First Union Buys Wachovia Bank: a Merger of Equals

question 91

Essay

First Union Buys Wachovia Bank: A Merger of Equals?

First Union announced on April 17, 2001, that an agreement had been reached to acquire Wachovia Corporation for about $13 billion in stock, thus uniting two fiercely independent rivals. With total assets of about $324 billion, the combination created the fourth largest bank in the United States behind Citigroup, Bank of America, and J.P. Morgan Chase. The merger also represents the joining of two banks with vastly different corporate cultures. Because both banks have substantial overlapping operations and branches in many southeastern U.S. cities, the combined banks are expected to be able to add to earnings in the first 2 years following closing. Wachovia, which is much smaller than First Union, agreed to the merger for only a small 6% premium.

The deal is being structured as a merger of equals. That is a rare step given that the merger of equals’ framework usually is used when two companies are similar in size and market capitalization. L. M. Baker, chair and CEO of Wachovia, will be chair of the new bank and G. Kennedy Thompson, First Union’s chair and CEO, will be CEO and president. The name Wachovia will survive. Of the other top executives, six will be from First Union and four from Wachovia. The board of directors will be evenly split, with nine coming form each bank. Wachovia shareholders own about 27% of the combined companies and received a special one-time dividend of $.48 per share because First Union recently had slashed its dividend.

To discourage a breakup, First Union and Wachovia used a fairly common mechanism called a “cross option,” which gives each bank the right to buy a 19.9% stake in the other using cash, stock, and other property including such assets as distressed loans, real estate, or less appealing assets. (At less than 20% ownership, neither bank would have to show the investment on its balance sheet for financial reporting purposes.) Thus, the bank exercising the option would not only be able to get a stake in the merged bank but also would be able to unload its least attractive assets. A hostile bidder would have to deal with the idea that another big bank owned a chunk of the stock and that it might be saddled with unattractive assets.

The deal structure also involved an unusual fee if First Union and Wachovia parted ways. Each bank is entitled to 6% of the $13 billion merger value, or about $780 million in cash and stock. The 6% is about twice the standard breakup fee. The cross-option and 6% fee were intended to discourage other last-minute suitors from making a bid for Wachovia.

According to a First Union filing with the Securities and Exchange Commission, Wachovia rebuffed an overture from an unidentified bank just 24 hours before accepting First Union’s offer. Analysts identified the bank as SunTrust Bank. SunTrust had been long considered a likely buyer of Wachovia after having pursued Wachovia unsuccessfully in late 2000. Wachovia’s board dismissed the offer as not being in the best interests of the Wachovia’s shareholders.

The transaction brings together two regional banking franchises. In the mid-1980s, First Union was much smaller than Wachovia. That was to change quickly, however. In the late 1980s and early 1990s, First Union went on an acquisition spree that made it much larger and better known than Wachovia. Under the direction of now-retired CEO Edward Crutchfield, First Union bought 90 banks. Mr. Crutchfield became known in banking circles as “fast Eddie.” However, acquisitions of the Money Store and CoreStates Financial Corporation hurt bank earnings in late 1990s, causing First Union’s stock to fall from $60 to less than $30 in 1999. First Union had paid $19.8 billion for CoreStates Financial in 1998 and then had trouble integrating the acquisition. Customers left in droves. Ill, Mr. Crutchfield resigned in 2000 and was replaced by G. Kennedy Thompson. He immediately took action to close the Money Store operation and exited the credit card business, resulting in a charge to earnings of $2.8 billion and the layoff of 2300 in 2000.

In contrast, Wachovia assiduously avoided buying up its competitors and its top executives frequently expressed shock at the premiums that were being paid for rival banks. Wachovia had a reputation as a cautious lender.

Whereas big banks like First Union did stumble mightily from acquisitions, Wachovia also suffered during the 1990s. Although Wachovia did acquire several small banks in Virginia and Florida in the mid-1990s, it remained a mid-tier player at a time when the size and scope of its bigger competitors put it at a sharp cost disadvantage. This was especially true with respect to credit cards and mortgages, which require the economies of scale associated with large operations. Moreover, Wachovia remained locked in the Southeast. Consequently, it was unable to diversify its portfolio geographically to minimize the effects of different regional growth rates across the United States.

In the past, big bank deals prompted a rash of buying of bank stocks, as investors bet on the next takeover in the banking sector. Banks such as First Union, Bank of America (formerly NationsBank), and Bank One acquired midsize regional banks at lofty premiums, expanding their franchises. They rationalized these premiums by noting the need for economies of scale and bigger branch networks. Many midsize banks that were obvious targets refused to sell themselves without receiving premiums bigger than previous transactions. However, things have changed.

Back in 1995 buyers of banks paid 1.94 times book value and 13.1 times after-tax earnings. By 1997, these multiples rose to 3.4 times book value and 22.2 times after-tax earnings. However, by 2000, buyers paid far less, averaging 2.3 times book value and 16.3 times earnings. First Union paid 2.47 times book value and 15.7 times after-tax earnings. The declining bank premiums reflect the declining demand for banks. Most of the big acquirers of the 1990s (e.g., Wells Fargo, Bank of America, and Bank One) now feel that they have reached an appropriate size.

Banking went through a wave of consolidation in the late 1990s, but many of the deals did not turn out well for the acquirers’ shareholders. Consequently, most buyers were unwilling to pay much of a premium for regional banks unless they had some unique characteristics. The First Union–Wachovia deal is remarkable in that it showed how banks that were considered prized entities in the late 1990s could barely command any premium at all by early 2001.
-How did big banks during the 1990s justify paying lofty premiums for smaller, regional banks? Why do you think their subsequent financial performance was hurt by these acquisitions?

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