A deal too far?

With his acquisition of U.S. Bancorp, Jerry Grundhofer is muscling into U.S. banking’s top ten.

With his acquisition of U.S. Bancorp, Jerry Grundhofer is muscling into U.S. banking’s top ten.

By Jack Milligan
November 2000
Institutional Investor Magazine

With his acquisition of U.S. Bancorp, Jerry Grundhofer is muscling into U.S. banking’s top ten. Investors worry that the Firstar CEO may be pushing too fast.

Bankers aren’t supposed to bet the bank.

But that’s what the market seems to think Jerry Grundhofer is doing.

In the past two years, Grundhofer, president and chief executive officer of Firstar Corp., has pushed through three acquisitions, doubling total assets each time. When the last of these is completed in the first half of 2001, Firstar will take the name and headquarters of its Minneapolis-based target, U.S. Bancorp. At $160 billion in assets, it will be the eighth-largest U.S. commercial bank.

That’s a stunning rise for a company that began life as Cincinnati’s Star Banc Corp. and had just $6 billion in assets when Grundhofer became CEO in 1993. With his first big acquisition, of Milwaukee-based Firstar in late 1998 (Star Banc assumed its acquisition’s name), analysts applauded, pushing shares to a split-adjusted $40 when Grundhofer, an inspired cheerleader and dedicated cost-cutter, convinced them of the deal’s wisdom. Just five months later he announced plans to buy Mercantile Bancorp. of St. Louis. That made even admiring analysts queasy, sending shares down to $26 but still leaving the company with a top-tier market multiple of 34.

The U.S. Bancorp deal is proving the toughest sell yet. News organizations tripped over themselves to celebrate the merger, which brings together not just two banks but two brothers -- Jerry Grundhofer’s older sibling, Jack, runs U.S. Bancorp -- triggering the inevitable “Brothers Grundhofer” headlines. But Wall Street’s reaction was far less sanguine. Within a week of the brothers’ handshake in early October, when the purchase was valued at $21 billion, Firstar’s share price had dropped $5, to $17. At $16 billion, the company’s market capitalization stood at half its level of 18 months earlier -- though the bank had roughly quadrupled in assets and earnings. (When financial stocks rebounded in late October, Firstar climbed back above $19, boosting market cap by $2 billion.) Its price-earnings multiple, once one of banking’s best, stands at 16, still high for big banks but well off its 28 of a year ago. And all this comes after the company posted a 22 percent increase in operating earnings for the third quarter and despite Grundhofer’s projection of “immediate accretion” in earnings from the U.S. Bancorp merger.

The market reaction has stunned Grundhofer, who prides himself on never missing earnings expectations. He is on course to exceed his 20 percent goal for income growth this year and has consistently delivered better profitability ratios than those of other large banks. A superb salesman, he can’t seem to convince the Street that Firstar and U.S. Bancorp are, as he puts it repeatedly, “a perfect fit” of complementary businesses: Firstar brings retail banking strengths, for example, and USB has an investment banking franchise in its Piper Jaffray subsidiary.

“This is a story made for fairy tales and history books,” says Grundhofer.

The problem is that the Street has seen too many banking fairy tales meet with unhappy endings. All shared similar plot elements: rapid growth from a regional base, superb cost-
cutting agendas and aggressive and experienced integrators who sought scale and power, only to fall flat on their faces. The names of the fallen heroes are all too familiar: Bank One Corp., First Union Corp., Wells Fargo & Co. and U.S. Bancorp itself. With news of his acquisition coming within three weeks of Chase Manhattan Corp.'s agreement to buy J.P. Morgan, some on the Street thought Jerry Grundhofer was simply jumping on a bandwagon, not following a clear-cut strategy. Says Keefe, Bruyette & Woods bank analyst Joseph Duwan, “This was very much an emotional reaction to another large transaction.”

“I couldn’t control that,” protests Grundhofer. “You can’t always do it on your time frame.”

Grundhofer sure hasn’t faced such skepticism in a long while. From the day he arrived at Star Banc, he has communicated often and effectively with Wall Street; his 28 consecutive quarterly records in per-share operating earnings didn’t hurt. Indeed, in this year’s third quarter, excluding merger-related charges, Firstar posted its highest-ever return on average assets, 2.0 percent, and an impressive return on equity of 23.7 percent. Through the first six months of this year, according to the Federal Deposit Insurance Corp., the industry averages -- also holding true for Firstar’s big-bank peers with more than $10 billion in assets -- were only 1.2 percent and 13.9 percent, respectively.

Part of the skepticism comes from what Grundhofer is attempting to undertake in swallowing the $86 billion USB, which has been struggling for the past year or so as growth slowed and its stock price went south after it missed its year-end 1999 earnings estimate. For the first nine months of 2000, income was up a mere 3 percent, and earnings from consumer banking were flat. But on an operating basis, excluding merger-related charges and securities transactions, return on assets was 1.9 percent and return on equity 20.4 percent. Those fundamentals combined with USB’s P/E of 10 made the Minneapolis bank attractive and affordable to Firstar.

USB did some soul-searching and, following a strategic review in September, concluded that revenue was not growing fast enough, that market capitalization ($18 billion in late October) was insufficient to make acquisitions, and that, says CEO Jack Grundhofer, “we needed scale to keep pace with the technology investments required to be a leader in our businesses.”

Analysts had been speculating for months about a USB-Firstar match, and the Grundhofers concurred with their reasoning. When Jack called Jerry to inform him of the assessment, Jerry knew he had to make a bid or see USB go to someone else. He couldn’t ask Jack to wait.

“You can’t say that to someone,” Jerry says incredulously. “You just can’t!”

Though he disagreed with the market’s reaction, Grundhofer knew that the postmerger integration of USB would be difficult. Thus, he says, he made “very conservative expense assumptions” and, to minimize employee and customer disruptions, stretched out the integration timetable to the first quarter of 2003. Analysts found that surprising and grilled Grundhofer about it on the day of the merger announcement. He insisted that it is best to be “conservative and realistic. We’ve never experienced an integration of this size.”

Then there was the lingering fear that he might not be done yet. When quizzed about any further deals, Jerry Grundhofer shot back: “We’re through. We’re not interested in more acquisitions. We’ll get this deal right.”

JERRY GRUNDHOFER, 56, HAS BUILT HIS RECORD and reputation on cost control. It is an obsession. Firstar’s efficiency ratio, the proportion of revenues eaten up by noninterest expenses, is the best in the business: 40.5 percent in the third quarter, though this excludes merger-related costs. (All told, the ratio was 50.1 percent, historically respectable for a big bank but not low enough to satisfy many analysts in the postreengineering era.) “Being a low-cost provider gives one a tremendous strategic advantage,” Grundhofer says. “It allows you to deal with challenges, be competitive on the asset and liability sides of the balance sheet and take care of customers.”

Grundhofer, like his 61-year-old brother, rose through the ranks of Wells Fargo Bank in California. Both took to heart the 1980s-era cost management principles instilled by former Wells chief executive Carl Reichardt. Jerry would later adapt what became known as the “Wells way” -- an intense focus on efficiency balanced by strategic investments and generous employee incentives -- into what might be termed a “Firstar way.” He says: “This business is really very simple. Grow revenues faster than expenses, and great things happen. That is the mantra.”

Grundhofer broke free of Wells and began to test this thinking elsewhere in 1987 when Robert Smith, chairman and CEO of Security Pacific Corp. in Los Angeles, recruited Grundhofer to run its retail banking business. Security Pacific would soon run into severe asset quality problems that led to its acquisition by BankAmerica Corp. Yet in a three-year period, Grundhofer’s unit increased its net income from $125 million to $425 million. “The guy was fabulous,” says Smith, now retired. While Smith and others dealt with the bank’s deepening financial troubles, Grundhofer “was the guy at the organization who kept earnings coming in, which saved our butt,” says Smith.

Grundhofer, whom Smith had promoted to president and chief operating officer, stayed with Bank of America for a year after its deal with Security Pacific was announced in April 1992. Few senior Security Pacific people lasted long as Bank of America asserted its dominance, and in May 1993 Grundhofer started running his own show in Cincinnati. Star Banc was reeling and distracted after fending off a takeover bid by local rival Fifth Third Bancorp.

Star needed some, well, star quality, and Grundhofer imported it. Working closely with fellow Security Pacific exiles Richard Davis and David Moffett -- still at his side today as vice chairman of retail banking and chief financial officer, respectively -- Grundhofer turned the institution into one of the country’s most profitable and efficient banks, dethroning longtime efficiency champion Fifth Third, whose third quarter 2000 efficiency ratio was 41.5 percent.

As Wall Street responded and Star’s stock valuation soared, Grundhofer used the deal-making currency to grow into something more consequential than a midsize regional bank. In November 1998 Star, with assets of $15 billion, paid $7.5 billion in stock for the struggling $23 billion-in-assets Firstar of Milwaukee. Five months later, the new Firstar plunked down
$10 billion more for St. Louisbased Mercantile Bancorp, a multistate holding company with $33 billion in assets.

The Star-Firstar combination served notice that Grundhofer would be a force on the M&A scene. But analysts were stunned by how quickly the Mercantile deal came along. Analysts’ skeptical response to the USB purchase echoes their reaction to the Mercantile acquisition -- just as Grundhofer’s claim of opportunism echoes what he said nearly a year ago. “Would I have liked for Mercantile to have been six months later? Sure,” he says. “But I’d do it again in a heartbeat. It was a great deal for our shareholders.”

To be sure, the Mercantile merger’s expense overhang wreaked havoc with Firstar’s vaunted efficiency ratio. But at the end of this year’s third quarter, Grundhofer proclaimed that the systems integration was complete: “We have accomplished the cost-saves and synergies of the merger, in addition to significantly improving the efficiency of the company.” Grundhofer points out that these results were promised for 2000 and were met “well before the end of the year.” But for a market absorbing the shock of the U.S. Bancorp news, that wasn’t soon enough.

“If you think the management of Firstar is that good, then they should be buying underperforming retail franchises,” says Salomon Smith Barney banking analyst Ruchi Madan, who sympathizes with Grundhofer and his logic. “I think the timing of the USB deal was disappointing, because Firstar never had a chance to prove the impact they had on Mercantile’s revenue trends. It kind of puts off the payoff.”

JERRY AND JACK HAVE NO DOUBTS ABOUT THE payoff -- or the logic -- of reinstituting their brother act. They grew up, along with a sister, in the Los Angeles suburb of Glendale. Their father was a bartender, and their mother worked in a catering business. Jerry often seemed to follow his older brother’s lead. Both attended Jesuit schools in Los Angeles, including Loyola High School and Loyola University. Both played baseball. Both went to work for Reichardt at Wells Fargo. “Jack and I are pretty similar,” Jerry once said. “We think about things the same way. We run our companies pretty much the same way.”

Their mutual affection and admiration will help, since they’ll be together for a while: Jack plans to serve as chairman of the combined board of directors until his retirement at the end of 2002. At their joint press conference on October 4, Jack introduced Jerry as their 90-year-old mother’s “favorite son.” Jerry, though now in the driver’s seat with superior profitability and acquisition currency, called Jack “the best banker in America.”

Jack spent the 1990s shaping up First Bank System and the Portland, Oregonbased U.S. Bancorp, which it acquired in 1997 and whose name it appropriated. He earned the sobriquet “Jack the Ripper” because of the draconian cutbacks and financial discipline he ordered. Like Jerry, he got the efficiency ratio down to the low-40 percent range. But the impressive turnaround hit a wall in the fourth quarter last year as loan growth slowed and costs related to the Piper Jaffray merger and technology investments pushed up noninterest expenses. Year-over-year earnings increases have been in single digits ever since. USB’s image was further tarnished by a judgment that it had violated consumer privacy regulations, and in August president and chief operating officer Philip Heasley resigned, saying he wanted to find a CEO job elsewhere.

For all that they have in common, the Grundhofers have different personalities and styles. Jack has a harder edge and a self-assuredness that is often interpreted as arrogance, although recent events may have mellowed him. “We made the mistake of overpromising and underdelivering,” Jack admits. He says USB turned an important corner when it focused less on cost reduction and more on the need to be “customercentric” -- a quality that should mesh well with Firstar. Adds the humbled Jack: “Jerry and Richard Davis have much more extensive experience than we do with large retail branch operations. They have a different model, and we think it is correct.”

Jerry entered Star Banc in a kinder and gentler fashion. In April 1993, shortly after accepting the job, Grundhofer was in Cincinnati for a brief stay, and before jetting back to California, he addressed a group of about 30 senior managers who had been hastily assembled to meet him. The troops, bracing for General George Patton, got something closer to Norman Vincent Peale.

“He said this is how it has been, but that’s behind us,” recalls Wayne Shircliff, an executive vice president who was in the room. “And then he began to lay out a vision.” More than a vision, Jerry Grundhofer gave a pep talk that fell like rain on parched earth. Grundhofer says he told them to “take off the sackcloth and stop beating yourselves. You’re much better than you think you are.” He saw them not as a bunch of underperforming laggards, but rather as “outstanding employees who just needed something to live for.” His charismatic ebullience and glass-half-full optimism seemed to be the ideal leadership prescription.

“It’s hard not to follow Jerry because he believes so much in what he’s doing,” says Smith, his former boss at Security Pacific. But it’s not just his enthusiasm that draws people in. He rewards performance, which is part and parcel of Firstar’s much-praised sales culture. Many retail banks, notorious for high employee turnover and low service quality, struggle to find the right compensation and incentive formulas. Grundhofer and his consumer czar, Davis, created a meritocracy and put their branch managers in charge. These officers have accountability for their own profit-and-loss statements and can augment base salaries by 40 to 50 percent if they perform.

Grundhofer’s “Wells way” rigor never lurks far from the surface. “He has an intense grasp of every business line and every market, and that permeates the entire company,” says Shircliff, a Firstar corporate lender in Cincinnati. Managers who can’t deliver their numbers don’t work for this Grundhofer long, either. “If you don’t do well, see how fast we ask you to leave,” says Davis.

AS CEO OF THE NEW U.S. BANCORP, GRUNDHOFER will lord over a 2,200-branch, 24-state empire from Tennessee to California. The only significant USB-Firstar overlap is in Minnesota. USB provides entrée to western consumer markets that are growing at an average clip of 7.5 percent annually, twice the rate of metropolitan areas in the Midwest. “We know how to compete if we have a distribution system, and U.S. Bancorp gives us that,” says Grundhofer. “We’ll combine the values of the heartland with the growth markets of the West.”

California alone is so big and enticing that the combative Grundhofer is content not to be vying for the No. 1 market share. “It doesn’t bother me,” he insists, that USB ranks only fourth in deposits in a state dominated by Bank of America Corp. and Wells Fargo. Adds brother Jack: “We have $6 billion in deposits in California, which is a nice foothold and growing very well. You don’t have to be No. 1 there to make a lot of money.”

On the wholesale side, USB has transaction processing and commercial payments businesses -- such as ATM services and corporate credit cards -- that Jerry Grundhofer says are growing at least 20 percent a year. Those plus the Piper Jaffray investment bank and its $145 billion of assets under management will boost the all-important fee income that Firstar needs if it is to clear growth hurdles and reduce dependence on the thinning interest rate spreads between deposits and loans. The postmerger U.S. Bancorp will get 43 percent of its revenues from fees, compared with 35 percent in Firstar’s third quarter. “We did not have a full complement of financial products,” says Grundhofer. “This changes our company. Hopefully, it will change our P/E.”

There are signs that the “Firstar way” is reaping dividends from the earlier deals. Between the second and third quarters of 1999, about six months after the Star-Firstar merger, loans in old Firstar branches grew 16 percent, according to Salomon’s Madan. That was double their rate a year earlier and was rising toward the 22 percent loan growth enjoyed by original Star branches in the 12 months through September 1999.

Madan, who did that research while at PaineWebber Group before she recently jumped to Salomon, has not formally updated the study. But she says that loan and deposit trends at the old Firstar are continuing to improve, and even the more recently integrated Mercantile branch system saw modest deposit growth this year. “That’s incredible compared to where it came from,” she says. “I think less risk would have been applied to the [USB] deal if investors could have seen what Firstar did with Mercantile.” But that would have taken a few quarters, and Grundhofer didn’t have the luxury of waiting.

Now he must prove the staying power of formulas that he started at the old Star Banc. From 1995 through 1999, Star’s and later Firstar’s earnings per share grew between 16 percent and 25 percent a year. According to First Security Van Kasper analyst Eric Rothman, Star was a “wholesale bank head on a consumer bank body.” Grundhofer and Davis turned it around by pushing greater authority out into the branch system, teaching platform personnel how to sell and emphasizing the virtues of being a low-cost producer. Davis replicates his retail success through a “buddy system,” pairing managers at acquired banks with mentors from Firstar.

Grundhofer holds monthly “profit meetings” with heads of the bank’s 23 major business lines. All are attuned to the principle of “operating leverage,” meaning that they must keep pushing costs below 50 percent of revenues so that the efficiency ratio keeps improving. Firstar expects to lower the combined annual expense base by $266 million before taxes. That’s 8 percent of USB’s costs and 5 percent of the two companies’ combined costs.

To enforce service quality, each Firstar unit commits to a “five-star service guarantee,” and if it fails to deliver, a customer can collect up to $250. Grundhofer says this will be a hallmark of the new USB. He also pays close attention to everyone’s pending business, the “pipeline,” as he calls it. Says Shircliff, “I carry my pipeline in my pocket in case I run into Jerry.” The hard-nosed, do-whatever-it-takes mentality is a central aspect of Firstar’s culture. Says Grundhofer: “We have the mental toughness to win. There’s no acceptance around here for not making it.”

The CEO spends much of his time out meeting either with Firstar customers or employees, with a zeal, by all accounts, that borders on the evangelical. “He sells his vision, his aspirations, extremely well,” says Moffett, a vice chairman who will retain his CFO role after the merger. “Jerry has incredible enthusiasm,” agrees Thomas Brown, the veteran analyst now running the Second Curve Capital hedge fund in New York. “And that enthusiasm is infectious.”

Grundhofer clearly believes that his investors should be catching that spirit, too. He has designated a management team for the merged bank that, he says, represents the best of both companies. The positions immediately below the two brothers are evenly divided. The Firstar contingent, in addition to Davis and Moffett, consists of technology chief William Chenevich (see box); Joseph Hasten, vice chairman and head of large-corporate banking; Steve Smith, executive vice president of human resources; and Lee Mitau, general counsel. From U.S. Bancorp: Andrew Duff, vice chairman and head of wealth management; Daniel Frate, head of the fast-growing payments businesses; Daniel Quinn, vice chairman of middle-market corporate banking; and Robert Hoffman, executive vice president and chief credit officer.

Grundhofer vows that this lineup will have “a real fighter pilot attitude -- take no prisoners and take care of the shareholders.”

“I think we do a very good job of acquiring companies, converting them and keeping our customers during that period of time,” he says. Perhaps his year-end earnings report, free of the Mercantile Bancorp. integration burden, will underscore those skills and give his share price a boost. But soon USB will bring another round of merger and restructuring charges, a projected $800 million between the closing date and year-end 2002.

“When you take a very long-term perspective,” says analyst Madan, “it’s a very good deal.” But to the short-term market mentality that is the bane of CEOs like Jerry Grundhofer, that can seem a long way off. i

Firstar’s quiet catalyst

Vice chairman William Chenevich knows his place in the Firstar firmament.

Chenevich, the Milwaukee bank’s head of information services and operations, will retain his title at the combined entity, but he won’t share the spotlight given to peers like Richard Davis or Joseph Hasten, heads of retail and large-corporate banking, respectively. The business lines get top billing at Firstar Corp. Essential though Chenevich’s group may be in powering these businesses and even making the purchase of the larger U.S. Bancorp possible, it definitely plays a supporting role. And Firstar’s chief technologist has no problem with that.

“We are business-driven first,
technology-driven second,” says Chenevich. “Technology is a supporter and a catalyst -- not a driver of business.”

Chenevich, in fact, has his hands full overseeing some 4,000 employees while reporting to a boss who is constantly trying to drive costs down. To CEO Jerry Grundhofer, being a “low-cost provider” is the key to everything. “It doesn’t mean you don’t have to invest,” Grundhofer says -- since 1997 Firstar has put $800 million into technology, product development and infrastructure.

Grundhofer promises that as long as costs continue to rise more slowly than revenues, there will be more of those necessary investments in the future. It’s Chenevich’s job to strike the balance between efficiency and investment.

“We are not a big development shop,” says Chenevich. “Our strategy is to buy best-of-breed third-party applications and integrate them into our delivery channel. Integration is one of our competencies, not the development of major applications.”

Chenevich, 56, has seen technology from all angles. A native of the Bronx, New York, he worked in the late 1960s as the chief industrial engineer for the former Grumman Corp.'s aerospace program. “I was the manufacturing planning manager for the lunar module,” he says.

After that he spent ten years with Citicorp. In the 1980s he worked at Security Pacific Corp. in Los Angeles, where he got to know Grundhofer, Davis and other eventual Firstar colleagues. Chenevich did not rejoin them until 1999, after serving as Visa International’s chief technology officer for half a decade.

Firstar is primed for the U.S. Bancorp systems conversions. The integrations of the old Firstar Corp. and Mercantile Bancorp. are complete, and the successful Y2K changeover, completed in the midst of those projects, is now a dim memory.

Following Firstar practice, the
U.S. Bancorp network -- like Firstar’s, conveniently based on demand-
deposit software from Hogan Systems -- is likely to be converted over a series of hectic weekends. “When we do 60 or 70 branches, that’s 1,200 pieces of equipment being installed between 5:00 Friday night and 8:00 Saturday morning,” says Chenevich.

Firstar’s pragmatism is evident in its approach to the Internet. Rather than spend hundreds of millions of dollars in search of elusive revenue, it prefers modest initiatives with identifiable paybacks in the form of back-office efficiencies. Once in place, the programs can be rolled out to customers.

A case in point is an online purchasing system designed to lower the cost and improve the timeliness of Firstar’s procurement process. Firstar plans to let customers buy goods via the e-procurement system at the prices the bank pays. “We’ll charge their checking accounts, and they will get the stuff delivered to them,” Chenevich says. Later, “we’ll take that same system and leverage it as a value-added service to our entire retail base.”

That almost sounds like a business
driver. -- J.M.