Muddled Market Befuddles Brokers

Like college kids heading into a new semester, brokerages were hoping everything was going to be new in 2002. Trading revenue would rise, initial public offerings would roll out the door and corporate chieftains would get back to playing the merger and acquisition game.

Alas, none of this has come to pass, and it's shaping up like another dry season for the brokers. After closing out an otherwise dismal 2001 on a good note, the brokerage stocks have fallen this year. Moreover, because observers say the fallout from Enron could further dent M&A activity, things may get only worse.

Analysts lately have been trimming back their numbers on the brokers. Tuesday, Robertson Stephens' Justin Hughes pulled in his 2002 estimates on Bear Stearns ( BSC), Goldman Sachs ( GS), Lehman Brothers ( LEH), Merrill Lynch ( MER) and Morgan Stanley Dean Witter ( MWD), citing the weakness in equity trading, equity issuance and M&A activity this year.

This followed an estimate reduction Monday by ABN Amro's Robert Napoli for Goldman, Lehman, Merrill and Morgan Stanley, for pretty much the same reasons. (Hughes and Napoli also reined in estimates for Schwab ( SCH), which unlike the other firms draws nearly all of its revenue from trading activity.) Bear, Goldman, Lehman and Merrill were down about 1% Tuesday; Morgan Stanley was up modestly.

With the stock market bogged down, it's hard to imagine what it would take to pull the brokers out of their rut, according to Julius Baer Investment Management's chief investment officer, Brett Gallagher.

"We don't have any positions in the brokers now, and haven't had any for well over a year," he says. "I'm not even going to look at the valuations on them until the fundamental picture becomes clearer."


Bearish
Bear, Lehman, Merrill off in 2002


It's hard to see that happening without a real turn in the stock market's fortunes. Dollar volume on the New York Stock Exchange was down 15% in January, and February doesn't look as if it will be much better. Coincident with that, the appetite for new equity offerings has further foundered. Witness how anxious Salomon Smith Barney was to get PayPal ( PYPL) out the door, when, with hindsight, holding off and addressing investor concerns seems as if it would have been more prudent.

The biggest hit to the brokers, however, is the steep reduction in M&A activity. Besides making up a big portion of revenue (25% at Goldman, for example), M&A is also a high-margin business that delivers an outsize portion of the brokers' earnings.

"I don't think M&A is going to rebound until 2003," says ABN-Amro's Napoli. "Maybe not until mid-2003." Napoli's only buy-rated broker stock is Merrill; Goldman Sachs and Lehman rate add and Morgan Stanley gets a hold. Napoli doesn't own shares in any of the companies, and ABN-Amro has done no recent underwriting in the group.

Napoli worries that M&A could be even worse than the poor trading environment and still-weakened economy suggests. After Enron, investors have a newfound love for one-business companies whose balance sheets they can understand. Highly acquisitive companies have fallen on hard times, as typified by Tyco ( TYC), whose stock has slid amid accounting accusations. The fall of many of the deal-obsessed conglomerates may in effect deter other companies from making deals -- in part because they don't want to be tarred with the serial-acquirer brush and in part because sliding stocks aren't very good currency.

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