Mellon Looking Overripe as Core Growth Softens

How fast can this Mellon (MEL Quote - Cramer on MEL - Stock Picks) grow?

That's the question many people are asking Tuesday after the Pittsburgh-based bank reported mediocre second-quarter earnings and detailed plans to sell some operations to Citizens Financial Group for $2 billion in cash. Mellon skidded $2, or 4.8%, to $40.20 Tuesday.

The divestiture of the retail and small business operations is part of the bank's long-held aim of plunging into businesses that earn fees, such as wealth management and custody. Because these fee businesses are thought to be less volatile and faster-growing than lending, banks involved in them command richer multiples than peers with large lending and capital markets businesses.

However, second-quarter earnings from Mellon cast a pall over this fee foray. The bank's finance chief, Steven Elliott, said on a conference call that earnings from Mellon's continuing operations could grow 14% next year. Not a bad number. And, at first blush, it looks possible, seeing as earnings from core businesses -- asset management, securities processing and corporate services -- jumped 13% in the year's first six months.

But hold it right there. A critical, but confusing, exercise in this quarter is to follow Mellon's two different earnings measures. As well as so-called core earnings, the bank reported another measure of profits in the quarter that is more comprehensive, and therefore more important. It's called earnings from continuing operations. These are core operations plus some other businesses that aren't clearly disclosed. These continuing operations actually rose only 2% in the first six months, to $428 million from $419 million. (These are "cash" numbers that exclude amortization of goodwill.)

Mellon believes it can make around $878 million in cash earnings from continuing operations in 2001. Add to that the $36 million of income it expects to get in the second half from investing the divestment proceeds, and the bank's profit could total $914 million in 2001. That's equivalent to $1.90 per share. Applying Elliot's 14% growth target, Mellon expects to make around $2.17 next year. At its Tuesday stock price of $40.20, Mellon is trading at 19 times those expected 2002 earnings. Compare that with Citigroup (C Quote - Cramer on C - Stock Picks), which has a much lower 2002 P/E of 14. It also boasts superior earnings growth, posting a 13% increase in core cash earnings in the second quarter, compared with 5% in continuing earnings for Mellon.

Core and Peel

Can Mellon grow by 14%? In theory. If its core operations, which contribute about 90% of continuing earnings, improved by 13% in the first half, when the stock market was awful, it may indeed be able to repeat that sort of growth -- especially if mutual fund investing and equity trading volumes pick up in 2002.

But what about those other businesses that are included in the continuing operations total (but not core operations) and acted as a drag on growth in 2001's first half? Those appear to be retail brokerage and recurring income from private equity, according to Jim Mitchell, a banks analyst at Putnam Lovell. (He rates Mellon a buy and his firm has done no recent underwriting for the bank.)

These both had poor second quarters that are likely to get better from here, says Mitchell, who believes that the hefty $91 million writedown in private equity, not included in recurring income, has likely positioned the private equity portfolio for gains in coming quarters. And he adds that the retail brokerage had such a poor second quarter, producing a paltry $10 million in revenue, that it, too, has quite possibly bottomed.

But there's evidence that Mellon really stretched in the second quarter and may have problems making its 14% growth target.

For example, asset management is hurting badly. Wealth-management businesses reported a 2% decline in pretax income in the first six months of 2001.

Loan Losses

And then there's the loan-loss accounting. The bank charged off $20 million of loans in the second quarter but added just $1 million to its loan-loss provision. Usually, investors expect the provision to at least match charge-offs. Failure to do that smacks of earnings management, because any addition to the provision has to be subtracted from earnings.

Mellon's Elliott contends that its lower reserve is appropriate. In the second quarter, it was equivalent to 2.38% of loans in continuing operations, compared with 2.35% of loans in the first quarter. What's more, nonperforming assets dropped 33% from first-quarter levels, to $128 million in the second quarter.

Finally, what to make of Mellon's decision to exclude its hefty private equity writedown from both core and continuing numbers? In the second quarter of 2000, Mellon was quite happy to include private equity in headline earnings numbers, when it reported a pretax gain of $17 million there. Now, in 2001's second quarter, when it's showing a $146 million loss, most of which is due to the writedown, the bank excludes it from headline numbers. Compare that with Wells Fargo (WFC Quote - Cramer on WFC - Stock Picks), which included its private-equity writedown in core numbers Tuesday.

This Mellon may look nice, but take a bite and it's distinctly bittersweet.