Updated from 9:15 a.m. EDTA bleak week on Wall Street brightened a bit Thursday when Lehman Brothers ( LEH) reported quarterly earnings and revenue that far surpassed even the rosiest estimates. The bond powerhouse earned $437 million, or $1.67 a share, up almost 50% from $296 million, or $1.08 a share, a year ago. According to Thomson First Call, analysts were expecting the firm to earn $1.17 a share in the quarter. Lehman's earnings were fueled by the strong performance of its fixed-income trading desk, a trend that has prevailed at many Wall Street firms this year. The revenue gains in bond trading more than made up for the firm's relatively small decline in investment banking revenue. Bond trading and bond underwriting traditionally have been staple business lines at Lehman, so it's not surprising that the firm would clean up in the current low interest rate environment, as investors have shown an appetite for higher yielding junk bonds. But Lehman's performance is even better than that of Bear Stearns ( BSC), another bond giant, which reported better-than-expected earnings on Wednesday. In the quarter, revenue from principal transactions -- mainly bond trading -- was $1.2 billion, compared with $627 million a year ago. Meanwhile, investment banking revenue declined by only 7% to $432 million. From a revenue perspective, it was one of Lehman's best quarters ever. Still, Lehman's strong performance wasn't enough to overcome a wave of selling in the financial sector on Thursday. In midday trading, Lehman's stock was down $2.15, or 2.9%, at $71.84, as investors seemed preoccupied with new worries about the strength of the much-anticipated economic recovery. Indeed, the selling in financial stocks outpaced the overall market decline Thursday, with the Amex Securities Broker/Dealer Index dropping 2.4% and the Philadelphia KBW Bank Index sliding 1.5%. One of the biggest losers on the day was Morgan Stanley ( MWD), falling $2.45, or 5.2%, to $44.44, in the aftermath of Wednesday's disappointing earnings report and a number of analyst downgrades.
Hedge fund manager Timothy Ghriskey, president of Ghriskey Capital, said the heavy selloff in financial stocks is indicative of the fact that stocks like Lehman have posted outsize gains this year based on the expectations of a strong second-half economic recovery. (Lehman's stock is up about 40% this year.) With those gains, financial stocks may be vulnerable if investors start doubting the second-half recovery scenario, or if the stars fail to line up for Wall Street later this year. Lehman shares trade at a lofty valuation, especially when compared with other financial stocks. The price-to-earnings ratio is 16.8, based on analysts' estimates for 2003 earnings, according to Thomson First Call. That's well above the average forward P/E of 13 for the entire financial sector. And it's higher than the financial sector's historical P/E average of 15. Even Lehman officials admitted during a conference call that they benefited in the quarter from a bit of luck and being in the right place at the right time. "In this quarter the planets were perfectly aligned for fixed income," said Lehman Chief Financial Officer Lehman David Goldfarb. "But our results were a lot more than the environment. We continue to gain market share across all fixed income products." Overall, revenue at Lehman soared 38% in the quarter to $2.29 billion -- the company's highest quarterly revenue ever. In a striking departure from the cautious and even downbeat tone set by Morgan Stanley on Wednesday, Lehman executives even said they see better days ahead for the Street. "We are beginning to see positive signs for our industry, as demonstrated by the improvement in the equity markets, as well as a rise in announced mergers and acquisitions transactions," said Lehman Chairman and Chief Executive Richard Fuld in a prepared statement. But in its conference call, Goldfarb said it was too soon for anyone to say the current rebound on Wall Street will stick. "We still have a long way to go," he said.