Why Wachovia is Banking on Purchase Accounting

First Union's CFO Robert Kelly talks about flexibility and more for the $13 billion deal.
Craig SchneiderApril 17, 2001

Monday’s $13.4 billion merger agreement between First Union Corp. and Wachovia Corp. has caused a stir among the M&A and accounting sets. Why?

Because the deal will be completed using the purchase method of accounting rather than pooling, traditionally the preferred accounting method among banks because it allows them to avoid amortization of goodwill and earnings dilution.

But with FASB expected to eliminate pooling and the amortization of goodwill by June 30, it is not surprising that the North Carolina-based banks would feel less threatened by the purchase method.

Certainly, First Union’s CFO Robert Kelly sees other advantages to the purchase rule changes. “It provides us with a lot more flexibility than pooling in that we can undertake much more active balance-sheet management like stock buybacks and divestitures immediately if we so desire,” he said in the merger conference call.

However, it takes more than desire to get purchase treatment.

Among the terms of the deal, Wachovia’s board is expected to approve a special 48 cents per common share dividend, payable prior to the deal’s expected closing in the third quarter. According to a Wachovia spokesman, the dividend is compensation to Wachovia shareholders because under the deal’s terms, they would for a time receive a dividend below the company’s recent level.

Todd Johnson, senior project manager at FASB, says Wachovia’s special dividend may conflict with a criterion for pooling, thereby requiring the deal to be accounted for as a purchase — not that the companies mind much. “They are not worried about the earnings penalty under the purchase method since goodwill [will] not have to be amortized,” Johnson says. “If the standards weren’t changed, they might feel differently about it.”

The macro trend, as reported in the CFO.com article “Why Pepsi Loves Pooling,” shows that some companies are straining to qualify for the [soon to be extinct] treatment.

A glaring exception came with the recent deal between Bergen Brunswig and AmeriSource. It was structured to be contingent on the issuance of the new standards for purchase accounting.

The combined company, to be known as Wachovia Corp., expects $890 million in pretax cost savings per annum over a three-year integration period. Also, it anticipates a one-time integration charge of $1.45 billion. Excluding some purchase accounting adjustments, Kelly says, “the cash charge would be lower; probably by about $100 million.”

But not everything is an exact science, as he explains. Says Kelly of the adjustments: “We have to mark to market the Wachovia balance sheet; fixed assets, loans, deposits, investments, options, benefit programs, etc.” He adds that it’s hard to know exactly what those numbers will be because it depends on where you identify branches and people.

The assumed impact of divestitures is $30 million on a net income basis foregone.

Here’s what this means: As the banks eliminate some of the branches that are too close to each other, the cost incurred will be about $30 million in net income. But the incomes that are lost are much less than the incomes saved. Why? Expected expense efficiencies of $303 million cancel out the $30 million from divestitures and $273 million in amortization of core deposits in 2002 and beyond.

As for share buybacks, Kelly says the purchase accounting method will offer significant flexibility to optimally manage and redeploy excess capital. “I wouldn’t say I’m going to be aggressively buying back stock,” he adds, “but the good news is that we have the option to do it.”

The combined company expects about $2.5 billion in excess capital that it anticipates will grow at a rate of 15 percent per annum beginning in 2002.

What does the company plan to do with this excess capital?

  • “If we took the $2.5 billion in excess free capital and reinvested it in our shares — which is a very simple thing to do and the one which would be the least attractive — we could generate a per annum share impact of 20 cents a share,” he says.
  • Invested internally with a hurdle rate of 15 percent, the impact is 27 cents a share, Kelly adds.

Of course, all bets are off if another bidder comes along and tops First Union’s offer. After all, First Union is only shelling out a slight premium to Wachovia’s closing stock prior to the deal’s announcement.

However, Kelly dismissed a suggestion on the call that another bidder will likely come into play. That said, he is prepared. “Hostile bids in our industry, of course, are enormously difficult,” he says. “We’ve taken this into account in our structuring of the merger, particularly in a post pooling world.”

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