KeyCorp to Buy First Niagara:  A Terrible Deal!

In 35 years of covering the banking industry, I’ve witnessed in awe some banking deals that I knew from the get-go were doomed to be disasters. Typically, they ended up destroying vast amounts of the acquiring entity’s shareholder value while boosting, rather than reducing, its risk profile. But I’d assumed the era of dumb deals ended for good in the mid-2000s once Hugh McColl, Ed Crutchfield, and Ken Lewis left the scene, and that bank CEOs and boards since then have come to their senses. It turns out that’s wrong. KeyCorp’s $4.1 billion acquisition of First Niagara, announced late last week, is almost certainly a ticking time bomb of value destruction on par with some of the classic bank mashups of the late 1990s. The deal will dilute Key shareholders via the overpriced addition of a mediocre franchise, while increasing its operating risk and—worst of all—it might start a cycle of serial acquisitions by Key that will result in further and ever-greater dilution down the road. No one, apparently, has learned anything.

All this is especially disappointing since KeyCorp CEO Beth Mooney had been doing a fine job of improving the performance of the company. I’m amazed that CFO Don Kimble can keep a straight face as he tries to justify why this is a good use of the company’s capital.  I’m not amazed, by contrast, by Morgan Stanley, who’ll get a big fee for selling what it surely knows is a misbegotten deal to Key and its board. Investment bankers, after all, will be investment bankers.

Specifically, here are seven reasons why this is an awful deal:

1. Too big! As a rule of thumb, deals in which the acquiree is 20% or less the size of the acquirer tend to have a much higher chance of success. In such deals, integration of everything from IT to corporate culture is much easier to manage. Political infighting can be held to a minimum. But in this case, First Niagara is 41% the size of Key. Combining these two entities into a coherent, smooth-running whole is going to involve the simultaneous execution of several huge integration efforts–and the battles that go with them. I’ve seen from experience that not all those integrations will go smoothly.

2. The acquisition won’t improve the strategic composition of KeyCorp or increase its long-term growth rate. To say First Niagara is a mediocre banking company is an insult to mediocre banking companies. It’s poorly run, and has a core growth rate that’s lower than KeyCorp’s. So Key is boosting its risk—operating, integration, regulatory, and who knows how else—to reduce its overall growth.

3. Way too expensive. Of course, just about any deal can be justified if the price is right. This is not one of those deals. KeyCorp is paying 1.7 times First Niagara’s tangible book value and 19 times its 2016 estimated earnings. The result is a 12% reduction in KeyCorp’s tangible book value, that the company says—and I can’t believe that I’m typing this—it will take ten years to recover. Earnings dilution will occur in 2015, 2016, and 2017 even if the company achieves all its plans. Which (see next item) it won’t.
4. The economic assumptions are an embarrassment. Mooney and Kimble must think investors are idiots. There’s never been a significant acquisition where there wasn’t some post-deal revenue and client loss at the acquiree. Never! We know from experience in particular that the greater the reduction of the acquiree’s branch network, the greater will be its revenue and customer attrition. Yet KeyCorp says it plans to reduce expenses by $400 million, or 40% of First Niagara’s current base, and not lose a dime of revenue! That’s delusional. Worse, CFO Kimble even has the gall to say he thinks Key will generate $300 million of revenue enhancements. Both logic and experience says that won’t happen. To suggest otherwise is the sort of thing that should cause the board to question his judgment.
5. Corporate governance will likely get worse. It’s my belief that companies should have a board that’s big enough to provide adequately diverse selection of viewpoints, but not so big that it becomes unwieldy and voices get lost. In my opinion, the right size is anywhere from seven to eleven seats. KeyCorp currently has 14 board members, and will add three more from First Niagara. This makes no sense to me, other than as a negotiating tactic aimed at bringing the First Niagara board around. But given the price KeyCorp paid, it shouldn’t have had to throw in anything else. If KeyCorp thought 14 was the appropriate number of board seats, it should have kept the total at 14 by, say, adding two directors from First Niagara and asking two existing board numbers to resign. Instead, Key will add three seats to the (already bloated) 14. KeyCorp’s management and board are simply being lazy and undisciplined with respect to corporate governance.
6. Poor capital management. Asked why it made more sense to pay 1.7 times tangible book value for an inferior banking franchise rather than buying KeyCorp’s own stock a back at 1.3 times, Don Kimble said he didn’t think the regulators would approve of such a large buyback in 2016. That may be true, but it still speaks poorly of Kimble’s patience with excess capital. He seems to think it’s a better idea to fritter it away quickly rather than hold it and wait for better opportunities longer-term.

7. What this deal says about the future is ominous for Key holders. The worst aspect of this deal for KeyCorp shareholders is what it says about the future. History suggests that large deals like this tend to take longer to integrate and be more costly than initially expected.  In the meantime, revenue will be disappointing and returns will fall generally. It usually takes 18 months or so for management to realize that it has a disaster on its hands, and that costly additional charges will be needed. When that happens, management will be tempted to hide the scale of the mess by . . . announcing another bigger, even more dilutive deal as a smokescreen! The charges associated with that new deal will conveniently obfuscate the added charges of associated with the earlier one, and a new round of self-delusion will begin. Then, after another 18 months or so . . . well, you get the picture. It’s rinse and repeat. The result is a systematic dilution and abuse of shareholders, all so management can hide its own incompetence. I’ve seen my share of serial diluters before, and can only hope someone at KeyCorp or on its board will wake up and prevent that from happening here.
   Consolidation in the banking industry is not only healthy, but a necessary outcome of the many external forces affecting the industry.  But managements and boards of acquirers need to balance the risk and reward they see in an acquisition with the price.

I use to get mad about such overpriced acquisitions, but now I get sick because I know we should have learned from history.  But human nature never changes. Morgan Stanley might at least take its fee in restricted KeyCorp shares—priced just before the deal was announced.

What do you think? Let me know!