Why SunTrust and BB&T? Why?

I know on the investor conference call, Kelly King of BB&T and Bill Rogers of SunTrust spoke to why. But I may not have been listening well.

I suppose much of the discussion revolved around scale. So, along with my first inclination, my second inclination was also... why?

The Numbers

Here are their slash lines (read: Assets/ROA/ROE/5-Year Annual EPS Growth/Dividend Yield)

BBT: $225B / 1.47% / 10.95% / 9.5% / 3.3%

STI:  $216B / 1.34% / 11.50% / 15.5% / 3.1%

BBT (bank only) had $6.3B in operating expenses in 2018, five percent of which is in the Call Report category "Data Processing Expense", defined as expenses paid for data processing and equipment such as telephones and modems. It does not include employees. STI (bank only) had $5.4B, 10% of which was in Data Processing Expense. I find it difficult to believe they can't find enough money in that pot or outside of the Data Processing pot for technology innovation. It would be a travesty of management. 

Perhaps they would find it difficult to maintain that level of EPS growth, given the law of large numbers. But they chose to solve that problem by becoming larger? BB&T will issue 1.295 shares for each SunTrust share outstanding, increasing their share count from 777 million to 1.4 billion. So to earn one cent per share more, the combined company would have to generate $14 million in additional net income. And at the 1.5% ROA BB&T already achieves, they would have to grow $933 million for each penny of EPS growth. To maintain 10% EPS growth, the combined bank would have to grow about $39 billion per year (42 cents x $933MM).

Perhaps they felt the pressure "to do something", as my BB&T regional business banker friend told me, saying that at their size they were in "no man's land". I don't know what that means. But an investment banker told me today that investors are intolerant of tangible book value per share dilution of more than three years. So if you feel you need to "do something", and can't overly dilute your book value, perhaps a merger of equals (MOE) makes sense.

I have preached MOE virtues for banks that could actually benefit from scale to achieve better efficiency ratios. Statistically, banks between $5B and $10B in total assets are better at it than larger financial institutions. But I digress.

Law of Large Numbers

I have written in the past about financial institutions running into the law of large numbers, leaving only acquisition as its means to meet shareholder expectations. I'm not saying it's impossible, as JPMorgan Chase did it ($2.6T in total assets, 14% EPS CAGR since 2014). But it's difficult. And JPM received a huge boost from tax cuts. 

Financial institutions, in my experience, are not keen on turning themselves into cash cows, maximizing their profitability with slower growth and paying a higher proportion of shareholder returns in dividends. Financial institutions also don't tend to buy and divest lines of business as a means to stoke shareholder returns, as very large industrial firms do (i.e. GE).

So if BB&T and SunTrust have ample operating budgets to invest in technology, and are delivering strong shareholder returns, in good markets.. i.e. almost the same markets... 

I ask: Why merge?

~ Jeff

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Earnings Guidance? Buy Side Wall Street Says Think Long-Term. Sell Side Wants Tax Rate.

In February, Larry Fink from Blackrock sent a letter to publicly traded CEOs to think long term and to stop giving earnings guidance. Specifically, he said "Today's culture of quarterly earnings hysteria is totally contrary to the long-term approach we need."

Let's see if bankers are heeding Larry's call on their first quarter earnings call.

Christian Bolu - Credit Suisse to Goldman Sachs CFO Harvey Scwhartz: "Tax rate was a bit lower in the quarter, just curious how we should think about the go-forward tax rate?"

Schwartz - "In terms of the go forward I guess if I was to give the best estimate, I'd say something similar to last year."

Bob Ramsey - FBR & Co. to BofI Holdings CFO Andy Micheletti: "I guess putting it all together, next quarter you'll have less Block [from acquisition of H&R Block portfolio]; sounds like your loan yields are stable-ish; plus you have some lift from the equipment finance; and deposit costs maybe tick up with a little growth. Does that put you somewhere in the ballpark of 4%? Or what is the right range for next quarter?"

Micheletti: "Yes, Bob, I think we're still in that 3.80% to 4% range. I would lean to the higher end of that, given where we're coming out, without the Block impact. But certainly in the 3.90%s would be fair."

Michael Rose - Raymond James & Associates to BB&T CEO Kelly King: "Can you give us your thoughts, in light of the environment, in terms of what we could expect for the efficiency ratio"?

King: "I think we will end up this year with improvement. It may be in the 57ish kind of range. Pretty confident about that."  

Dave Rochester - Deutsche Bank to Great Western Bancorp CFO Peter Chapman: "And then just one last one on the margin. Just trying to get your sense for the trend that we should see from here?"

Chapman: "Not much change really to what guidance we have given in the past. So as we have said, Dave, I think if rates remain low, if it ticks down a point or two a quarter, then we wouldn't be surprised with that." 

Chris McGratty - KBW to UMB Financial Corporation Chairman & CEO Mariner Kemper: "And given the stock movement, should we be assuming that those 2 million shares [stock buyback] will be used kind of consistently through the year?"

Kemper: "You know, all I can really tell you is that we certainly think we are very thoughtful about how we think about how to deploy our capital. I know you want more but that is about all I can give you."

Amen Mariner!

To be fair to these banks and their executives, equity analysts bombard them with questions each quarterly call to help them with their projection models. What are they to do? 

In the spirit of Larry Fink's comments and wishes, as one of the largest investment funds in the world, and to be consistent with my belief that managing for the long-term opens doors to investments that can transform your financial institution for an enduring future, here is a sample analyst question and a proposed answer.

Joe Spreadsheet - Bank Stock Investment Firm, Inc. to Chris Evert, CEO of Schmidlap National Bank: "So, Chris, I have this spreadsheet in front of me and I have to enter in an effective tax rate to spit out net income projections. I don't want to be surprised next quarter when I make my estimates, what number should I put in cell F72?"

Evert: "Joe, our long-term strategy has been to transform our bank into a core funding machine, and away from the asset-driven strategy that resulted in large amounts of wholesale funding. As we make this strategic transition, our loan to deposit ratio will fall and, if successful, will result in greater margin as a result of lower cost of funds, offset somewhat by a lower yield because we are becoming more liquid and more assets will be in our investment portfolio. We'll manage taxes from there. Good luck to you buddy on cell F72."

How do you think we can transition from this "here's what we promised the investment community next quarter" to using the investment community to give us discipline in executing long-term strategy?

I'd like to hear from you.

~ Jeff

Bonus: Lloyd Blankfein, CEO of Goldman Sachs, talks about Fink's letter on CNBC Feb 3rd.

http://www.cnbc.com/2016/02/03/cnbc-exclusive-cnbc-transcript-goldman-sachs-chairman-ceo-lloyd-blankfein-speaks-with-cnbcs-squawk-box-today.html

Does your bank achieve positive operating leverage?

When a significant portion of your cost structure is fixed, then growing revenues should generate positive operating leverage... the cost of generating the next $100 of revenue should be less expensive than generating the previous $100.  This fundamental logic stands behind the banking industry buzzphrase, economies of scale. The fixed cost of your IT infrastructure is less on a relative basis for a $1 billion in assets financial institution (FI) than a $500 million in assets FI.

Because it is intuitive, doesn't make it so. Over the course of the past 10 years, the number of FDIC-insured FIs decreased by 23% (see chart). The average asset size per institution increased from $753 million to $1.7 billion. Clearly, part of this consolidation wave was attributable to FIs striving for economies of scale and positive operating leverage.

Has this consolidation, partly designed to give surviving institutions scale so they can spread relatively fixed costs over a larger franchise, resulted in positive operating leverage? My research into the subject says no.

One measure of achieving positive operating leverage is the efficiency ratio, defined as operating expense divided by the result of net interest income plus fee income. The lower the efficiency ratio, the greater the profitability. As an institution grows and is able to spread costs over a larger base, the efficiency ratio should go down.

But over the past ten years, efficiency ratios have risen in every asset category in both banks and thrifts with the exception of the very largest (>$10B in assets) banks (see charts).

The efficiency ratio measures how much in operating expense it takes to generate a dollar of revenue. So what if revenues (net interest margin, or fee income) are on the decline? Naturally, the efficiency ratio will go up. To further isolate expenses, I reviewed how expense ratios, defined as operating expenses divided by average assets, fared for our industry (see chart).

For banks, expense ratios have not budged during the period that resulted in a 23% reduction in FIs. Thrift expense ratios rose materially. I reviewed my company's bank and thrift product profitability reports to see if operating expenses per account declined during the 2000-2010 period. The answer: not one spread product group showed a decline in annualized cost per account. Not one.

Let's look at a couple of highly acquisitive FIs to see if they are achieving positive operating leverage by growing their balance sheets through mergers.

Fifth Third Bancorp

Fifth Third Bancorp is a $110 billion in assets financial institution with 1,363 branches and is headquartered in Cincinnati, Ohio. It has made six acquisitions totaling $32.6 billion in acquired assets between 2000 and 2007. The largest acquisition by far was the second quarter 2001 acquisition of Old Kent Financial, a $22.5 billion in assets bank. I chose this period to offset any impact from the 2008-2009 financial crisis. Clearly Fifth Third undertook acquisitions to achieve economies of scale. Relevant statistics during this period include:

While Fifth Third’s assets grew at a compound annual growth rate (CAGR) of 13.5%, earnings per share grew at a 1.1% CAGR and both the efficiency and expense ratios were higher in 2007 than when the bank was $45 billion in assets in 2000. Positive operating leverage should result in EPS growing faster than asset size because adding the next $100 in assets should cost less than the previous $100. Has Fifth Third achieved positive operating leverage by more than doubling the size of the bank during the measurement period?

 

 

BB&T

 

BB&T is a $157 billion in assets financial institution with 1,791 branches headquartered in Winston-Salem, North Carolina. It made 21 acquisitions totaling $44.6 billion in acquired assets from 2000 through 2007.  BB&T acquired more, and often smaller, financial institutions during the measurement period than Fifth Third.  Relevant statistics include:

 

While BB&T’s assets grew at a CAGR of 12.2%, earnings per share grew at 10.8%. But the efficiency ratio remained relatively steady in spite of BB&T’s net interest margin falling from 4.20% in 2000 to 3.46% in 2007. The expense ratio declined, realizing economies of scale from its asset growth. Although EPS did not exceed asset growth, the culprit lies more in revenue generation than on realizing efficiencies from growth.

This analysis is a simple undertaking to determine if your financial institution is getting the results you want when executing a growth strategy to achieve economies of scale and positive operating leverage. If your results more closely resemble Fifth Third’s than BB&T’s, you should ask yourself why.

Economies of scale should result in lower efficiency and expense ratios, and greater profitability… i.e. positive operating leverage. If you are growing to spread relatively fixed costs over a greater revenue base, then you should measure to determine if you are succeeding. Success should result in better results to peer, industry benchmarks, and downward trends in operating costs per account. Growing absent success in these metrics means you are simply managing a more complex organization for no additional benefit. 

   

Do you measure and hold yourself accountable for reducing relative costs as you grow?

 

~ Jeff

 

Note: The above post was excerpted from a soon to be published Financial Managers Society (FMS) white paper drafted by the author.