ALEXANDRIA, VA (April 6, 1998) -- We'll take the day off from our normal programming to look at the financial world's biggest proposed merger, which was announced this morning. Back with our look at the financial services industry tomorrow.
In a proposed merger of stunning size, Citicorp (NYSE: CCI) and Travelers Group (NYSE: TRV) revealed this morning that they've agreed to get together in a merger of equals. If that is shocking, it shouldn't be, as trends in the world of financial services have been pointing toward a deal of this sort for at least a year. Driven in part by speculation that it would merge with Chase Manhattan (NYSE: CMB), Merrill Lynch's (NYSE: MER) move to the high $80s makes all the sense in the world. When assets under management are measured in high fractions of the trillions of dollars and look to be moving to whole-number multiples to trillions, deals of this size to form what Europeans call the "universal bank" are inevitable. Travelers exploded $11 5/16 higher to $73 and Citicorp jumped $37 5/8 to $180 1/2.
Although the pundits will come up with fin de siecle moans that these are end-of-bull-run mergers of delusion, the size of the global economy doesn't necessarily demand, but definitely accepts, universal banks of this size. When looking at a company of this potential size, or GE (NYSE: GE) or Coca-Cola (NYSE: KO), it makes no sense at all to compare market capitalization to U.S. GDP or to look at 1990s bank valuation multiples with 1950s rules of thumb on multiples to book. Rather, one should compare equity capitalizations to the size of global gross economic product. Had it not been for the Glass-Steagall Act, which tore apart the nascent universal banks such as National City, Citicorp's forerunner, this sort of U.S. company would already exist. One should also consider that the days in which these companies traded at peak multiples of 1.5 book value and 15 times earnings are a thing of the past.
The regulatory environment and business realities, where a holding company can operate insurance underwriters, securities underwriters, commercial banks, merchant banks, and securities brokerages, are totally different from the "good old days" of banking. The more diversified financial services companies become and the more risk they can transfer to third parties rather than keeping it for themselves, the less capital constrained they will be and the less multiples to shareholders' equity will adhere to a uniform valuation band. Capital efficiency, shareholder return, risk-adjusted returns, strategy, asset quality, and capital management will rule determination of returns and valuations in the future. That is the natural progression of a market undergoing deregulation.
Merger of Equals
This merger of equals, under which Citicorp shareholders will receive 2.5 shares in the new company and Travelers shareholders will receive one share for each of their shares, calls for a new holding company, Citigroup Inc., to be formed. Each company's shareholders will receive half of the new company's equity, which is valued on a pro forma basis at $172 billion with approximately 2.358 billion shares outstanding. With a combined equity valuation of about $145 billion as of Friday's close, today's trading added close to $30 billion in market value to the combined entity.
There are virtually no smaller companies the new company could not subsume with ease. If it wanted to take out a super-regional such as KeyCorp. (NYSE: KEY), SunTrust (NYSE: STI), or something the size of the former Barnett Banks, no problem. Those would be bite-sized deals for Citigroup. On a global scale, financial institutions trading at price/book, price/earnings, price/assets, or price/capital at fractions of U.S. multiples could also be fodder for the Big Red One.
The merger has reminded arbitrageurs of the imperative that size matters in the global economy. American Express (NYSE: AXP), a virtual bank and financial services giant and very nice fit for many possible merger partners, climbed $5 3/4 to $104 3/4. Some have mentioned PaineWebber (NYSE: PWJ), which climbed $2 13/16 to $44 1/2, as a possible partner or even a reunion with Lehman Brothers (NYSE: LEH), but Amex will be very selective about possible merger partners. J.P. Morgan (NYSE: JPM), already on the lookout for strategic partners, slimming down to the image desired by Wall Street and basking in the glow of increased multiples gained over the last 45 days, surged $10 13/16 to $144 3/4 on the news. Morgan could be an interesting fit for Amex, combining asset management businesses, commercial and consumer lending, business services, and wholesale banking services.
Morgan Stanley Dean Witter (NYSE: MWD), which in part set the tone for the latest wave of large-scale mergers when Morgan Stanley and Dean Witter Discover got together last year, gained $4 9/16 to $80, while the financial world's most eligible bachelor, Merrill Lynch & Co., jumped $10 1/2 to $97. Merrill has said that it doesn't need to team up with a commercial bank, and it really doesn't given that Merrill is almost the prototype of what all other banks want to be. The only thing that Merrill might lack compared to its now-larger rival is insurance underwriting proficiencies. While AXA (NYSE: AXA) and its Equitable (NYSE: EQ) unit both moved up today, insurance and finance company TransAmerica (NYSE: TA) went sideways. Merrill might choose to slowly develop insurance underwriting capabilities with niche players rather than jump into a very difficult insurance market environment.
Regulatory hurdles might face Travelers and Citicorp, though the merger partners apparently believe they can get around them. Perhaps Citicorp will abandon its federal banking charter, which is possible because so few of its deposits are low-cost transaction deposits. What it loses on its funding costs might be made up on the revenues side, making such a move neutral to margins.
With seemingly every financial services company moving up today, investors surprisingly left asset manager Franklin Resources (NYSE: BEN) alone. Though expensive in the eyes of some, the company would make a tempting strategic target, providing beautiful annuity cash flow for any company with the equity value to take it over. If it's a financial services company and it moved up today, thank CEOs Sandy Weill and John Reed. They've now confirmed the trend toward universal banking in the U.S.