Understanding Your Strategic Options

A banker friend I`ve known for 20 years, now chairman of the board, recently lost a lot of sleep agonizing over whether to sell the bank. He said that if he knew the impact of the sale on shareholders, customers, and employees, his decision would have been much easier. He jokingly remarked that prophetic powers would be a nice addition to his management skills. While relying on divine inspiration might seem like an attractive approach at times, most executives would prefer to base their decisions on hard facts. One way to do so is by using strategic options analysis. Utilizing sophisticated financial modeling techniques, strategic options analysis puts predictive capabilities at the disposal of managers and directors grappling with major business decisions. In a nutshell, strategic options analysis weighs the long-term impact on earnings and shareholder value of various strategic alternatives. It`s better than a crystal ball because it displays not just one future but optional futures, depending on what management and the board decide to do.

Evaluating your optionsThe types of decisions supported by strategic options analysis fall under the general categories of financial engineering, improving current earnings, and implementing growth strategies. Each decision turns on its impact on future shareholder value. You may find your financial institution at an important juncture in its history. An uncertain economic environment, new competition, technology, financial modernization, and changing customer behavior are all converging to put pressure on bank earnings. Or possibly a more isolated set of circumstances has arisen, such as the impending retirement of the CEO, a merger offer, or the opportunity to buy branch offices being cast off by a megabank. Picture the executive management team and the board of directors wrestling with questions about the institution`s future course. They may have on the table a series of options, each of which will fundamentally impact shareholder value. Those options will likely include some or a combination of the following:Financial engineering

• converting to a Subchapter S corporation
• issuing trust-preferred securities
• establishing a leveraged employee stock ownership plan
• buying back stock
• changing the cash dividend policy

Improving current earnings

• increasing noninterest income
• capitalizing on technology
• improving interest spreads
• rightsizing staff levels
• reviewing product offerings

Implementing growth strategies

• internally growing the core business
• establishing a new branch
• buying a branch
• starting a de novo bank somewhere else
• buying a bank
• engaging in a merger of equals

When choosing among these or other strategic options, it is important to have a means of understanding and comparing their probable impact on shareholder return over time. Does one or several courses of action clearly have an advantage? Or will the status quou00e2u20ac”for example, remaining an independent bank or maintaining the current dividend policy structureu00e2u20ac”achieve the best results over a five-year period? Making such strategic decisions has become more challenging for several reasons, the most significant being the drop in the price/earnings ratios of actively acquiring banks. This change in the market has put the brakes on extremely high valuations and slowed the pace of merger and acquisition activity. Another reason for the slowdown in bank M&A is the loss of the pooling-of-interests method of accounting. Pooling was a method of accounting that created fertile ground for high-valued acquisitions, fueling the consolidation boom of the late 1990s. When selling the bank could so dramatically increase shareholder value, it was often more difficult to argue for pursuing other strategic alternatives than it is today. Why was the pooling method so attractive? The short answer is that no goodwill needed to be recognized because the assets were recorded at book value. Because no goodwill was amortized, the acquirer`s reported earnings and tangible capital were significantly higher than under the purchase method. As expected, the elimination of pooling has dramatically affected bank acquisition activity and prices. The Financial Accounting Standards Board adopted revisions to its accounting standards governing the transfer of financial assets after June 30, 2001 or December 31, 2001, depending on certain triggers.

Henceforward, the purchase method of accounting must be used. Under the purchase method, the seller`s balance sheet is adjusted to fair market value and then added to the acquirer`s financials; the difference between the purchase price and the net asset value of the seller is treated as goodwill on the acquirer`s books, which impacts tangible equity.

Despite these obstacles, the era of bank mergers and acquisitions is certainly not over. Selling the bank can still be a highly rewarding option, depending on the situation. What has changed, though, is the fact that many other strategic alternatives are available that might be equally or more attractive. But which one should you chose. Measuring shareholder returnA strategic options analysis carefully and objectively weighs alternative strategies and combinations of strategies. As a result, management and the board become fully informed as to how each one compares on a purely financial basis. The focus is on measuring shareholder return for each option from a cash-flow and market valuation perspective. Armed with the results, the decision makers can add their own personal insights in terms of the institution`s market, culture, risk tolerance, and resources to arrive at a proper conclusion. Here`s a brief description of the process: 1. A strategic options analysis starts with a baseline evaluation, which involves collecting information from management about how the institution is presently structured and positioned. The institution`s primary strengths and challenges are identified, and its rate of growth, return on assets, dividend rate, and other performance variables are quantified. 2. The financial benchmark for measuring value is the present value of the bank`s existing business cash flows under its current operating strategy and financial structure. For many institutions, the current business model is a strong equity position, good asset quality, and acceptable but not superior profitability. 3. If a particular bank is not publicly traded, the valuation reflects an expert opinion of how the market would currently value the bank. These values and general economic indicators are analyzed to arrive at several reasoned assumptions about the institution`s performance over a five-year period if the bank stays on its present course. 4. The baseline analysis then extrapolates earnings per share, shareholder value, the present value impact, and present versus future value of the institution over a five-year period. 5. These baseline measures are incorporated into financial models to compare what would happen to earnings and shareholder value if the institution were to adopt a series of alternative strategies, such as converting to a Sub S corporation or acquiring another bank or branch. The result is easily comparable future valuations for each strategy under consideration. To illustrate how a strategic options analysis works, I have included a sample graph that shows the present versus future value of a community bank based on two different scenarios: 1. It continues to operate without significant changes in strategy and with growth rates that management believes are achievable. 2. It pursues one of the strategic alternatives it is considering and converts to a Sub S corporation. In Figure 1, the arrowhead lines represent change in shareholder value over a five-year period. (Shareholder value is the sum of the dividends received and the market value of the stock.) The lower line of the graph reflects the future value of the bank`s cash flows, assuming no change in the standard C corporation structure. The upper line reflects the future value of the bank`s cash flows, assuming a Subchapter S conversion. Even considering the costs of the Subchapter S election and the buyout of shares often required to accommodate the statutory shareholder limit, the Subchapter S conversion option is very compelling. In most cases, however, two optionsu00e2u20ac”the status quo and one alternativeu00e2u20ac”are not enough to give management and the board certainty about the best future course. Would an overcapitalized bank be better off repurchasing shares or increasing dividends? Or would shareholder value be better served if the institution applied its capital to buy a nonbanking business? For this particular bank at this time, converting to a Subchapter S corporation provides a significantly greater return to shareholders over the next five years than simply maintaining the status quo.

For another organization, a different answer is entirely possible. Keep in mind that improvements in current earnings in conjunction with growing the bank will often provide the highest returns over time, irrespective of the institution`s financial structure. A success storyEarlier this year, New Era Bank, a $180 million institution in Fredericktown, Missouri, was at a crossroads, and senior management and the board needed some guidance to help illuminate the way. In approaching our firm for assistance, Stephen R. Green, president and CEO, said he was “not interested in a canned approach to strategic planning.” A strategic options analysis gave the bank`s management team and board a market value perspective based solely on the cash flow return to investors for a broad range of alternatives. “The analysis was tailored to our specific situation,” notes Green. “All the numbers were pertinent to our situation, and we didn`t waste time dealing with generalizations.” Our firm, working with senior management, determined the financial impact of each option they believed to be viable and then led the board in an in-depth discussion of how the differences in financial results would add to or detract from the value of the bank over time. The strategic options analysis was presented and thoroughly discussed in a manner that enabled everyoneu00e2u20ac”the executive management team and all board membersu00e2u20ac”to evaluate the alternatives before the institution. “We were able to carefully analyze each of the options.

What was interesting was that, at the time, we were leaning toward one decision. The analysis showed us alternative strategies that would actually be more attractive over the long term,” notes Green. Informed decision makingArmed with a cash flow and market valuation perspective, a bank`s board will be in a strong position to decide whether to implement changes in financial structure or business strategy, given the impact on earnings and shareholder value. The board will also have a clear understanding of the financial impact of a decision to maintain the current strategy. The bottom line is that a strategic options analysis provides powerful information and a solid framework for selecting the best strategy or combination of strategies for the institution. |BD|