Scoreboard, Winter 2000

With Share Prices Depressed,
Deals Were Way Down in 1999

Outlook for Improvement Hangs on Fundamentals,
and Analysts Disagree on Trend

by Mary Beausoleil

While other economic sectors were exuberantly setting new deal-making records in 1999, the bank and thrift sector languished. Not only was deal activity far less than in 1998 — which set a mark so extraordinary it's not surprising that it wasn't topped — but it was far less than in most years of the decade.

Only two years in the decade had fewer deals than the 339 in 1999, and one must go back to the beginning to find them. In 1990 and 1991, with a recession going on, there were just 216 and 305 deals, respectively. In all other years until last year there were more.

In terms of total deal values, 1999 fared much better. The $75.7 billion for the year was the third-highest total of the decade, following 1998 and 1997. That shows how banks have grown over the decade: A year that ranks third from the bottom in numbers ranks third from the top in deal values.

What is the outlook for 2000? It will depend largely on what happens to bank stock prices.

Currency Devalued

The main reason for the slow year in 1999, of course, was that bank stocks were clobbered, with the frequent buyers club generally being hit hardest.

It started in the late summer of 1998 with the financial crisis in Asia, and except for brief interludes of improvement, it hasn't let up.

Eventually it became clear that the Asian disaster wasn't going to turn into a worldwide depression, but other worries took over. Interest rates are up, and could rise again. Credit quality has deteriorated, although in most cases not seriously, but fears about a worsening persist because it's the top of the cycle and could turn at any moment. The credit cycle, unlike Y2K, is something that Wall Street analysts and Main Street bankers — some of them, anyway — have experienced before.

In addition, several large banks issued earnings warnings for 1999, many because of setbacks with past mergers. They either experienced integration problems or failed to produce promised revenue gains.

Other factors also played a role. The Y2K bug didn't bite, but it was a truly unique event and therefore unpredictable, and it soaked up billions of dollars in preventive maintenance. It no doubt contributed somewhat to the reduced deal activity, although probably more in the first two quarters than the last two.

There's a vicious cycle at work, too. The reduced stock prices depress deal activity, and depressed deal activity contributes to the reduced stock prices. Some of the earlier run-up in bank stocks was on merger speculation — still a factor in some individual cases.

A Fundamental Question

Whether fundamentals improve or worsen is a major question now.

Anthony J. Polini and Salvatore J. DiMartino, analysts at Advest Inc., expect them to worsen. They wrote in a recent research report, "By the time we return to a stable interest rate environment with reasonable near-term prospects for rate reductions going forward, banks and thrifts will likely be at least knee deep in slowing revenue growth and rising nonperforming assets." They also see competitive pricing pressure continuing. In sum: "We expect industry growth rates to slow, profitability ratios to moderate, and consolidation activity to wane," they wrote.

Susan Webber, who is a consultant serving the financial services industry and president of Aurora Advisors Inc. in New York, is also concerned about rising interest rates, possible inflation arising from higher oil prices and overblown stock market sectors, and declining credit quality.

She also notes that when so many people are spending more money than they earn, as they are now, if they stop doing that or start saving, the change could precipitate a recession and hurt banks a good deal. A general stock market decline would also affect the spending of millions of people, and Webber cited several indicators of a classic market top. So she is somewhat pessimistic on the outlook for general improvements in bank stock prices and consequent increases in M&A activity.

And the view toward consolidation has definitely dampened on Wall Street, although who knows for how long. Webber sees one of the "salient events" of 1999 in the switch in M&A outlook of Edward Crutchfield, First Union Corp.'s chief executive officer. After issuing several earnings warnings and watching the stock fall early last year, Crutchfield said First Union wouldn't be looking for acquisitions anytime soon. It was a concession to the facts of life, but it was still a sharp switch for a company that had done dozens of deals during the decade.

Webber noted that Crutchfield and John McCoy, the former CEO of Bank One Corp. who resigned after a series of disappointments for that busy acquirer, were both particularly visible figures in the M&A landscape during the 1990s.

"Who knows if they are a harbinger of things to come?" she said.

Analyst Sean Ryan thinks fundamentals will improve, and then M&A activity will pick up.

Ryan said we are in a period now that is much like 1994, when the Fed was also raising interest rates amid concerns about revenue growth and credit quality. But instead of worsening, things improved, and bank stocks had a three-year run of great performance. Ryan thinks it will happen again.

Interest rates have already risen, and each new hike brings them closer to where they will top out, he pointed out. Asset quality has deteriorated somewhat, but only from what were abnormally high levels; it is just reverting to the norm and will level out.

"Asset quality and interest rates are legitimate items of concern," he said, but in the end, stock prices are going to follow earnings, and earnings for most are showing healthy growth.

Then M&A activity will benefit from the "hydraulic effect": A rally in fundamentals will be followed by an even greater rally in takeover activity. That could happen by mid-year, he said.

Until January, Ryan was with Bear, Stearns & Co., but he sat out much of last year, with respect to making public pronouncements, after he criticized First Union and put it high on his list of takeover prospects. Now, Ryan and a partner have started an independent research company, Byrne, Ryan & Co., based in White Plains, NY, and he can say anything he wants.

Does he still consider First Union a prime takeover target?

"Absolutely," he said.

A large institutional shareholder is exerting pressure for improvement, and the board will eventually see that a sale is in shareholders' best interests, Ryan said.

The End is Near

The end to pooling-of-interest accounting, expected early in 2001, has been widely viewed as favoring more M&A activity this year, especially for big deals.

But nearly everyone agrees that sellers will have to accept lower prices if that is to happen, assuming stock prices stay about the same. Sellers can't have their deal and eat a huge takeout premium too, many say.

Anyway, sellers should look at more than the buyer's absolute price. In a pooling, what matters most is whose stock the selling shareholders are getting in exchange, and the relative proportion they will own in the resulting company.

Another event from late 1999 could influence the drive, or lack of one, to get in last-minute poolings this year. Zions Bancorp. announced near the end of 1999 it would postpone its merger with First Security Corp. because it was going to have to restate financial results back through 1996. The Securities and Exchange Commission was requiring some earlier Zions deals previously accounted for as poolings to be accounted for as purchases instead, apparently because Zions broke the poolings rules by repurchasing too much of its own stock.

It remains to be seen whether the SEC moves against other acquirers in the same way. If it does, the restatements will almost have the effect of ending poolings three years ago, because the market will be forced to evaulate their financial results apart from the goodwill — a development expected in any case after poolings are actually abolished.

Or, perhaps the SEC's move against Zions will be like the one it made against SunTrust Banks Inc. in 1998, delaying SunTrust's acquisition of Crestar Financial Corp. The SEC made SunTrust restate some financial results because of SunTrust's allowance for loan losses. Where most saw simply good, conservative reserves policy, the SEC saw potential earnings management.

That case didn't turn into an industry-wide trend, but banks paid attention and in some cases adapted their reserves policy.

In any case, nobody expects bank consolidation to stop. Banks may not be the hottest sector, but the deals are far from over.

— Mary Beausoleil, Editor
(201) 963-1000