April 2006

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Merging for Growth

By Dave Kaytes & Rick Spitler

The merger of Capital One Financial Corp. and North Fork Bancorp. fired the first shot in a new round of bank consolidation. But this time acquirers must focus on revenue growth, not cost reduction, to justify purchase premiums. It’s a different game from past decades, when efficiency was the prime operational aspects of their transactions, such as the elimination of overlapping branches and redundant headquarters staff. After twenty years of wringing out costs, banks now must look elsewhere for opportunity.

As investors clamor for revenue growth momentum, the simplistic answer is to stake out positions in high growth markets. Buoyed by regions enjoying high deposit growth, banks with even average talent can outperform well-managed institutions mired in lagging regions. For valuation purposes, it’s better to be a mediocre bank in Las Vegas, where annual deposit growth rates exceeding 12% can be achieved, than a superb institution in Cincinnati, where the growth potential is closer to 1%.

For those suggesting that capturing “organic growth” is the new merger formula, however, one has to ask what commune they live on. After all, there is little to no organic growth in 60% of the U.S. banking markets. Institutions cannot pick up and move when regional growth dynamics slow or hasten. Already today, many leading banks are growing in spite of local market conditions, not because of them, although this often goes unrecognized by investors looking only at national averages.

So if not organic, then growth must come through smart mergers. And smart mergers arise from tapping the unrealized potential in each regional market served by a particular franchise. Certainly the best scenario is to buy underperforming franchises in high-potential markets, but in reality target banks usually are a mix of high- and low-performing branches in high- and low-potential regions.

In this light, it’s imperative to parse and analyze the individual components of the portfolio. Where is the bank underperforming regional markets? How can the acquirer’s business model improve the target’s performance and capture its unrealized potential? As part of this analysis, acquirers must be rigorous in evaluating their own business systems.

Previously, many banks overpaid for “growth” franchises whose dynamics were misunderstood, shelling out for transactions that actually had poor inherent potential. In fact, the worst merger experiences during the 1990s came about as underperforming banks in good markets acquired overachievers in mediocre markets. The acquirers’ weak business systems negated the targets’ ability to continue exceeding the local growth norms, and deposits and customer relationships quickly dwindled.