PNC Financial Services Group Inc (PNC) 2003 Q4 法說會逐字稿

Good morning and welcome to today's Mercantile Bankshares' earnings conference call. (Operator Instructions). It is now my pleasure to turn the floor over to Dave Borowy, Director of Investor Relations for Mercantile. Sir the floor is yours.

Thank you, Dina. Good morning everyone, and thank you for joining us today. I would like to inform you that this call is being recorded and will be available for replay along with our earnings release at our company's investor relations Web site, www.mercantile.com. With me on the call this morning are Ned Kelly, Chairman, President, and CEO of Mercantile Bankshares Corporation, Terry Troupe, our Treasurer and CFO, and Ellen Harvey, Senior Vice President and Portfolio Manager. Before I turn the call over to Mr. Kelly, I'd like to address some obligatory disclosure matters.

The press release announcing our earnings was distributed via PR newswire at 7:00 a.m. Eastern Time. I'd like to remind you during the course of this conference call, we may make forward-looking statements within the meaning of and pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. A forward-looking statement encompasses any estimate, prediction, opinion or statement of belief and the underlying management assumptions. Forward-looking statements are based on current expectations and assessments of potential developments affecting market conditions, interest rates, and other economic conditions and results may ultimately vary from the statements made during this call. In this call, we will discuss some non-GAAP measures in talking about our company's performance and you can find the reconciliation of those measures to GAAP measures within our news release, which is posted in the investor relation's section of our Web site. I now present to you Mr. Ned Kelly.

Good morning. I appreciate your being here for our fourth quarter earnings conference call. The year-over-year December 31st 2003 versus 2002, as you know, is not particular relevant. The comparisons between those two periods are significantly affected by F&M and the investment in wealth management acquisitions we did during the year. I will focus briefly on the year-over-year and then try to focus on the fourth quarter, which I think is particularly relevant in this case.

GAAP net income for the year was 196.8 million, that was up 4% over 2002. Our GAAP diluted EPS was 268 for 2003 versus 272 for 2002. As you know that's due an to increase in average shares outstanding in connect with the F&M acquisition and that number moved from 70.1 million to 73.4 million on an average basis during the course of the year. We also incurred 7 cents in merger-related charges and 4 cents in non-cash amortization during 2003.

Our EPS for the year was 279, if you exclude the merger related and the non-cash amortization. As we have gone through some of your analysis, it's been difficult frankly to discern on what basis you've been thinking about earnings, but as we look at it I think the EPS for the year could range from 275 to 279. It would be 279 if you took the 268 GAAP and added the 7 cents in merger-related charges. It would be 279 on a variety of bases, which would be involved among other things, taking the first two quarters GAAP and than just adding the third and fourth quarter operating or taking our operating EPS of 273 and adding 6 cents of securities gains.

With respect to the fourth quarter in particular which as I said I believe is more relevant in this case, our GAAP diluted EPS was 63 cents, that was flat for the third quarter. Our operating EPS, as we have defined it in the press release, as you know, was 69 cents versus 67 cents for the third quarter. And that increase was driven in part by 4 cents in merger related charges versus 2 cents in the third quarter, and there was 2 cents in non-cash amortization, which was flat for the third quarter. The fourth quarter returns were 147 return on assets, return on average tangible equity was 1649, if you exclude the merger related charges those numbers become 155 and 1740. Our average tangible capital ratio at year-end was 951. The end of period tangible capital ratio was 978.

Turning to operating income, it was 54.5 million, which was up 9% over the 49.9 million for the third quarter. Net interest income was up from 122.2 million to 133.2. Notably the margin improved during the quarter from 419 to 428, which as you know reverses a trend that we've been experiencing during the course of the year.

Margin improvement was driven by slow prepayments in refinancing, which in turn had a positive impact on the consumer and residential real estate loans and the securities portfolio, or put in another way, reduced the bleeding that we've been suffering during the course of 2003 given the interest rate environment.

The other positive news from the fourth quarter was that loan growth was actually up 2.9% in a linked quarter basis and was up in all categories but leasing, which as you know has been a planned runoff for us. That results in 11.3% annualized growth. Deposits were down slightly, about 30 basis points but there were relatively significant increases in non-interest bearing deposits, which are still 26% of our total deposits.

Non-interest bearing deposits grew roughly 2% on a linked quarter basis, which is about 7.7% annualized. Savings and checking with interest also grew. That growth was offset by runoff in time deposits and money market accounts. To some extent that was planned, the yield on our deposits was actually down to 1.18 from 1.27 on a linked quarter basis.

Securities portfolio was stable at 25% of earning assets, which is about where it's been. The yield was helped by the slowing of pre-payments. It was 414 for the fourth quarter versus 403 for the third quarter and again that's where reversal and fairly significant declines earlier in the year. Composition of the portfolio is relatively unchanged since September 30th and relative to the numbers that we gave you during the third quarter earnings conference call.

Treasuries are 27% roughly, agencies are 27%, mortgages are at 42%, and municipals are at 4%. The weighted average maturity is 3.0 versus 2.9 at the end of September 30th, the duration is 2.4 versus 2.3. The unrealized gain is roughly 36 million, which is down from 52 million September 30th.

Our targets with respect to the portfolio are still roughly 40, 20, 40, treasuries, agencies, mortgages, but we are trying to be opportunistic and sensible about reaching those targets rather than mechanistic and we are dealing with incorporation of F&M portfolio, which I think -- all of you know our securities portfolio is still very conservative by peer standards.

Non-interest income was 47.4 million versus 45.9 for the third quarter. Investment and wealth management revenues were 21.5 versus 20.6 for the third quarter. Assets under management were up from 20.6 to 21.8. As you know we had a strong equity market during the third quarter -- fourth quarter rather -- that helps us, having said that, only a third of our assets are in equities so the effect of it is somewhat muted as a result of that.

We also had improving sales in the business, which helped us. I believe that there's still work to be done in the investment wealth management area. Continues to be a focus of ours. Having said that, some positive trends emerged during the fourth quarter, which heartened us and I think create a positive outlook potentially for 2004.

Mortgage banking fees were actually down, 17% in the third quarter. I think you've seen that in the variety of context. Fortunately we were not as mortgage banking dependent as some others but having said that those fees were down considerably during the fourth quarter as refinancing activity slowed.

Non-interest expenses on a linked quarter basis were up 9%, 99.4 million versus 91.2 million, I think its important to analyze those in the context of what was going on and if you exclude the F&M full quarter run rate since we had it only for part of the third quarter and all the fourth quarter that was about 8.5 million.

We had incremental merger-related charges fourth quarter versus third quarter of about 2.3 million. We terminated a technology contract, which was related to investment wealth management, which cost us about 525,000 and there was an incremental increase in the direct of deferred comp of 871,000. As you know that number fluctuates with our stock rate, its one of that which we don't have a great deal of control for continuing to look at ways in which we can eliminate that volatility because while it's not at the end of the day, a huge deal is a little nettlesome to have it be as volatile as it is quarter to quarter.

If you take those numbers they add to about 12.2 million. But for apple-to-apple purposes we have been deducted the severance of 3.24 million that we paid in the third quarter, on the theory that was extraordinary as well and if you net all of that out expenses linked quarter were actually down about $700,000 or roughly 1%.

As I look at the fourth quarter versus the third and think of it in a way that many of you might, if I add back the severance in the third quarter to the 67 cents operating and that severance was roughly 3 cents after tax that would generate a number of 70 cents. That leaves the fourth quarter at 69 cents, one cent short of the third quarter.

The reasons for that are the increase in the directors deferred comp, which was about one cent after tax and then there was about another penny and a half after tax due to the slowing of mortgage banking and the termination of that investment in wealth management technology contract. The bulk of that was attributable to the slowdown in mortgage banking.

Credit quality, linked quarter was stable. Non-performers are down slightly from 57 basis points to 55 basis points. The dynamic associated with that as we pointed out in the press release was restructuring of a credit, which had been non-performing. That resulted in a $5 million reduction in the non-performers roughly.

There are also certain charge-offs. That was offset by the addition of a nursing home credit, which we had mentioned in the context of the third quarter, which was about 6.5 million. Monitored down slightly from 38.5 to 28.4, the migration of the nursing home did not perform, it was offset by affiliate credit to a government contractor of about 5.6 million.

But the fact is that the credit the monitored credits were down slightly in a linked quarter basis. Thirty to 89 day loans were up to 43.6 million from 40.7 million in the quarter but given the seasonality, which we pointed out to you last year that compares very favorably to 104 million last year at the end of year 1231 especially given the fact that F&M is now in the mix and contributes to that category.

As I'm sure you can see from some of the schedules interestingly enough the driver of that was residential home equity and consumer loans, which is attributable to the F&M portfolio, what we would think as the old core Mercantile portfolio was actually performing pretty well in that connection.

The allowance is at 155 million or 1.68% of loans, down from 1.73. The coverage of non-performance is actually up slightly from 305 to 308. Net charge-offs were up from 3.5 million - I'm sorry from 2.7 million to 3.5 million.

We believe F&M is going well. As I said we had 7 cents in merger related charges this year. We believe there should not be more than another penny during 2004. We have some work left to do but not a lot. We suspect, as I said that any additional charges will not exceed one cent.

We also believe the stage has been set to realize substantially all the 26.5 million projected annual cost phase. We've closed 18 of the 21 branches that we planned to close. We have severed 242 people in connection with the deal. We're focused very heavily in the execution in terms of both cost savings and growth and a principal concern of ours continues to be customer retention, which at least in the early days seems to be going well.

With respect to 2004, I think it's very difficult to predict. There are some encouraging signs. Loan growth, as I mentioned during the fourth quarter, seemed to pick up. There have been mixed signals throughout the industry about that as you know with some bank is experiencing some substantial growth and others suggesting it may continue to be muted. At least in our case it seems as if there were some encouraging signs in the fourth quarter. Clearly the biggest boost for us would come from an increase in rates and improving economy. Still not clear to me whether that's going to happen. My sense is that the consensus is that if there is to be an increase it's likely to be in the latter half of the year but my predictive powers are certainly no better than yours.

What is clear is that the compression in margin during the course of 2003 clearly hurt us, continues to hurt us. If you look at it in terms roughly of 29 basis point compression, which is about where I think about it, because we went from 457 in the first quarter to 428 at the end of the fourth quarter, if you look at it on an average basis during the course of the year with 465 at the end of 2002, 434 at the end of 2003 on an average basis, it's about 29, 30 basis points. If you apply that to our asset base of roughly 13 billion that equates to as much as 29% -- 29 cents in earnings per share, roughly $23 million after tax. I

mentioned that only to show the depressing effect, obviously, that compression had on earnings during 2003 but also to highlight the leverage associated with an improving economy and increase in interest rates during 2004. But as I said we're not necessarily depending on that, the consensus seems to be that if it does occur it won't occur until later in the year.

The good news is that F&M gives us operating leverage and the opportunity to grow. I think we can get the costs out, I think we can grow the franchise. I think there's also additional leverage in the improving invested of wealth management business but as you know at the end of the day that's still a relatively small part of the firm. We have ways to go but as I mentioned I thought there were some encouraging signs.

The offsets of the F&M cost saves during 2004, and as I said, I think the stage has been well set to achieve those cost savings, are in the form of additional investments we might make. We opened 9 branches in 2003, many of which are put online in 2002 or had been planned to be put online from 2002 forward. We have also opened, as many of you know in Washington and Northern Virginia. We may open some new branches in 2004.

I've made it clear, however, and I believe everybody here subscribes to the notion that to the extent we open new branches, we should be very careful to analyze those that we have in place for the purposes of rationalizing the network as a whole and financing any expansion through saves associated with making our branch system more efficient.

The other burden, which I'm sure you've heard about from others, is compliance. Compliance is clearly become much more of an issue with the regulators both in the form of the SEC and the Fed. There are additional costs associated with that. At the end of the day they're not significantly material but they are there. And it's something regulators have focused on.

I think as many of you know from conversations with me I have very little in fact zero appetite for regulatory or legal risk and we're doing our level best to ensure that we satisfy even beyond the letter of the law or what they seem to suggest with respect to the regulators and other authorities' interest in compliance. With that I would be happy to open it to questions -- oh, one other thing that I might add.

On the acquisition front and, you know, I've noticed that many of you have commented on this and we have looked at it for a whole range of reasons very hard ourselves. It continues to be a seller's market especially at the lower end of the market notwithstanding the fact that some of these larger deals are being done on what are perceived to be either small or no premium basis with respect with the exception of Bank America Fleet.

The fact is if you go down in the market the smaller banks by and large are still commanding very significant premiums. There have been a couple of examples recently one this week where the tangible ratios seem to be pretty consistently exceeding three. Where the earnings per share, the PE multiples seem to be exceeding 20 and the core deposit premiums have escalated.

We're going to continue to be very disciplined as we look at that and try to measure any acquisition against what we believe we might be able to do on an organic or de novo basis and given the prices that seem to be commanded in the market at this stage, my suspicion is that at least for us acquisition activity may end up being muted in 2004 although that will depend heavily how things evolve at particular banks. With that I'd be happy to open it up to questions.

Thank you. (Operator Instructions). Our first question is coming from Todd Hagerman with Fox-Pitt, Kelton.

Good morning, everyone.

Todd, how are you?

Good, thanks. Couple questions, if I could. Delve into the expense side a little bit and get your comments on the wealth management. You've had a lot of noise kind of in the expense line the last couple of quarters. And I guess I'm curious to hear a little bit more about on the wealth management side some of the -- A, deposit of transit you mentioned in the quarter. And then just in terms to kind of how we should think about the direction of your plans in terms of enhancing the distribution and service capabilities in the wealth management area particularly in '04?

Yeah, Todd, I think the positive trends is -- has been revenue-driven certainly in the fourth quarter. As I mentioned I think revenues were up to 21.5 from the mid 20s.That gave gives you a run rate for the year of 84 million relative to the prior year roughly the run rate with 68 million. That's in part driven by acquisitions but it's also driven by organic growth. I think we're doing better on the sales front. I think we have the organization at this stage more focused.

With respect to the noise that you site that were two principle charges basically, one was obviously the severance charges associated with loses departure in the third quarter, the second one was a technology termination fee, which I had mentioned which is about $525,000, which frankly due to the very good work of the people involved turned out to be considerably lower than we would have thought but that was designed to put us on a better footing on the technology front.

In 2004, I think we'll continue to look opportunistically in particular at acquisitions. Some of the people every once in a while we look at firms as well but it will be designed to fulfill two goals. One as you say to enhance distribution and service with respect to people that we might be able to acquire.

Secondly, as we look at it there may be niche product areas that we'd like to try to fill too. Our business as you know is composed of both personal and institutional. There are varying demands in those areas and we look at both principally because we're involved in both and I think it's important to try to grow both. But as I said I've been encouraged not only by the trends in the fourth quarter but also my sense of the momentum we're developing internally and people's greater confidence in our ability to achieve not only additional growth but also profitability in that area.

OK. You mentioned the increasing cost of compliance.

Yes.

Is that -- can you give us a little bit more color there?

Yeah, I think that revolves around the holding company, basically -- revolves around the holding company. The Fed in particular and other bank regulators on the heels of the SEC and some of the things that have happened and there have been circumstances in the banking area that I think have given them some pause. Obviously our neighbors across the street had a huge problem at one point, which I think got people's attention and they become much more aggressive on the regulatory front.

I think the regulators by and large in the past were most interested in how was that you performed. And to the extent that you performed well, they were willing to give you the benefit of the doubt. I think they've concluded that at the end of the day process is as important as performance and to the extent they can't understand based on the process you got in place how do you generate that performance, they want to understand it better.

We are in the process here notwithstanding our historic very strong performance and very strong regulatory position of in fact just documenting a lot of processes that in fact led to that performance but in some respects had not been fully institutionalized in terms of being setting pen to paper and having everybody share a view. I think it's just an increased focus on their part on risk in particular, whether it's credit risk or operational risk or market risk and they're asking people to take additional steps to ensure that they handle them properly.

The most vivid example of the regulators' increased focus in that area for me at least has been fifth third about, which I don't know a lot of details other than what have been published but fifth third as you know has been one of the best performing banking institutions in the United States over the last 10 years and they ran into some reasonably serious issues with regulators it appears based on their risk management systems.

If I could just follow up on that. On the flip side, have you noticed -- are you seeing any opportunities from a revenue perspective as some of this kind of shakes out in the industry?

We're hoping. And in fact we have on an opportunistic basis launched some advertising campaigns trying to highlight our integrity, reliability and dependability especially in the investment wealth management front on the back obviously of some of the issues in the mutual fund industry. I think it's always very difficult to tell whether in fact you're benefiting from it or not. But we like you have identified that as a potential opportunity.

Great. Thanks very much.

Sure.

Thank you and our next question is coming from Claire Percarpio with Janney Montgomery.

Hi, Claire.

Hi, Ned. Couple of questions. You mentioned feeling encouraged in the wealth management area. And if you could go into a little bit of detail there other than, you know, market lift as to what -- what's giving you encouragement?

And then second, net interest margin was a bit wider than I was expecting. The average securities portfolio balances were lower. So the dollar, you know, the net interest income was sort of what I was looking for. I'm just kind of -- I don't know if I was just off on my estimates as I can be or was there, you know, sort of intentional shrinking in the securities portfolio?

And then third, if you could comment on any share buybacks. And if I you could go out with some guidance on the net interest margin that would be great for the next quarter or two anyway?

Claire, let me go back, let me go to the first point. I think on an average balance bases we have not intentionally trying to shrink the securities portfolio. Having said that as we have incorporated F&M, we tried to look at the portfolio, frankly conform it to what we do and it may be as part of that the numbers fluctuate. But there is no intent on that front. No conscious effort essentially to reduce the size of it.

As you can see we fortunately have been in the position where our Fed fund fold number has gone down, which has helped us obviously on the margin front. And in generally it had been helped by the fact that refinancing have slowed. We're still very liquid fortunately but given the pickup in loans, given some of the other dynamic I feel actually better about how it is that we're deploying our liabilities in the form of the assets. With respect to projecting net interest margin, as you know Claire I've been a miserable failure at that over the last couple of years, unfortunately. I think our view has been as we said I think in the third quarter that if the market stabilized we thought the net interest margin would stabilize.

The fact is if they improved slightly from our perspective in terms of the slowing and refinancing and our being able to generate some loan growth, so we were able to get a 9 basis point pickup in the margin. I hope to the extent that loan growth continues as we saw it in the fourth quarter that the margin should continue to improve. As you know from my comments I think we got as you know notwithstanding the fact that we've had conversations about this back and forth and I think there's a difference in the view of degree, not in kind with respect to our leverage in connection with increases in interest rates it's very substantial.

On the investment and wealth management front I think what encouraged me most Claire is just the fact that we are selling more. Unfortunately or fortunately only a third of our assets are in equities so whatever happens in the equity market has an impact but not as great it might on others with a higher concentration of equities. But if you look at what we did during the course of 2003, for example, we had 600 million in asset sales and 2.9 million in revenues and that compares to 2002, for example, where we were able to sell 450 million in assets and 2 million in revenues. So we are in fact generating some greater momentum just in terms of attracting new clients, which I think is the most important thing for me.

The other thing as we discussed in connection with the third quarter earnings is that I think we now have greater focus in terms of what it is that we're trying to do. We are a niche product player. We are in fact a service and distribution oriented firm. Trying to offer the best advice that we can. And I think we're now going down that path.

One other thing I might mention there, Claire, that as you know historically we had done nothing to leverage the affiliate network in connection with invest and wealth management. There have been very encouraging signs of progress on that front as well as we've deployed a team to tried to do more on what might be broadly construed as the retail front in terms of our funds through the affiliate network and they are very good early signs on that. Very good early signs on that front as well.

Thank you. And any comment on share buybacks?

Yes. One of the reasons that I mentioned I will probably give you my standard answer but being as astute as you are I'm sure you realized I mentioned the tangible asset ratio for a reason. It was 951 average, it was 978 at period end. As I've said before we clearly have the capacity of something that we look at very intently.

Thank you.

Thank you. Our next question is coming from Gary Townsend with Friedman Billings, & Ramsey.

I didn't want to disappoint you with that share buyback answer, Gary.

No, no, you didn't. I think described it once as a monument to clarity or something. But you did it again. It sounds as though you're quite busy retooling, reengineering the F&M bank corps bank structure. How much more in the way of any color that you could add on that but specifically how much of the cost saves have you already realized, how much more can we expect in coming quarters?

Well I think as you know, the 26.5 million -- let me take your first question first. We plan to close 21 branches. We have closed 18 of them. One of those additional closings may be deferred for some time, for business reasons. The other two will go and one is the sale. The fact is that I think we should get that done in the first quarter of 2004. That may result in net addition penny of charges. That is the incremental merger related charges we may have in 2004. With respect to the rest of it, we're done. So if you take the 26.5 million in cost saves which, as you know is essentially an annualized number, we believe that should begin to flow through on a quarterly basis during 2004.

And how much might have been reflected already in the fourth quarter is another way to ask that?

It's hard to say. We think in part as you know given how we incorporated F&M, it is very much an art rather than a science in terms of actually looking at run rates third quarter versus fourth quarter and determining how much there was. A bunch of the people that we let go in fact were let go during the course of the fourth quarter on sort of an average basis, as you know the other things that we did in terms of branch closings and tech were staggered as well.

We think the decline on an apples-to-apples basis third quarter over fourth quarter were the first early signs of those cost saves but we also believe that they should come through much more prominently in connection with the first quarter because we have in fact laid the vast majority if not virtually all the groundwork for realizing them during the last two quarters of last year.

Thank you very much.

Sure.

Thank you and our next question is coming from Ariel Whitman with Sandler O'Neill.

Hi, Ariel.

Hi, Ned, how are you?

Fine, thanks.

My question focuses a little bit on the landscape, and it's two fold. Your comments were that it's unlikely that we'll expect to see additional acquisitions given the pricing of them. If you could share with us your thoughts on the novo branches and what areas and then maybe tie that into little bit discussing the competitive nature of the landscape and anything with respect to the first Virginia fallout or any other acquisitions.

Yeah. I think we still -- and again, Ariel, as you know, as I've said before and as I mentioned in connection with Todd's question, it's very difficult for us to discern how much we benefit from the fallout of acquisitions or other industry trends. We can see business we get, usually a mixed motive in terms of how we get it but we still see signs of picking things up as a result not only of first Virginia but M&T offers as well, which is to be expected. Part of that may have happened anyway.

With respect to your question about the landscape, we continue, no surprise, to look at deals in areas and we think make sense for us. I think all of us have been stunned by some of the prices that have been paid. And it has caused us in each case, obviously, with no announcements, to back off. You know, there were some those deals that might very well have been made sense as a strategy and tactical matter but were difficult for us to justify. Also frankly we had due regard to people's concerns about fully incorporating F&M and realizing the benefits of that before we did anything else.

Sure.

I think the interesting dynamic in the market as a macro matter as you know there's a fair amount going on across the top. I think that generates some pressure on those just the level below that in terms of deciding what they want to do. I think as they think about it they may choose to do acquisitions themselves. And then the level below us frankly if you get to the smaller banks I think you've got a bunch of people who are concluding that they might have a double dip opportunity if they sell and some others who are concluding that I better bulk up in order to make myself attractive to that super regional group as a potential target. And I think that's generated, you know, some very fulsome and to some extent one could argue some very aggressive pricing in connection with those acquisitions.

On the de novo branching front, as you know we've opened one Washington, D.C. and four in northern Virginia. We may open two more in northern Virginia during the course of 2004. We're looking at them. That's long been an area of focus for us. I believe the market there in one respect is very fragmented especially at the lower end. All the big players are there but when you look at the number of smaller players, community-type players such as we are or midsize players there are relatively few at this stage. We have historically done a fair amount of business there and had some very good clients. I believe that we can capitalize on that and grow it and for what we offer, which is as you know niche middle market lending I think we can do very well in that market.

It is a huge market, roughly 5 million people. I think it's currently the sixth largest market in the United States. It's 40, 50 miles away and from some of our affiliates it's just across the river, it's an obvious opportunity for us and one I think that we'll continue to pursue. As we look at those costs associated with opening the branches and staffing them up, they are not huge. I think the staffing costs, my recollection is we've looked at it are a couple of million dollars I'm not even sure what the capitalized costs with respect to the branch is but it strikes me as a far cheaper alternative to growth in that region than paying some of the prices on the acquisition front that people seem to be commanding.

OK. Thank you, Ned.

Sure.

Thank you and our next question is coming from Chris Matusiyo (ph) of Legg Mason.

Hi Chris.

Good morning Ned, how are you?

Fine, thanks.

Good. Ned, if I exclude the 4.7 million in M&A charges in the quarter, operating expenses are pushing about 52% of revenues, which is up from, in my calculations are correct from about 350% in third quarter '03. Can you kind of give me some thought, another way of looking at expense on where that ratio may be going? I purposely included in that number the amortization of intangibles because that's going to be there for some time so I kind of want to know on a poor man's operating efficiency ratio what we can expect in '04?

Well Chris I think there are two other things you've got to keep in mind there actually and I don't disagree with you on the amortization, I can understand why you might look at it that way but just to question it and you included or excluded for that purpose the incremental cost before run rate of F&M obviously otherwise you wouldn't have gotten to that number.

The other two factors as I mentioned is direct to deferred comp which is another 871,000 I think is the delta between the third and the fourth quarter. We planned to something about that. We're going to figure out how to do it 'cause you know that number has jumped around wildly from 100,000 roughly to over a million in terms of the pretax impact so we're looking at that.

Right.

But I think in terms, general drift of your question which is I think is right. I've said for some time as we continue to make investments in this firm, whether it's an investment in wealth management, which is you know historically has had a higher efficiency ratio if you will than the banking industry generally or in connection with an acquisition as significant as F&M, which had a higher efficiency ratio than ours it probably will drift up. I think the fact is that our intent is try to keep it below 50%.

On an operating basis as we calculate it which did exclude the amortization but we looked at it just on a cash basis, rough numbers 50.9, which is 51 for the fourth quarter. And we would like to get it back below that. If I'm right about where we are with respect to F&M, we should be able to get there. And I can tell you that we have a renewed focus especially given F&M on expense area given compliance, given the investments we want to make, given our investment and hopeful success in investment wealth management is going to be awfully difficult.

On the deferred comp what kind of things can you do and how soon can that be done?

I wish I were more of an expert on it but we've been looking on it for a couple of quarters. Terry's been working on it. I think there are fortunately some of our ingenious friends in the investment banking industry have come up with ideas. We're actually looking at some potential insurance alternatives. I think we should be able to get it done we're going to try to get it done sometime in the first or second quarter.

Thank you very much.

Sure, thank you.

Thank you our next question is coming from Dawn Gilbert of Ryan Beck.

Thanks. Good morning, Ned. Couple questions, there's clearly a theme on the expense side and one of my questions follows up on that. Do you know what percent of your operating expenses is attributed to the investment and wealth management division?

If you give me a second to think about that I can probably tell you. It would be the percentage of operating expense there would probably be -- let me just think where they were. I can't tell you that off the top of my head but I can't imagine it's much more than 10, 12%.

OK. Do you see that percentage changing? I mean, as you -- certainly this is an area you're going to expand and -

Yes, as revenues change I hope so. I mean, obviously our principal objective during 2004 is to try to make sure revenues grow faster than expenses but I think so your point's a fair one, you know, with respect to the efficiency ratio overall at the end of the day investment in investment and wealth management until it gets considerably larger will not have that much impact. Having said that it's having a drag right now because we've had expense exceeding revenues if you see what I'm saying.

Right.

I think we can get it back below even consistent with doing some acquisitions of firms for whatever reasons tend to be more retail oriented have higher efficiency ratios than we do. Our objective, our goal is to try to get that number below 50. But as I said I have no aspirations because I don't think it would make sense in our current context to get back to the mid 40s.

OK. OK and then just two more quick questions.

Going back to it, it's 15%.

15%.

Terry checked for me to have.

OK, thanks. And then in terms of the mortgage banking, while it's down obviously from the third quarter but it's certainly nothing like at least I've seen some of the companies that I follow because some people are seeing 50, 60% drops, do you - or have we not seen the worst of it, what's your sense for the outlook for the mortgage banking business?

It's interesting, we've had a long -- we've had a long internal debate about that as a matter of fact. And my view has been, as you know, that we have not historically done enough on the mortgage front within the banking network. And by that I mean we haven't made enough mortgages. We simply haven't originated enough, held enough for our own portfolio. Our percentages have been well below some of the others.

With the addition of F&M and with the addition of mortgage banking business they've got I think the opportunity is huge for them to penetrate our network generally. So if you look at it appears-to-apples I think the opportunity for the F&M business to grow in the context of Mercantile as a whole and given our appetite for additional mortgages is pretty considerable. And that should take the edge off of any secular decline in the business, which you're seeing elsewhere principally because of the additional opportunity we've got in the network.

OK. OK.

As you know, we had -- what I would describe as sporadic and skeletal. You know, with respect to our interest in generating mortgage loans. It was done principally by the affiliates on a one off basis by each of them and we're trying to bring greater sense to that from a holding company standpoint realizing we're willing to buy mortgage securities from a securities portfolio, which should be particularly willing to originate sensible mortgage loans.

OK and then my final question is just, do your budgetary purposes are you factoring a rate hike at all in '04?

No.

OK, all right, great. Thanks, guys.

Sure, thank you.

Thank you. Our next question is coming from Ross Demorrow with Hilliard Lyons.

I was answered.

Hey, Ross.

The other question was answered, thank you.

Thank you sir. We will move on to Henry Coffee with Ferris Baker Watts.

Hello, everyone.

How are you?

Great. As you build up at the holding company level and start taking a more detailed look at the franchise as a whole, are there any large technology expenditures likely to come out of this process?

No. Not that I'm aware of. Having said that I've also been clear in the past that we have no aspiration to be cutting edge on the technology front. We will be strong followers and very responsive to our customers' interest but I don't see any significant technology -

Are the branches within the various holding -- I mean, within the various banks, are the branches able to communicate?

Frankly, not as efficiently as we would like. One of the things that we have trumpeted in the past and as we looked at it in the cold light of day in connection with F&M is what we call seamless banking as between, you know, our affiliate network. That banking is less seamless than I would like it to be. I'm not sure at the end of the day there may be some technology improvements there. I think part of it frankly has to do with just getting people to focus on the fact that we would like a customer who walks into a Potomac valley branch to have the same access to his account and information as he does if he's an F&M customer in Frederick who happens to commute to Washington if you see what I'm saying. So we're focused on that. I don't think at the end of the day I don't think that those technology expenses other than what we do as a run rate matter to ensure we keep abreast of what makes sense are going to stick out.

Does that lead to maybe a branding campaign?

It may very well, as a matter of fact and one of the things that my good friend and colleague Alex Mason's been looking at since he's been here is how it is we can leverage the Mercantile brand through out the network more effectively than we have past and in particular in connection with our ventures in Washington and northern Virginia.

Thank you.

Yeah.

(Operator Instructions). Our next question is coming Christopher Marinack with FIG Partners.

Hi Ned, how are you?

Chris, I wondered where you were.

I'm here. A question on the timing of acquisitions on the bank side, do you feel that you're ready to do that soon or when would be an appropriate time to kind of make that -- all things being equal?

It's the perfect time from our standpoint frankly mid-year. Could we do one now if it came to us? Yeah. I think people would be not stretched but would be potentially fatigued, you know, having just gotten through the F&M one but I think they could do it. I think the great news about F&M from our standpoint Chris was we actually now have a bunch of people who have been through it, I think done it reasonably effectively and therefore feel prepared to do another one. But at the end of the day, if I had my absolute rather as I'd wait another couple of quarters.

Ned, you've seen cycles like this before. How would you portray where we are now with not only pricing but also sort of the sense of urgency from your personal?

I think there's a lot more activity than there was, you know, is my own sense of it. A lot of that is indirect. Just in terms of chatter that I hear and conversations that I've had not directly about any interest of ours. I think there's a lot of people assessing their options at this stage and I think that ranges from the top of the market all the way down to the bottom in terms of people thinking about what it is that they might be able to achieve on their own, versus getting an acquisition premium and then potentially getting another one and in some cases even getting a third one.

And it's not unlike, in some respects, the beginning of the mid-'90s, as people looked at these pricing parameters and said, my goodness, it's going to be awfully difficult for me to get there on my own and in addition to that if this keeps up I might very well find myself in a position to generate two or three premiums. And I think that's gotten people's attention. I don't think it's reached in any way shape or form the level of fervor that we reached in the mid '90s but it wouldn't surprise me to see it get there, especially since, as you know, to the extent the economy improves and rates begin to pick up, that may be good for us but it's not good for everybody.

From the standpoint of new entrants coming into your region, thinking of commerce as one example, does that make any difference as to how your folks are operating or game planning in the future?

No. I mean, just entirely different markets for us. I think commerce is as near as I can tell fabulous job, I don't know much about them, obviously they have done great job growing the liabilities side of the balance sheet. They are clearly very service oriented, they make a big splash, they got a great marketing campaign. But from our standpoint, given kind of banking we do and what we focused on I think it would be interesting to see them in the market but I can't imagine frankly it would have that much impact on us.

Great Ned. Thank you.

Thank you.

Thank you and the last question is a follow-up from Ariel Whitman.

Hi, Ned. Thank you for taking this.

Sure.

I just have one question, which focuses on your comments with respect to the investment portfolio.

Yes.

And your 40, 20, 40 percentage breakdown. Can you just share with us, you know, why you think that that's the best percentage and why that breakdown is ideal?

To be honest, Ariel, it's arbitrary. You know, I think it's arbitrary in the sense that we have obviously coming a long way from effectively being 100% treasuries. In order to avoid shocking people like your selves and other investors we've try to maintain a conservative stance. It is important to maintain liquidity and this firm historically that be conservative.

I thought as initial cut getting to 40, 20, 40 and we're now slightly out of line with that but not very much made some sense. We're going to continue to assess the return profile and cash flows of the portfolio. To the extent we choose to change that, you know, we'll certainly let you know. But to be blunt about it there was no science in it, it's just where we've decided we would try to get and we've gotten there.

And you got there. OK. Thank you.

Ladies and gentlemen, I'm showing no further questions in the queue. Do you have any closing comments?

I don't. Thank you very much.