Morgan Deal Will Leave Chase Swimming Upstream

Updated from 7:29 p.m. Tuesday

Like Pierpont's nose, the latest investment-banking deal promises to be big -- but it won't be beautiful.

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Chase's (CMB Quote) agreement to acquire J.P. Morgan (JPM Quote) in a deal valued at more than $30 billion creates a real juggernaut of a bank. On paper.

Chase will pay 3.7 of its shares for every share of J.P. Morgan, the most illustrious name in American banking. The combined J.P. Morgan Chase will have annual income approaching $10 billion and a market value around $100 billion, a number that would place it second only to Sandy Weill's $250 billion powerhouse, Citigroup (C Quote).

For sure, Morgan Chase will dominate massive chunks of the capital markets in the U.S., Europe and across the developing world. And, without doubt, Chase and Morgan executives -- led by Morgan Chairman Sandy Warner and Chase CEO William Harrison -- will triumphantly pump up the deal's potential for cost cuts and revenue enhancements at a conference call they hold Wednesday. But at the same time, the deal will represent a defeat for Morgan's Warner, who several years ago promised shareholders he would build a top-tier investment bank independently.

And will this be a bank that can go up against the likes of Goldman Sachs (GS Quote), Morgan Stanley Dean Witter (MWD Quote) or Citigroup? Extremely doubtful, according to bank watchers.

Rhinoplasty

"I don't follow the logic of this transaction at all," says Larry Cohn, banks analyst at Ryan Beck. (He rates both banks a hold and Ryan Beck hasn't done underwriting.) Cohn's main beef is that it doesn't make Chase a big hitter where it wants, and needs, to be: equity underwriting, an activity that has been extremely lucrative during this decade-long bull market.

Leapfrogging Solid gains for combined firm in worldwide M&A
Company	2000 Ranking	Worldwide M&A advisory
		Deal value ($billions)	Market share (percent)
Goldman Sachs	1	1,601	43
Morgan Stanley Dean Witter	2	1,343	36.1
Merrill Lynch	3	1,072	28.8
Chase-J.P. Morgan*	4	884	23.6
Salomon Smith Barney	5	663	17.8
UBS Warburg	6	627	16.8
J.P. Morgan**	7	556	14.9
Chase**	9	328	8.8
*If combined. **Alone, excluding effects of merger. Source: Thomson Financial Securities Data, through Sept. 12, 2000.

Charles Peabody, banks analyst at New York-based Mitchell Securities, thinks the fusion of the two institutions will create nasty turf battles between the two cultures that will cause many executives, particularly on the Morgan side, to leave.

"It's going to be an integration nightmare," says Peabody. "There'll be bloodletting and many of the best assets -- the people -- will walk out of the door." This struggle will likely take place even at the highest echelons. One revealing exercise will be to see what sort of role Morgan's Warner gets compared to Chase's Harrison. The Wall Street Journal is reporting that Harrison will likely head the merged company.

Reflecting the market's unease with any Chase and Morgan merger, Chase stock slid sharply in after-hours trading Tuesday, taking its overall drop for the day to $4.69, or 8.2%, to $52.81. Morgan's stock was up $16.19, or 9.6%, on the day to $185.50. Wednesday morning in pre-open trading, Chase shares were changing hands at $51 a share, while J.P. Morgan's were trading at $179.25.

Salmon Tartare

There are some elements of the deal that look attractive, of course. Chase gets a strong international presence through Morgan, which got 40% of its revenue from Europe last year. Combined, the two would have a hefty asset management business that could generate lots of the steady revenue growth that shareholders adore. Morgan has $372 billion in assets under management, and Chase $255 billion. In addition, Chase execs probably believe they can get a better return out of Morgan's businesses than its current managers, especially since so much of what the firms do overlaps.

For example, both have powerful bond and corporate-lending divisions and both dominate the markets for derivatives, which are complex financial instruments. Overall, Chase returns 23% on equity vs. 20% at Morgan, according to second-quarter figures from the banks. Morgan had to depend on its volatile trading desks to beat earnings estimates in the second quarter. And, together, its six capital markets businesses have been lackluster so far this year. Their pretax earnings grew by only 7% in the year's first half, as expense growth of 15% outstripped revenue growth of 11%.

Little Impact Chase gains little in stock underwriting
Company	2000 Ranking	U.S. stock underwriting
		Deal value ($billions)	Market share (percent)
Goldman Sachs	1	51	20.8
Morgan Stanley Dean Witter	2	44	17.9
Credit Suisse First Boston	3	25	10.2
Merrill Lynch	4	25	10.2
Salomon Smith Barney	5	22	9
Chase-J.P. Morgan*	6	16	6.7
J.P. Morgan**	6	12	4.8
Chase**	11	5	1.9
*If combined. **Alone, excluding effects of merger. Source: Thomson Financial Securities Data, through Sept. 12, 2000.

But if Morgan is lagging, why would Chase want to buy it for around $200 a share, especially when Chase's top execs have recently said that they wouldn't pay big premiums on future acquisitions? It's hard to see their reasoning. Chase would presumably issue stock to pay for a deal this big. At $200 per share, and assuming that Morgan meets analysts' 2000 per-share earnings estimate of $11.48, the deal would be 7% dilutive, causing per-share earnings at the fused entity to drop by that amount, according to Peabody. As a result, to make the deal break even, Chase would have to make pretax cost reductions at Morgan of $800 million, or 11% of its cost base, according to Peabody. Of course, the less Morgan earns, or the higher the deal price, the deeper the cuts would have to be.

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The real head-scratcher here -- and a question the execs will have to address in detail -- is why Chase opted for a deal that didn't make it an equity powerhouse. Chase could have done this through a merger with Merrill Lynch (MER Quote), once frequently rumored, or Morgan Stanley.

"I saw the headlines and assumed that they'd got the wrong Morgan," Cohn says. "It would've made a lot more sense for Chase to merge with Morgan Stanley." In fact, a Chase Morgan entity would not be higher in the U.S. equity underwriting league tables than Morgan's current sixth place (see table). It would have done $16 billion of deals, leaving it just behind Salomon Smith Barney and well behind the top four. True, in worldwide mergers and acquisitions advisory, "Chorgan" would jump to fourth place, from Morgan's current seventh, with transactions worth $884 billion. But it'd still be well short of the top three in this league.

For sure, Morgan Chase will dominate bonds and derivatives, but Cohn even has doubts here. Doing bond underwriting for highly rated companies is a low-margin business. And Cohn contends that "Morgace's" share of the derivatives market could actually slip. Why? Because corporate customers don't like to have their derivatives exposure concentrated at a few banks.

The Gold Coast

It's possible that many of Morgan's top employees will resent working under Chase managers, whose investment bankers are showier and grittier, as personified by its former investment banking honcho, Jimmy Lee. True, Lee, who still works at Chase, was replaced as investment banking chief in May by Geoffrey Boisi, a smooth, highly-regarded ex-Goldman Sachs banker brought in when Chase bought his investment banking boutique, the Beacon Group.

Onward and Upward Pierpont's boys forge ahead

Source: BigCharts

But the shock departure last Friday of Morgan's chief financial officer, Peter Hancock, who may have known a bid deal was imminent, could be a sign that top managers are already heading for the doors.

This deal would cap an acquisitive year for Chase, which has bought San Francisco-based tech investment bank Hambrecht & Quist for $1.35 billion and the U.K.'s Flemings for $7.7 billion.