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By expanding into Eastern Europe, Austria's Erste Bank has drastically improved its bottom line -- and may have turned itself into a takeover target.

By expanding into Eastern Europe, Austria's Erste Bank has drastically improved its bottom line -- and may have turned itself into a takeover target.

By David Lanchner
January 2003
Institutional Investor Magazine

Andreas Treichl had a bright idea -- or so he thought. It was May 1999, and Treichl, chairman and chief executive of Vienna's Erste Bank Group, had called his top 30 executives into the boardroom to lay it out: The Czech Republic government was preparing to privatize the national savings bank. Treichl thought he could buy it on the cheap and turn it around with Western-style management.

The CEO's course was set, but to gauge his colleagues' thinking he put his idea to an anonymous vote. The result: 29 out of 30 disapproved. And for good reason. The Czech bank, Ceská Sporitelna, had two times Erste's employees but only a quarter of its assets, it was deep in the red, and it had a mountain of uncollectible loans. Treichl's team was also gun-shy -- two years earlier Erste had bought a bank in Hungary that failed to meet expectations.

"The very simple truth is that they thought I was crazy," Treichl recalls.

No one questions his sanity now. Austria's second-largest bank, Erste is thriving today largely because Treichl went through with the purchase of 52 percent of Ceská Sporitelna, or CS, for E526 million ($510 million) in January 2000. By last year, under the leadership of American banker Jack Stack, CS had trimmed its bloated workforce by 27 percent, to 11,500, and through September it had earned 4.9 billion Czech koruny ($162 million), four times the year-earlier figure. The Czech bank was far outperforming its acquirer, with a 24 percent return on equity versus Erste's overall 12 percent. Of Erste's projected 2002 net profit of E223 million, CS is expected to contribute E127 million, or 57 percent, up from virtually zero in 2000.

Erste shareholders have weighed in with their approval, subscribing to a E642 million rights issue in July that financed the August purchase of an additional 36 percent of CS. Investors see Erste as a proxy for the emerging economies of Central Europe. Of Erste's more than 10 million customers, 80 percent are outside of Austria, and half of those are in the Czech Republic. Through late December, Erste's stock price had risen 8 percent for the year, significantly besting benchmarks like the Dow Jones Euro Stoxx Banks index, which fell 24 percent.

"The popularity of this stock is driven almost exclusively by its exposure to the Czech Republic," says Andrew Ness, a portfolio manager at Deutsche Asset Management in London, which has $800 billion under management and a stake of undisclosed size in Erste. "Erste is one of the best ways to invest in the growth that will come with the accession of one of the region's strongest economies to the European Union in 2004."

Treichl believes that by 2005 Erste's Central European operations -- in Croatia and Slovakia as well as in the Czech Republic and Hungary -- will boost the overall group return on equity to 15 percent while doubling earnings, to E500 million. He figures that will push Erste's market capitalization from E4 billion to E10 billion.

"If we had failed to take over CS, we would not be around anymore," asserts Treichl.

The irony isn't lost on the CEO. He knew Erste needed to expand beyond its homeland to survive in the consolidating European financial sector. Austria, he laments, has too many banks chasing too little business, a legacy of overregulation and of market dominance by institutions that historically lacked a commercial profit motive and that still control 60 percent of the country's retail market. That's one reason Erste's 315-branch retail banking operation in Austria is unprofitable -- and is a drag on the group's momentum. "Many of our competitors are cooperative banks or state banks that are not shareholder-oriented and that fight purely for market share," complains Treichl.

He is convinced that market forces will eventually bring these competitors -- including the Austrian Federation of Trade Unions' BAWAG-P.S.K. Gruppe, the cooperative Raiffeisen Banking Group and several state mortgage banks -- into more open, profit-driven competition. He doesn't expect much to happen, however, in the next two or three years. The two biggest financial institutions in the country are now Munich-based HVB Group, which in 2000 acquired Bank Austria-Creditanstalt and has E150 billion of its E714 billion of assets in Austria, and Erste, with E125 billion in assets.

"Someone is going to have to leave retail banking, and it won't be us. Out of all the domestic banks, we have the strongest profit base outside of Austria," says Treichl. "What we will do in Austria for now is streamline our business and cut costs where possible -- but always with the intention of staying in the market."

Analysts aren't so sure that Erste can hold to its goals given the sorry state of the local market. Treichl is shooting for a 14 percent ROE this year. But Peter Breyer, a banking analyst at Bank Austria-Creditanstalt, predicts that Erste's Austrian retail bank, which accounts for 35 percent of the group's assets, will post a loss of at least E4 million for 2002 and a slim E8 million profit this year. That will keep Erste's ROE at about 12 percent, the same as in 2002, says Breyer.

Still, that's a pretty healthy figure in Europe these days: HVB posted a 0.7 percent ROE in the first nine months of 2002, and Deutsche Bank earned 1.7 percent. Breyer warns, though, that if Erste's core business keeps falling short, investors will bid down the stock, which could threaten the company's independence.

That, of course, would be the ultimate irony for Erste. Treichl took the bank into Eastern Europe to survive; in the process he may have turned it into a tempting target for other would-be acquirers.

Who might the suitors be? Analysts rattle off names like France's BNP Paribas, Italy's IntesaBCI, Spain's Banco Bilbao Vizcaya Argentaria or Banco Santander Central Hispano, and U.K.­based HSBC Holdings. But all these banks' stock valuations are down, and the acquisitions market is quiet -- and Treichl is determined to go his own way.

"Central Europe is the key reason I don't want us to merge," says Treichl. "If we linked with a bank based anywhere else, we would dilute that potential dramatically for the shareholder."

Treichl will surely have a say in the matter because he has at least one big, management-friendly shareholder: the Anteilsverwaltungssparkasse, or AVS, a nonprofit foundation that has loose ties to the conservative Austrian People's Party and owned Erste before its 1997 initial public offering, and that retains a 35.6 percent stake.

The AVS and other Erste shareholders have seen the bank's assets grow almost fivefold since 1997, and its customers from 600,000 to 10.6 million. For now they are sitting tight with Treichl, banking on that potential in the East.

ERSTE, LIKE THE BANK IT ACQUIRED IN THE CZECH Republic, started out as a thrift institution -- it was founded by a priest in 1819 to serve laborers and artisans -- and evolved according to government fiat and changing political winds.

Thanks to its size and central Viennese location, Erste grew to be first among equals in the loose confederation of Austrian Sparkassen, or savings banks, serving as a central treasury and clearing bank for the group. But the sector, consisting of dozens of small institutions controlled by independent foundations and municipalities, was grossly inefficient. In a government-supported attempt to consolidate the sector, Erste made 17 acquisitions between 1993 and 1997. These extended the bank's reach but didn't improve its bottom line.

"Our principal aim at the time was to make loans, not to make a profit," says Treichl, a wiry and urbane 50-year-old who joined Erste in 1994 after spending most of his career with Chase Manhattan Bank.

The thrift's transformation under Treichl began with an agreement between the People's Party and the left-wing Social-Demo-cratic Party of Austria to rationalize their respective competing financial interests. Bank Austria, which traditionally financed the projects and political campaigns of the leftists, acquired right-leaning Creditanstalt in January 1997. Correspondingly, Erste gained control of the leftist GiroCredit Bank in October 1997.

Treichl, the son of a former Creditanstalt chairman, graduated in 1975 with a degree in macroeconomics from the University of Vienna and briefly considered going into politics. Instead, he entered training programs in New York at Citibank, Morgan Stanley and Brown Brothers Harriman & Co. before becoming a credit analyst at Chase Manhattan in 1977. He moved through a series of increasingly senior positions in corporate finance and asset management in New York, Brussels and Athens before returning to Vienna in 1986 as chief executive of Chase (Austria).

Over the next seven years, Treichl built a thriving corporate loan business. He also served as treasurer of the People's Party, a post he relinquished when he joined Erste. There he was given responsibility for corporate lending, one of the bank's few profitable divisions, while his autocratic predecessor as CEO, Konrad Fuchs, kept a tight rein on the core retail network, where inefficiencies were rife. In July 1997, Fuchs, then 60, "was gently persuaded to retire," says an Erste insider, and Treichl was tapped to modernize the bank.

Domestically, Treichl didn't have much room to maneuver. Bank Austria-Creditanstalt, the dominant commercial bank, had a lucrative investment banking arm and had expanded through start-ups and acquisitions in Eastern Europe. Raiffeisen Banking Group, the depositor-owned cooperative that was then No. 2 in Austria, had embarked on an even more aggressive eastern expansion, all the way to Russia. Although Erste more than doubled its assets, to E54 billion, following its merger with GiroCredit, it remained a distant third in Austria. Its principal source of revenue was the retail market, which yielded a slim net interest margin of about 1 percent.

"Erste was facing a strategic cul-de-sac," says Edgar Bettridge, a banking analyst at Fox-Pitt, Kelton in London.

Treichl rejected a corporate or investment banking strategy; Erste was too small and lacked the necessary global or pan-European presence to compete effectively. The Austrian retail market was hardly more promising. "Yet it was the only market where we thought we could create value," Treichl says. "If we wanted to have a chance to become a successful, viable entity long-term, we had to expand in retail regionally."

To cut, or at least control, his domestic losses, Treichl decided to squeeze out as many efficiencies as he could through market discipline. In December 1997, with AVS's endorsement, Erste floated 30 percent of its shares, raising E508 million. Treichl replaced many of Erste's more lax managers with bottom-line-oriented recruits from Creditanstalt, and he introduced Austria's first stock-option incentives as part of a revamped compensation scheme.

To gain market share, Treichl within two years had swapped 77 branches with nine smaller savings banks in return for equity stakes ranging from 5.8 percent to 98.7 percent. Erste also forged an agreement to supply the entire 64-member Austrian savings bank federation with insurance and investment products as well as securities processing services. In turn, the savings banks adopted common branding and advertising; the entire sector, in effect, now shows a common face to the customer. "That boosted the number of our domestic clients from 600,000 to more than 2 million," boasts Treichl.

What's more, Treichl came up with a way to consolidate the assets of other savings banks on Erste's books without expending his capital on formal acquisitions. He devised the Haftungsverbund, or cross-guarantee arrangement, which as of January 1, 2002, pooled the financial resources of 55 participating institutions under Erste's central oversight. As a result, Erste manages a combined balance sheet of E124.8 billion, up from E94.4 billion last year, and uses that increased clout to lower the sector's funding costs and to provide a cushion against member failures. Erste has gained the quasiregulatory power to replace management at any bank that fails to hit certain performance benchmarks. Treichl also introduced a common computer system for risk management and for customer marketing and profitability analysis.

Fox-Pitt's Bettridge views the cross-guarantee system as a step toward Erste's de facto control of the Austrian savings sector. But the strategy will succeed only if efficiency improves, and that's a work in progress. Since 1997, Erste's cost-to-income ratio has fallen to 68.3 percent from 73 percent. Treichl expects closer cooperation to bring that down to 60 to 62 percent by 2005, still above the high 50s that large U.S. and European commercial banks consider minimally acceptable.

Some observers say, however, that there are limits to what Erste can accomplish without taking full ownership of smaller institutions and eliminating the remaining redundancies in administrative staffs and advisory boards. "To raise efficiency from here, Erste will have to keep on pushing for even greater control, possibly through further share swaps -- something that has been resisted so far," says one Frankfurt-based analyst.

WHERE OTHER BANKERS SEE HOPELESS inefficiency, Treichl sees a turnaround opportunity. That was the allure of Ceská Sporitelna, but Erste's executives were not the only ones wondering if he might have been hallucinating. "He wanted to buy the most inefficient bank in an economy that, at the time, was the weakest among Central Europe's major economies," recalls a senior banker at the competing Raiffeisen group. "It looked like a move of desperation."

Nor did Erste's September 1997 acquisition of Hungary's Mezöbank inspire much confidence. Now called Erste Bank Hungary, it has yet to make much of an impact, with a mere 4.4 percent share of the retail market. Its margins are constantly being squeezed by larger rivals like Hungary's publicly quoted, state-owned OTP Bank, which has a 22.4 percent share, roughly double that of its nearest competitor.

Treichl diplomatically calls Hungary "a learning experience. It taught me that you had to be big if you wanted to be a success in Central European retail banking." And that, he says, is what made CS different.

Created in 1953 as Czechoslovakia's consumer banking monopoly, CS was still by far the biggest retail bank in its market, with a 34 percent deposit share, a decade after the fall of communism. But it lacked such fundamentals as a proper risk management system for loans. Controlled by the state, but with a publicly quoted share price following an early wave of privatizations in 1993, CS was weighed down by nonperforming loans to state-owned companies. In the summer of 1999, the new Social Democratic government of Milos Zeman had to subscribe to a Kcs7.6 billion rights issue to keep CS afloat, and it put the bank up for sale.

Lacking consolidated accounting systems and other technologies that bankers in the West take for granted, auditors couldn't tot up CS's bad-loan ratio, but estimates ranged from a fifth to a third of its roughly Kcs145 billion portfolio. (At most healthy banks it is in low-single-digit percentages.) Yet, says Treichl, "we felt that CS was the ideal fit. We wanted to be a regional retail bank with a strong distribution network, and this was the biggest in the Czech Republic, with 4 million clients." Treichl believed that if he could clean up CS's balance sheet and get its branch system in working order, his investment would pay dividends for years.

Treichl wasn't discouraged by the anemic Czech economy, which had grown an average 0.8 percent annually since 1996. "The Czech Republic was determined to join the EU, and we felt that was bound to bring in foreign direct investment and bring down interest rates, leading to rapid growth and demand for financial products," he says.

He was also willing to go where no one else dared: Erste was the only serious bidder for CS, and it cut a sweet deal. The Prague government gave in to Erste's demand to drop its asking price by 26 percent (the E526 million for a 52 percent interest was still 40 percent above the market price) and agreed to cover any bad loans found on the bank's books over the following year. The government wanted to cap its bad-debt exposure at Kcs22 billion, but Erste bargained that figure up to Kcs29 billion.

"Had the Czech economy or CS been in better shape, we would never have been able to acquire the bank," says Manfred Wimmer, Erste's head of Central European strategy, who spent most of the autumn of 1999 negotiating the terms with the Czech government. "We were, in a sense, very lucky."

Apart from its deficiencies in technology and infrastructure, CS had far too many employees and no sales culture. The staff in its 700 branches knew little about loan or investment products, almost never suggested them and were surly when customers asked questions.

Enter Jack Stack, whom Treichl recruited to usher CS into the 21st century. A Harvard MBA, Stack decided to leave his job as head of marketing at Chase Manhattan in early 1999. "I wanted to be a CEO," says the 56-year-old Stack, who worked at a Chase predecessor, Chemical Bank, in the years when Treichl was in the old Chase's international department. "My daughter was grown, my parents were dead, and I'd lived all my life in New York City. My wife and I were looking for adventure."

A Korn/Ferry International headhunter brought Stack to the attention of Treichl, who hired him initially as a consultant while the acquisition was being negotiated. Says Stack: "I saw a country moving toward EU accession, which in the past has always led to increasing demand for financial products. The appeal of CS was very, very straightforward."

Treichl offered Stack the job of CEO before he was certain he would close the CS deal. "In a way it was a very natural choice. We did not want to create the impression that we were returning to impose an Austrian yoke on Czech banking," says one Erste executive, referring to the way the Hapsburg monarchy had suppressed Czech nationalist movements. "We wanted a third-country national who understood the merger process."

Stack speaks Czech poorly but is a gregarious personality who at Christmastime two years ago went out on branch inspections dressed as Santa Claus to break the ice with employees. The son of Irish immigrants and a onetime aide to former New York mayor John Lindsay, Stack is also a hard dollars-and-cents man. During the Lindsay administration in the 1960s and early 1970s, he cut employment in the municipal court system by 15 percent. When Chemical and Chase merged in 1995, Stack took charge of amalgamating the branch networks.

"At CS, I brought to the table an understanding that it should not take a lot of people to run this bank," says Stack. "I had been through various rounds of expense cuts, and I had a sense of what the end solution should be. Being American, I was also neutral. I did not come with the baggage of the Hapsburg empire."

In cutting personnel, Stack tried to target recalcitrant branch managers and others who treated their areas as independent fiefdoms. "You had a new owner and a new business model. So either you were on board, or you were out,"explains Stack.

He has cut more than 4,000 workers but has raised salaries 33 percent. Stack has also spent E8.8 million on staff training and by year-end 2003 will have sunk E230 million into information technology -- both amounts up from virtually zero in the years before the takeover. With CS's administrative and back-office functions now highly automated, its cost-to-income ratio has fallen to 63.3 percent from more than 70 percent in 2000. And with advances in risk management, the loan-loss provision shrank 89 percent in the past year, to Kcs213 million.

CS has increased its client base by 1 million and its assets by 19 percent, to Kcs523 billion, since Erste took over. But an even bigger bonanza could come from a pickup in consumer loans as the economy grows. Tax breaks have helped to lift the previously lame GDP growth to above 3 percent. Reflecting that trend, retail loans at CS in the first nine months last year grew 24 percent, to Kcs49.1 billion, with mortgages accounting for most of the increase. "This year we would like to see similar growth in credit cards and life insurance sales, but the rapid expansion of deposits alone should allow us to achieve a return on equity of 21 percent," estimates Stack. He also expects double-digit growth in loans to small and medium-size businesses over the next two to three years. Further down the line, CS anticipates a surge in mutual funds, though from a small base of Kcs30 billion under management. "We have to educate our customer base on the variety of financial products that exist," says Stack.

ERSTE VIEWS CS AS A PROTOTYPE, AND TOP management is now fully on board. In the spring of 2000, Treichl put another proposal -- the acquisition of Slovenská Sporitel'na, the biggest retail bank in Slovakia -- to a straw vote in the boardroom, and this time he won unanimous approval.

In June 2001, Erste paid E411 million for the Slovak bank, which has 215.3 billion Slovakian koruny ($5.2 billion) in assets and more than 2.3 million customers. The Slovakian economy, like the Czech economy, is growing faster than 3 percent a year, and the country is also set to join the EU in 2004. Analysts expect Slovenská to increase its earnings this year by 30 percent above the 2002 level of E13 million.

Similarly on the fast track is Rijecka Banka, the No. 4 retail player in Croatia, which Erste acquired in April for E55 million. With assets of E962 million and 600,000 clients, analysts say, Rijecka's earnings -- E20 million pretax in 2002 -- should rise 15 percent annually over the next five years.

Treichl says he will stay focused on the countries that border Austria, only one of which -- Slovenia -- Erste has not entered. Erste last year took a look at Nova Ljubljanska Banka, a bank being privatized there, but walked away when the government signaled that it would not cede a controlling stake. Treichl says he can wait for another opportunity to come along, or he might start an operation in that country from scratch.

As for Hungary, where Erste's 400,000 customers are too few to be considered a critical mass, Treichl is eyeing the national post office bank, Postabank es Takarekpenztar, which may be privatized this year. "We will look at whatever comes on the market, but we won't pay any price," says Treichl. "We are willing to bide our time until the right opportunity comes along."

Treichl is, in fact, playing a dual waiting game: for the doddering Austrian market to arise from its slumber, and for the dynamic Eastern European countries to mature. He is confident that he can hold out on both counts.

"The reason we make E200 million to E250 million in net income today, rather than E2 billion, is that out of our 10.6 million clients, 8.2 million still have very little money," says Treichl. "If an investor believes, as we do, that Central Europeans will be the wealth gainers of tomorrow, then he should be convinced, as we are, that Erste will come out on top not only in the region but also in Austria."

Then again, maybe Treichl is just crazy.