Down and Out on the Street: Merrill Warning a Bleak Sign for Brokers - TheStreet

Merrill Lynch

(MER)

rattled the financial sector with a dismal second-quarter outlook Tuesday, but the news likely means even worse things are in store for the rest of the broker pack.

That's because Merrill Lynch reports its quarterly results about a month after most of the other brokers, including

Goldman Sachs

(GS) - Get Report

,

Morgan Stanley

(MWD)

and

Bear Stearns

(BSC)

. Those firms, whose second quarters ended in May, reported lackluster numbers last week.

But if those brokers are experiencing the same problems as Merrill, which is likely, then Merrill's warning indicates that the first month of their current quarters has been lousy, setting the stage for a poor quarter. Merrill said its second-quarter results, which will be released July 17, will be as much as 37% below the consensus expectation of 82 cents largely due to weak stock trading volumes and lower volatility.

Lower

Merrill fell $7.54, or 11%, to $58.91 Tuesday, while Goldman slipped just 65 cents to $90.30 and Morgan Stanley was off 70 cents to $63.82.

"If you think the second quarter was the trough, think again," says James Mitchell, banks analyst at

Putnam Lovell

. "May was weaker than April and June is much worse than May," he notes referring to investment banking business lines including merger and acquisitions advisory fees, underwriting and trading revenues. "Unless conditions in the capital markets pick up meaningfully in the near term, we expect third quarter earnings to be weaker than the second quarter." (Mitchell rates Merrill hold. His firm has no underwriting relationship with the broker)

UBS Warburg

analyst Diane Glossman concurred. "The business environment deteriorated in June relative to May, which suggests further challenges for the investment banks in their third-quarter reports that would include June," Glossman said in a report Tuesday morning. Warburg cut Merrill's EPS estimate for 2001 to $3.10 from $3.70 and 2002 EPS estimate to $3.85 from $4.35. (UBS Warburg has a hold rating on the stock and has had an underwriting relationship with the firm in the past three years)

As Mitchell points out, announced M&A deal volume is down more than 50% so far this year, which will lead to weak fees in the second half when the deals actually close. And with the market facing slow summer months ahead, equity trading likely will slow further. "The real negative surprise in both Goldman Sachs and Merrill's number is coming out of the equity business," says Mitchell.

Faring Better

But Mitchell says some of the multinational bank stocks such as

Citigroup

(C) - Get Report

and

J.P. Morgan Chase

(JPM) - Get Report

may fare better than some of their pure-play brokerage counterparts.

"Given the warning from J.P. Morgan on the

venture capital side and what we've seen in the past few weeks, the expectations for J.P. Morgan are pretty much in line at this point," says Mitchell (Putnam Lovell hasn't done underwritting for either bank). He thinks that the significant fixed-income businesses of Citigroup and J.P. Morgan could help offset some of the weakness in investment banking.

Following a run-up last week as brokers beat lowered earnings estimates amid interest rate optimism, Mitchell says he remains cautious on the group and doesn't believe a sustained rally will occur until there is "evidence of improved fundamentals."