This column was originally published on RealMoney on Feb. 6 at 11:00 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
Large acquisitions -- with their accompanying press releases, conference calls, PowerPoint presentations and eventually proxy statements -- provide analysts with reams of data about the businesses of both the target and the acquirer.
While analysts are poring through these data, investors who are fortunate enough to be long shares of the target are considering whether to hold or sell their shares. Meanwhile, risk arbitragers are busy buying shares of the target and shorting those of the acquirer, frantically estimating the risks and timing of a deal as well as the possibility for other bidders.
This process was set in motion yesterday, when
announced the acquisition of crosstown Boston rival
, sending State Street's shares down 6.5% on the day.
I bought some shares of State Street for my fund as a trade on Monday. After the proxy statement is filed (probably in April), I'll write a follow-up column about whether this trade will turn into a long-term investment. In the interim, I will continue to research this deal.
State Street and Investors Financial are both in the global custody business, providing back-office services to asset managers, pension plans and endowments. Investors Financial has a larger presence in the hedge-fund and private-equity spaces, which are good places to be, but the company has recently stumbled.
In the third and fourth quarters, Investors Financial experienced negative operating leverage (meaning that expenses grew faster than revenue), and in January, the company forecast 2007 revenue growth of 15% to 18%, less than its expense growth of 21% to 24%. The stated reason is that it needs to add to its personnel, technology and office space to attract new clients. Some say this is necessary to service its existing clients, particularly
, which contributes 20% of its revenue. Investors Financial has said it would return to positive operating leverage in the second half of 2007.
We may never know whether Investors Financial could have returned to positive operating leverage, but it appears certain that State Street is taking advantage of this stumble by striking a deal, even though the premium paid is high. The companies expect to reduce expenses by an amount equal to 50% of Investors Financial's total expense base, while projecting 10% client attrition. They also have a reasonable chance to cross-sell State Street's products to Investors Financial's clients, as there is little client overlap.
Therefore, if State Street can execute on this merger plan -- growing revenue while cutting costs -- it will then be acquiring a business with significant operating leverage. If Investors Financial had not had a recent misstep, any price to acquire it would likely have been much higher -- if the company would have sold at all.
A Matter of Scale
Execution risk is real, but State Street has done well with its acquisition of
global securities business, which happened four years ago. That business had multiple systems to consolidate, while Investors Financial has one, and the Deutsche Bank property was far more geographically disparate. Investors Financial is mostly in Boston and the "usual suspect" offshore hedge-fund locales.
In addition, two of State Street's principal competitors will be consolidating at the same time:
Bank of New York
. This is good timing, as it reduces the possibility of client attrition, though there are other good competitors in the space as well.
My bottom line is that this is a business where scale matters. Both State Street and Investors Financial have shown exceptional revenue growth. State Street has grown its earnings per share for each of the past 28 years, and at 13% compounded for the past 10 years.
This deal will further help State Street achieve its long-term targets of 8% to 12% revenue growth, 10% to 15% operating EPS growth and 14% to 17% return on equity. For 2007, a stand-alone State Street expects to be in the top half of these ranges. Its price tag of 15.4 times 2008 EPS does not seem expensive at all. After the deal closes, which is targeted to happen July 1, State Street expects to repurchase $1 billion of its shares, providing a cushion.
State Street is holding a previously scheduled analyst meeting at 12:30 p.m. EST Tuesday. I expect the company to provide the Street with more reassurance about how it will meet its long-term goals, making a P/E/G of 1 look pretty cheap.
I believe State Street shares can move over their preannouncement price over the next few weeks as investors digest all of this information.
At the time of publication, Capone and/or his fund was long State Street, although positions may change at any time. Joe Capone is a managing member and founder of SMaRT Financial Partners LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Capone appreciates your feedback;
to send him an email.