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It seems as though big investment banks are about as vulnerable as big game these days, and the hunt isn't over yet, analysts say. Consider what has already happened. On the afternoon of Sept. 12, the news wires vibrated with reports that Chase Manhattan Bank is in talks to acquire J.P. Morgan for $30 billion, although Deutsche Bank may be a dark-horse bidder. Only that morning, the papers were full of Germany's Dresdner Bank announcing that it would acquire Wasserstein Perella. Credit Suisse First Boston had already declared on Aug. 30 that it would buy Donaldson, Lufkin & Jenrette (
DLJ
). And on July 12, CSFB's Swiss rival, UBS, said it would purchase PaineWebber.
Most of these acquisitions reflect the latest thinking in financial institutions: That big is beautiful, and global is glamorous. Wall Street's dominant players, including Merrill Lynch and Goldman Sachs, have been playing this game for some time. And now it's becoming fashionable with Wall Street wannabes.
Question is: Do the recent rash of deals reflect rational strategies or merely merger envy? Take Chase. It has a broader business mix than J.P. Morgan, but what does Morgan bring really bring to the party except more of the stuff Chase already has? (A Morgan deal with Deutsche, by contrast, would create a global powerhouse and strengthen an already significant U.S. business.) Why are two giant Swiss banks, Credit Suisse and UBS, making big investments in the U.S. market, where each already has a sizable presence? And is the prospect of being able to offer "full service" -- from investment banking to plain old bank loans for everyone from companies to John Q. Public -- justification enough for marrying PaineWebber and UBS to create a monster that might aptly be named Citigroup Too?
LOOK OUT BELOW. If you're an investor instead of an M&A maven, you don't have to answer these riddles to know what to do. Just listen to the rising chorus of analysts who argue that the stocks of investment-bank takeover targets are already inflated to the bursting point. They say if the lemmings -- or rather, bidders -- don't keep piling in, then look out below. At the very least, if you're going to risk a bundle at these prices, first get straight what each potential takeover target might bring to a lovesick suitor.
Actually, only a couple of potential targets remain. Assuming that Chase really does get Morgan -- and neither would confirm a deal as of Sept. 12 -- that would leave Lehman Brothers and Bear Stearns as the two most eligible brides on Wall Street. At least, when it comes to midsize independent financial services firms with significant investment-banking and trading operations. Indeed, the stocks of Lehman (
LEH
) and Bear Stearns (
BSC
) shot up just as much as J.P. Morgan (
JPM
) did back in August on news of the Credit Suisse deal. The critical thing to note, if you thrive on risky investments, is that the two veteran Wall Street firms offer advantages to potential acquirers that Morgan can't, mainly in the way of investment-banking services.
Indeed, the hottest of this bunch may remain on the table. "Lehman is still undervalued from a fundamental point of view," declares Clare Nickson, brokerage analyst at UBS Warburg. "At the end of last week, it was trading at 11 times [next year's] earnings, vs. its peers' 15 times [earnings]." If you consider that DLJ and PaineWebber were sold at 18 times (next year's) earnings, Lehman would be worth $200 a share at a conservative 16 times earnings, says Nickson. The stock is currently trading at around $150. Can you say "upside?"
TURNAROUND. Lehman's traditional franchise in U.S. bond trading may have kept its valuation unfairly low in the equity frenzy of the past few years. And that may mask efforts the firm has made to get into other lines of business. "Lehman isn't the big debt house it used to be," says Nickson. "It has turned itself around since the early '90s." In fact, Nickson says she's impressed with Lehman's co-marketing relationship with mutual-fund giant Fidelity, which has gotten Lehman exposure in the retail market. But the real value drivers at Lehman Brothers are its high-margin businesses of advising on mergers and acquisitions, and underwriting sales of stock to the public.
That's what has analysts predicting revenues of around $8 billion for fiscal 2000, up 51%, with earnings of $12 per share, give or take a few pennies, up around 47%. Of course, analysts acknowledge that such predictions mean virtually nothing for 2001. "For broker-dealers, you always forecast lower for the next year," says David Berry, director of research at Keefe, Bruyette & Woods. "That's because each year analysts say this year's performance was so unbelievably good, they can't possibly meet it next year."
Who might link up with Lehman? Analysts imagine several potential combinations. One might be a foreign acquirer. "Lehman would get a huge advantage from a foreign parent because it wouldn't have the politics [of overlapping franchises] to deal with," says UBS Warburg's Nickson, referring to a problem that doomed Lehman's proposed combination with American Express back in the early '90s.
BIG OVERLAP. Domestically, analysts have long said that either J.P. Morgan or Chase Manhattan would be logical acquirers of Lehman. Of course, if Chase buys Morgan, it's unlikely that it would also swallow Lehman anytime soon, even though that would significantly beef up Chase's investment banking and gain it one of the hottest merger-and-acquisition advisory teams around. Already, in fact, Chase has made some important acquisitions to deepen its investment-banking capabilities, with purchases of Hambrecht & Quist and Flemings Bank. One big drawback of a Chase-Lehman deal would be a significant overlap in the huge bond business of both banks.
By the same token, though, Morgan could be a dear buy for Chase. Morgan's stock has been the most expensive of the obvious takeover targets. The morning of Sept. 12, it was trading around $170, about 16 times earnings, or 2.8 times net asset value. The rumored Chase offer of $196 a share would be almost 18 times earnings, and about 3.1 times net asset value. That's in the ballpark of what DLJ and PaineWebber were valued at by their potential acquirers. And Morgan's investment banking business isn't as productive as the operations of those two. Still, CIBC's Eisman says Morgan is worth $180 to $200 a share because of the value of the firm's asset-management business. Eisman predicts revenues of $10 billion in 2000 for Morgan, up 12%, with earnings per share of $11.72, up 13%.
Morgan's stock rose 16 and change on Sept. 12, to close at $182, on the merger rumors, while Chase's dropped a bit. That could be merely the typical pattern of an acquirer's stock dropping because of the inevitable merger expense and dilution to earnings per share -- but it might also presage the market's reaction to the value created by this deal.
EERIE THROWBACK. Even though Morgan's assets under management have tremendous value, it isn't clear what Chase would emerge with, aside from sheer size. The two businesses overlap a lot. Chase ranks 9th in world in merger-and-acquisition advisory services this year, and Morgan 10th. For U.S. equity underwritings, Chase is 10th and Morgan 11th. For debt underwriting, Chase is 5th and Morgan 9th.
If Chase's strategy is bigger-is-better, it's eerily reminiscent of the '80s, a decade during which banks, in a their frantic bid to grab market share at any price, made loans too cheaply, saw profit margins decline, and found themselves having to recapitalize in the decade that followed. Their return on assets, the measure of efficiency for banks, scraped bottom. In the '90s, banks cleaned up their acts in what became the industry's golden age, according to Dickson. In the unprecedented bull market, the shareholder has been king -- and any operation that didn't show profits has been chopped.
The odd man out in the takeover wave could be Bear Stearns. A firm with a rough-and-ready trading culture that fit perfectly with the 1980s, it's somewhat out of vogue these days. "Bear Stearns is not what everyone wants to own," says Berry. "It has no dominant franchise in investment banking or underwriting."
CINDY CALLING? Although Bear Stearns management has said it will sell if the price were right -- specifically, four times net asset value -- analysts are skeptical that anyone would pay that much. "It's one thing to dream that Cindy Crawford will come up to you on the street and [ask you out on a date], it's another for it to actually happen," says CIBC's Eisman. His target price for the stock is $65, which is below its current trading range of around $70. Eisman thinks Bear Stearns' yet-to-be released fiscal 2000 revenues (for the year ended June) were around $5 billion, down 37%, with earnings per share of $5.52, down 23%.
If Bear Stearns doesn't come up with a buyer, Wall Street is convinced that it will be too small to survive -- that it would slowly but steadily lose market share. "This is a difficult environment for smaller investment banks," says Guy Moszkowski, a managing director and investment-banking and brokerage analyst at Salomon Smith Barney. Global players such as Merrill Lynch, Morgan Stanley, Dean Witter, and Goldman Sachs are leaving few corners of the industry unattended, he says. Morgan, it appears, is already adjusting to this painful reality.
The question for investors to ponder -- and it could be answered soon, the way things are going -- is when will Lehman and Bear Stearns come up with their own merger deals?
Popper covers the financial markets for Business Week Online in New York Edited by Beth Belton
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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