Preamble to a Bank Strategic Alternatives Analysis

Bloggers pepper me with insights on how to be a more successful blogger. One such insight is to create a compelling title. In this regard, this blog's title is an outright fail. Try to say it three times fast!

I recently sat in front of a client board committee reviewing the bank's strategic alternatives (see a prior post on performing such analysis here). Before you think this bank is on the auction block, think again. This bank's board was delivering on its fiduciary duty to shareholders to maximize value.

Before getting into the details, I prefaced my analysis on where a strategic alternatives analysis fits in the overall scheme of executing strategy. Because, my readers, it occupies a far too important perch than you might think.

The following is my paraphrased preamble to the analysis:

"Strategic Alternatives Analysis is a critical component to strategy development and execution. For example, we see various planning tools as subsets to your overall strategic plan: Marketing and IT Plans, ERM/Risk Appetite, Capital Plan, Budget, and a Strategic Alternatives Analysis. All are linked.

'We espouse multiple projection scenarios when developing strategy. The first, we typically call the base scenario. The base represents the likely outcome of executing your strategy. In banking parlance, this is the basis for your budget. It is the starting point for the remaining scenarios. You should have a 50%-75% confidence level you can achieve the base scenario.

'The second is the stress scenario. Here you are trying to gauge what could go wrong based on relevant and defensible stressors, such as credit or interest rate shocks. This scenario is important to determining the risk-level of your strategy and the adequacy of your capital to withstand shocks. Your capital plan, of course, will have additional scenarios to identify the most attractive capital augmentation strategies should the stress case come to pass.

'The third projection scenario is the stretch. When developing strategy, it is critical to envision what success would look like upon successful execution. Rare is the case that achieving your vision would result in solely hitting your budget. You want to envision what success would look like in financial terms, too. Your management team should have a 30%-50% confidence level you can achieve stretch goals. Stretch projections should be your base for a Strategic Alternatives Analysis.

'Evaluating strategic alternatives goes beyond what you can pay for a target or what a buyer can pay for you. True, it is an important element of it. But the decision to buy should be based on your perceived inability to achieve stretch goals on your own. It is a lower risk strategy to achieve earnings and tangible book growth organically than through acquisition. But if your strategy does not deliver the shareholder value improvement you desire, then perhaps buying a competitor can bridge that gap. The strategic alternatives analysis shows the targets you have the greatest opportunity to buy.

'How do you know if you should sell? This analysis will show what buyers can likely pay. Normally, and in this case, the values are greater than where your bank currently trades. So, absent additional analysis or other considerations such as employees and customers, you should sell, right? Not so fast.

'Stretch projections should be discounted back to present day to determine the present value of successfully executing your strategy. If such an analysis delivers a present value in acceptable proximity to your take-out value, then your Board may conclude that it is best to remain independent and execute your plan. This keeps the keys to your shop in your hands, where you may have greater confidence than in somebody else's hands. Without developing stretch projections, how would you know if and when to sell? How would you know that there is a value gap and your management team must develop more aggressive strategies? You wouldn't. You would be guessing.

'This is the critical link to strategic planning and strategic alternatives analysis. It keeps the management team focused on delivering value to shareholders, keeps the Board focused on their fiduciary duties, and models successful execution of strategy, in financial terms. It is the very definition of your right to remain indepenedent, or is the basis to putting M&A as a critical component to your strategy."

Does your FI perform routine strategic alternatives analysis?

~ Jeff

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.