Bob the Builder
Mellon Financial’s new leader is salvaging the money manager’s credibility after years of wretched performance. Now comes the harder part: designing a profit machine for shareholders
It took all of five minutes for Robert Kelly to make his mark on Mellon Financial Corp. On February 13, his first day as chairman, president and CEO, Kelly paused outside the executive suite at the firm’s Pittsburgh headquarters to admire a luminous seascape by 19th-century American artist William Stanley Haseltine. Then he ordered that the painting be taken down and replaced with two sprawling plasma television screens tuned to CNBC and to CNN’s Headline News.
“Don’t get me wrong — I love art,” says the 51-year-old Canadian, who left Wachovia Corp. after a five-year stint as finance chief to run Mellon. “But I want to remind people what we’re about here. We’re not in the art business. We’re money managers.”
The big TV screens serve as a much-needed reminder. Before Kelly’s arrival, Mellon had endured what critics describe as a series of strategic and tactical blunders under Martin McGuinn, who became CEO in 1999. The company’s stock price was drooping, and shareholders were rebelling. Now, amid ongoing efforts to mend relations with investors and Wall Street, Kelly faces a much bigger challenge: how to improve Mellon’s profitability without repeating the mistakes of his predecessor.
McGuinn — a 25-year veteran of the firm who retired earlier than expected at age 63 — played a key role in Mellon’s long transition from banking to the more-profitable, faster-growing asset management and custody businesses. In the early 1990s the firm had begun to gobble up money managers, including Boston Co. and Dreyfus Corp., after suffering the fallout from a series of bad corporate loans; McGuinn, however, pursued scale at the expense of profit, relying on lavish spending and price-cutting to gain market share. And he picked a bad time to get out of banking completely: He sold Mellon’s retail banking operations to Citizens Financial Group in July 2001, just as millions of bubble-weary individual investors were beating a retreat from the stock market to the relative safety of bank accounts.
The result: McGuinn’s revamped firm grew respectably but didn’t generate profits fast enough to satisfy investors. From 2002 through 2005 assets under management expanded by 38 percent, to $781 billion, and assets in the custody division, which processes executed transactions for other institutions, soared by 77 percent, to $3.9 trillion. But even as companywide revenues climbed 34 percent during that period, expenses surged 40 percent and earnings per share grew only 25 percent, dragged down by Mellon’s $275 million purchase in 2002 of PricewaterhouseCoopers’ human resources consulting unit. By 2005 that money-losing business had diluted profits from Mellon’s core asset management operations and failed to provide hoped-for cross-selling opportunities, prompting Mellon to sell it to Affiliated Computer Services.
Today, Mellon’s $870 billion in investment assets and $4.2 trillion in custody assets rank it fourth and fifth globally in those respective businesses, but the firm’s 26 percent profit margin lags far behind the 33 percent industry average for money managers, according to investment bank Keefe, Bruyette & Woods. And in early August its shares traded at about $35, down from the mid-40s five years ago and just 17 times projected 2006 earnings. By comparison, peers Northern Trust Corp. and State Street Corp. trade at P/Es of 19, and pure-play asset managers like BlackRock and Janus Capital Group enjoy multiples in the mid- to high-20s.
Last year Mellon’s shareholders, including activist funds Highfields Capital Management and Relational Investors, rebelled, prompting the board to begin the CEO search that ended with Kelly’s hiring in January. Highfields, whose 5.2 million shares gave it a 1.3 percent stake in Mellon as of May 15, urged the firm to cast off its lower-margin custody business. In April the $205 billion California Public Employees’ Retirement System, owner of 2.5 million Mellon shares, added the firm to its dreaded “focus list” of underperforming, poorly governed corporations. CalPERS complains that Mellon’s takeover defenses are excessive and points out that the –2.14 percent total return for the firm’s shares over the past five years compares with 21.46 percent for the Standard & Poor’s 500 index and 57.95 percent for Mellon’s peers in money management and capital markets.
“We see stock underperformance as a problem at Mellon,” says a spokesman for CalPERS, which as of mid-June had been trying without success to meet with the firm’s independent directors to discuss governance reforms. “We believe the company can do better if it adopts our proposed changes, and we’re not walking away from the table while we still have a stake in what happens.”
All this presents quite a set of hurdles for a new CEO, but in Kelly, Mellon has found an executive known both for his energy and his talent for problem-solving. At Wachovia the Nova Scotia native was credited with shoring up the balance sheet, helping to execute the acclaimed merger with First Union Corp. and mending fractured relationships with analysts and shareholders. That was preceded by an impressive 19 years at Toronto-Dominion Bank, where Kelly built successful trading operations and pushed the bank to embrace new technology. Nevertheless, when he arrived at Mellon he had never worked as a CEO or overseen asset management operations — a fact not lost on those who believe a similar lack of experience undid McGuinn, who was Mellon’s in-house counsel for most of his career.
Kelly, however, is nothing if not ambitious. Stephen McDonald, co-chairman of ScotiaCapital, the wholesale banking arm of Scotiabank Group, recalls seeing that ambition on display in the 1980s, when he and Kelly were midlevel managers at TD. “Bob said, ‘You and I are both going to be at the top of this organization someday,’” McDonald recalls. “I was blown away that he had those kinds of aspirations. But he has been positioning himself to be CEO of a major financial services company his entire career.”
One of Kelly’s first acts as Mellon’s CEO was to set up a meeting with several of the firm’s major shareholders. He invited portfolio managers and analysts from big investment houses to a dinner in New York, during which he said little but listened intently, according to one analyst who attended. Kelly has also improved communications with Wall Street. Mellon’s first-quarter earnings presentation, for example, had the new chief’s fingerprints all over it, featuring a detailed, 20-page “earnings summary” of the sort Kelly had first implemented at Wachovia.
“He has really reached out and is listening to what investors want him to do with the Mellon franchise,” says Kyle Cerminara, an analyst at T. Rowe Price Group, which owns 15.3 million Mellon shares, giving it a 3.7 percent stake. “The Street is taking to him in a positive way.”
The glad-handing appears to have bought Kelly time to carry out the more critical task of boosting Mellon’s profits. Since February he has reorganized the custody unit, streamlining three business lines into a single division headed by vice chairman James Palermo. The reshuffling resulted from a strategic review that began before Kelly joined the firm and follows a similar move last year in asset management that combined Mellon’s institutional and mutual funds businesses into one entity, Mellon Asset Management.
One road that Mellon won’t be taking is a return to retail banking, even though its five-year noncompete agreement with Citizens expires at the end of this year. “Retail banking is a good business, but it’s a lower-growth business than ours,” says Kelly. “And it’s a scale business. So it wouldn’t make sense for us to reenter at this point.”
Any subsequent decisions about Mellon’s business model and strategy will likely wait until the completion of a companywide review initiated by Kelly in March. One issue the firm is studying is whether to separate money management from slower-growing divisions like custody and cash management, the latter a holdover from Mellon’s corporate banking days. Another question is whether to further restructure the asset management business, which is now largely a collection of product- and style-specific boutiques. Centralizing these operations would reduce expenses by eliminating overlapping functions. The review is scheduled to be finished in time for the October meeting of Mellon’s board.
Kelly won’t commit to a specific course of action before the review is complete, but he appears to favor keeping the current business mix intact while expanding asset management. Custody and cash management fit well strategically with asset management, and they provide diversification and offer cross-selling opportunities, he says. He has indicated that operating separate investment boutiques makes sense because it fosters superior performance and allows Mellon to appeal to a variety of clients.
In short, Kelly is more likely to build Mellon than to break it apart. In May he authorized the purchase of Walter Scott & Partners, an Edinburgh equity manager with $27 billion in assets, for a reported £300 million ($564 million). The deal, Mellon’s biggest acquisition since it bought mutual fund giant Dreyfus in 1994, had been in the works for months. Kelly could have nixed it but instead judged that it made sense because Mellon needed a boost in international large-cap funds — Walter Scott’s strength. He flew to Edinburgh shortly after taking over as CEO to talk with the Scottish firm’s principals and help cement the transaction. More recently, Mellon has been trying — unsuccessfully thus far — to acquire a stake in a Chinese mutual fund firm.
“I love merger and acquisition activity,” says Kelly, admitting that he is a deal maker at heart. “And I believe in betting capital on businesses that you think are going to grow faster than the other businesses in the mix.”
Clearly, he has the means to make more deals: Mellon has $4.5 billion in the bank and generates a healthy $900 million in cash annually.
“What Mellon needs is someone who can effectively put that excess cash flow to work,” says Punk, Ziegel & Co. bank analyst Richard Bove. “Kelly has that ability, and that’s why he’s there.”
FOUNDED IN 1869, MELLON BANK WAS A PILLAR of Gilded Age capitalism, financing industrial giants like Alcoa, Gulf Oil and Westinghouse; Andrew Mellon, a son of founder Thomas Mellon, went on to serve as Treasury secretary in the 1920s. Mellon Financial Corp.’s illustrious history can be seen in the extensive art collection and sumptuous dining rooms of its headquarters. Framed traveler’s checks issued by Mellon Bank a century ago adorn Kelly’s corner office, 47 floors above downtown Pittsburgh.
The atmosphere at Mellon may be a little stuffy, but the CEO is not. Informal and enthusiastic, he interrupts an interview to show off a hockey jersey autographed by rookie phenom Sidney Crosby of the Pittsburgh Penguins, who skates a few blocks away at — what else — Mellon Arena. Crosby, a fellow Nova Scotian, had sent over the jersey as a housewarming gift on Kelly’s first day at the firm.
The CEO is well aware of his firm’s deep bond with Pittsburgh, where streets, parks and a university all bear the Mellon name. In February, shortly after the hometown Steelers had won the Super Bowl — and just after he joined the firm — Kelly showed up at an employee gathering wearing the number of popular running back Jerome Bettis. Just as he has worked to repair relations with shareholders and Wall Street, he has reached out to staff: On his first day he stood in the lobby of One Mellon Center and greeted more than 1,000 employees as they showed up for work.
“He’s more approachable and less formal” than McGuinn, who was regarded as distant and stiff, says Mary Gallagher, a communications staffer in the human resources department. “He’s down-to-earth. There’s a feeling that the gap between his position and yours isn’t quite so big as it was before.”
Every February and March, Mellon holds a series of leadership meetings with some 5,000 managers in 13 locations around the world. Under McGuinn these were staid affairs, heavy on PowerPoint presentations, that allowed only a few, prescreened questions. This year, Kelly surprised many participants when he solicited queries directly from audience members. “The minute he picked up the microphone, there was a sense of comfort in the room,” says Robert Mehrabian, CEO of electronic components maker Teledyne Technologies and a Mellon director, who attended one such meeting in Los Angeles.
“This is a generational change,” adds senior vice chairman Steven Elliott, a 19-year Mellon veteran who was a key deputy of McGuinn’s. “Marty was a formal gentleman lawyer. Bob’s more in sync agewise with our employees, and he has a more conversational, relaxed style.”
Friends say Kelly is a practical joker who isn’t afraid to laugh at himself. For relaxation he enjoys archery — the required concentration takes his mind off everything else — or playing tennis with his wife of 25 years, Rose. The couple has two children, a son who attends Tufts University and a daughter who will start at Miami University of Ohio in the fall.
“Bob has a geeky, nerdy component to him — almost a childlike enthusiasm for business,” says ScotiaCapital’s McDonald.
In fact, Kelly’s geek credentials are impeccable, stretching all the way back to Nova Scotia: In 1979, after earning an accounting degree from St. Mary’s University in Halifax and working for a few years at his father’s accounting firm, he bought a Radio Shack TRS-80, one of the earliest personal computers. He taught himself how to program the machine and carved out a niche helping small businesses keep their books electronically.
Dreaming of one day launching his own computer consulting firm and hoping to gain experience, he took a job in Toronto-Dominion’s fledgling information technology department in 1981. Soon he was being dispatched around the world to work on the bank’s computer systems. In 1983 he moved to London as controller of TD’s operations in Europe and Africa, studying at night toward an MBA from City University. A year later he switched to trading and made a splash by introducing computer power to TD’s London dealing room. Interest rate and currency derivatives were just becoming popular in Europe, and after Kelly wrote programs that allowed traders to quickly value the instruments, the firm made a killing.
He ran TD’s global derivatives trading operation and later its retail and investment banking groups before becoming CFO in 1992 at 36. One of his biggest successes in that job came three years later, when he oversaw TD’s acquisition of Internet brokerage Waterhouse Securities, just before online trading took off. Waterhouse owned a stake in Knight Trading Group, a firm that executed trades for several online brokerages. By 1999, Knight had gone public and its shares were soaring. TD sold its holding in Knight for $525 million — precisely the amount it had paid to acquire Waterhouse. “We essentially got Waterhouse for free,” Kelly explains.
By the late 1990s many thought that Kelly would be TD’s next CEO. But in 2000 the company acquired Canada Trust Financial Services, whose CEO, W. Edmund Clark, became TD’s president and heir apparent to the top job. (He was named to the position in 2002.) Kelly left the bank, and a few months later, First Union came calling.
When Kelly arrived in Charlotte, nonperforming loans represented an above-average 1.22 percent of First Union’s loan portfolio, resulting in a charge-off ratio of 0.59 percent and a capital-to-asset ratio of 7 percent (anything below 10 percent is considered dire). The new CFO tightened lending standards, cut expenses and reduced the bank’s dividend. By the time he left last year, nonperformers had been slashed to 0.28 percent of loans, just 0.09 percent were written off, and capital was nearly 11 percent of assets. CEO G. Kennedy Thompson rightly gets most of the credit for turning First Union around, but “the guy who fixed the balance-sheet problems was Bob Kelly,” says veteran bank analyst Bove.
Kelly also patched up the bank’s relations with the financial media and analysts, many of whom had hammered former First Union CEO Edward Crutchfield for his earnings-dilutive serial acquisitions — and had been treated with equal contempt. Kelly favored an open style, clearly communicating First Union’s story in earnings presentations and meetings. But perhaps his most lasting contribution was his effort to help price, structure and integrate First Union’s 2001 acquisition of Wachovia, won after a brutal proxy battle with SunTrust Banks. Although conventional wisdom maintained that acquisitions should be absorbed quickly, Kelly preferred taking a measured approach.
“Bob got everyone to think about slowing down the integration process and to consider the cultural issues — the relationships with communities and employees,” says Wachovia’s current CFO, Thomas Wurtz, who headed treasury and planning under Kelly. “That has become one of the company’s strengths today.” (First Union took Wachovia’s name after the deal.)
While Kelly’s star was rising, Mellon remained earthbound. Soon after taking over as CEO in 1999, McGuinn changed the firm’s name from Mellon Bank Corp. to Mellon Financial Corp. to reflect its diversification into money management. He also sold the firm’s mortgage and credit card lending operations in a move that foreshadowed the 2001 sale of Mellon’s 345 retail branches to Citizens, a Providence, Rhode Island–based subsidiary of Royal Bank of Scotland. The plan to shift capital into the faster-growing, higher-margin asset management and custody businesses made sense at the time. But over the next five years, as low interest rates, balky securities markets and strong credit quality made retail banking a cash cow, Mellon sat on the sidelines. Between 2001 and 2003 more than half of the firm’s market value evaporated.
McGuinn’s big bet on human resources consulting only made matters worse. Although the CEO believed that HR would help Mellon win mandates to manage corporate pension funds, the cross-selling proved disappointing, leaving Mellon the fourth-biggest player in a business that is heavily dependent on scale. The unit accounted for a quarter of firm revenues but either lost money or barely broke even before it was sold off in 2005.
“When 25 percent of your business is shrinking, it’s tough to grow as a company,” says T. Rowe’s Cerminara. “That capital would have been much better deployed in asset management.” (McGuinn declines to comment.)
Kelly stresses that, despite these fumbles, Mellon’s core business is strong. Overall, net income slid by 2 percent last year, to $782 million; but exclude the jettisoned HR unit and it rose 15 percent. Income from asset management and custody, which account for nearly 80 percent of pretax income, grew by 17 percent and 24 percent, respectively. In the past 12 months, custody assets have jumped 26 percent as the company has lured business away from its rivals. In August, for example, the Louisiana State Employees’ Retirement System picked Mellon as master custodian for its $7.8 billion portfolio. Chief investment officer Robert Beale says his fund switched the account from State Street because Mellon offered better performance analytics and customized reporting capabilities. “They had the best personnel and the best technology,” says Beale. (State Street declines to comment.)
SO FAR KELLY’S big-gest achievement may have been calming Mellon’s cranky shareholders. Highfields has toned down the harsh rhetoric it directed toward the firm during McGuinn’s final days as CEO. Relational Investors has sold its Mellon stake and is no longer agitating for change. And CalPERS’s concerns are being addressed: In the proxy statement for its 2006 annual meeting, held April 18 in Pittsburgh, Mellon promised to phase out staggered terms for directors; beginning in 2010 the entire board will stand for reelection each year. Kelly also pledged to complete a thorough review of the firm’s takeover defenses by year-end and named longtime board member Wesley von Schack, CEO of Energy East Corp., as lead director.
“We’ll nail every one of these things this year,” says Kelly of CalPERS’s demands. “We’ll look at every one in detail, and we’ll make changes in due course. I will get it done. Anything I commit to, I deliver on.”
Still, the harder work lies ahead. Much as Mellon’s shareholders may appreciate clear communications and improved relations, they ultimately will judge Kelly on how well he handles the big issues of structure and growth.
Perhaps the biggest structural issue is how to organize asset management. Some analysts and shareholders have suggested that Mellon restructure these operations, which account for 61 percent of profits and are run as a collection of independent firms rather than a fully integrated unit. Consolidating functions such as sales and marketing or research and trading, they say, could yield big savings.
But operating a collection of boutiques has worked rather well for some publicly traded asset managers, Legg Mason and Franklin Resources among them. Under this model, money managers at each subsidiary tailor products to clients’ needs and investment styles; their autonomy allows them to assure customers that their investment process is ingrained in their boutique’s culture, so that performance can be maintained over many years. That’s often an important test for pension consultants, who have immense power in deciding which money managers win mandates from plan sponsors. Also, the boutique model helps a firm like Mellon grow through acquisition: Smaller shops may be loath to sell if they know they will be forced to merge into a corporate monolith.
“The key thing you’re selling is the consistency of the process,” says Robert Lee, an analyst at Keefe, Bruyette & Woods. “The boutique approach can be effective if it’s executed properly.”
Kelly says that the strategic review will consider, as one option, consolidating Mellon’s boutiques. So far, though, he seems to accept the arguments in favor of keeping the boutique structure largely intact. “I’ve created much greater certainty in my own mind that I like the model,” he says. “It’s a higher growth, higher innovation model than having one overall structure.” Kelly does believe, however, that he can squeeze greater operational efficiency out of Mellon’s boutiques by encouraging them to share technology and other services in ways that don’t directly affect the investment process.
Indeed, controlling the firm’s expenses, which have soared by 20 percent in the past year alone, is one of the new CEO’s biggest challenges. Concurrent with his strategic review, Kelly is conducting a line-by-line expense review of every Mellon business, with the goal of identifying and eliminating redundant spending.
But his single most important priority is finding better ways to deploy Mellon’s substantial cash flow than paying dividends and buying back stock. Since 2003 the company has boosted its dividend by 69 percent; since 1999 it has repurchased more than 178 million shares, including 3.5 million in the second quarter of 2006. Stockholders, however, would much rather see strong earnings growth, and Kelly is likely to reallocate a significant chunk of capital to acquisitions. He has no doubts about which business is most valuable and worthy of investment. “Asset management is where the juice is,” he says.
The right acquisitions would broaden his company’s product offerings and geographic reach. The deal for Walter Scott & Partners, for example, boosted Mellon’s presence in the U.K. and garnered a host of large-cap growth funds to complement the more-conservative products that dominate the U.S. firm’s lineup. Kelly’s unsuccessful attempt last month to acquire a stake in Soochow Securities Co., a Chinese brokerage firm that owns 49 percent of Soochow Fund Management, exemplifies his desire to buy into a fast-growing market. After Soochow broke off the talks, Mellon announced that it would open a Beijing office with market research and lobbying staff.
Kelly considers private banking a particularly attractive segment of the money management business. In March, Mellon acquired U.S. Trust’s planned-giving business, which helps wealthy individuals administer their gifts to charity. The deal brought $700 million in assets to Mellon, making it the biggest planned-giving services provider in the U.S.
For Kelly, smaller transactions like this are a way to keep Mellon’s top line growing without taking on too much risk. “You should probably expect some level of acquisitions from us, but they will be very disciplined, and they won’t be large,” he says. He won’t categorically rule out a big deal, but “it would have to be very financially and strategically compelling.”
Acquisitions aren’t Kelly’s only strategy for growth. He also wants to commit more capital to new endeavors such as the family-office business that the firm’s private banking division started in the U.K. last month aimed at clients with more than $100 million in assets. Mellon plans to add private banking offices and salespeople in California, Florida and Texas, whose rising populations include many well-heeled retirees. And the CEO plans to use his banking know-how to provide a broader suite of debt products for ultra-wealthy customers. Mellon will likely expand its $6.5 billion loan portfolio by taking more credit risk on individual clients in the hopes of earning higher returns. “Our credit products are not very competitive today,” Kelly says. “We need better credit and deposit capabilities for our private banking clients.”
To figure the future allocation of capital, Kelly says he likes to keep a running tally — a ranking, of sorts — in his head of “where each one of our businesses is headed, what each is going to look like in five years’ time and the quality of the management running those businesses.” This approach, learned largely from Robin Korthals — once Kelly’s mentor at TD and now chairman of the Ontario Teachers’ Pension Plan — “helps me form a simplistic view for each business: Do I want to make an acquisition or add capital, or do I want to reduce the flow of capital and sell it?”
Once Kelly completes his strategic review and ponders his internal ranking of Mellon’s businesses, some less profitable, noncore units may be cast off. But so far the CEO is taking the same measured approach that served him well when he was helping to merge First Union with Wachovia. Given Mellon’s recent past — characterized by strategic distractions and problematic profits but also by strong revenue growth and a healthy core business — that may be the best course.
“This company is not broken,” says analyst Bove. “All Kelly really has to do is not mess things up.”