward mid-cap performers that didn't sacrifice profitability for size. For the most part, the best-performing bank stocks over the past year belong to mid-sized banks with names that will sound foreign to many investors, such as Commerce Bancorp (NYSE: CBH), TCF Financial (NYSE: TCB), M&T Bank (NYSE: MTB), and First Tennessee National (NYSE: FTN). For investors looking for long-term investments in the banking sector, it's more important than ever to screen out the far-out promotional hype and focus on the fundamentals. This includes such basic blocking and tackling as deposit growth, customer service and retention, and management execution ability. These are the items that drive profitability and produce an above-average valuation multiple for a bank stock these days -- not how far and fast a franchise can be extended to a banking public that long ago tired of trading in their ATM cards with every new merger. That leads us back to the big risk in today's First Union-Wachovia merger. Both of these banks have been circling their wagons around their major business lines lately, getting out of areas such as credit cards and home equity lending, and focusing on "core competencies" in retail and commercial banking, asset management, and capital markets activities. If this merger is intended to wring capacity out of the system and focus both companies more on these core areas, then it might just have a chance of working to the shareholders' advantage, despite the lukewarm reception in the stock market today. But if this latest merger simply represents a reversion to First Union's old empire-building ways, investors have a sound reason for being skeptical. Interested long-term banking investors should watch closely, and take care before jumping on any new banking value-creation bandwagons. Brian Graney's favorite bank is Paris' Left Bank. At the time of publishing, he did not hold shares in any of the companies mentioned above. The Motley Fool is investors writing for investors.
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