M&A Thaw Won't Melt Deep Freeze for Brokerage Stocks

The recent rash of multibillion-dollar mergers has warmed investors to the idea that corporate America is shaking off its slumber. But while the spike in activity may have psychological importance for investors, it probably isn't enough to lift the shares of the companies who arrange the deals.

"I think it's too early to tell," said James Mitchell, brokerage analyst at Putnam Lovell Securities. "It's a positive, but I'm not sure if it really gives you, or implies, a real rebound."

Brokerage firms get a big chunk of revenue from advising and financing M&A. Like the other segments of the investment banking business, success is tied to the economic and profit outlook; companies tend to expand when they're doing well. For that reason, M&A volume has dropped sharply, as strapped companies have pared expansion plans and investment initiatives.

According to Mitchell, announced M&A volume in the fourth quarter fell by 30% from the third quarter, although the number of completed deals was unchanged. Year to date, the announced volume has tumbled 45% from 2000. Glassman estimated that for a firm like Goldman Sachs (GS), M&A revenue makes up about 20% of overall 2001 investment banking revenue, which includes underwriting and trading.

Several multibillion-dollar deals were announced on Wall Street Monday. The biggest was Amgen's (AMGN) agreement to acquire rival Immunex (IMNX) for cash and stock worth about $30 a share, or $16 billion in sum.

Investors also cheered Vivendi Universal's (V) plan to acquire the entertainment assets of USA Networks (USAI) for about $10.3 billion in cash and stock. It was Vivendi's second big global foray in a week after it agreed to invest $1.5 billion in Echostar(DISH).

Meanwhile, P&O Princess Cruises (POC), rejecting an unsolicited takeover proposal from Carnival (CCL), reaffirmed merger plans with Royal Caribbean (RCL). Over the weekend, Carnival entered the fray with a hostile $4.5 billion offer that P&O rejected, citing among other issues greater "regulatory risk" in Europe and the U.S.

Also Monday, Cendant (CD) agreed to acquire vacation timeshare seller Equivest Finance (EQUI) for about $100 million. It will also assume about $60 million of debt.

And pipeline operator Kinder Morgan Energy Partners (KMP) announced it was buying Tejas Gas, a wholly owned subsidiary of Royal Dutch Shell (RD) and Bechtel, for about $750 million in cash.

Lost Our Lease

Analysts say overall M&A trends still reflect a sluggish business environment. "A lot of companies, given the economic slowdown, have been in trouble, and need to sell," said Mitchell, adding he's noticed more forced sales to generate cash and offset debt, compared with the more robust investment environment three or four years ago. "You're not seeing some of the more aggressive or growth-oriented acquisitions materializing," Mitchell said.

Capital markets have also become tighter, and many firms are finding it hard to get financing for research and development purposes, Mitchell said. The Amgen-Immunex deal, for example, reflects a trend of smaller firms that "hook up with bigger firms that have bigger balance sheets," Mitchell said.

"I don't think you're going to see a real and significant uptick in some of the capital markets businesses, including M&A, until 2003," Mitchell said.

High Tide

Brokerage stocks have seen their shares rebound with the rest of the market since mid-September. Morgan Stanley (MWD) is up 31% since the market hit its lows on Sept. 21, while Merrill Lynch (MER) has soared 35%. Goldman Sachs (GS) has gained about 33% over the same period.

But concern has surfaced that the stocks ran up too quickly on hopes of recovery, a lot of which has already been priced in, said Diana Yates, analyst at A.G. Edwards & Sons. Mitchell thinks the stocks, which are trading at around three times price-to-book, aren't cheap right now, and that investors should pay heed to valuations and the sector's earnings potential.

On Wednesday, Morgan Stanley will report its fourth-quarter results, while Thursday brings earnings from Bear Stearns (BSC) and Goldman Sachs.

Reilly Tierney, senior vice president of Fox-Pitt Kelton, believes a meaningful turnaround in the brokerage business won't come before the second half of 2002.

"It seems like the market has greeted any large M&A deals in recent months unenthusiastically," said Tierney, citing Hewlett-Packard (HWP) and Compaq's (CPQ) troubled $22.8 billion merger proposal as an example.

"I think investors believe we're not really through this current cycle of earnings disappointments and downsizing," Tierney said. "And companies have to get their own house in order before they try to get somebody else's house in order."

Mitchell believes only an economic recovery could lead the M&A business out of its blight. "I don't see a real boom indicated by the current couple of deals we've seen," he said. "You'll need a growing economy again, and it's going to take a few quarters after that before you see companies being comfortable about being aggressive."

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