It's been a banner year for brokerage stocks, but few have outshone Lehman Brothers ( LEH). To date, shares of the Wall Street firm are up a robust 45%, far outpacing the 30% gain racked up this year by the Amex Broker Dealer Index. And it's no contest comparing Lehman's performance with the meager, single-digit gains posted by the three major market indices. Look for Lehman to help set the pace in the brokerage sector when it reports fourth-quarter earnings next week, along with Bear Stearns ( BSC), Goldman Sachs ( GS) and Morgan Stanley ( MWD). On the basis of the latest Thomson Financial estimates, analysts expect earnings at Lehman to rise 34% in the fourth quarter, which ended Nov. 30. Only Goldman Sachs is expected to do better, with earnings predicted to rise 40% over the same period last year. Bear Stearns and Morgan Stanley are likely to be the laggards. Analysts expect earnings at both securities firms to be largely unchanged from a year ago. Earnings at Bear Stearns also could be weighed down by another legal charge stemming from the firm's involvement in the more than two-year-old mutual fund trading scandal. Bear, after six months of heated negotiations, is close to reaching a final settlement with the Securities and Exchange Commission, sources say. To date, Bear Stearns has set aside at least $200 million to cover the cost of reaching a settlement; sources expect a final deal to exceed $300 million. A Bear Stearns spokesman declined to comment on the investigation. But the big story next week undoubtedly will be Lehman's continuing transformation into a diversified securities firm that's no longer just associated with bond trading and debt underwriting. Much of Lehman's metamorphosis can be attributed to its shrewd purchase of the asset-management firm Neuberger Berman in 2003 and a timely decision to beef up its merger-and-acquisition investment-banking group. The wisdom of those moves is being borne out in this year's results.
For the full year, revenue at Lehman is expected to rise 25% to $14.5 billion. On a percentage basis, that's higher than the increase at any other big Wall Street firm. Full-year revenue at Goldman Sachs and Merrill Lynch ( MER), for instance, are expected to rise 17%. Pulling up the rear is Bear Stearns with a paltry 7% gain in revenue. "Lehman has done a much better job growing its non-debt-related business. They've improved the equity-side made mergers and acquisition," says Michael Stead, the manager of River Aire Investment, a hedge fund with no position in the stock. "The results are great. You can see the results in the stock price." The big surge in Lehman's shares has narrowed the historic valuation gap between it and Goldman Sachs, which is still regarded by many as the premier investment house. On the basis of 2006 estimates, shares of Lehman and Goldman Sachs are both trading at 12 times earnings. The stocks also are comparable on price-to-book ratio, a valuation metric favored by most Wall Street analysts in assessing brokerage stocks. Lehman shares trade at a price/book multiple of 2.25, compared with the 2.35 multiple Goldman garners. In jumping into the same league as Goldman Sachs, Lehman also has put a good deal of distance between itself and Bear Stearns -- the Wall Street firm with which it is most often compared. Shares of Bear Stearns trade at a price/earnings ratio of just under 11 on the basis of next year's earnings. On a price-to-book basis, Bear Stearns fares even worse, trading at a lowly multiple of 1.73. But for all its big gains in 2005, it looks as though investors won't be able to bank on a repeat performance from Lehman in 2006. Analysts are looking for its earnings to be largely unchanged in the coming year. Revenue is expected to rise a scant 4%. However, Lehman will not be alone.
The consensus on Wall Street is that brokers will post small or modest earnings gains next year. While corporate merger activity is expected to keep generating fat fees for investment banks, the pace of growth in the economy is expected to slow. The threat of rising interest rates in the first half of the year is expected to keep the stock market under wraps. "They are going to run out of rabbits to pull out of the bag," says David Hendler, an analyst with CreditSights. Hendler says rising interest rates will put a further chill in the market for fixed-income trading and bond underwriting. He says investment firms may not be able to count on their proprietary bond trading desks to generate the kind of outsized revenue that they've consistently produced for the past two years. "Lehman and Goldman all had their huge rallies. Bear had it last year," says Hendler. "Now it may be time to rotate into the guys who had more noise in 2005." Hendler prefers Merrill Lynch, which is up 16% in 2005 but has underperformed many of its brokerage peers. He likes Merrill Lynch, in part, because "retail brokerage is picking up a head of steam."