Juggling Act
By Jack Milligan
To improve performance and market valuation, institutions need to find the right balance between diversification and strategic focus.
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Specialization is good, but can too much of it be bad?
This issue is being debated around the industry in the wake of flat results and falling stock prices at some of the nation's most specialized banks — State Street Corp., Bank of New York Corp., Mellon Financial Corp. and Northern Trust Corp.
These institutions, which focus on securities processing and/or asset management, have traditionally enjoyed some of the industry's loftiest stock valuations. But all four have seen their earnings hurt, to some degree, by the three-year slump in the financial markets.
To be sure, the four still command trading multiples that beat the average for the nation's largest banks. But the worst stock market in decades has underscored the drawbacks of heavy exposure to one line of business. That further complicates the picture for the many banks that have embraced focus as a way to revitalize their franchises. Is it better to remain modestly diversified, and how much diversification is enough?
These questions take on more urgency now that two major drivers of bank profitability have stalled. A decade of consolidation has thinned the ranks of acquisition targets, reducing the possibility of big cost reductions. And growth from non-interest income, typically generated by increasing fees on many retail products, is harder to come by in a tight market where customers have more bargaining power and are less interested in fee-generating investment transactions to begin with.
"There were other levers you could pull to drive earnings in the '90s," says Trevor Gruzin, global managing partner for banking at New York-based consulting firm Accenture. "Now you have to be much more differentiated and much more specialized."
The specialist banks clearly did the best job of generating organic growth during the '90s and amply demonstrated that you can indeed accomplish more by doing less. Yet the exposure of State Street, Bank of New York, Mellon and Northern Trust to the slumping securities markets does raise a warning flag about the consequences of specialization. Meanwhile, the continuing strong earnings power of companies such as Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. affirms the virtues of a broadly diversified business mix, where weaknesses in one area can be offset by gains in another.
Another group of banks is thriving on a blend of moderate diversification and highly disciplined execution, with regional standouts such as Fifth Third Bancorp and Commerce Bancorp rivaling the specialists' stock market performance. So the debate, essentially, comes down to identifying the "sweet spot" on the specialization continuum.
Robert Kelly, chief financial officer of Charlotte-based Wachovia Corp., tags that sweet spot at "four or five" lines of business, preferably not correlated with each other in the economic cycle. He notes that Wachovia's retail operation is currently helping pick up the slack from weaker investment banking and corporate banking units. "Over time, firms have to specialize in order to out-perform," Kelly adds.
Obviously, there's no single solution appropriate to all institutions. Most banks will never become as highly specialized as State Street — nor should they. But even broadly diversified institutions can improve their financial performance and stock price by honing their strategic focus. "You should be deploying capital into businesses where you have a sustained competitive advantage — and limiting your outlays otherwise," says Thomas McCandless, a bank analyst at Keefe, Bruyette & Woods Inc., New York City.
Envy of the Industry
The appeal of specialization is underscored by the high performance of focused banks in recent times. A good example of the edge they enjoyed is drawn from 2000's third quarter. A weighted core return on equity of 21.65% towered over a 16.26% weighted return by the remainder of the top 50 banks (excluding Citigroup), according to data provided by SNL Financial LC, Charlottesville, Va. At the end of that period, the stocks of the focused banks were collectively valued at 33 times core earnings, as opposed to a collective multiple of 16 for the remainder of the top 50 banks. And this scenario was played out repeatedly between 1997 and 2001.
All four institutions are big players in the investment servicing business, where they provide a variety of back-office administrative functions for institutional clients. This global servicing market has grown nicely over the past decade, which has enabled these banks to post sparkling financial results that are the envy of the industry. The business is also dominated by a handful of global institutions. It relies heavily on economies of scale and requires significant ongoing technological investments, which keeps the barrier to entry high. "It would be extremely difficult to break into that market now," says Accenture's Gruzin.
The market will become even more consolidated when State Street completes its $1.5 billion purchase of Deutsche Bank's global custody business. Currently ranked third in this business, State Street — which outbid Mellon and Bank of New York — will become the world leader in global custody assets. "They're trying to go deeper into a market that's already very much an oligopoly," says Hal Schroeder, a portfolio manager at New York-based hedge fund Carlton Capital L.P.
Mellon, meanwhile, spent the past decade transitioning from a broadly diversified institution into one that now has just three primary activities: money management, investment servicing and benefits consulting. The final stage of this journey was completed last year when Mellon sold its profitable retail banking franchise to Citizens Financial Corp., Providence, R.I.
At the time, CEO Martin McGuinn stated that one of his primary objectives was to attain the high stock multiples accorded the three other specialist banks, which were further along on that journey. State Street, for example, sold off its retail franchise in 1999.
"The first benefit of being more focused is that you're able to concentrate capital and management attention in areas where you think you have a competitive advantage," says Bruno Bonacchi, a senior vice president for corporate strategic planning at Mellon. Focusing on a smaller set of customers then helps you to know them better and address their needs more effectively, he adds. "You can provide very powerful solutions to a customer base you understand much better."
Another advantage of strategic focus is clarity: Institutional investors have a better idea of what they're getting. Traditional banks with a more diverse collection of businesses are in effect conglomerates, and their stocks are inherently more difficult for security analysts and portfolio managers to value than those of more focused companies. Bonacchi believes an institution with a "clear story" is easier for investors to evaluate.
Hunkering Down
While all that may be true, there is a downside to specialization. It's the classic problem of placing too many eggs in one basket. After the nation's stock market began its precipitous decline in the spring of 2000, investors bailed out of companies exposed to that beleaguered industry, which included asset managers and securities processors.
All four specialist banks reported lackluster financial results for third quarter 2002 compared with the year-ago period. In every instance, fees from their core investment management and servicing activities were either down or flat. Bank of New York and Northern Trust were also hurt by an increase in bad loans, which further reduced their net income.
Though the trading multiples of the mighty four still compare favorably with other banks, Wall Street clearly is having second thoughts. In early December, according to SNL Financial, Northern Trust was trading at a 42% discount to its 52-week high. State Street's stock was off 28%, Bank of New York's 43%, and Mellon's 32%. "People liked the processing companies because they supposedly weren't exposed to any risk. Well, sure they were," says analyst Schroeder.
And when market forces buffet a specialist company, it can do little but hunker down and ride out the storm. Of the four banks, only Mellon would agree to be interviewed by Banking Strategies. Bonacchi says his company has "no misgivings" about its focused strategy and insisted that Mellon's current predicament is simply a reflection of the business cycle. "In times like these, you have to take the long view; you can't get caught up in the moment."
Yet the lesson is clear: Being narrowly focused is not unlike making a leveraged investment, in that both the upside and downside tend to be magnified. Further evidence of this is provided by the monoline credit card companies, arguably the most specialized firms of all. Institutions such as Falls Church, Va.-based Capital One Financial Corp. and MBNA Corp. in Wilmington, Del., were the darlings of Wall Street during the '90s, when a booming economy and their own aggressive marketing campaigns led to dramatic growth in customers and earnings.
But a weakening economy and surge in problem loans soured investors on the entire credit card sector. Capital One, which has struggled with credit quality, was trading at a 50% discount to its 52-week high in early December; MBNA, despite reporting good credit stats, was off 22% from its 52-week high.
Thrifts provide another example of the drawbacks of specialization. Most of them focus on two basic activities — taking in deposits and making mortgage loans. Yet, they typically sport some of the lowest trading valuations in the financial services industry, in part because the barriers to entry are so low in the heavily-commoditized mortgage banking business. The weakness of the thrift business model — over-exposure to housing markets and interest rate fluctuations — became glaringly obvious during the thrift crisis and subsequent bailout of the late 1980s and early '90s.
Clearly, markets matter a lot to specialized companies. It's interesting, in this context, to look at Cincinnati-based Fifth Third and Commerce Bancorp of Cherry Hill, N.J., which continue to sport above-average P/E ratios. Although both operate a diverse range of businesses, they are distinguished by a sharp focus on basic retail banking. Fifth Third's skill at controlling costs has given it one of the industry's lowest overhead ratios over the past several years, while its sales culture has generated strong top-line growth.
Commerce Bancorp, on the other hand, is often described as a "deposit-gathering monoline" because of its single-minded focus on checking accounts. Commerce Bancorp's branch network and service culture are designed almost exclusively to attract and retain mass-market checking accounts. "We believe the value of a bank is its core deposit base," says Vernon W. Hill 2d, chairman and chief executive officer. "To the extent that you can attract low-cost deposits, the more profitable you become."
Since they have little exposure to commercial banking (and none to investment banking), these two institutions have fared well in an economy where business activity is depressed but consumer demand remains strong.
Recent research backs up the idea that moderately diversified companies, such as Fifth Third and Commerce Bancorp, may have found the true sweet spot on the diversity continuum. Two McKinsey & Co. analysts ranked 412 S&P 500 companies by their level of diversification and corresponding financial performance. In a published report, Neil W.C. Harper and S. Patrick Viguerie found that strategic focus did indeed boost stock market valuations, but that "moderately diversified" companies did best of all.
"The popular view that 'focus is better' simply isn't right at all times and certainly isn't applicable at each and every stage of a corporation's life cycle," the analysts concluded. Their reasoning: companies need the flexibility to nurture new growth businesses to pick up the revenue slack when their established businesses mature.
New Business Model
Much of this discussion would seem academic were it not for the fact that strategic focus — if not outright specialization — is seen as the key to financial services earnings growth in the years ahead.
The problem banks face right now is that certain sources of earnings growth they tapped in the '90s — acquisition-derived cost savings and fee-driven noninterest income — will not be so helpful in this decade. Acquisitions will continue, of course, but most of the nation's largest banks have signaled that their franchise-building days are largely behind them. Increasing fees is likewise mostly off the table in an environment where banks need to win back customer loyalty through improved service.
So what's left? As interest rates keep dropping, net interest margins are getting squeezed. More and more banks are turning to cost control as their last remedy for sluggish earnings. Since those exercises can only be taken so far, many in the industry are looking at the concept of strategic focus, or specialization, as a way to gin up organic growth.
This focus can be interpreted in different ways. Wells Fargo has about seven major business lines, but is noted for a strong emphasis on cross-selling. That means product manufacturing units and the primary retail distribution channels are expected to cooperate so customers can easily be sold multiple products. "You've got to organize around customers if you want to sell six to eight products per customer," says John G. Stumpf, a group executive vice president at the San Francisco-based company.
Just as Wells Fargo has chosen to focus its energies on cross-selling, other institutions need to identify a core competency they can rally around. "Figure out what strengths you can use to create differentiating capabilities in the marketplace," says Accenture's Gruzin. Ideally, this should lead to a business model organized around those distinctive skill sets. Fifth Third, for example, has used incentives and sales campaigns to build a sales culture that is then harnessed to the task of marketing a fairly narrow range of products to its customer base.
It may sound simplistic, but a decision to concentrate on a particular activity usually results in an organization becoming more proficient at it. This emerged from a joint BAI/First Manhattan Consulting Group study of deposit growth in 2001. "The key for growth in core deposits turned out to be a decision to focus on that business," says FMCG president James McCormick.
The next step is to realign the bank's cost structure around this new business model. Rather than cutting costs indiscriminately, downsizing can be engineered in a way that does not undermine the bank's focused strategy. This may lead to a decision to sell off businesses that no longer fit with the new model. For example, in recent years a number of large regional banks got out of the mortgage and indirect auto markets when returns no longer met their requirements.
In the case of residential mortgages, there is an opportunity for banks to outsource that activity to a specialist, as FleetBoston Financial Corp. did when it sold its mortgage business a few years ago to Washington Mutual Inc. and then outsourced the production of new mortgage loans to the Seattle-based thrift. "Regional banks don't have to do everything themselves," says analyst Mark Fitzgibbons at Sandler O'Neill & Partners in New York.
Realignment can also result in a decision to strengthen a particular business line if it enhances the new model. Commerce Bancorp, for example, decided several years ago to develop insurance distribution into a core business. After buying up nine independent agencies, the New Jersey bank now derives about 7% of its total revenues from insurance brokerage.
What should emerge from this refocusing process is a bank that is still diversified, but now concentrates more tightly on a narrower set of businesses and competencies. It may not be a true specialist like State Street or MBNA. But it's also no longer a department store generalist fated to produce average financial results because it tries to accomplish too much. "If you're going to be different, you can't continue to try to do everything brilliantly," Gruzin says.
All that's left now is to execute — which of course is a difficult task in itself. But even here the benefits of focus can make a difference. "The clarity that comes from having a focused strategy is enormous," McCormick says. "You execute more effectively and you get more efficiency of management going down the line."
Mr. Milligan is a freelance writer based in Charlottesville, Va.