Saturday, February 26, 2011

Does "Evaluate Strategic Alternatives" mean the end of your bank?

There is a lot of soul searching happening in the executive suites and boardrooms of community financial institutions (FIs). Nearly three years of economic malaise, political activism, media vilification, and regulatory over-reach have made us weary of continuing as an independent FI.

When Boards or CEOs reach this point, they determine to undertake a review of their "strategic alternatives". I recently spoke at a Financial Managers Society meeting packed with FI CFOs and controllers and asked the crowd what they thought "evaluate strategic alternatives" meant. In unison, they responded "sell". But should a board, in exercising their fiduciary duties, perform this analysis routinely without determining to sell the FI first?

A rhetorical question because the answer is obvious. But what should such an analysis entail if it is to contain an assessment of the FI's strategy, the value of successfully executing such a strategy, the possibility of acquiring, or in the absence of opportunity the value that can be received in a sale?

The first step, not often taken, is to develop a present value analysis of the FI's strategic plan. What do you compare the value in a sale to if you do not perform this analysis? See below for a version that we often use in determining the present value per share of an FI. In the chart, I projected out five years. Why five? Many executives think it involves too much guesswork when projecting so far into the future. True about the guesswork, but you must assess the amount of time your strategy will take to fully realize its value. Strategy execution typically lends itself to a long-term view.

The above analysis places a present value per share on Schmidlap's strategic plan at $23.95 using a 13x earnings multiple and a 9% discount rate. These two factors are important and the FI should use empirical data to determine the earnings multiple and discount rate. For example, in a strategic planning retreat I performed such an analysis on a client using a 12x earnings multiple, to which the CFO took exception. Upon reviewing 10 years of trading history I discovered he was correct, and the appropriate multiple was 14x. This had a meaningful impact on value.

The discount rate is often a point of contention among executives, board members, and industry analysts. I will not pull out my business school textbook and go through a Cap-M exercise (because I would have to find my textbook to accurately do so). In its simplest form, the discount rate in the above sample should be the shareholders' expected capital appreciation of the FIs stock. If shareholders expect a 10% total return from holding this FIs stock, and the FI pays a 2% dividend yield, then the discount rate should be 8%.

Once the FI performs a present value analysis of its business plan, it should assess the M&A market and the value it can receive in a sale. But there should be an additional step: assessing the potential stock price appreciation of a would-be acquirer's stock after the acquisition. In many if not most cases, the selling FI shareholders will be invested in the acquirer.

A textbook case for celebrating the "pop", or premium price received by a seller to celebrating the blues post-transaction because the buyer's prospects and stock tanked was First Union's (now owned by Wells Fargo) acquisition of CoreStates in Philadelphia. Had CoreStates assessed the potential for a post acquisition First Union, perhaps disaster could have been averted. Don't put your FI in the same situation.

But evaluating strategic alternatives should not only be about a sale or remaining independent and executing your plan. What about a "buy"? Your FI should identify potential targets for their ability to propel your strategy, build economies of scale, and accelerate earnings growth.

It is less complex to execute strategy without having to negotiate and integrate an acquisition. So acquiring should accomplish the above objectives, particularly if the present value of your business plan is trumped by your takeout value. Then you have what I term a "strategy gap" that must be filled by either/or: faster organic revenue growth, cost savings, and/or acquisitions. All should be part of your regularly scheduled strategic alternatives meeting.

I recently heard a respected investment banker predict that the 8,000 banks/thrifts in the United States will decline to 5,000. Bold prediction, to say the least. If we are to take faith in it, then there will be a lot of "reviewing strategic alternatives" happening in upcoming board meetings. But in performing such an analysis, the FI should assess the present value of its strategy, determine the reasonable value it can receive in a sale and the prospects of would-be buyers, and the opportunities to acquire to fill "strategy gaps". Looking at only one aspect of the above will only shortchange your employees, customers, and shareholders.

How does your FI perform a "strategic alternative" review or what do you think should be included in such an undertaking?

~ Jeff

Note: The above present value analysis was performed on an actual FI, using actual historical numbers from 2001 (base year) through 2006 (five year projected years). The FI was trading at $39.57/share on 12/31/01, the base period. Therefore, the strategy eroded value over time, primarily because earnings grew at a 3.23% compound annual growth rate. To be fair, the FI made an acquisition in 2005 which may have resulted in a temporary downtick in earnings.

Saturday, February 19, 2011

Is customer service your bank's difference maker?... Really?

My non-scientific estimate of how many community financial institutions (FIs) claim "customer service" as the factor that differentiates them from their competition: nine out of ten.

But if 90% of banks have superior customer service, then no banks have superior customer service and 10% of banks are inferior. So, in this respect, it may be the perception that a community FI has great service, not the reality.

If a community FI truly has superior service, then it should be able to: 1) charge higher prices, 2) improve customer acquisition, and/or 3) improve customer retention and wallet share.  I can think of no other reason why an FI would invest in having superior customer service. When challenged, FI executives tend to go to the commodity argument... "We can't charge higher prices because money is a commodity. Our money is no different than another FI's." 

To that argument, I offer the following story, sent to me by a bank CEO from The Simple Truths of Service:

'When a cab pulled up, the first thing Harvey noticed was that the taxi was polished to a bright shine. Smartly dressed in a white shirt, black tie, and freshly pressed black slacks, the cab driver jumped out and rounded the car to open the back passenger door for Harvey. He handed my friend a laminated card and said: “I’m Wally, your driver. While I’m loading your bags in the trunk I’d like you to read my mission statement.”

Taken aback, Harvey read the card. It said:

Wally’s Mission Statement:

To get my customers to their destination in the quickest,
Safest and cheapest way possible in a friendly environment.

This blew Harvey away. Especially when he noticed that the inside of the cab matched the outside. Spotlessly clean!

As he slid behind the wheel, Wally said, “Would you like a cup of coffee? I have a thermos of regular and one of decaf.” My friend said jokingly, “No, I’d prefer a soft drink.”

Wally smiled and said, “No problem. I have a cooler up front with regular and Diet Coke, water and orange juice.” Almost stuttering, Harvey said, “I’ll take a Diet Coke.”

Handing him his drink, Wally said, “If you’d like something to read, I have The Wall Street Journal, Time, Sports Illustrated and USA Today.”

As they were pulling away, Wally handed my friend another laminated card. “These are the stations I get and the music they play, if you’d like to listen to the radio.”

And as if that weren’t enough, Wally told Harvey that he had the air conditioning on and asked if the temperature was comfortable for him. Then he advised Harvey of the best route to his destination for that time of day. He also let him know that he’d be happy to chat and tell him about some of the sights or, if Harvey preferred, to leave him with his own thoughts.

“Tell me, Wally,” my amazed friend asked the driver, “have you always served customers like this?”

Wally smiled into the rearview mirror. “No, not always. In fact, it’s only been in the last two years. My first five years driving, I spent most of my time complaining like all the rest of the cabbies do.

Then I heard the personal growth guru, Wayne Dyer, on the radio one day. He had just written a book called You’ll See It When You Believe It.

Dyer said: If you get up in the morning expecting to have a bad day, you’ll rarely disappoint yourself. He said, ‘Stop complaining!

Differentiate yourself from your competition. Don’t be a duck. Be an eagle. Ducks quack and complain. Eagles soar above the crowd.’”

“That hit me right between the eyes,” said Wally. “Dyer was really talking about me. I was always quacking and complaining, so I decided to change my attitude and become an eagle. I looked around at the other cabs and their drivers. The cabs were dirty, the drivers were unfriendly, and the customers were unhappy. So I decided to make some changes. I put in a few at a time. When my customers responded well, I did more.”

“I take it that has paid off for you,” Harvey said.

“It sure has,” Wally replied. “My first year as an eagle, I doubled my income from the previous year. This year I’ll probably quadruple it. You were lucky to get me today. I don’t sit at cabstands anymore. My customers call me for appointments on my cell phone or leave a message on my answering machine. If I can’t pick them up myself, I get a reliable cabbie friend to do it and I take a piece of the action.”

Wally was phenomenal. He was running a limo service out of a Yellow Cab. I’ve probably told that story to more than fifty cab drivers over the years, and only two took the idea and ran with it. Whenever I go to their cities, I give them a call. The rest of the drivers quacked like ducks and told me all the reasons they couldn’t do any of what I was suggesting.'
Long story, I know. But worth telling because I perceive a taxi ride as a commodity too. In fact, in most cities, taxis are subject to price fixing, charging the same fare per mile. But if Wally delivers his commodity in a manner that is valued by his customers, they will call him more often and tip him better. If Wally can do it, so can we.
We are so "in the weeds" in our day to day business we may not view the long-term decline in customer service. A recent Carmax commercial, aired during the Super Bowl, exemplifies how such service has declined over the generations (see below). But if community FIs determine to develop strategies focused on differentiation and not price, then we must take a serious look at our service and implement strategies to elevate our performance, build our brand, and sustain our future.
What is your FI doing to improve service?
~ Jeff

Saturday, February 12, 2011

Banker Quotes: As Told to Me

I learn a lot from bankers as I visit their offices, speak to them on the phone or at industry events. Occasionally they will offer an insight that I think my Twitter followers would find interesting. Below are quotes that I tweeted so far this year along with my brief insights or background regarding the comment. Note that if the quotes exceeded 140 characters, I would have abbreviated or substituted some words to make them fit. So if you are a CPA and want to count, a few of the quotes may exceed the 140 here, but not on Twitter. I quote bankers anonymously to protect the innocent.

@JeffMarsico Bank CEO to me: "My least tenured board member has been on the board 31 years."

jfb note: This is a common theme in community FI boardrooms. Board members hang on with white knuckles to their board seats, contributing to our industry’s slow progress in adapting to change.

@JeffMarsico Bank COO to me: “We're thinking of selling a business line but are afraid to ask accountants the impact for fear they'll make us write it down.”

jfb note: This may seem silly to you, but it is very common. FI senior executives fear what their accountants and regulators might make them do.

@JeffMarsico Chief Credit Officer to me: “Every lender I know has made good and bad loans. The key is to get them to admit to the bad.”

jfb Note: A key lesson learned by me after this crisis was the eternal optimism by lenders that their bad loans will be fine if we just let them be.

@JeffMarsico Bank finance officer to me: "If you figure out our strategy, let me know."

jfb note: This person was not a senior executive at their FI and was not tuned into the FIs strategy. Both she, and presumably her coworkers, were left out of the secret or the bank didn’t have a strategy. Either way, common themes.

@JeffMarsico Bank CEO to me: "I don't know who is making the decisions [at the FDIC], but they are making some pretty poor ones!"

jfb note: Enough said.

@JeffMarsico Me to snow blower maker: “I can't start it.” SBM: "Did you leave gas in all year. Yeah, there's your problem. Clogs the carb."

jfb note: This has nothing to do with banking, but I’m still smarting from having to manually shovel a fairly large volume of snow off of a big driveway. Not good for my 45 year old back? (rest of me is much younger)

@JeffMarsico Chief Credit Officer to me: "63% of our non-accrual loans have never missed a payment and are paying as agreed."

jfb note: I was shocked by this revelation. Their regulator made this FI put those loans on non-accrual because they didn’t cash flow.

What interesting things have you heard about our industry?

~ Jeff

Sunday, February 06, 2011

Are the regulators getting you down?

These past two years have often been extremely difficult. As consultants, we should try not to personalize engagements. But I can’t change the internal wiring. Last year, a client failed, and many more received regulatory orders.

Memorandums of Understanding (“MOU”), Formal Agreements (“FA”), and Cease and Desist Orders (“C&D”) have been on top of our reading list for the past two years. The stark increase in such orders has been alarming. The FDIC has nearly quadrupled its enforcement actions (“EA”) over the past three years.

Many of these EAs have very similar, if not identical, provisions. Take for example the language from an FA Article relating to a strategic plan issued by the OCC to The Suffolk County National Bank of Riverhead (“SCNB”) in New York on October 25, 2010:

“The Board shall adopt, implement, and thereafter ensure Bank adherence to a written strategic plan for the Bank covering at least a three-year period. The strategic plan shall establish objectives for the Bank's overall risk profile, earnings performance, growth, balance sheet mix, loan mix, off-balance sheet activities, liability structure, capital adequacy, reduction in the volume of nonperforming assets, product line development and market segments that the Bank intends to promote or develop, together with strategies to achieve those objectives…”

Get in your time machine and go back to February 6, 2009 when the OCC issued a Consent Order to Bay National Bank in Lutherville, Maryland. It too had an Article regarding a strategic plan that read:

“The Board must within sixty (60) days of the date of this Order, adopt, implement, and thereafter ensure Bank adherence to a written strategic plan for the Bank covering at least a three-year period. The strategic plan shall establish objectives for the Bank's overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in the volume of nonperforming assets, product line development and market segments that the Bank intends to promote or develop, together with strategies to achieve those objectives…”

So what, right? The OCC cut and paste because they wanted a similar strategic plan from both institutions. People and organizations do this all of the time.

The difference here is that SCNB has been profitable throughout the crisis, and achieved a 1.12% ROA for the third quarter 2010. Bay National failed on July 9th. In this context, is similar treatment in an EA fair?

I would vote no. There are many Articles in EAs, and the strategic planning article in the above institutions is one of many. But life, and business, is not necessarily fair. I’m not sure the lesson we should glean from the similarity of these two orders should be about fairness.

The productive view about the similarity of EAs is why haven’t we been doing some of the things required by regulators in the first place? Why do many, if not most of these orders contain Articles relating to strategic and capital plans?

Banking is a highly regulated industry, and has been since the Great Depression. Regulators must approve our initial business plans, capital plans, and various other operating procedures prior to granting a charter. Once granted, regulators examine us at least annually, and frequently more often, to ensure we are complying with the myriads of laws and regulations designed to promote safety and soundness. They used to approve interest rates and limit products.

Given the highly regulated environment, bankers are kept in a tight box of things they can and can’t do. So why develop a strategy? Budgets have successfully served as strategy the past three generations, haven’t they?

In the context of EAs, I don’t believe regulators are compelling bankers to develop strategic plans to identify a competitive advantage, to differentiate from other banks, or to build a roadmap to the future. When we read between the lines of EAs, we see regulators looking to tighten the box, remove gray areas, and exert greater control by requiring banks to seek permission to deviate from the plan.

But that should not stop those operating under EAs from taking maximum advantage of the consulting and advisory dollars they are required to spend. If required to develop a strategic plan, why don’t banks assess the competitive environment and build a vision and plan for their sustainable future? Similarly and almost complementary, the capital plan should be a component of bank strategy. How much capital will the bank need to execute the plan? What are the preferred and secondary sources of capital?

Imagine a bank that seeks to grow organically by positioning itself as a small business expert within its communities. This will drive products, risk appetite, credit decisions, strategic alliances, training, and capital requirements, to name a few. Perhaps the bank would like to pay higher than market dividend yields because their investor base enjoys dividends. So growth can only be partly funded by retained earnings.

Planning for this, perhaps the bank can establish dividend re-investment plans and employee stock ownership plans to enhance capital. In this context, the bank decides what it wants to be, and sets strategy to accomplish it. We don’t need the OCC to tell us that!

A third Article that is oft repeated in EAs is a management study, requiring the bank to hire a consultant to evaluate the board, senior management, and/or staffing levels. Strategic plans, capital plans, and management studies are my firm's top three regulatory-mandated engagements over the past two years. So if these appear in your EA, fear not. They are appearing in many.

Similar to strategic and capital plans, why not take advantage of the required management study expenditure to determine if you have the right team in place to execute your strategy and succeed into the future? I understand that management studies are not particularly comfortable. But, since you are required to undertake one, why not make it as beneficial to the future of your bank as it can be? You have a good idea what team members might be holding you down. Chances are the outside advisors will discover it too, and perhaps find some diamonds in the rough!

The level of regulatory activism is greater today than at any other time in the past 20 years. The political climate is exasperating the situation and creating uncertainty. Amidst our efforts to avoid or get out of enforcement actions, perhaps we should take advantage of the required introspection to determine a strategy that improves our competitive position and sustains our future.

I would like to read your thoughts on the regulatory environment.

~ Jeff

Note: The above post was taken from my firm's First Quarter, 2011 newsletter. To obtain a copy of the newsletter see the link below: