Preserving the Legacy

By Kenneth Cline

Under CEO Frank V. Cahouet, Mellon Bank Corp. has built one of the industry's most diversified earnings streams. But the bank's independence remains in doubt until he settles the succession issue.

Frank V. Cahouet seemingly has done everything right. In ten years as chairman and chief executive, he lifted Mellon Bank Corp. from near-failure to a grand success story. The Pittsburgh-based banking company is hitting on all cylinders and boasts nearly unrivaled earnings diversification. The company's stock has outpaced most peers.

So why is Mellon popping up on so many analyst takeover lists?

There are several answers, all of which bear on the difficulty of managing a financial services company in today's pressured environment. Despite its strong financials, Mellon is a potential target because of its digestible profile in a consolidating industry. The company's $42 billion asset base is unquestionably substantial, but institutions in this size category are inevitably regarded as prey for the acquisitive megabanks that now exceed $100 billion in size.

More specific to Mellon, Cahouet's very success in building an asset management and processing powerhouse has painted a red bull's eye on the company. Once a narrowly focused corporate bank, Mellon today derives 59% of its revenues from fee-based businesses such as leasing, asset management, trust and securities custody. The 1994 acquisition of Dreyfus Corp. made it the largest bank retailer of mutual funds. Potential acquirers would love to get their hands on these fast-growing jewels in Mellon's crown.

Some of Mellon's perceived vulnerability can also be laid at the door of Cahouet, whose guarded stance contributes an element of uncertainty. Although he is 65 years old and scheduled to retire at the end of next year, Cahouet has declined to anoint a successor. He says he will make his recommendation to the board "when the time comes" but is in no evident hurry to hand off the reins of power. "I'm not looking forward, you know, to just circling the globe and having a fun time," he says pointedly. "I'm paid to run a company!"

The response is typical of a man who often talks about the need for a CEO to make tough decisions and execute policy regardless of what critics might say. Frank Cahouet, known for his self-reliance, will handle the succession issue as he handles everything else -- on his own terms and by his own schedule.

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But leaving that issue open also leaves Wall Street room to speculate about Mellon's future. "A lot of it has to do with Frank," says Dillon Read & Co. analyst Anthony R. Davis. "Cahouet's age, the lack of an heir apparent and his proclivity to surprise provide the raw ingredients for something to happen."

Assuming Cahouet doesn't opt for a deal, his challenge for the next year and a half will be to maintain the bank's earnings momentum and manage the succession issue while fending off takeover overtures and speculation. It will be a dangerous period, when any major portfolio or operational glitch could exacerbate the company's vulnerability.

Right now, no grim scenarios can be discerned. Like many banks, Mellon experienced serious losses in its credit card operation. But that problem seems well contained for now, and the bank is enjoying robust growth in several specialty businesses, including leasing, asset-based financing, cash management and global custody.

If Mellon survives as an independent entity, it could even serve as a prototype for the financial services company of the future. Not only has Mellon diversified further than most banks into mutual fund and other fee businesses, but it also is a leader in the area of alternative delivery. Investing about $350 million a year on technology, Mellon is a pioneer in the use of PC banking and video banking. Additionally, vice chairman Martin G. McGuinn oversees one of the industry's most aggressive branch reconfiguration projects. In the last three years, Mellon has closed 30% of its traditional branches, replacing them with supermarket locations and "financial centers" that combine investment and banking services with the latest electronics.

"Our big objective is to continue to play out our strategy and not get distracted," Cahouet says. "We want to make darn sure we keep the pace going."

Takeover Talk

The spectacular rise in Mellon's stock, particularly since 1994, has made it a difficult bank to acquire. With a $12 billion market cap, Mellon would intimidate all but the largest aggressors. But the hurdle is not insurmountable. It may be possible, for example, to buy the company for its fee-based businesses and then sell off the banking franchise to pay for the deal.

This spring, influential analyst Thomas K. Brown of Donaldson, Lufkin & Jenrette Securities Corp. included Mellon on his newly unveiled list of bank takeover candidates. Smith Barney's Henry C. Dickson likewise fingered Mellon in his most recent analysis of potential buyout targets. And Salomon Brothers, in the April update of its comprehensive "Merger Modeler" report, listed Mellon as one of its top takeover picks. Salomon further identified $135 billion-asset First Union Corp. as the "most logical" Mellon acquirer, based on First Union's well known desire to expand its mutual funds operation and the fact that First Union president Anthony Terracciano once served as president of Mellon Bank.

Salomon analyst Diane B. Glossman says her firm takes a strict by-the-numbers approach to takeover analysis. "A number of institutions could afford to pay an attractive price that still would leave some accretion for the acquirer's shareholders. Mellon has a variety of businesses that lots of companies would love to have and could afford to pay for." Still, she concedes, "That doesn't in any way suggest we believe Frank is dying to have his bank purchased."

Cahouet himself dismisses all the takeover talk as irrelevant to the real issues of running a financial services company. "I don't understand this fascination with consolidation," he avers. "The real issue is: are you really doing a good job for your customers? That's the driver."

The executive points to Mellon's financial performance as proof that the company can well serve customers and shareholders as an independent entity. Last year, Mellon posted a 20% return on equity -- one of the industry's best performances -- highlighting the fact that fee-based businesses require less capital support than those that produce spread income. The bank's ROE would have hit 32% but for its practice of using purchase accounting in its acquisitions. Such accounting loads the balance sheet with so-called goodwill, sums reflecting purchase premiums, whose amortization cost Mellon 60 cents a share after-tax last year. Even with that drag, ROE reached 22% in the second quarter of 1997, with an annualized return on assets at the lofty 1.8% level.

The problem is Mellon has not yet demonstrated the ability to generate high returns over an extended period of time. The company's financial track record includes near collapse in the late '80s and earnings shortfalls related to its acquisitions of The Boston Co. and Dreyfus in 1993 and 1994 respectively. While Mellon currently trades at a very respectable price/earnings ratio of 17, chief financial officer Steven G. Elliott acknowledges that consistent performance over time is needed to reach higher multiples.

Elliott does express confidence the market will eventually reward Mellon's unique business mix with higher valuations. The company's fundamental strategy is already set in place; all that is required now is tweaking performance while adding a selected acquisition here and there. Mellon is looking for asset management, trust and cash management opportunities in Europe and Latin America, for example. Says Elliott, "Now the focus is on day-to-day blocking and tackling -- execution and follow through."

But consistency is not assured. Diversified as it is, Mellon is still subject to the vagaries of the business cycle, which can unexpectedly disrupt earnings momentum. Owing to an overly aggressive national mail solicitation, for example, Mellon was one of the first banks to suffer sharply rising credit card delinquencies, in 1996. While embarrassing, the card problem appears contained for now. Troubled credits are well reserved and involve only a fourth of the $2.2 billion card portfolio, which in turn accounts for less than 5% of total loans.

A major stock market reversal could slow Mellon's investment management units, which currently provide its strongest percentage earnings gains. Vice chairman Christopher M. Condron, who runs this side of the company, says the all-important Dreyfus unit is "in a very good bear market position," given that only 22% of its assets are in equities. Yet a market slump would certainly reduce assets under management, cutting fee income in turn.

On the other hand, Mellon's low dependence on spread income probably gives it an above-average ability to ride out the next credit cycle. The bank's diverse earnings stream should cushion the blow if corporate loans begin to turn sour. "In a recession, those fee revenues may go down, but they're not going to create losses," says analyst George A. Bicher, with Alex Brown & Sons Inc.

Rescue Effort

Mellon knows something about bad loans. When Cahouet arrived in Pittsburgh in 1987, the once-admired "J.P. Morgan of the Alleghenies" was foundering. An over-dependence on spread income had lured this premier corporate and trust bank into high-risk lending to southwestern oil patch developers and Latin American governments. The two markets collapsed, and Mellon lost $844 million in 1987 after booking a loan-loss provision of nearly $1 billion.

Cahouet, formerly CEO of California's Crocker National Bank, implemented a two-part program to save Mellon. He formed Grant Street National Bank, a so-called "bad bank," to gradually sell off Mellon's marked-down loans. Second, and more fundamentally, he transformed the nature of the company itself. The lending focus went from wholesale to retail. Consumer loans today account for 42% of Mellon's portfolio, up from 17% in 1986. The Dreyfus acquisition later contributed a major investment management component. Cahouet also built on Mellon's strengths in back office processing, which include cash management for corporations, master trust for corporate pension plans, and data processing for small banks. Mellon now ranks among the top cash management and securities transfer banks in the country.

The concepts driving this transformation can be traced back to the early 1970s, when Cahouet was a top executive at California's Security Pacific National Bank, charged with building an array of nonbank financial businesses. Working with David R. Lovejoy, now Mellon's vice chairman in charge of financial markets and corporate development, Cahouet took SecPac into consumer finance, leasing, institutional funds management and insurance. SecPac's consumer finance unit, most recently part of BankAmerica Corp., fetched $1.6 billion when sold to Travelers Group in June.

Cahouet's experience at SecPac taught him how diversification can help contain risk. He concluded that spread-dependent banks -- such as Mellon in the '80s -- tend to over-concentrate, by industry, customer or geography, which leaves them vulnerable when the economy turns down. "You tend not to see the traps," Cahouet says. "The steps you might have to take to protect yourself can be directly counter to improving near-term profits. Unfortunately, you can't just suddenly collapse your business."

The executive further observed how "customer needs were changing." Retail clients were shunning bank depository products in favor of mutual funds and securities. And corporate customers were increasingly obtaining credit from other sources, such as commercial paper and insurance companies.

Cahouet can now envision a time, perhaps ten years hence, when investment grade corporations will cease borrowing from banks entirely. He fears these corporate customers will relegate banks to the role of providing "liquidity insurance" through standby lines of credit.

Concluding that "the narrowly focused bank was invariably going to get out of touch with its customer base," Cahouet moved to create a new kind of bank at Mellon. He set in motion a comprehensive planning process to identify customer needs and design products and services to meet those needs. He specifically told his officers to think outside the limitations inherent in the traditional banking structure.

Cahouet continues to proselytize for a new mindset in banking. During the Bank Administration Institute's finance and accounting management conference in June, he was asked what advice he had for other banks interested in buying a mutual funds company. His prompt reply: if they still thought of themselves as a regulated, commercial bank, they probably "should stay away from it."

Controversial Deals

Defying conventional wisdom has its risks. As Cahouet likes to say, "You can never be an innovator and not be criticized." In Cahouet's case, the criticism came over the two deals that did more than anything to solidify Mellon's status as a leading edge bank.

Acquiring the Boston Co. and its institutional custody business in 1993 boosted Mellon into the ranks of the top three private asset managers, along with J.P. Morgan & Co. Inc. and Northern Trust Corp. The following year's Dreyfus acquisition vaulted Mellon to the top spot among bank retailers of mutual funds and seventh among mutual funds companies overall.

But the prices paid -- $1.5 billion for Boston Co. and $1.8 billion for Dreyfus -- were judged excessive at the time. Mellon also endured negative publicity over some talent defections from both Dreyfus and the Boston Co., although Cahouet now insists he didn't lose anyone he wanted to keep.

"There are those who will take issue with Frank because they never got comfortable with his acquisitions," says analyst Bicher. "At the time he bought Boston Co. and Dreyfus, people viewed those deals as risky. But in retrospect, they've been excellent." Indeed, Mellon's overall financial performance has improved markedly since 1995 while its stock price has tripled. And what might have looked expensive back in 1993 and 1994 would be considered a bargain today, given the overall market's tremendous rise since then.

Cahouet's other deals have been less controversial, since they lacked the scale of Dreyfus or Boston Co. and clearly enhanced existing business lines. In July, for example, Mellon bought the commercial mortgage servicing portfolio of Bankers Trust New York Co., which added $7.9 billion in servicing to an existing $11.1 billion portfolio, making Mellon the second-largest servicer of commercial mortgage loans after General Motors Acceptance Corp. Last year's deals fall into the same pattern: the acquisition of USL Capital Corp.'s business equipment finance unit made Mellon the sixth largest bank lessor; and 1st Business Bank, a $1.1 billion-asset institution in Los Angeles, supports Mellon's corporate lending and services operation on the West Coast. Buck Consultants Inc. contributed an employee benefits outsourcing component to Mellon's existing 401(K) and corporate pension services operation.

Mellon's collection of business units might seem haphazard, at first glance. In fact, they fit together nicely when viewed in terms of Mellon's own analytical framework. The company places each individual business unit into one of four categories: consumer investment, consumer banking, institutional investment, and institutional banking. The retail portion of Dreyfus, for example, falls under consumer investment services. This framework functions as both an analytical and a managerial tool and is intended to help Mellon balance its business mix and earnings. Capital is allocated to business units individually, but with an eye to maintaining some rough balance among the quadrants.

Cahouet insists that all of Mellon's business units be allowed to reach their full potential in terms of growth and access to capital as long as certain hurdle rates are met. The one exception is major corporate lending, part of institutional banking. It produced an ROE of only 13% last year, compared with 23% for retail banking. Consumer investment services generated the highest return, with a lucrative 49% ROE. Cahouet concedes that corporate banking cannot meet its hurdle rates on account of inherently low margins in that business. But he says Mellon stays in that market to retain corporate relationships.

Mellon's overall strategy for dealing with customers rests on two goals. One is to migrate consumer and corporate clients along product lines. When the process goes according to form, a commercial customer, for example, will "graduate" from a line of credit to cash management services. A consumer would go, say, from a college loan to a home mortgage. The key operational issue is handing off the customer from one department to another at the appropriate time.

The second goal in customer handling is boosting "share of wallet," or the number of products used per customer. While banks have been focused on this problem for a decade or more, Mellon believes it can accomplish the task better than most because of its product diversity.

Acquisitions remain an important element in Mellon's strategy for increasing market share. The company sees opportunity overseas for its asset management business as markets in Europe and Latin America begin to develop U.S.-style pension systems. Officials also don't rule out traditional branch networks. The problem has been price. Vice chairman Lovejoy says Mellon has unsuccessfully bid on banks for sale in its region but continues to look. "You cannot ignore the strength of a good banking franchise," he says. "It has a natural attractiveness to consumers and businesses."

Succession Issue

If Cahouet retires at the end of next year as scheduled, he will leave a legacy of achievement and innovation at Mellon. Preserving that legacy, however, will require deft handling of the succession issue.

Mellon currently employs nine vice chairmen -- an unusually large number for the banking industry -- who convene for several hours, twice a week, at meetings chaired by Cahouet. In this way, the vice-chairmen, who run Mellon's various business units, become familiar with each other's products and services. Cahouet contends this arrangement allows for better collaboration between units than would be obtainable in a more hierarchical management structure.

The true test of cohesion will come with Cahouet's departure. He picked his chief lieutenants carefully and they are beholden to him. Five of them worked with him in California, at either SecPac or Crocker. Up to now, Cahouet has been the strong leader, the glue holding this management team together. Will they continue to work harmoniously under the stress of a succession contest?

"My guess is that each and everyone of us ultimately wants to run his own show," says Lovejoy, one of the nine. "I'll put that on the table. But I'd also submit that each and everyone of us understands the strength of teams and that good teams always beat collections of individuals."

Analysts generally agree that Cahouet's successor must be someone with expertise in some of Mellon's niche businesses -- institutional and retail investment, trust, custody and mutual funds -- as opposed to a narrowly trained banker. Candidates who fit that criteria include Elliott, Condron and W. Keith Smith, the vice chairman overseeing Mellon's trust and investment businesses.

It is also critical that Cahouet's successor share his vision of the future of financial services. During his long career, Cahouet has been motivated by nothing less than a desire to transform the very nature of banking. Recognizing that the different elements of financial services will increasingly converge, relegating most bank products to commodity status, he has advocated that banks reorganize around specific customer needs and distribution channels. He bills Mellon as "a diversified financial services company with a bank at its core."

That sense of adventure and missionary zeal remains intact. As Cahouet told the BAI conference attendees in June, "Those of us who are truly involved in the financial services industry come to work in the morning in this era and recognize it's not a job anymore -- it's an odyssey."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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