Merrill Slaps Sell on LaBranche

Updated from 11:11 a.m. EST

If you haven't sold shares of LaBranche LAB already, now might be the time to do so, according to Merrill Lynch analyst Colin Clark.

In a note to clients Thursday, Clark slashed his rating on the NYSE specialist firm to sell from hold and halved his fourth quarter earnings estimate to 5 cents, citing "heightened regulatory scrutiny from the ongoing specialist investigation."

The Securities and Exchange Commission is investigating LaBranche, and the New York Stock Exchange has warned that the firm could face big fines for violating trading rules. Meanwhile, the California Public Employees' Retirement System has filed suit against the company and six other specialist firms alleging that they engaged in fraudulent trading practices.

"While we do not see the specialist system going away, we do see secular challenges from potential market structure changes over time," Clark said in a research note. "The most significant reform could potentially come with a change in the trade-through rule, such as a 2-cent "de minimis" exemption, which could open the NYSE up to greater competition from ECNs and brokers."

The trade-through rule requires traders to send orders to the exchange with the best price. For example, if an investor were willing to buy shares of IBMIBM at $90.01 but the Big Board was offering a price of $90, the electronic exchange would be forced to let the NYSE process the trade.

While this sounds good in theory, some critics say it can take up to 30 seconds to execute a trade at the NYSE, in which time the price could have changed. Electronic exchanges argue that while their prices might not look as good as those on the NYSE, the orders can be processed immediately.

The trade-through rule is under active review by the SEC right now, and some believe it will enact a 3-cent exemption rule, which has already proven to be successful in a pilot program.

"We also believe the NYSE could move toward an electronic order book over time, which could adversely impact the fortunes of the specialists by reducing dealer participation," Clark said. Specialists earn much of their revenue from principal trading in the largest stocks, he added.

Shares of LaBranche shed almost 11% Thursday to $9.75. While the stock has lost almost 50% of its value since Sept. 3, it is up some 31% since hitting a low on Nov 18, mostly due to short covering. Clark said that at current levels, the shares remain expensive, with a price to earnings multiple of 22 based on 2004 expected earnings. The historical average for this stock has been 19, he said.

Among other factors cited for the downgrade Thursday were low volatility and growing low margin program trading on the NYSE. Clark is now looking for LaBranche to earn just 49 cents this year, down from a previous estimate of 64 cents. The new forecast is still above the consensus estimate of 45 cents and Clark said his numbers could prove too optimistic if significant market structure changes occur. For 2005, Clarke is calling for a 45 cent profit while analysts surveyed by First Call are looking for just 21 cents.

The NYSE has accused specialists of violating the exchange's negative obligation rule, which requires them to "stand out of the way" when a buyer and seller agree on a price. The exchange has said it is looking into a number of instances in which specialists might have violated that rule by stepping in and buying stock from a seller at one price and then reselling it to a buyer at slightly higher price.

LaBranche says it acted properly in carrying out its duties as a specialist but the NYSE has notified the firm that it faces at least $43 million in potential liability for the trading violations.

The SEC opened its own investigation because it was dissatisfied with the pace of the NYSE probe. In fact, the NYSE seemed to be willing to impose lesser penalties on LaBranche and the other specialist firms, until the SEC prodded the Big Board to take a tougher stance.

In the third quarter, total revenues at LaBranche fell 40% to $70 million as the firm took a big hit in revenue from stock trades made for its own account. So-called principal transaction revenue tumbled 52% to $45 million.

LaBranche wasn't the only firm on Clark's hit list Thursday. He also sliced his rating on AmeriTradeAMTD to neutral from buy, citing valuation concerns. The stock has jumped sharply over the past month and has now surpassed Clark's price target.

"At its current valuation level, we believe Ameritrade shares reflect suitably optimistic EPS expectations given improving retail brokerage trends for three consecutive quarters," he wrote.

E*Trade ET received better news, however, as Clark raised his price target on the stock to $15.40 from $14. E*Trade fell 1% to $13.24 while AmeriTrade shed 3% to $14.71.