The securities industry will have to make room for another behemoth once Wachovia Securities teams up with A.G. Edwards Inc. to become the second largest retail brokerage in the U.S.
Charlotte-based financial services giant Wachovia Corp. (WB), whose Wachovia Securities unit is the fourth largest retail broker, is buying St. Louis-based A.G. Edwards (AGE), the sixth-largest player, for about $6.8 billion. A.G. Edwards' shareholders will receive 0.9844 shares of Wachovia common stock plus $35.80 in cash for each of their A.G. Edwards shares. The deal is valued at $89.50 per share, a 16% premium to A.G. Edwards' $77.15 closing price on Wednesday.
A.G. Edwards' (AGE) shares were up 13.7% at $87.73 in NYSE trading May 31. Wachovia (WB) was down 0.7% at $54.18.
News of the deal sparked a rally in the stocks of other independent brokerages such as Stifel Financial (SF) and Jefferies Group (JEF) on May 31, with Stifel up 7.7% at $60.04 and Jefferies up 3.6% at $35.33.
Wachovia has built its franchise through six transactions since 1998, the largest being a joint venture with Prudential Securities in 2003.
The combined entity would have a 14% U.S. market share and would dramatically increase Wachovia's market penetration in California, Florida and Texas, according to Standard & Poor's. "We believe Wachovia's experience with its venture with Prudential Securities, and five other broker integrations since 1998 will help Wachovia achieve its annual expense savings target of $395 million by 2009, Standard & Poor's said in a research note on May 31.
The merger with A.G. Edwards deal is expected to close in the fourth quarter of 2007, with integration to be completed by the end of the first quarter of 2009.
Deutsche Bank Securities cited Wachovia's potential to improve performance at A.G. Edwards, given the wide gap between the two companies' revenues and client assets per financial advisor. A.G. Edwards' client base appears to be less affluent than Wachovia's, with $57 million in client assets per Series 7 representative versus $80 million at Wachovia, according to a Sandler O'Neill research note on May 31.
"But it does increase the operational risk in our view," Deutsche Bank said in a research note, coming at a time when Wachovia is still digesting its 2006 acquisition of Golden West Financial Corp.
The price tag for Golden West was a staggering $24.2 billion, presumably worth it for the entrance it gives Wachovia to the California market, plus mortgage banking business in nine other states.
Responding to a question during a conference call to discuss the merger, Wachovia said the integration of Golden West and that of A.G. Edwards are two very different animals, one being of mortgage banks and the other of retail investment brokers.
Kevin Fitzsimmons, managing director of Sandler O'Neill said in an interview with Businessweek that while he regards the two kinds of integration as apples and oranges, it's a valid concern in that Wachovia "will have a lot on their plate."
The price of the deal might be a bit rich for some investors'comfort. Although at roughly 6% of Wachovia's market capitalization the deal isn't all that big, at 21 times earnings it isn't cheap, compared with sales prices of other brokerages such as Alex Brown and PaineWebber between 13 and 20 times earnings, Deutsche Bank said.
Bank of America Securities calculated the price as somewhat cheaper at 3.2 times A.G. Edwards' book value and 19.3 times the projected average earnings estimate for 2008 and viewed it as reasonable, but said it will boost Wachovia's earnings only if it can achieve significant cost savings. The company said it expects the deal to add a penny per share to its 2008 earnings and four cents per share in 2009.
The premium price is likely a bet by Wachovia on the operating leverage of the retail brokerage business model and on being able to rein in expenses, as well as on the potential to reduce the effective price by recovering the surplus capital held on A.G. Edwards' balance sheet, Sanford C. Bernstein & Co. said in its research note.
The greater risk for Wachovia will be whether or not it can retain A.G. Edwards' 6,618 financial advisors.
“The uncertainty of an ownership change, the threat of tighter expense control, the future restructuring of management and the almost certain changed payout schedules under Wachovia will serve as an opportunity for A.G. Edwards brokers to bolt to the ranks of Independent Investment Advisors (IIA) and attempt to take their clients with them,” the Bernstein note said.
That suggests that the real winner from the merger may be Charles Schwab Corp. (SCHW), which has the largest IIA network, Bernstein said.
The May 31 rally in shares of independent firms highlights their scarcity value, said Kevin Fitzsimmons, managing director of Sandler O'Neill, in an interview with Businessweek. "It's the sort of business where if you're going to be in it, there's a recognition you have to be large and you have to have scale."
The merger may hasten the disappearance of traditional brokerages with a regional footprint. It's not that they aren't able to survive by staying small, but more that they will increasingly be targets of larger investment banks willing to bid up to acquire them, Fitzsimmons said.
(Bank of America has done investment banking with both Wachovia and A.G. Edwards in the past year, and Sanford C. Bersntein & Co. has done non-investment banking with Charles Schwab in the past year. Deutsche Bank and Sandler O’Neill either do or seek to do business with the companies they cover in their research reports.)