Banks need to show merger makes commercial sense

Whatever the longer-term ambitions of Anglo Irish Bank and First Active, their merger proposal will need to show clear commercial logic to get the approval of fund managers. At present the logic for Anglo of such a deal is hard to see. The outlook rests on the terms agreed.

Building scale and expanding product/service ranges makes sense in current banking markets. But it must be done at the lowest possible cost and with careful attention to the way the market is evolving.

Merging with a high cost operator in a new market where the manner of product distribution is changing involves risks for Anglo, which would be moving beyond its stated strategic direction and area of expertise. Earnings growth could be dented. Because of this risk and to ensure the future growth of their share price and dividends, Anglo shareholders should only give approval to a deal which involves further severe cost cutting and sweeping changes at the top at First Active, and sets out a clear and attainable future development strategy for a merged bank.

Anglo needs the merger to take place at a valuation for First Active which reflects the risks involved.

For First Active shareholders, who have seen their shares which floated in October 1998 at €2.79 (£2.20), rise to €5 and now fall back to around €2.10, the issues are more simple. The company has been a poor performer since flotation and could benefit from the application of the proven management skills of Anglo.

First Active chairman Mr John Callaghan has made much of the broader strategic plans of a merged bank, which he says he cannot yet reveal but which would show that the merger makes commercial sense. That remains to be seen but at this stage Anglo shareholders have every right to remain sceptical.

A merged Anglo/First Active may have plans to take over TSB or ICC in a drive to achieve scale in the banking market and to build a major Internet operation, but there is no guarantee these targets would be achieved.

In the meantime, the two banks need to convince their own shareholders that the first step along their scale-building path makes sound commercial sense.

Both companies operate in the banking market, but that is where the similarities end. Anglo, specialising in the small to medium-sized business end of the market, is a tightly-run operation where cost control and targeted expansion have produced steady profits growth.

First Active specialises in the retail end of the market, largely mortgages and deposits, where margins are under severe pressure as new lower cost operators come into the market. A converted mutual, it has a high cost base, which it is taking steps to reduce. It was caught with its eye off the ball when new direct players entered the mortgage and deposit markets.

Anglo had a cost/income ratio of about 35 per cent, while First Active's ratio is almost double that at over 63 per cent, according to the banks' last full year figures. Cost saving measures already implemented at First Active are not expected to have much impact on the ratio because of the pressure on income, the impact of rationalisation on income and restructuring costs.

Anglo produced a return on equity of 27 per cent in the year to end September 1999 and is expected to generate a return of 28.7 per cent in the current year (Davy forecast). At First Active the return on equity was 6.4 per cent for the year to end-December 1999. Anglo's return on assets in its last full financial year was 0.9 per cent compared with 0.3 per cent at First Active, or 0.53 per cent before exceptionals.

These figures show that for Anglo there are both opportunities and risks associated with a merger.

If Anglo management can achieve really significant cost cuts at First Active to turn the bank into a lower, if not a low, cost operation, profits will be improved. (The process has already been started by First Active with the closure of 25 branches and 175 job losses).

But in making further cost cuts Anglo will have to be careful not to damage the income generating potential of the operation. In addition, there will be other merger-based scope for cost savings through, for example, having one set of headquarter costs and administrative savings.

The figures also indicate that with aggressive and focused management there is potential to make First Active's assets work a lot harder, improving the bottom line and the return on assets. And there should be some, if limited, cross-selling opportunities between the two banks.

There is undoubtedly room to improve First Active's performance. But for Anglo the merger would be a foray into entirely new territory. It is a territory where there are significant dangers in current changing markets and where Anglo has no track record. And it would mean Anglo moving outside its clearly stated strategic direction, a move which it will have to justify to nervous fund managers.

Moving into the mortgage market through a merger with a relatively high cost supplier when margins are shrinking as new lower cost operators target that market is a clear risk. It remains a risk to continuing strong earnings growth at Anglo even if the merger is agreed at share prices which place a low valuation on First Active.

A merged bank would be a bigger market player with a market capitalisation of just over €1 billion. But it would still be a minnow compared with AIB, Bank of Ireland and Irish Life & Permanent with their respective market capitalisations of €9.5 billion, €7.2 billion and €2.9 billion.

A merger would give Anglo a stronger balance sheet with the addition of First Active's excess capital of about €80 million, enhancing its ability to fund future growth and acquisitions. Anglo would get access to a wider deposit base. First Active had customer accounts of €3.6 billion at the end of 1999 - but some €2.8 billion of this was repayable on demand or within three months.

First Active needs to find a partner but the need to make a move is less pressing at Anglo. Whether the deal makes commercial sense for Anglo will depend on the terms agreed and the future strategy the parties map out.

For Anglo it would mean moving in a new direction. Chief executive Sean Fitzpatrick will be hoping to convince his shareholders, including fund managers, that he can apply his successful acquisition track record to this merger.

And the deal may indicate a realisation at Anglo that in a rapidly changing banking market its concentration on niche relationship banking may not be a viable longer-term strategy. It may have decided that it needs to do some strategic "big" deals now which may slow earnings growth for a time in the interests of a stronger medium to long-term performance for shareholders.