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Merrill Lynch Walks on Street's Mild Side

Lacking a big commodities desk, earnings won't be huge, but they should be solid.

Investors who have gotten used to blowout numbers from brokerage firms this quarter will probably be disappointed by

Merrill Lynch


. Ultimately, however, it's a good thing.

The latest quarter has been all about trading on Wall Street, particularly trading in bonds, commodities and currencies. For Merrill Lynch, those are not strong suits, and analysts are warning that company's results, due before the bell Tuesday, will be decent but not blockbuster.

Merrill bulls aren't overly worried. A shortfall in trading revenue in assets like currencies and commodities, they say, will make for a more stable company in the long run. With Merrill's retail group being one of the best on Wall Street, the stock could be one of the securities sector's safest bets, particularly if an economic downturn comes to pass.

"The beauty of retail, unlike investment banking, is that it has massive operating leverage," said Brad Hintz, equity analyst at Bernstein Research, "Buying into a retail company is a late-cycle play in terms of the economic cycle. Retail companies do well late in the cycle because the operating leverage really pushes up the margins."

In the near term, Merrill has a few strikes against it. Bond, currency and commodity trading hasn't been a barnburner group at the firm, even as it was the main reason for success at other brokerages. At

Goldman Sachs


, revenue in its fixed-income, commodity and currency group rose 50% in the first quarter from a year ago and was up 125% from the prior quarter. FICC contributed almost 40% of the firm's total revenue.

Merrill Lynch, however, decided to slim down its corresponding group a few years back, something that isn't uncommon for banks when the fixed-income market isn't doing well.

"They made the mistake of getting out of that business," said Richard Bove, equity analyst at Punk Ziegel & Co. "They are trying to rebuild it, but they aren't going to do it rapidly."

Adding to the woes, Merrill will record a $1.8 billion pretax charge in the first quarter associated with the adoption of SFAS 123R, the modification to how companies account for existing stock-based awards. Merrill Lynch's competitors also had this charge in the first quarter, but in every case, it was far smaller than the one Merrill is planning. (Notably, the existing Thomson First Call earnings consensus of 32 cents a share for Merrill's March quarter incorporates the charge.)

Despite the snag, analysts are confident in Merrill's performance in the near term.

"In days when trading is bad, firms post miserable results. I do think that

the lack of FICC trading is a weakness for Merrill Lynch because trading is the most exciting and fastest-growing business for brokerages," said Bove. "But arguably it makes Merrill a more stable business."

As analysts see it, the main motor at Merrill Lynch is still humming, and management is making the needed decisions to ensure growth in the coming quarters. The highest-profile move the company made was the sale of its asset management group to bond fund manager



in return for a 49% stake in the combined firm. The market honored that move, pushing shares up $9.86, or 14.6%, to a recent quote of $77.59 since the beginning of the year.

Analysts also applaud Merrill Lynch's retail banking group, which is considered to be one of the finest on Wall Street. The strong retail division can give stock investors security in the coming quarters if banking and trading don't continue their robust activity through the end of the year. According to Hintz's estimates, Merrill's retail business adds 42-cent pretax income for every dollar of additional revenue, margins he predicts will keep up even as the market's growth subsides. UBS' recent purchase of Piper Jaffray's retail group shows the market is confident in the business, he said.

Recently, Merrill Lynch's private client division faced-off against Morgan Stanley in a courtroom battle after several Merrill employees followed James Gorman, the former head of the group, to Morgan Stanley. Merrill accused Gorman of breaking an employment contract that would have prohibited him from luring employees to Morgan Stanley. Ultimately, the court ruled against Merrill Lynch, but analysts have a hard time saying that anything, including Morgan Stanley, can dent Merrill Lynch's retail success.

"Merrill Lynch has over 15,000 salespeople," said Bove. "No one else in the industry can touch that."

Hintz echoes Bove's assertions. "There is nobody that dominates retail distribution like Merrill Lynch."

While earnings for Merrill Lynch this quarter probably won't be as strong as some of its competitors, analysts aren't expecting a disaster. While the 32-cent consensus EPS estimate is down about 70% from a year ago, the reason is the accounting charge, something most analysts don't consider economically pertinent.

Without the item, Hintz is estimating Merrill shareholders will make $1.58 per share, up 7 cents per share from the fourth quarter. The slight increase is pale in comparison to Goldman's and Morgan's results. But in the uncertain business of Wall Street, depending on stability isn't always such a bad thing.