At Firstar, Sharpening the Ax for a U.S. Bancorp Buy - TheStreet

Jerry Grundhofer is buying his brother Jack's bank. But a closer look at

Firstar's

(FSR)

planned $21 billion purchase of

U.S. Bancorp

(USB) - Get Report

suggests that Jerry may need Jack as much as Jack needs Jerry.

Sure, U.S. Bancorp, where Jack is chief exec and chairman, has been plagued recently with subpar results, and was therefore a sitting duck for the acquisitive brother. But Jerry's Firstar is also experiencing flagging revenue growth. What better than another big deal to goose the top line at Milwaukee-based Firstar, which posted revenue growth of only 3% in the year's first half?

Investors weren't impressed. They booed the deal, sending Firstar's stock down $2.44, or 11%, to $19.81 Wednesday. U.S. Bancorp rose $1.81, or 7.8%, to $25.

Here's Why

The selloff took place even as the banks claimed that earnings at the combined institution wouldn't suffer. Reflecting the low price-to-earnings ratio at which it's acquiring U.S. Bancorp, Firstar expects the deal to immediately add to per-share operating earnings. Without factoring in any potential revenue improvements from synergies, Firstar now thinks it'll make $1.82 per share in 2001, 3.7% higher than the $1.75 per share forecast by analysts surveyed by

First Call/Thomson Financial

. As is customary, these operating earnings leave out merger-related charges, which total a sizable $800 million, or three times cost savings, in this deal.

Firstar, which expects to close the deal in 2001's first quarter, is swapping 1.265 shares for each U.S. Bancorp share. At Firstar's closing price Tuesday, Minneapolis-based U.S. Bancorp is being acquired for $28.15 per share, a 21% premium to its Tuesday close. The acquisition price is 12.1 times the $2.35 in per-share earnings that Firstar thinks U.S. Bancorp can make next year, and around 2.6 times book value. Firstar expects to make pretax cost savings of $266 million in the 2001-2003 period, equivalent to about 8% of U.S. Bancorp's annual cost base. All in all, it's hard to argue that Firstar has overpaid.

On a conference call, Jerry Grundhofer, chief exec and president of Firstar, stated three main objectives behind the deal. He thinks Firstar's managers can get better returns out of U.S. Bancorp's consumer business. He was glad to get his hands on U.S. Bancorp's faster-growing nonbank operations, like its payments systems business. And he acquires a franchise with a big presence in Western states that have more attractive demographics.

The goals look realizable. Firstar probably can squeeze better margins out of U.S. Bancorp's retail business because it's one of the most efficient big banks in the country, with its noninterest expenses equivalent to only 40% of revenue, well below the big bank average ratio in the mid-50s.

"This deal makes a lot of strategic sense," says Charles Peabody, banks analyst at Mitchell Securities. (Peabody rates U.S. Bancorp a buy, but doesn't cover Firstar; Mitchell hasn't done underwriting for either firm.)

Squeezing the Stone

But doubts there are. U.S. Bancorp is already an efficient organization: Noninterest expenses there are equivalent to 41% of revenue (excluding its investment banking and brokerage unit, where pay is well above traditional banking levels). The question is: How many more costs can Firstar eke out of U.S. Bancorp? In its merger with

Mercantile

, completed a year ago, Firstar managers took out a much higher 19% of Mercantile's expenses. What's more, one of the criticisms often leveled at U.S. Bancorp's management was that it had relied too much on expense reductions to boost the bottom line, hurting customer relations in the process.

Clearly, Firstar has to pull more out of the bag than an ax. And that's why the slowdown in revenue growth at Firstar is troubling. Of course, synergies will help revenue growth. But the Mercantile example doesn't hold out a huge amount of hope. When the Mercantile merger was announced in April 1999, Firstar expected to be posting revenue growth around 10% in 2000, says Adam Levy, analyst at the

(FSFSX)

Invesco Financial Services fund, which is long Firstar shares but has no position in U.S. Bancorp. Of course, so far this year, it's been a lot slower, at around 3%.

Firstar didn't return calls seeking comment.

Safety Dance

To be sure, it's not scandalous if Firstar is shoring up growth with acquisitions; after all, lots of banks have taken this path. This tack tends not to work when the acquirer pays too much and has to chop savagely to meet goals, and angers customers in the process. On valuation, Firstar looks safe. Peabody notes that institutions now selling out are accepting lower multiples now than in the bank mega-merger boom of 1997-98, which spawned less-than-beautiful creations such as

First Union

(FTU)

and

Bank of America

(BAC) - Get Report

. Taking a less aggressive stance at the outset could ensure a better performance for the merged bank's shares in the future, Peabody contends.

And with Firstar's stock down heavily Wednesday, Invesco's Levy thinks this might be a good time to pick up a potentially powerful bank at a good price.

Here's to brotherly love.