Poised to Grow

By Kenneth Cline

Fifth Third Bancorp's earnings power and market multiples are such that it can buy virtually anything it wants on a non-dilutive basis. CEO George Schaefer, looking for ways to expand, seems increasingly willing to exploit that firepower.

George A. Schaefer Jr. says he doesn't have to buy anything. But that doesn't mean he won't. The chairman and chief executive of Fifth Third Bancorp is in the enviable position of being able to control his own destiny.

His Cincinnati-based outfit boasts one of the best performance records in the industry and a market valuation appropriate for a much larger institution.With $21.4 billion of assets at yearend 1997, Fifth Third ranked 35th in terms of size, but a sharply higher 22nd in market capitalization. With its commanding trading multiples, Fifth Third can limit the number of shares offered in stock-swap acquisitions, minimizing the odds for earnings dilution.

The 53-year old Schaefer, in charge of Fifth Third for the last eight years, rarely exploits that firepower. As voracious rivals built sprawling empires across the nation's heartland, Schaefer focused on a small slice of the Midwest encompassing Ohio, Kentucky and Indiana. His deals have been frequent but small -- typically community banks and thrifts that could be grafted onto existing Fifth Third operations.

But there is an increasing emphasis on takeovers.

Earlier this year, for example, Fifth Third inked contracts on the largest acquisitions in its history, two Ohio-based thrifts that together will bring in $6 billion of new assets. The largest prior deal was but a fourth that size. Last June, Schaefer shifted former chief financial officer P. Michael Brumm into a new corporate development post; Brumm's main job is to scout for deals. About the same time, Fifth Third began securitizing assets to free up capital, telling analysts the excess cash would either be deployed into acquisitions or returned to shareholders. The bank also commenced a stock buyback program to gin up its already stellar earnings per-share growth rate, which provides additional market currency for deals. "The name of the game for Fifth Third in 1998 is using its very high stock price as a strategic weapon," asserts Lehman Brothers analyst Michael A. Plodwick.

Ramping up acquisitions carries some risk for Schaefer and his management team, however. While Fifth Third has developed a reputation for efficient and speedy merger integrations, the recent experience of Wells Fargo & Co. with the former First Interstate Bancorp demonstrates the high price to be paid for mistakes in this area. With the two thrifts plus two small brokerage companies on its plate for assimilation, Fifth Third is already taking on more systems integration work than ever before in its history.

So long as the market remains convinced that Schaefer can elevate his targets to Fifth Third's performance level and deal pricing does not get out of hand, stock-swap economics will remain favorable and deal-related earnings dilution probably won't be an issue.

But cultural dilution could be a problem. Fifth Third has one of the most aggressive sales cultures in banking. The quality that Schaefer terms "hustle" has contributed enormously to the bank's 24 years of consecutive earnings gains. The need to retrain and integrate unprecedented numbers of acquired employees could weaken the very attributes that make Fifth Third a model for the rest of the industry. "I would be concerned with a large acquisition that dilutes the culture," says analyst Joe Duwan, with Keefe, Bruyette & Woods Inc. "It really depends on management control. I would be more comfortable with the Fifth Third management team clearly in charge."

Such issues must be navigated with care. On the one hand, Schaefer certainly wants to avoid a flawed acquisition that disrupts Fifth Third's cherished earnings momentum and market multiples. On the other hand, failing to act could eventually leave the bank at a competitive disadvantage when others snap up the most attractive franchises.

Fifth Third's track record does instill confidence that Schaefer and his teammates will make the right choices. At least in the short term, moreover, Schaefer is under no pressure to act precipitously. This is one CEO who can choose his targets carefully and fire only when ready.

At the same time, the strategic inflection point at Fifth Third suggests an important issue for the banking industry's senior managers. Notwithstanding its stellar performance characteristics, Fifth Third cannot rely strictly on internally-generated business for all of the growth that it wants. What's true for one of the nation's top performing institutions certainly holds for the larger and more cumbersome megabanks now being formed. But the Goliaths of the banking world face looming constraints: a dwindling inventory of merger targets and national market share limits on deposits. Unless giant entities such as the merged BankAmerica Corp./NationsBank Corp. find new markets (such as insurance) in which to continue their acquisitive ways, growth will slow. Can they compensate by attaining Fifth Third's performance level? Time will tell.

Fortress Fifth Third

Schaefer contemplates possible offensive moves from a secure home base. Analysts agree that while many megabanks could come up with the dollars to buy Fifth Third, none could economically justify the premium price. Beyond its formidable market multiples, the company operates with an industry-beating 41% ratio of operating expenses to revenues. Since no potential acquirer operates more efficiently than Fifth Third, none could extract enough cost savings to warrant a deal.

This defensive strength gives Schaefer enormous flexibility and room to maneuver. And it is particularly noteworthy considering that Fifth Third belongs to a category of banks -- the midsize regionals -- generally considered doomed to extinction. Many midsize regionals are, in fact, vulnerable to takeover by megabanks backed by massive market capitalizations and economies of scale. But Fifth Third can pretty much control its own destiny, even with the likes of Banc One Corp., First Chicago/NBD Corp., KeyCorp and NationsBank Corp. prowling in its territory.

"You don't have to attain massive scale to do well," Schaefer insists, citing Fifth Third's focus on salesmanship and day-to-day execution.

There is a footnote to that statement, however. Schaefer does believe scale is important in local retail markets, allowing banks to leverage systems and marketing resources. A key element in Fifth Third's strategy over the past decade has been boosting share in select Ohio markets such as Cincinnati, Cleveland, Toledo, Dayton, and Columbus. Schaefer has accomplished this through small acquisitions and de novo branching programs. By installing its highly efficient operating platform, Fifth Third significantly reduces overhead expenses at the companies it acquires.

Defying emerging strategic wisdom, the company also contends that its decentralized management structure promotes revenue growth. Fifth Third is one of the few large banks in the country that retains a network of separately chartered affiliate banks whose executives "control" their local markets. Schaefer believes this structure encourages initiative and energizes Fifth Third's sales culture.

The upshot is that Fifth Third competes as a low-cost provider. It usually undercuts the competition in pricing. Pricing power and sales hustle enable Fifth Third to take share in new markets. Since buying Toledo's third-ranked 1st Ohio Bancshares in 1989, for example, Fifth Third has captured the top share in that market while boosting the unit's return on assets from 0.9% to 1.9%. Schaefer wants to perform such feats throughout his three-state region, underscoring acquisitions as an important aspect of strategy. For Fifth Third's managers, "The challenge is to get a continuous supply of raw material with which to work their magic with their operating platform," says Keefe Bruyette's Duwan.

Room to Roam

Fortunately for Schaefer, the Midwest, unlike the Southeast or West Coast, remains a fragmented market. Ohio, for example, still hosts more than 400 independent banks and thrifts. The statewide market leader, Cleveland's National City Corp., controls only 11.2% of deposits; third-ranked Fifth Third is not far behind with 10.5%. "There's plenty of room for us to grow right here," Schaefer says. "Before I go and try to buy 10% in Michigan, it's a lot cheaper for me to try to get up to 20% in Ohio. I already have my infrastructure and marketing presence here."

After assimilating its two recent thrift acquisitions, Fifth Third will enjoy what some analysts consider the best position in the Buckeye State: top-ranked shares in Cincinnati, Toledo and Dayton, fourth in Columbus and fifth in Cleveland. It's an open secret that Schaefer would jump at the chance to acquire either of two like-sized Ohio rivals, hometown competitor Star Banc Corp. and Huntington Bancshares Inc., Columbus. "We could handle a pretty large transaction," he says. "It's not like we're going to go on a rampage -- but hey, if an opportunity became available, we'd certainly be interested."

Outside of Ohio, Fifth Third falls much lower in the market share rankings: sixth in Louisville and Lexington; ninth in Indianapolis. It's inevitable that Fifth Third's expansion energies will be increasingly deployed beyond the borders of Ohio -- not only to Kentucky and Indiana, where the bank currently operates, but also on to Michigan and Tennessee.

Brumm, the M&A czar, says he's having "social conversations" with bankers in the latter two states. He also suggests the deal-making pace at Fifth Third is likely to pick up. "I wouldn't be surprised to see it accelerate because of the pace of industry consolidation and the fact that we're operating in a relatively unconsolidated market."

Meanwhile, Fifth Third has been bolstering its financial firepower through securitizations, which free up capital on the balance sheet. In 1997, the bank securitized $1.4 billion of the $1.9 billion of consumer loans it originated, mostly first mortgages. As a result, the total consumer portfolio grew only slightly, from $6.4 billion to $6.9 billion.

This increases flexibility but also highlights the challenge Schaefer faces in rationalizing Fifth Third's equity base. In a performance study based on Economic Value Added prepared for Banking Strategies by Stern Stewart and Co. (page 18), Fifth Third placed 19th among the top 50 banks last year, despite having the top ROA figure for the group. One reason for the disparity is that Fifth Third maintains a disproportionately large (10.7%) pool of equity capital -- on which, under the tenets of EVA, commensurately outsized required returns are owed. Schaefer has already said he wants to return some of Fifth Third's excess capital to shareholders and/or judiciously leverage it through acquisitions.

From a purely financial standpoint, the prospect of Fifth Third becoming a more active acquirer does not provoke alarm on Wall Street. Says Lehman Brothers' Plodwick, "When you're selling at roughly 550% of book value and 30 times earnings, and have a 41% efficiency ratio, it's virtually impossible to make a dilutive deal."

The more immediate risks are managerial and cultural. Fifth Third prides itself on an affiliate bank structure that provides great latitude to local executives. Although Schaefer believes this schematic can accommodate continued growth, the industry trend is decidedly contrary, moving towards centralization and line-of-business configurations. Fifth Third may some day reach a point, as have other growing banking companies, when the affiliate management structure no longer proves adequate.

Another problem is that each acquisition will bring a fresh wave of employees who are unschooled in the Fifth Third culture. Yes, these workers can be retrained, but there is no substitute for hiring people straight out of college and imbuing them with the company ethos, as Fifth Third does now. The banking company's vaunted efficiency largely hinges on this ethos, which has two key components: an aggressive sales culture and relentless attention to cost control. Take away those traits, and Fifth Third becomes just another bank. "That's our big concern," Schaefer says. "We could go out and do 10 deals and get really big. But at the end of the day, all of our employees must reflect the Fifth Third culture."

Given these considerations, one can well understand why growth for growth's sake has never been the guiding principle at Fifth Third.

Street Corner Banking

Even as he mulls his strategic options, Schaefer stays focused on what Fifth Third does best: day-to-day execution. Basic strategy at Fifth Third, Schaefer says, "is always the same: We tell everybody we want them to be up at least 20% on the revenue side and hold expense growth to single digits. Now, go execute."

This dogma is embodied in Fifth Third's rolling one-year forecast. By its very nature, the forecast is constantly updated, but it never attempts to look beyond one year. This ties in with Schaefer's "street corner" philosophy of banking, which posits that the only thing that matters is how well you execute in local markets on a daily basis. "If we do very well on the corner today and a fine job tomorrow, we're going to have fine results at the end of the year." This attitudinal framework is backed up by generous stock option and bonus plans that reward performance.

Fifth Third's corporate ethos begins with Schaefer. The West Point-trained former engineer is often seen prowling the halls engaging in hands-on management. "George walks the floors a lot asking people questions," says Diane L. Dewbrey, senior vice president of operations. He also makes his fair share of sales calls, just like other Fifth Third executives.

It sounds almost simplistic but works beautifully. Fifth Third concluded its 24th year of earnings increases in 1997, posting a hearty 19.6% return on its massive equity base. With returns like that, Fifth Third can continue doing things its own way and at its own speed. "As long as we're successful," Schaefer says, "why should we change?"

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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