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Turbocharged Trading Numbers Push Lehman Past Estimates

The firm says trading revenue is just as sustainable as other sources of income.

Whatever happened to diversification on Wall Street?

Look at

Lehman Brothers'


blowout fiscal third-quarter

earnings, released Wednesday.


Goldman Sachs

(GS) - Get Report

, which

reported Tuesday, Lehman waltzed past analysts' profit estimates mainly as the result of turbocharged trading revenue. Other businesses at Lehman did fine, but dependence on potentially volatile trading operations was heavier in 2000's third quarter than in any of the previous seven quarters. Lehman replies that trading revenue is more sustainable than people think. The bank adds that it's misleading to focus on trading as a share of overall numbers.

Investment banks have said that they want to get more revenue from businesses that are less affected by market swings. But even though recent numbers show that diversification is progressing slowly, brokerage stocks have rallied sharply recently as a consolidation wave has swept the sector. Recent pending deals have taken place at high prices, including


(UBS) - Get Report

purchase of




Credit Suisse's



TheStreet Recommends






J.P. Morgan

(JPM) - Get Report

. It's not clear whether Lehman, the focus of much acquisition chatter, wants to remain independent. But well-diversified numbers would help the bank either sell at a good price or protect itself from predators.

Trading Places

Lehman's $1.07 billion in net revenue from trading, or so-called principal transactions, constituted 52% of the firm's $2.05 billion in total revenue in the fiscal third quarter, ended Aug. 31. That's higher than the 50% in the prior quarter, and well above the 36% in the year-ago period. Typically, 12%-15% of trading revenue comes from profits the bank makes betting with its own capital; the rest comes from much less risky customer flows, the bank says.

Lehman's Revenue Volatility
Trading revenue, in millions of dollars (left scale)
and as proportion of total revenue (right scale).
Data by quarter; most recent quarter at right.

Lehman doesn't like investors to focus on the principal transactions line, which it says is a meaningless accounting classification that it must comply with. Therefore, in its earnings releases, it also divides up revenues in its own preferred fashion, with trading revenue making up the lion's share of its so-called capital markets line.

For the past four quarters, capital markets revenue has accounted for around 60% of the total.

Infield Shift

"Capital-markets revenue is just as sustainable as investment banking revenue," says David Goldfarb, Lehman's finance chief. He adds that the bank's plan is to shift its focus toward investment banking and equity trading, which takes up less of the bank's capital than bonds.

One problem: In the third quarter, it was bond trading that did really well, as fears of interest hikes subsided and tempted investors back into the fixed-income market. In the capital markets line, fixed-income revenue of $557 million was a colossal 138% higher than in the year-ago period, and nearly 50% up on the prior quarter. Meanwhile, equities' $725 million in net revenue was 56% higher than in the year-earlier period, but only 3% above the prior quarter.

Investment banking revenue of $571 million was up 15% over the year-earlier number, reflecting strong M&A and equity underwriting income, offset by a decline in bond underwriting income. Although 31% of net revenue came from Europe in the third quarter, Goldfarb says Lehman isn't getting hurt by the weak euro. In fact, he says, its derivatives business there is doing well, as European companies now have a greater need to do currency hedging.

Lehman's numbers were good, but hardly surprising in the midst of a bull market. With stocks looking shaky again, Lehman's dependence on trading and investment banking would put it more at the mercy of a downturn than, say,

Merrill Lynch


, which gets some 20% of its revenue from its relatively stable asset management business. Then again, Merrill trades at 16 times estimated 2000 earnings, compared with Lehman's 12 times. Assuming that the markets don't continue melting, Lehman could probably sell out at Merrill's multiple, which would translate into a buyout price around $190, a third higher than Wednesday's $142.

But the ultimate question: Who wants to rely on a company that relies almost totally on