Wachovia's $400 Million Hunch

Its deal for Prudential's brokers is a bold contrarian bet

When G. Kennedy Thompson took the helm of First Union Corp. in early 2000, it quickly became clear he was cut from a different cloth than his predecessor, Edward E. Crutchfield Jr. The blustery Crutchfield was known for his aggressive dealmaking: He once boasted that to land one of the 70-plus banks he bought during his tenure, he "just kept stacking billion-dollar bills on the table" until the other side caved in.

Thompson, however, prefers a more understated strategy. After approaching fellow North Carolina bank Wachovia WB ) Corp. in 2001 about a "merger of equals" -- one that gave Wachovia shareholders a scant 6% premium on their stock -- Thompson covertly drove week after week to a Comfort Inn in rural Salisbury, N.C., to win over Wachovia's top executives. As Thompson, who even at age 52 looks ever the Boy Scout, returned the key after one such afternoon tête-à-tête with Wachovia CEO L.M. Baker Jr., he sheepishly asked the desk clerk: "Ever had anybody check out so soon?" Replied the clerk: "Not anybody that looks like you."

The deal, sealed on Sept. 4, 2001, showed that Thompson could pull off a major buyout on the cheap. He persuaded Wachovia shareholders to forgo the usual big up-front premium and has since integrated the banks without the customer defections that dogged Crutchfield in his last deals. Thompson, a 27-year First Union veteran who made his mark heading up corporate and investment banking, also made money for shareholders. Operating income for the bank, now known as Wachovia Corp., nearly doubled in 2002, to $4.9 billion, and is on track to rise 24% this year. The stock, recently at $43.82, has returned investors 40% since the merger.

Now Thompson is trying to work his magic again. But this time he's flying in the face of industry convention. His recently closed deal to merge Wachovia's brokerage business with that of Prudential Financial Inc. (PRU ) adds Pru's 4,400 retail brokers to Wachovia's own middling brokerage operation. The deal comes at a time when many big brokerages are thinning their sales ranks and fighting to get back into investors' good graces after the spate of Wall Street scandals. What's more, the track record for big broker combinations is decidedly mixed. Think of American Express) Co.'s (AXP failed acquisition of Lehman Brothers (LEH ), or Credit Suisse First Boston's (CSR ) struggles with onetime hotshot Donaldson, Lufkin & Jenrette.

Thompson thinks he can beat the odds. For one, he is betting that Wall Street's doldrums are over. "This country is a stock-buying country," he reasons. He also thinks that the Pru deal positions Wachovia to benefit from the coming huge wealth transfer to baby boomers from their aging parents. "Trillions of dollars are going to change hands, and the brokerage industry is going to be a tollgate. I like our odds."

Like the Wachovia takeover, Thompson's deal for a piece of the rock promises a big return on a relatively small outlay. It gives Thompson a coast-to-coast network of 12,000 brokers to peddle mortgages, car loans, and other consumer-banking products as well as securities. In terms of pure heft, Wachovia Securities trails only Merrill Lynch and Solomon Smith Barney and runs neck-and-neck with Morgan Stanley. And by structuring the stealth takeover as a joint venture -- in which Wachovia maintains 62% ownership, management control, and an option to buy Prudential's 38% stake in the future -- Thompson gains a national brokerage force for the nation's fifth-largest bank for only about $400 million in up-front integration costs.

The plan? Merge back offices, close overlapping branches, and aim to double the share of profits from the brokerage business to 10%. Some investors foresee little risk because even if the market tanks -- an increasingly unlikely prospect -- Wachovia has a relatively small investment in the deal. "The downside risk is very small, and the upside is tremendous, particularly if you believe the bear market is over," says Thomas K. Brown, chief executive of Second Curve Capital LLC, a New York hedge fund that owns Wachovia shares.

For its part, Prudential, long dogged by internal conflict between its stock and insurance sales forces, was happy to cede control of its unprofitable brokerage business to Thompson because of the increased scale and efficiencies that will result from the deal. "We'd rather own 38% of No. 3 than 100% of No. 10," says John R. Strangfeld Jr., vice-chairman of Prudential Financial.

Still, Thompson is taking on some serious management challenges. The First Union-Wachovia merger involved combining two like-minded Southeastern banks. Now, though, he must mesh his small-market brokerage -- known for its tight cost controls -- with Prudential's mostly urban sales force, whose average compensation is much higher than Wachovia's brokers. The average Wachovia broker has $44.5 million in client assets, vs. $55 million at Prudential. "Any time you try to merge two distinctive cultures like that, it's a real challenge," says Paul E. Purcell, chief executive of Robert W. Baird & Co., a Milwaukee-based securities firm.

To try and forestall an exodus of Pru brokers, Wachovia is giving them retention bonuses. It is also taking the unusual step of providing retention bonuses for the brokers' assistants. In fact, while it will not disclose numbers, Wachovia says it has offered far more in bonuses for the Pru deal than it did for all employees in the much larger First Union-Wachovia merger. With Wachovia generating $2.5 billion in excess capital annually, the bank can afford it.

Yet UBS PaineWebber (UBS ) says that it has already lured away several Prudential branch managers in the Northeast and Midwest, and industry analysts say Merrill Lynch has done so as well. Moreover, with many of the Prudential brokers grumbling over retention packages that are lavish for the highest producers but skimpy for everybody else, Pru's rank-and-file sales people also could soon be headed for the door. Wachovia notes that the attrition rate for Pru's top-producing brokers has actually dropped from an annualized 8%-to-10% rate before the merger to 6.5% -- thanks to the retention bonuses offered them and their assistants. "We are very pleased with where we are right now. We're not seeing any mass exodus," Donald A. McMullen Jr., president of Wachovia's Capital Management Group, told analysts in July.

Although Wachovia has $350 billion in assets, its relatively small investment banking operation never had the hot initial public offerings and wide array of financial products that attracted upscale investors to its larger competitors. With the market shaking off the bear, however, the company says it's ready with new products. In recent months, it has also won more underwriting deals in such niches as real estate investment trusts.

Thompson has made a bold gamble, going deeper into the brokerage business just as most of Wall Street is retrenching. Like any shrewd investor, he hopes that he bought at the bottom of the market. Many an investor has tried that same strategy -- only to get burned. But Thompson knows that the ones who time it right have no regrets.

By Dean Foust in Charlotte, N.C., with Brian Grow in Orlando and Emily Thornton in New York

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