Sector Spotlight: For Brokers, Nothing to Underwrite Home About

Brokerage stocks bolted up more than 20% over the past few weeks as investors considered interest-rate cuts cause for celebration. But with core brokerage businesses still under pressure and just a few weeks left in the quarter, experts are worried that earnings won't live up to the hype.

As financial companies muddled through difficult fourth- and first-quarter earnings, the common theme seemed to be wait till next quarter. Despite an uptick in certain segments in the latest week, consensus estimates have been trending down as the much-hoped for rebound in merger-and-acquisition, underwriting and trading fees failed to materialize. Investors are hoping there's still enough time for profits to pick up, but there is good reason to be skeptical.

Toweling Down

"We had been previously unwilling to throw in the towel on full-year earnings based on one quarter's worth of data," said Putnam Lovell banks analyst James Mitchell in a recent report. But citing "a continuation of the negative investment banking trends" and a trading environment that "appears materially worse," Mitchell this month cut 2001 and 2002 estimates on a group of major names including Lehman Brothers (LEH Quote), Morgan Stanley Dean Witter (MWD Quote), Goldman Sachs (GS Quote) and Bear Stearns (BSC Quote).

(Mitchell lowered his short-term rating on the sector to hold. He rates Lehman, Morgan Stanley and Goldman Sachs buy and Bear Stearns hold. Putnam Lovell has no underwriting relationship with these firms.)

It appears other analysts are in agreement. The current Thomson Financial/First Call analyst consensus earnings estimate for Morgan Stanley's second quarter is 83 cents. That's a far cry from the $1.06 estimate at the time of its first-quarter report on March 21. One analyst expects as little as 61 cents from Morgan Stanley's second quarter. Similarly, consensus estimates for Goldman Sachs have also been trending lower, currently at $1.14, down from $1.41 on March 20, when the company posted first-quarter results.

If It's Broke... Second-quarter earnings, now and before
	Current estimate	Estimate at time of 1Q report	Year-ago 2Q EPS
Bear Stearns (BSC Quote)	$1.14	1.28	1.40
Goldman Sachs (GS Quote)	1.14	1.41	1.48
Lehman Brothers (LEH Quote)	1.22	1.29	1.39
Morgan Stanley (MWD Quote)	0.83	1.06	1.26
Source: First Call/Thomson Financial.

Lehman Brothers analysts took the step of significantly reducing second-quarter estimates as soon as first-quarter results hit the Street. On March 21, the consensus tumbled to $1.29 from $1.40 as the firm posted profits more than 25% below year-ago levels. Analysts now expect the firm to earn $1.22 a share.

Dearth and Taxes

Among the major causes for weaker profits, says Mitchell, is the dearth of merger deals, which means less of the lucrative advisory fees that boosted results in prior years. Mitchell estimates that merger-and-acquisition completions are down about 50% from a year ago this quarter. "Moreover, although the pipeline for equity underwriting continues to improve, we don't believe there will be enough volume this quarter to offset the weakness in M&A fees," the analyst says.

Indeed, equity underwriting picked up in the latest week, with a total of 12 deals brought to market, making it the second-best week of the year according to Thomson Securities Data. Five of those deals were IPOs and seven were secondary offerings. Helping raise the profile was Reuters' (RTRSY Quote) closely watched offering of the Instinet Group (INET Quote), an electronic communications network, or ECN, that matches buyers and sellers of shares. The deal, which raised $464 million and started trading Friday, was underwritten by Credit Suisse First Boston. The firm sold 32 million shares at $14.50 each, above the estimated offer price of $11.50 to $13.50.

But debt issuance suffered a reversal of fortune, dropping to $14.7 billion from $27 billion in the previous week, according to Thomson Securities Data. The drop could be due, in part, to bankers taking a break as they waited for the results of the Fed meeting on Tuesday, says Rich Peterson, spokesman at Thomson Securities Data.

Brokers seem to have numerous head winds to fight at the moment. And the run-up in valuations since early April isn't making things any easier. "Valuations are a little bit ahead of themselves, given that we don't see any real or meaningful pickup in M&A or equities," says Mitchell. "We believe there will be an opportunity to buy these stocks at lower valuation over the next three to six months."