Downgrade Pounds Brokers, but Rate Cuts Could Ease Pain

A cloud of disappointment hung over the financial sector Wednesday after prominent Merrill Lynch analyst Judah Kraushaar slashed first-quarter profit estimates for leading brokers. But with a rate cut still likely at the Fed's meeting in three weeks, some observers think these stocks could soon rally.

Topping the list of big decliners on the New York Stock Exchange Wednesday was Goldman Sachs (GS Quote), which was down $5.49, or 5.6%, to $92.85. Tagging close behind were Lehman Brothers (LEH Quote), down $2.88, or 3.9%, to $70.27 and Morgan Stanley Dean Witter (MWD Quote), down $3.79, or 5.4%, to $65.87.

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Kraushaar cut first-quarter estimates on all three based on the expectation of weak commissions from retail trading, lackluster advisory fees and pressures on private-equity investments. The market sat up and took notice of the moves, judging from a look at the American Stock Exchange Broker/Dealer Index, down 3.9%. It didn't help matters that Alan Greenspan today put to rest the much-desired notion of another intermeeting rate cut from the Fed.

Still, on the silver-lining side, many of these brokers will get a boost from further rate cuts. Lower rates reduce financial institutions' funding costs and improve lending margins. And unlike banks, the brokerage houses tend to lack the sort of credit exposure that costs banks in an economic slowdown. Kraushaar himself pointed that out in his research note, conceding that the potential for first-quarter disappointments and possible rate cuts poses "a tug of war" for investors in broker-dealer stocks.

"The benefits of a Fed easing [include] the liquidity it gives back to the fixed-income market and tightening credit spreads, [which] mean a greater ability to issue debt," says Joan Solotar, banks analyst at Credit Suisse First Boston. "Over a longer period of time that tends to spill over into the equity market and opens up a window for more equity underwriting." She adds that "I think the lowering of estimates was probably appropriate, given that it reflected the first quarter. Now we're mostly through the quarter, though."

"On balance, we think the benefit of lower rates will ultimately win out, and we are more inclined to accumulate these stocks selectively even knowing that broker-dealer consensus estimates likely will fall in coming weeks," wrote Kraushaar.

The Amex broker/dealer index shot up 32% in December and January amid the first round of rate cuts. In February, the index handed back about half of that gain. Odds are there will likely be another swing higher as the Fed's March 20 meeting nears.

"Most of these [stocks] are getting to valuations where they're starting to get attractive again," says James Mitchell, banks analyst at Putnam Lovell. "Still, the trading business in February has been pretty sluggish. Retail brokerage is not looking good. I'm a little wary that the brokers with the big retail operations won't rebound as quickly as the institutional side."

Mitchell adds that in the near term he expects brokers with solid fixed-income businesses to hold up well, including Lehman Brothers and Bear Stearns (BSC Quote). (Mitchell rates Lehman a buy and Bear a hold, and his firm has no underwriting relationship with either company.)

Merrill cut Lehman's first-quarter earnings estimate to $1.39 from $1.46, putting it 7% below the current consensus. On the upside, the 2001 estimate rose to $6.20 from $6.05.

Kraushaar cut Goldman's first-quarter earnings per share view to $1.18, putting it 15% below the consensus, and lowered 2001 expectation to $6 from $6.15, citing weaker-than-expected profits at the Spear Leeds & Kellogg clearing unit and pressure on the private-equity portfolio.

Merrill raised Morgan Stanley's first-quarter profit estimate to 88 cents from 79 cents, though its EPS view remains about 15% below consensus. Merrill cut Morgan Stanley's 2001 estimates based on the expectation of private-equity losses and weaker trading commissions. "However, we are hopeful that lower interest rates and narrower spreads in fixed income may give MWD an unusual boost in trading results 1Q/4Q," Kraushaar said.