Search for Growth

By Kenneth Cline

While Ken Thompson has restored investor confidence in Wachovia Corp., revenue growth remains a challenge.

Unquestionably, G. Kennedy "Ken" Thompson has created a new and better banking company out of the recently merged First Union Corp. and Wachovia Corp. The new Wachovia features improved capital ratios, a lower risk profile, better customer satisfaction scores and more transparent financial reporting.

It remains to be seen, however, whether Charlotte-based Wachovia can grow on the strength of its established businesses, without relying on acquisitions. This challenge long haunted the old First Union, the predecessor organization that dominates the new entity, and now it is Thompson's turn to confront it. "We want to show we can deliver on the promise of organic growth, or at least do better than our competitors," says the chairman and chief executive of the $342 billion-asset colossus. "You don't want to get into a position where all you're doing is acquisitions."

Success in avoiding that fate hinges on a variety of factors. The first is the parlous state of the U.S. economy, which has beset banks with credit problems, sluggish loan growth and constricted net interest margins. Another problem, more specific to Wachovia, is a high exposure to capital markets activities, which has depressed revenue growth in recent years as Wall Street swooned.

Thompson, 52, acknowledges the growth challenge but asserts that a more focused business model will eventually overcome these hurdles. Since taking command of the old First Union in April 2000, he has shed a variety of non-core units, including subprime lending, auto leasing, credit cards and mortgage servicing. Now he is focusing on four key areas: retail banking; corporate/investment banking; capital management; and wealth management. The goal is to offer a full range of banking, investment and insurance products to consumer, small business and middle-market commercial customers.

Linked with that strategy is a big push on customer service, which had become a weakness at the old First Union. Today, Wachovia's customer satisfaction scores, as measured by the Gallup Organization and University of Michigan, are greatly improved. "You're not going to grow organically if you're not producing value for your customers," Thompson says. "Achieving success long-term only comes about through doing a good job with customers; you don't do it through financial engineering, acquisitions and interest rate management."

Still, deal-making has loomed large in Thompson's three-year reign. Only 12 months after becoming CEO, he launched a surprise $14 billion bid for the predecessor Wachovia, then based in Winston-Salem, N.C., creating the nation's fifth-largest bank. This year, even as final deposit system conversions were being completed for that deal, Thompson announced a joint venture with Prudential Financial Corp.'s retail brokerage operation. The new company, to be branded as Wachovia Securities and based in Richmond, Va., will rank as the third-largest U.S. brokerage as measured by revenues and client assets.

So the question lingers: is the new Wachovia really that different from the old First Union — more focused and disciplined, perhaps, but still essentially relying on mergers for growth? The issue resonates across the industry because large banking organizations generally failed to produce much internal growth during the last decade, at least as measured by retail deposits.

Out of the Fast Lane

Wall Street has greeted Thompson's performance enthusiastically, at least so far. Last year, Wachovia posted a 19.5% total return to stockholders (stock appreciation plus dividends), the highest among the top 50 banks. A total return of 16% in 2001 also was strong, and the two years together reflect a return of investor confidence since First Union sank to its nadir in 2000.

What analysts seem to like best about Thompson is his methodical approach, which stands in contrast to the reputed style of his predecessor, Edward E. Crutchfield, who seemed obsessed with deal-fueled growth. "Thompson is much more disciplined and patient," says John Kline, with Sandler O'Neill & Partners L.P. in New York City.

This discipline has manifested itself on many fronts. Since taking command of the old First Union in 2000, Thompson has revamped top management, rebuilt capital, shed non-core units and reduced risk exposure (sidebar, page 12). Importantly, he has also taken a starkly different approach to acquisitions.

Under Crutchfield, First Union was known for rapid-fire deals that incorporated often-generous premiums to the targets (CoreStates Financial Corp. received a record 530% of book value in 1998); deep cost-cutting to earn back those premiums; and swift systems integrations to clear the decks for the next transaction. Although that formula fueled growth through most of the '90s, it ultimately fizzled, and customer disaffection actually turned the CoreStates deal into a financial debacle.

Turning this playbook on its head, Thompson structured the Wachovia purchase with a low premium (204% of book); careful cost cutting; and a generous systems integration schedule (three years) designed to avoid the disruptions in customer service that reaped so much havoc with CoreStates.

The Prudential deal, likewise, was rumored for months before it was officially announced, and then on terms seen as being advantageous to Wachovia, which received 62% control over the combined brokerage operation. Although Wachovia will contribute $400 million in capital initially, it did not have to pay a purchase premium and will benefit from cost savings going forward. "Thompson made the deal he wanted in terms of control and structure," Kline says.

All this care doesn't mean Wachovia is immune to execution risk. While the unhurried approach to systems integration has helped to minimize customer defections in the First Union/Wachovia merger, some of the heavy lifting remains, such as systems conversions for the Carolinas and Virginia and sign changing in the northeast, all of which distracts from day-to-day business. In the Prudential transaction, there's the prospect of broker defections, although Wachovia is paying incentives to avoid that.

A more long-term issue for the company has to do with the overall economy. Like many other banks, Wachovia is struggling with a tight net interest margin and sluggish loan growth. The slack environment has produced what is known as a flat yield curve, where long-term and short-term rates are close to equilibrium. Banks, in turn, have trouble earning good spreads on the money they lend and invest. "The combination of a flattening yield curve and a lack of loan growth is not good," says chief financial officer Robert P. Kelly. "Those are two perfect storms."

Echoing company guidance to investors, Kelly says Wachovia has positioned itself, through asset/liability management techniques, to maintain the margin it posted at the end of last year (3.86%, compared with a median of 4.01% for the top fifty banks, excluding Citigroup) "without taking on additional risk." But continued pressure in this area, Kelly adds, would put pressure on all banks to cut costs and/or resort to mergers.

Revenue Lag

The weak state of the national economy highlights Wachovia's own exposure to capital markets. The company estimates that one-fourth of its revenues are "market-sensitive," specifically those produced by investment banking, wealth management, principal investing and capital management, which includes brokerage and asset management.

All of these units have been hurt by the stock market's three-year slump, underscoring the difficulties of diversifying into a market that is inherently volatile. In the company's 2002 annual report, Thompson wrote, "É over the past few years, we have lagged our peer group in revenue growth, largely because of the impact on our market-sensitive businesses during the economic downturn." Says Jason M. Goldberg, an analyst with Lehman Brothers in New York City: "Greater sensitivity works for you when capital markets behave, and works against you when they don't."

Wachovia has not offered any official guidance on 2003 revenues, except to predict net interest income will be "consistent" with 2002 levels and fee income growth will reach "middle single digits."

The sluggish revenue growth (about 3% last year) affects other metrics. Wachovia's overhead or efficiency ratio (65.8%) is higher than most peers, while key profitability measures, such as returns on assets (1.08%) and equity (11.2%), can be considered mediocre, although much of the weakness in ROE can be attributed to acquisitions-related goodwill.

In a broad sense, Thompson can't achieve his goals without some help from the economy. What he can do is prepare the company to thrive when conditions do improve, which helps explain why he undertook the Prudential transaction despite all the current market uncertainties. "We're positioning ourselves to participate in future growth," says Donald A. McMullen Jr., president of Wachovia's capital management group.

On the face of it, retail brokerage is not a good place to be right now. Millions of investors have fled the stock market and there's no guarantee they will return anytime soon, at least not to the level of participation seen in the last decade.

But Thompson, who declares himself a believer in "demographics," says a coming shift of wealth from baby boomers to the next generation will play to Wachovia's strengths, since more people will need access to the broad range of products and services offered by Wachovia's financial supermarket. "You want to be in the business of managing money," Thompson says. "You want to be in the mutual funds, brokerage and banking businesses."

With its fully fleshed out mutual funds and brokerage operation, Wachovia is unquestionably better positioned than most banks to take advantage of this trend. CFO Kelly points out that economic advantage throughout the economy is shifting from manufacturers to distributors of products. "If you own the customer relationship, you can charge more for the privilege of distributing the manufacturer's product. Over time, we want to focus more energy on the retail distribution business."

To that end, Wachovia has been gradually shifting capital out of commercial banking to retail distribution, which includes retail banking, brokerage, insurance distribution and wealth management. Kelly does not, however, anticipate Wachovia divesting its corporate lending operation, which he views as a good complement to the current array of businesses. "While commercial banking can't match the returns of retail banking, it can still produce returns exceeding its cost of capital," Kelly insists.

An increasing focus on the retail side does have its own risks, however. While retail-oriented banks have done well in the last few years, consumer confidence has been hurt by economic and political uncertainty, the latter exacerbated by the war in Iraq, which bodes ill for banks dependent on retail profits. The American Bankers Association recently documented an alarming rise in delinquencies in several consumer loan categories in the fourth quarter, with past-due credit card accounts reaching a record level.

If Wachovia, like its peers, cannot expect much help from the economy, at least in the short term, where can it turn for growth? Thompson maintains that Wachovia doesn't have to do anything strategic. He says the company can produce internal growth even in the current pinched environment, pointing to recent gains in the sale of annuities and checking accounts. But he also declines to rule out acquisitions should opportunity come knocking, as it did in the First Union/Wachovia transaction. "We're not saying we're never going to pass," he says, using a football analogy. "We're just not going to drop back and throw on every down."

Fair enough: a prolonged economic slump could present all kinds of opportunities for well-capitalized banks such as Wachovia. But then Thompson goes further, when asked whether he would rule out expanding the company beyond its East Coast franchise. "I believe that over time, there are going to be a handful of companies that are going to be more national in scope on the retail side, and it makes sense to me that we'll be one of those," he says.

Could that be a hint of the old First Union bubbling to the surface?

Mr. Cline is senior editor with Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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