Two recently announced deals highlight the importance of offering a clear rationale for M&A

With BofA’s $47 billion offer for Fleet in October and J.P. Morgan’s $58 billion bid for Bank One in January, the industry has been jolted out of a long slumber in mega-merger activity. Between October 2000 and October 2003, only two bank acquisitions had price tags of more than $10 billion, a long way from the 15 deals of that size between 1995 and 2000.

But with a rebound in the economy and several large banks posting strong profits, concerns over credit risks and profitability have begun to subside. The focus is now on growth. Thus, many bank CEOs are once again asking, what better way to grow than in a single leap with a big acquisition? Yet for acquirers who care about enhancing value for their shareholders, a degree of caution is due. Not all bank acquisitions increase value. The two recent announcements provide insights into why some do and others don’t.

First, the good deal (at least in some respects). J.P. Morgan’s strategic and financial logic in buying Bank One appears reasonably sound. The business lines and geographic presence of the companies are highly complementary, suggesting that banking consolidation in the U.S. will increasingly be about "filling out the map" rather than exploiting cost overlaps. This isn’t to say, however, that cost reduction is not going to be required for the deal to make sense. To recover the $7 billion premium it is paying for Bank One, J.P. Morgan is counting more on cost savings than on revenue synergies (from cross-selling and other activities). That’s prudent. Cost savings are easier to identify and deliver than revenue synergies (although they’re often less than the savings announced at the time of the deal). J.P. Morgan and Bank One predict annual post-tax cost savings of $1.4 billion from eliminating overlapping wholesale and retail operations, as well as savings in the back office operations of the corporate center and credit card divisions. After adjusting for merger costs, those synergies have a present value of about $11 billion.

So if the projected synergy benefits do come through, J.P. Morgan will more than earn back its $7 billion premium for Bank One (a modest 14% over Bank One’s market cap at announcement) and absorb a retail banking powerhouse that should stabilize its earnings. Given that J.P. Morgan’s share price barely moved in the days after the merger, it appears investors are convinced the deal will – at worst – do no harm.

It is therefore surprising that Bank One shareholders agreed to sell for such a small premium, particularly given the precedent set by the Bank of America-Fleet deal. Since there seems to be little obvious benefit to Bank One shareholders relative to Bank One’s having remained independent, some of these shareholders will no doubt ask whether money was left on the table to influence the top management structure of the combined entity. In that light, what may be good news for corporate acquirers (cheaper deals for better management team outcomes) may well be bad news for corporate governance.

Now the bad deal. Bank of America’s bid for Fleet makes some strategic but little financial sense. In Fleet, BofA found two things it valued: a new, profitable geography (Fleet’s New England region was virgin territory for BofA) and scale (the combined banks will have a nearly 10% share of U.S. deposits). The management teams predict $1.1 billion in annual cost savings and about $200 million in new revenue for the combined entity. Some commentators regard these projections as optimistic. If they came through, they would have a present value of around $11 billion.

Since BofA is paying a hefty 42% premium – $14 billion – for Fleet, BofA’s management team is therefore transferring several billion dollars of shareholder value to Fleet’s shareholders. As a result, BofA’s market cap plummeted by $9 billion (8%) in the days after the announcement, suggesting its shareholders view the projected synergies to be not just insufficient but highly optimistic. They have reason to be wary: BofA’s track record at integration is not particularly strong.

Deals like this one give M&A a bad name, with the usual commentaries still to come on the destruction of value that M&A causes. However, our research² suggests that while most deals do destroy value, M&A can also create significant value. In a study of 389 companies between 1996 and 2001, we found that more than half of those that delivered top-quartile shareholder returns in their industries were more acquisitive³ than their peers. The percentage was even greater in financial services and other mature industries.

But these companies played the M&A game by a different set of rules than those that were equally acquisitive but trailed their peers in shareholder performance. M&A leaders tend to buy small, buy often and integrate better with their acquisitions. True of equals" with small premiums also have reasonable odds of success. It’s the deals in the middle ground that create problems. These are major deals with high premiums – deals like BofA’s takeover of Fleet. A high premium can be warranted as long as management has a clear plan for recovering it. Alas, BofA has communicated no such plan to date. That isn’t the logic on which good M&A is based.

Ron Langford
rlangford@marakon.com