Sunday, July 15, 2007

BofA Profit Trails as Citigroup, JPMorgan Go Abroad

Bloomberg, Bradley Keoun and Will Edwards, 16 July 2007

Bank of America Corp. does more business in the U.S. than any of its competitors, and that's eroding returns for shareholders of the Charlotte, North Carolina-based company.

Demand for financial services is increasing three times as fast outside the U.S., fueled by companies and investors in Brazil, China, India and Russia. While Bank of America operates in 45 countries, they produce only 13 percent of its revenue. That's puny compared with Citigroup Inc., which derives almost half its sales from abroad and ranks among the biggest banks in Mexico, Poland and South Korea.

The same domestic focus that made Bank of America, Wachovia Corp. and Wells Fargo & Co. the best performing of the biggest U.S. bank stocks during the first half of the decade is working against them now. With Europe and Asia accounting for more than half of the world's economic output and home to six of every 10 millionaires, the banks and securities firms that expanded internationally stand to benefit most.

``Bank of America is largely a play on the U.S. and it's suffering more because the domestic economy has been growing at sub-3 percent,'' said Chris Hagedorn, who helps oversee about $22 billion at Cincinnati-based Fifth Third Asset Management, which owns shares of Citigroup, Bank of America and Wachovia. ``The growth right now is coming internationally.''

Kenneth Lewis, Bank of America's 60-year-old chief executive officer, is unswayed. He says the U.S. represents the best opportunity because it's still the world's single biggest source of banking, brokerage and money-management fees.

``We do better when we play to our strengths, and our strengths are in the U.S.,'' Lewis said in a June 19 interview in New York.

For now, the geographic divide between U.S. banks is growing, and it may widen even further this week when the five largest, Citigroup, Bank of America, JPMorgan Chase & Co., Wachovia and Wells Fargo, report second-quarter results.

Analysts surveyed by Bloomberg estimate that New York-based Citigroup, led by CEO Charles Prince, increased earnings by 7.7 percent, and JPMorgan, which gets a quarter of revenue from outside the U.S., had a 6.4 percent gain. Bank of America may post a 2 percent profit drop, its first decline since 2005, the survey shows.

The situation is already playing out on Wall Street, with Lehman Brothers Holdings Inc. generating almost all of its $1.1 billion increase in second-quarter revenue from international markets. Lehman, the fourth-largest securities firm, said profit increased 27 percent in the three months ended in May.

It was a different story for Bear Stearns Cos., which relied on the U.S. for 87 percent of last year's business. Chief Executive Officer James E. ``Jimmy'' Cayne, who resisted the pressure to expand in investment banking and trading overseas, reported a 10 percent drop in profit as mounting home-loan defaults in the U.S. hurt trading.

Merrill Lynch & Co. shareholders will find out tomorrow how much the world's No. 3 securities firm benefited from its overseas operations, which typically provide 35 percent or more of revenue. The New York-based firm probably will report an 18 percent increase in earnings, the Bloomberg survey shows.

The Boston Consulting Group's ``heat map,'' a color-coded chart showing where financial-services demand is expanding fastest, makes the point graphically. Over on the far right of the page, China's 8.5 percent growth stands out in fiery red. The U.S., where such revenue is rising 2.8 percent a year, sits on the left in an icy blue.

Overall, the pool of fees for everything from investment banking to retail-brokerage services and basic savings accounts will swell by 896 billion euros ($1.2 trillion), or 43 percent, from 2005 to 2015, according to Boston Consulting. About 671 billion euros of the growth will come from abroad.

``Other markets are going to grow faster than the U.S. for the foreseeable future,'' said Michael McKeon, managing partner in the financial services practice of consulting firm Booz Allen Hamilton in New York.

If anything, Bank of America's Lewis is doubling down on the U.S. His agreement to buy ABN Amro Holding NV's Chicago-based LaSalle Bank unit for $21 billion won the backing of the Dutch Supreme Court on July 13. The purchase would bring the bank right up against the federally enforced 10 percent market-share cap on U.S. deposits. The bank currently has almost 6,000 branches in 31 states.

Lewis points to research by McKinsey & Co. and studies by Bank of America that show the U.S. will generate the largest pool of banking fees over the next decade. He predicts that Bank of America can boost earnings per share by 10 percent a year just by gaining a greater share of the U.S. market and making selective investments overseas.

Bank of America became the nation's largest private bank earlier this month with the $3.3 billion acquisition of U.S. Trust Corp. In addition to holding the most U.S. deposits, Bank of America also is the nation's biggest credit-card issuer.

While Bank of America has plans to expand in some developing markets, such as China, it's scaling back operations in others. Last year, the bank swapped its Brazilian unit for a stake in Banco Itau Holding Financiero SA, completing a two-year effort to dispose of assets acquired in the 2004 purchase of FleetBoston Financial Corp.

Lewis says he doesn't like doing business directly anywhere in the world ``where we're 13th.''

Investors have second-guessed Lewis before and lost. When Bank of America agreed to buy FleetBoston in October 2003, its shares tumbled 10 percent. Shareholders rebelled similarly after Lewis proposed buying credit-card issuer MBNA Corp. in June 2005 for 30 percent more than market value. In both cases, Bank of America met or exceeded the cost savings Lewis promised.

In Lewis's first five years as CEO following his promotion in April 2001, Bank of America's stock gained 72 percent. Citigroup's rose 4 percent and JPMorgan's fell 11 percent.

``Up to now you have to give Ken Lewis a lot of credit,'' said Marshall Front, who helps manage about 500,000 Citigroup shares and 300,000 Bank of America shares at Front Barnett Associates in Chicago. ``Our largest holding has been Citigroup, and it hasn't particularly been a good investment.''

The tables have turned during the past year. Bank of America shares advanced 2.5 percent, while Citigroup gained 10 percent and shares of New York-based JPMorgan jumped 22 percent.

Citigroup does business in more than 100 countries, and the $9.2 billion it earned overseas last year exceeded net income at Charlotte-based Wachovia, the fourth-largest U.S. bank.

``When I think about our competition trying to go international, one country at a time, it's not always going to take forever, but it's a very risky strategy because you could happen to be to be in the wrong country at the wrong time,'' CEO Prince said at an investor conference in May.

Prince, 57, spent at least $10 billion in the past eight months on foreign acquisitions. Citigroup bought control of Nikko Cordial Corp., Japan's No. 3 brokerage, and acquired London-based Egg Banking Plc, the world's largest independent online bank. It invested in banks in El Salvador, India and Turkey and agreed to buy another in Taiwan. Citigroup's current expansion plans include doubling branches in Japan to 50, signing up 20,000 customers a month in Russia and building a securities business in China. The company also may purchase 50 percent of Chile's second-biggest bank.

Citigroup is an ``underappreciated global franchise, with first-mover advantage in a lot of developing countries,'' said Hagedorn of Fifth Third. In the U.S., ``banks are looking at 2 percent earnings growth, and that's not terribly exciting.''

Bank of America's overseas strategy has centered on partnerships. Under Lewis, the company has spent almost $5 billion since 2002 taking stakes in China Construction Bank Corp., China's third-biggest bank, and Grupo Financiero Santander Serfin, Mexico's No. 3 bank.

For now, Bank of America is limiting its international expansion mainly to capital markets and credit cards. The company will invest $300 million to $400 million over the next several years to gain a greater share of securities sales and trading in Europe and Asia.

Lewis also wants to sell banking products to credit-card customers in Europe by direct mail. Bank of America's $35 billion purchase of Wilmington, Delaware-based MBNA last year made it a leading credit-card issuer in the U.K., Ireland and Spain.

In the U.S., banks have been squeezed by the so-called flattening yield curve. That's when long-term rates decline and short-term rates increase, narrowing the spread banks earn on the difference between rates on deposits and loans.

Now, with the collapse of the U.S. subprime-mortgage market and the decline in house prices, banks also face bigger losses on home-equity debt and loans to homebuilders, Citigroup analyst Keith Horowitz wrote in a July 10 research note.

Wachovia and San Francisco-based Wells Fargo, the fifth- biggest U.S. bank, both generate less than 5 percent of their revenue from abroad. Wells Fargo Chairman Richard Kovacevich has referred to U.S. states east of the Mississippi River as ``overseas markets.''

Expanding into Europe was easier for Citigroup and JPMorgan in past decades because state-owned banks such as France's Credit Lyonnais SA and Banque Nationale de Paris couldn't keep up with the more nimble Americans, said Giorgio Questa, a finance professor at Cass Business School in London who used to oversee international investment banking at Italy's IMI SpA.

In the securities industry, U.K. brokers were snapped up by U.S. giants such as Merrill, which bought the biggest, Smith New Court, in 1995. Now, ``banks like Bear Stearns, Wachovia and Bank of America are finding entrenched and stiff competition from U.S. banks that were there before,'' Questa said. ``Largely, they have missed the boat.''

That's costing them opportunities to tap into the surge in international demand for financial services. European and Asian companies have accounted for 61 percent of equity-underwriting fees paid to investment banks this year, data compiled by Bloomberg show. In 2000, U.S. companies paid 57 percent.

``You clearly have a much higher growth rate in Asia and in Eastern Europe, compared with the U.S.,'' David Sidwell, chief financial officer at Morgan Stanley, said in a July 12 interview. ``Can you just shift resources out of the U.S. to Asia? The simple answer is no. You need to make sure you're investing in both.''

Bear Stearns, the fifth-biggest Wall Street firm, wants to forge more international partnerships to invest in companies that operate in faster-growing economies, Co-President Alan Schwartz said in March. In March, the company formed a $500 million fund with Huang Guangyu, the richest man in China, to invest in the country's retail industry.

International markets don't come without the kinds of risks Bank of America's Lewis prefers to avoid. Citigroup said it would shut about 80 percent of its consumer-finance branches in Japan earlier this year after the government passed legislation capping interest rates. The company raised its loan-loss reserves in Japan by $375 million and had closure costs of $40 million.

Morgan Stanley, Citigroup and Bank of America all are scheduled to stand trial in coming months for their financing of Parmalat Finanziaria Spa, the Italian dairy company that went bankrupt in 2003 after revealing a 3.95 billion-euro bank account didn't exist. The banks face allegations that they didn't have sufficient internal controls to prevent Parmalat employees from committing fraud.

Goldman CEO Lloyd Blankfein says the cost of staying too close to home may be greater. Developing markets such as Brazil, Russia and China have reached a ``tipping point'' that makes them harder than ever for investment banks to ignore, he said at a conference last month.

``If you forgo the opportunities in emerging markets, you're putting your global franchise at risk,'' Blankfein said. ``Isn't it better to invest in a place where everything is growing at 11 percent than where everything is growing at 2 percent?''