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CSFB Faces Difficult Road Back

Cost cuts and fines hammer earnings at the investment bank.

Updated from 10:36 a.m. EST

CS First Boston joined a host of other brokerages Thursday in reporting a large decline in fourth quarter earnings as it slashed expenses amid tough market conditions. Executives hope some short-term pain will deliver long-term results, but some analysts say it may take more than aggressive cost cuts to stem the losses.

"What you need is more demand," noted Justin Hughes, an analyst at Robertson Stephens. "If the equity market rebounds in the second half of this year, a rebound in IPOs will follow but M&A activity typically lags that."

The brokerage industry's close ties to the financial markets make it very hard to predict, analysts note.

Based on preliminary results, CS First Boston said it expects $1 billion loss in its fourth quarter, including pretax charges of $845 million relating to heavy cost cuts as well as fines paid to the SEC. Excluding these charges, the brokerage expects a net operating loss of $196 million.

Pain for Gain

"Although some of the actions we took at Credit Suisse First Boston had a negative impact on our short-term financial results, they have allowed us to take great strides forward in enhancing the business unit's competitiveness," noted Credit Suisse Group CEO Lukas Muhlemann.

The firm cut 2,500 jobs in the quarter, reducing costs by $745 million. Fourth quarter results were also significantly affected by weaker fixed income revenue and equity write-downs of $104 million. In addition, the company posted a pretax loss of $213 million related to Argentina and a $126 million loss relating to Enron.

For the full year 2001, the firm said it expects a profit of $338 million, excluding charges, and a loss of $961 million, including charges.

CS First Boston is the latest in a string of brokerages to report disappointing results. Earlier this month,

Merrill Lynch


reported a fourth-quarter net loss of $1.26 billion, down from earnings of $877 million in the year-ago period.

Lehman Brothers


posted a 49% drop in its fourth quarter earnings,

Bear Stearns


said earnings fell 20% and

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recorded a 61% drop in profits from a year earlier.


The sharp slowdown in M&A activity and a prolonged stock market slump forced many brokerages to unwind the excesses of prior years, when a number of companies made expensive acquisitions and overpaid their senior executives. Brokerages slashed 32,700 jobs last year, the most cuts in about 10 years.

"The revenue outlook is very uncertain going into 2002, so the best thing they can do is to get the cost structure to a point where they don't have to rely on strong revenues," said Reilly Tierney, an analyst at Fox-Pitt Kelton.

The risk, of course, is that the market comes screaming back and brokerages, particularly those that have cut a large chunk of their workforce like Merrill Lynch, are unprepared, he added.

Tierney expects fixed income growth to be flat to down 10% this year after a stellar performance in 2001. Others say global debt could fall 20%, which would reduce investment banking fees by $1.7 billion. Tierney also notes that stock offerings could fall as much as 20% this year.

"Last year was much better than people think for equity, it was down 30% from 2000 but was still the third best year on record," he noted. "We're facing difficult comparisons."

Fee for Service

As a result, many brokerages are pinning their hopes on a turnaround in the high margin M&A business in the second half of the year. Analysts say they expect M&A activity to be "uneven," although some believe it could rise 10% to 15% this year after falling about 50% last year.

Another risk to the industry, analysts note, is the increased scrutiny from the Federal Reserve and SEC over off balance sheet reporting.

"Blanket denials aren't very useful because banks and brokerages do all kinds of things off balance sheet," Tierney noted. Still, he added that most of these deals are "completely legitimate."

Despite the concerns, some analysts say they like the outlook for specific stocks in the group. Bear Stearns analyst Amy Butte upgraded shares of Morgan Stanley Thursday to "attractive" from "neutral." The upgrade "incorporates the potential risk ? and evident investor concern ? surrounding financial institutions accounting and off-balance sheet structures," she noted.

Gross Spread

Robertson's Hughes said he expects 8% to 10% revenue growth for the industry as a whole this year. Like Tierney, he expects little to no growth in fixed income but said equity issuance could rise from last year.

"If you ex out convertibles, last year was the worst since 1996 for equity issuance," he said. "So we could see a slight rebound."

Already, equity filings for January have doubled from December, are 72% higher than January last year and are a third higher than the 2001 monthly average, according to Prudential Securities.

In addition, Hughes said continued expense reduction should help the group going forward. Some 60% to 70% of a brokerage firm's total expenses are compensation-related, meaning they are "very easy to switch on and off." He also noted that the industry as a whole has not had a losing year since 1991 and has only had 3 losing years in 35 years.

Broker dealers currently trade at a discount to the broader market at a median of 14.4 times 2002 earnings estimates and 12.6 times 2003 estimates. By comparison, the S&P 500 trades at 23 times forward earnings.

But given the unpredictable nature of the markets, growing competition from commercial banks and increased off balance sheet risk, few analysts are offering glowing endorsements of the industry at this point.

The Amex Broker Dealer index has climbed almost 47% since Sept. 20 but is down about 3.5% since the start of the year.