Banks And P/C Agencies Reality Check — Part III: Implement The Plan

PERFECT IMPLEMENTATION

The three keys to perfect implementation are:

1. Set reasonable and realistic expectations (see below).
2. Realize that each deal is different. Cookie-cutter approaches don’t work. No matter how many agencies the buyer has acquired, each seller is different.
3. Create a detailed assimilation plan with provisions to change it at least every six months.

If the buyer does adequate due diligence and follows these three steps, they’ll likely merge the two corporations successfully. I strongly believe that good due diligence will lead to reasonable expectations and uncover the unique aspects of the specific deal. This in turn will lead to a detailed and comprehensive assimilation plan. To suggest that any specific assimilation plan or strategy will succeed without completing Steps 1 & 2, as so many financial experts believe, is like putting the cart before the horse. Not only will the cart not move much, it’ll get run over.

REASONABLE EXPECTATIONS VS. PURCHASE PRICE

The desire to acquire is often fueled by grand expectations. Cross-selling, high profit margins, and investment opportunities are a few common areas in which expectations often exceed reality.

Grand illusions of life made easy by great cross-selling opportunities are hard to resist. Consider these true stories:

These three stories are typical of banks’ expectations — and many bankers and agents have even higher hopes. These high expectations are one reason that bankers have been willing to pay such high premiums for agencies. According to Marsh-Berry & Co., Inc.’s 2001 data, the average EBITDA multiple paid by banks upon first expansion was 8.01, which is far higher than the 5.53 average paid by privately held agencies.

Buying an agency and expecting cross-selling to be the growth engine that pays huge dividends is a mistake. One reason cross-selling is so difficult is that loan officers and insurance producers don’t want to risk another department ruining their relationships. People value the chance of a loss, like the potential loss of a customer, at twice the value of gaining something new, such as a new customer. As the old saying goes, 'A bird in the hand is worth two in the bush.' So, if a bank depends on harvesting existing relationships, it must make sure that current customer satisfaction is strong within the bank and the agency. Here are a few actions taken by banks that own insurance agencies (from Robert Heady’s April 2002 column in the Denver Post):

• A $9 finance charge for being $.11 short on a credit-card payment.
• A $35 charge for receiving and depositing a check, written by someone else, that bounced, rather than charging the person who wrote the bad check.
• Raising credit card interest rates from 23.99% (which many people already consider usurious) to 28.99% without prior notice.
• Requesting a 'paid-in-full' release for a mortgage more than four times and never receiving one.
• Not acting on the request of an estate administrator, though the person was entirely within their legal rights to make their requests, without the administrator having to involve an attorney.

Insurance has a bad enough name that such customer service horror stories definitely don’t increase an insurance producer’s desire to cross-sell. Nor do they encourage a customer’s desire to buy more banking products and services. (On an additional note related to cultural differences, 99% of all agents would write-off these finance charges and any producer I’ve ever met would be insulted, embarrassed, and angry if their insurance customers received such charges from the bank). One might hope these are exceptions — but too often they’re not. Although all businesses would like to think they offer good, even great, customer service, few companies can prove it because they seldom ask their customers’ opinions.

Even such notoriously poor customer service companies as airlines think they provide good service. One airline, Southwest, has enjoyed great service ratings for years even though they don’t offer two items that many airlines consider essential to good customer service: preassigned seating and food. Instead, Southwest serves peanuts and their customers describe the boarding process as being loaded like cattle. Yet when airline customers are asked which airline provides great service, Southwest gets top billing. The other airlines just don’t 'get it.'

Southwest’s excellence continually pays off. After 9-11-01, they actually reported a profit and were the only large airline not to lay off employees. Their customers sent them cash, voluntarily, just to keep them flying (Texas Monthly, February 2002). Since the insurance industry was hurt by 9-11-01 too, are your customers sending you $20 bills just to make sure you stay in business? Because the poor economy has hurt banks, have your customers sent you cold cash just to make sure you stay in business?

My personal experience with banks suggests they fall short of the customer service they advertise. Not long ago my former bank failed to notify me that they’d canceled my ATM card due to a software glitch. I found out several thousand miles away while on vacation. I’d fully expected to be able to get cash as needed, when lo and behold, my ATM card wouldn’t work, leaving me stranded without cash in another country. This bank has recently purchased a large insurance agency and by their own admission, have achieved extremely little success (Go figure!).

Many buyers are basing deals on forecasts of 25% and higher pro forma profit margins. This is dangerous. In late 2002, the SEC released a warning to investors about companies that report or stress pro forma earnings because they’re so often overly optimistic.

Also, bear in mind that not only do Wall Street sharks use misleading pro forma and EBITDA statements, buyers often mislead themselves. For example, think of all the deals done based on EBITDA profits that will never be realized since they contain too many rosy assumptions. As mentioned earlier, because bank-agency deals don’t create synergies, basing a deal on an EBITDA that assumes synergies only causes disappointment.

Consider the following, less optimistic deal: A $1 million insurance agency, with a 20% EBITDA, and an EBITDA multiple of 8.0, translates to a 1.6 times revenue price or $1.6 million. At a 20% margin and 7% growth, the bank won’t break even for between 10 and 12 years. Additionally, the probability of achieving both a 20% profit margin and 7% growth is near zero. A Bain & Co. study of 1,854 companies found that only 13% achieved real annual growth of 5.5% and earned the company’s cost of capital over 10 years. The study also found that 99% 'of management teams will fail to meet shareholder /expectations.' Shareholder disappointment is likely because the P&C industry has averaged nominal growth of only 4%-5% during the past five years (agencies are growing slightly faster due to consolidation). As mentioned earlier, profit margins even in the biggest and most professionally run brokerages are currently only 10%.

Some experts would advise that such calculations underestimate the investment return because at the end of 10 to12 years, the agency can be sold, returning additional capital. This is true if the agency is run well during those dozen years. Given the number of banks that have sold agencies for pennies on the dollar after learning that the insurance business was much more difficult than expected, I wouldn’t recommend counting on selling the agency for a significant sum.

Other experts state that buying an insurance agency presents an arbitrage opportunity because banks’ P/E ratios are higher than agencies, so a bank can buy an agency and immediately have the agency’s earnings repriced at the bank’s P/E ratio. An arbitrage opportunity is possible if the market doesn’t realize and adjust for the less valuable cash flows of an insurance agency. If the market acts efficiently, a weighted average P/E ratio will result.

Other experts recommend using the bank’s stock for acquisitions because stock doesn’t result in cash outlays. However, it does dilute the current stockholders’ value. What’s more, most acquisitions trigger an immediate fall in the acquirer’s stock price (slightly more than 2% on the day before the acquisition). So while the deal looks good on the income statement, the bank’s stockholders still suffer. Moreover, using stock and saying it has no effect just because it doesn’t affect the income statement is too simple. This is similar to Warren Buffett’s famous comment about stock options. To paraphrase, 'If they’re compensation, but not an expense, what are they?'