Drip
Portfolio Report
Monday, June 8, 1998
by Dale Wettlaufer ( [email protected])
Alexandria, VA (June 8, 1998) --Our first stop today is San Francisco. The city on the hill lost the headquarters of one of its two large banks earlier this year, but it looks like the other, Wells Fargo (NYSE: WFC), is going to make up for that by today announcing a proposed merger with Norwest Corp. (NYSE: NOB). For more on that merger, here's a link to this afternoon's Fool Plate Special.
Now off we go to Charlotte, North Carolina. Two of the country's largest banks, First Union (NYSE: FTU) and NationsBank (NYSE: NB) are headquartered there. We will take a look at one or both of these in our second look at the banks, but for a while they've been in a state of limbo with the huge mergers they've engineered. For NationsBank, almost no sooner had it closed its (excellent, in my opinion) merger with Florida's Barnett Banks than it announced its audacious merger with BankAmerica (NYSE: BA). That transaction will result in the largest bank holding company in the United States, though Travelers - Citicorp will be the largest financial services company.
First Union recently completed its merger with CoreStates Financial of Philadelphia, which I would argue is a less attractive merger than NationsBank's Barnett deal. First, NationsBank's Hugh McColl hurt First Union chairman and CEO Ed Crutchfield's eastern seaboard expansion strategy. First Union is a significant presence in Florida, but in no way is it equal to what it would have been had it acquired Barnett. Throughout the cycle of bank mergers from late 1994 to the present, it's been NationsBank that has been willing to do deals at progressive valuation multiples that people thought were too rich.
There are a couple reasons why NationsBank has done these deals at these multiples. First, when a bank does an intra-state merger or acquisition, it can take out up to and over 40% of the acquired bank's overhead expenses by integrating back-office functions. The economies of scale that a large bank has allows it to take on the acquired bank's clearance, servicing, legal and administrative, and information technology services at a very low marginal cost to the acquiring company. In an interstate merger, the acquiring company should be able to take out 25% of the acquired company's overhead. So, while some were looking at acquisitions such as NationsBank's deals with BankSouth in Atlanta or Boatmen's Bancshares in St. Louis and saying, "Why would you pay 2.5 to 3.5 times book," NationsBank was looking at the cost savings that it could achieve as well as the incredibly good-looking balance sheets at such institutions.
When the press and others have commented on the price/book multiples that have been paid in this merger cycle, many of those commentators didn't examine the price-to-cash flow multiples, price-to-earnings multiples, composition of those book values, and excess capital and/or excellent growth characteristics of the acquired banks. It's one thing to pay 1.5 times book for a bank with a strained capital position, and it's an entirely different thing to pay 3.5 times book for a diversified bank with market share in excess of 20% and with a very liquid balance sheet.
At the moment, the Charlotte banks themselves are not that pricey. Having performed in line with the S&P 500 but having outperformed the earnings growth of the S&P 500 this year (on a continuing operations basis), these banks are priced about where they started the year at an inexpensive price. Compare the multiples we see below, remembering that NationsBank and Wells Fargo especially have tons of goodwill amortization in their expense base that understates their profitability:
P/E multiple on fiscal 1999 estimates:
American Express.....19.2
Merrill Lynch.....17.3
Wells Fargo.....16.6 (I've adjusted this, taking out goodwill amortization)
US Bancorp.....16.5
Citicorp.....14.8
KeyCorp.....14.7
BANC ONE.....13.2
NationsBank.....13.6
BankAmerica.....13.1
(about 13.4 times combined, before cost savings)
First Union.....12.7
Compared to the largest financial services companies in the country, then, First Union is trading at a 17.5% discount and NationsBank is trading at a 12.9% discount. To trade at parity with the average forward multiple, NationsBank would increase in value 14.8% and First Union would increase in value 21%. There are two components to outperforming the stock market averages. One is to buy superior quality and the other is to buy superior quality at a discount. There's very good quality in the Charlotte banks, in my opinion, and it's selling at a discount.
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