The Revenue Chase

By Kenneth W. Smith

While bank acquirers have done a good job of cost cutting, revenue synergies have lagged. The solution: revise merger planning priorities.

When it comes to acquisitions, banks have their cost-cutting act down cold. Routinely, acquirers will slash from 30% to 50% of their target's annual expense base following a deal. Some have turned this cost-cutting exercise into a virtual line of business.

Yet, bank mergers typically reward only the target's shareholders, disserving investors in the acquiring entity. In fact, a recent Mitchell Madison Group study found that bank acquirers in North America lagged the market by an average of 13% in the three years following their transactions.

So why are shareholders of acquiring banks often shortchanged? The issue, we believe, is that acquirers fall short in the pursuit of revenue synergies. More often than not, revenue growth stalls following an acquisition. Instead of quickly and deftly improving customer service, newly merged companies spend their early years dealing with internal controversies. All the glittering benefits touted in merger press conferences tend to get lost amid the rigors of integrating two disparate entities.

On one level, this seems surprising. Clearly, there is enormous potential upside in joint product development, cross-selling, segmentation of a pooled customer base, and mining the customer database for greater share of wallet and/or a better risk profile. However, achieving revenue synergies is a fundamentally different and more challenging task than cutting costs.

When pursuing cost savings, a company mostly confronts internal decisions. Though often difficult, these decisions are nevertheless within the acquirer's power to make. Managers can decide whom to fire, which headquarters to abandon, which branches to close, which systems to use, and so on.

Achieving revenue synergy, by contrast, requires decisions from powerful external constituents -- the customers. They must be offered an attractive value proposition, a reason to keep their accounts at the merged entity and expand their business with it. While bank acquirers have not necessarily overestimated -- or even overpaid for -- anticipated revenue synergies, they have massively underestimated the time and effort required to develop and market a better proposition.

It's possible to do better, and there are a number of steps managers of acquiring banks can take to assure the realization of promised revenue synergies. The first step has to do with customer segmentation. Rather than trying to staunch customer attrition across-the-board -- the typical strategy -- managers should identify their most valuable wholesale and retail customers and concentrate marketing efforts in those segments. Some clients may defect, but the most profitable likely will stay, buttressing the institution's fortunes.

Secondly, acquirers should avoid the trap of indiscriminate branch consolidation. Branch rationalization models typically do a good job assessing the likelihood of customer attrition, but they fail to take into account a branch's value in attracting future customers. Managers who wield the cost-cutting axe too heavily may inadvertently truncate future growth.

Excessive timidity can also be harmful. Fearing customer attrition, acquirers often adjust pricing to the level of the lowest common denominator among the two predecessor companies. This is ironic, considering that improved pricing power is usually touted as a merger benefit. Again, segmentation is the key. Step three is to identify less price-sensitive customer segments and treat them accordingly, therefore preserving the opportunity to capture more revenue from those customers.

When it comes to integrating products and support systems, fast works better than slow. Enamored of a "best-of-both" product set, acquirers often lavish extra time and resources on software integration. A fourth step is to spend instead on customer development, since that's what really brings in the revenues.

Finally, consolidators need to do a better job nurturing the creative and entrepreneurial aspects of the companies they acquire, lest they lose revenue growth momentum. That requires leaders who are capable of inspiring, not just firing.

Escalating Premiums

It's old news that fewer than half of large acquisitions ultimately achieve positive financial returns for shareholders. But the reasons are less well understood.

Our recent comprehensive analysis tracked shareholder returns for every large, publicly-traded North American acquirer in the 1990s. The study showed that only 44% of deals initiated by these companies yielded superior investor returns. On average, acquirers under-performed their respective industries by 3%.

This is bad enough, given the big bets being placed on these deals. However, banking deals in the U.S. performed much worse. Only 18% of acquirers provided superior returns to shareholders. Consolidators under-performed the total return index for their industry by an average of 13% during the three years following their deals. In other words, their shareholders were 13% worse off than if they had simply held a bank industry portfolio mirroring the index.

This is not only disappointing, but also somewhat surprising. After all, bank consolidation is well advanced, and most major dealmakers have a decade or so of experience at the job. Consolidators move quickly and skillfully to rationalize organizational structures and physical assets. Some have even learned how to leverage scale to reduce the cost of purchased goods.

However, since most consolidators possess this level of expertise and know the potential for takeover cost synergies, they tend to bid prices up to a level commensurate with these essentially guaranteed returns. Then, in order to win the prize, they begin to bet on the promise, the hope, and finally the illusion of revenue synergies. Indeed, deal multiples rose steadily through the '90s as consolidators got better and faster at extracting cost synergies. The premiums must now be justified by anticipated revenue synergies.

So far, acquiring shareholders have lost in this race. Generally, they would have been better off holding an industry mutual fund.

Restoring Value

Fortunately, all is not lost. We believe managers can enhance revenue synergies with a few measures categorized under the five Ps of marketing: Promotion, Place, Price, Product, and (the forgotten one) People.

Promotion — Segment first, before spending on customer retention. Merging banks agonize over customer attrition. They spend significant time, energy and marketing resources on blanket campaigns aimed at minimizing consolidation's impact on customers. Not all accounts are equally attractive, however. Absent proper segmentation, retention resources won't be expended where they can do the most good.

Identifying the most valuable customers -- wholesale and retail -- is key to unleashing marketing promotions that will really pay off. Prime clients will be less likely to leave if they receive extra attention and a value proposition that includes a wider array of products and services.

An effective segmentation scheme would categorize customers across a range of attractiveness. Some would warrant substantial investment, some less, and some none.

Place — Leverage coverage, don't slash indiscriminately. Branch and sales force consolidation is often handled in a manner that is rash and myopic. Granted, rationalization models typically do assess branch profitability with great accuracy, and they do correctly estimate customer defections that may result from reduced coverage. However, most models fail to assess the value of the branch, and other elements of sales and service coverage, in attracting future customers.

Coverage is, in fact, substantially less critical to customer retention than to customer acquisition. People don't like changing banks because it is inconvenient to do so. Considerable inertia therefore disposes them to stay with the bank after a merger, even after ensuing sales force changes and branch closures. In fact, direct contact is progressively losing importance for established customers, who have access to automated teller machines, call centers, and Internet banking.

Prospecting is another matter altogether. The value of market coverage lies mostly in acquiring new customers through the branch and sales network. Managers who go to extremes with traditional branch rationalization models may be inadvertently closing off opportunities for future growth.

Price — Segment and optimize price/volume tradeoffs. Marketers are reluctant to raise prices for any customer segment following a merger. They fear customer attrition, and regulators also frown on that. So when merger partners begin comparing respective products, they tend to settle on the lower of the two price structures. This is ironic, in that dealmakers often tout improved pricing power as one of the potential benefits from the transaction. By settling for the lowest price of the two banks, they actually end up creating negative revenue synergy.

A few banks recognize the low price elasticity of demand for certain types of bank services and have achieved large and immediate returns by raising prices in acquired local banks. But many such across-the-board opportunities are being tapped out as consolidation progresses. The next step is to apply a greater level of sophistication to differential pricing based on willingness to pay.

By segmenting and applying various forms of bundling and differential pricing, banks can optimize pricing of credit cards, service charges, savings rates and financial advisory services. Risk need not be the sole factor in loan pricing. Banks often forfeit yield with low-risk, less price-sensitive borrowers. Both risk profile and purchase propensity should be factored into more sophisticated bundling and pricing strategies.

Product — Be willing to temporarily constrict product features in order to integrate systems quickly. Most banks have been timid about systems integration. Out of fear of losing customers, they try to retain all of the bells and whistles that had accompanied the products and services of both predecessor companies. "Transparent to the customer" is the catch phrase.

In fact, mergers cannot be transparent to the customer and still get results. By trying to integrate systems in a "best of both" style, managers spend too much time and money on software development. And in the end, customers are still affected.

The proponents of this approach argue that the change will be for the better. But consider this, albeit extreme, alternative. Suppose the merger managers just pick one bank's system and slam the other bank's data into it. Then suppose they lavish all of the conserved integration resources on customer service and new product development. Wouldn't the customer and the company be better off in the long run? The illustration is extreme to make the point, but some banks have learned that spending on customers can produce a better and earlier impact than spending on systems consultants and contract programmers.

Coincidentally, rapid integration can also support strategic systems goals. Instead of tying up all their resources for two to three years in the merger process, systems departments can put mergers behind them quickly and focus on strategic platform development. The biggest merger prize may go to the banks that can transform systems to support integrated financial services, i.e., to offer transaction services, credit, investments, insurance and financial planning on a relationship basis using a powerful common customer database.

People — Nurture the acquired growth culture. Acquisitions of high-revenue growth companies are the mergers that most often disappoint. At first this seems counterintuitive. After all, buyers seek growth companies because of the high value placed on their future revenue growth.

However, higher growth companies command a higher share price multiple and a higher acquisition premium. Typically, the market will make the buyer pay at least the present value of the growth trajectory of the target. But buyers, unfortunately, can seldom sustain the acquired institution's internally generated growth. The culture of the larger acquirer tends to overwhelm the service-focused, entrepreneurial culture of the acquired. Some of the best people leave, more bureaucracy creeps in, and -- particularly amid frequent acquisitions and restructuring -- fear stifles creativity.

Consolidators should go out of their way to nurture a creative, service-focused, entrepreneurial growth culture. They must express and demonstrate the values of customer service and product development. They must carefully integrate work and decision processes to realize synergies without introducing unnecessary bureaucracy.

Even at current prices, bank acquirers can still create value in their deals. But with cost synergies already built into these prices, the only way to do that is by achieving revenue synergies. And that difficult process requires customers to make decisions in favor of the merging entity. Those banks that can demonstrate the value of the merger to their customers will create value for their shareholders -- and emerge as leaders in the restructured industry.

Mr. Smith is a partner in the Toronto office of the Mitchell Madison Group.

Copyright © 2003 by Banking Strategies, published by BAI.

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