Mellon Banks on Numbers
Restructuring to focus on high returns

by Jeff Fischer (TMFJeff@aol.com)

Paris, France (Jan. 20, 1999) -- I've received several e-mails asking us to explain the recent and interesting changes at Mellon Bank (NYSE: MEL), our newest investment. The timing of the request is appropriate. We've sent all of our monthly investment to Mellon the last two months, and we'll send another $100 to Mellon at the end of this week for our February investment.

We're locking our investments into Mellon's vault every month for several reasons: 1) we want to get the position up-to-size in the portfolio; 2) we like the higher dividend yield of Mellon (especially earlier); 3) we also appreciate Mellon's valuation; and 4) one needs to own at least five shares before dividends can be reinvested. Following our next optional cash payment to Mellon, we'll own about five shares.

Onto the news!

Last Friday, Mellon announced fourth quarter and year-end results. Our Pittsburgh-based heavyweight achieved record 1998 diluted earnings per share of $3.25, up 13% from '97. Net income for the quarter grew 16% to $222 million. On a tangible basis -- which excludes goodwill amortization -- Mellon grew earnings per share 15% and, more importantly for long-term investors, the company increased its profitability and efficiency ratios. Mellon grew its return on equity to 46% and return on assets to an impressive 2.13%. (If you're wondering what these terms mean, please visit our Mellon buy report, which offers Dale's definitions.)

Alongside successful operating results, Mellon reported (almost off the cuff) that it will sell several non-core businesses. Mellon's newly organized management is fond of saying that business will continue with "strategic continuity," but what that really means is that the company will continue to change itself with a strategic goal of focusing on its highest return, most profitable core businesses. (Makes sense.) This trend has been taking place since we began to buy shares last fall (around the same time that new management initiatives really began to kick in). The company won't use the term "restructuring" to describe itself, but in many ways, it is. And this is good.

What's the story?

Mellon announced on Friday that it will sell its mortgage business, credit card portfolio, and also its network services transaction-processing unit. Three businesses, gone in a flash! Or almost. The transactions should occur by the third quarter of this year.

But why do them?

Mellon is one of the largest financial services companies in the country when measured by market value. It has $2.2 trillion under administration or management (actually, $390 billion is under management, and the rest is under administration). Divestiture of the three aforementioned businesses should reduce Mellon's balance sheet by over $4 billion and lower the company's exposure to higher-risk assets that are also prone to underperformance (and thus lower Mellon's profitability ratios while reducing its focus, too).

What are the issues?

Mellon has about $815 million of its capital (or 20%) committed to large corporate banking businesses, but about 45% of it (around $360 million) is underperforming Mellon's target of 18% return on equity (ROE). Overall, Mellon's corporate banking unit earns an impressive 21% ROE, but the fact that nearly half of this segment earns less than 18% ROE demands attention. Given this example, Mellon is reviewing all of its mid-term (three year) growth plans in each of its business lines. As it does so, it will continue to juggle, wiggle, and reconfigure several of its businesses.

Hence, Mellon is selling its mortgage services business where it has about $150 million in committed capital. This capital is at best breaking even (not good!), but the resale value of the mortgage portfolio is attractive. (The company can't give specific numbers.) Mellon is also selling its credit card portfolio and transaction processing units, both of which have underperformed the company's goals and aren't exactly in line with the company's long-term objectives. Meanwhile, Mellon will push hard to improve the profitability of its underperforming corporate banking segments (because the dynamic of these business lines matches its objectives and returns are usually high), but it will jump ship on divisions or investments that don't mesh or meet profitability objectives.

It's that simple. The recent performance of Campbell Soup (NYSE: CPB) might not carry the best connotations, but what Mellon is doing is very similar (in its own way) to what Campbell Soup is doing. That is: Mellon is working to improve profitability across the board by focusing on its strongest business lines. In the long term, shareholders should benefit most.

Assuming the success of just two of Mellon's new initiatives (strengthening its corporate banking biz and selling its mortgage portfolio), it's estimated by Merrill Lynch that Mellon could improve its current net income by 6% to 7%, near term. And with money saved and the free cash flow earned (about $585 million in free cash flow this year is reasonable), Mellon is in a position to buy back more stock. Management might buy as much as 2% to 3% of outstanding shares this year, increasing the possibility for an upside surprise or at least offering assurance that annual estimates will be met (barring significant downside surprises).

Mellon trades at 19 times 1999 earnings per share estimates of $3.61, and 17 times potential year 2000 EPS. Over 50% of Mellon's shares are owned by institutions, hopefully ones without itchy trigger fingers (although turnover ratios in the industry belie this hope).

For information on the transactions that Mellon completed in 1998, and for more on what 1999 might hold, read Dale Wettlaufer's column (if you haven't already) from December 30th. And to discuss Mellon, other Drip companies, or Drip investing, please visit the message boards linked in the top right of this page. We hope to see you tomorrow.

Fool on!

-Jeff Fischer

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