Can Regional Brokers Keep Outperforming?

By choice or circumstance, smaller brokerage firms like Stifel Financial ( SF) and SWS Group ( SWS) have maintained their independence. More importantly for investors, they have also outperformed the banking giants.

These regionals may not have as much recognition as the mammoth securities firms -- Stifel's market cap is $962 million, SWS's market cap is $488 million -- but they won't be receiving as many unwanted headlines either.

Like the big guys, regionals provide a range of services including financial advice, banking, asset management and fixed income and equity products. Of course regionals can't ignore the ravages of the recession, because their customers are just as frightened as are customers of the financial supermarkets.

For the most part, however, they have avoided the severe stock shocks of jumbo names like Goldman Sachs ( GS) and the mishaps of financial supermarkets like Bank of America ( BAC) and Citigroup ( C).

How have they managed to do this? Regional brokerages have done comparatively well thanks to healthy balance sheets and investment philosophies that are more conservative than those of larger financial institutions.

"Although the private client business tends to be the marquee business segment from a revenue and recognition standpoint, capital markets and banking have grown in their importance to each firm's overall business mix," says a recent report by Keefe, Bruyette & Woods, which specializes in analyzing financial services firms and banks.

KBW predicts the recession will take a toll on regional brokers as clients make fewer trades and investments. "As a result, commission- and transaction-based revenue will be lower than 2008's levels," the firm says. Low interest rates will cause a drop in net interest income in 2009 vs. 2008.

Still, those strong balance sheets should help them grow. "We believe that they will continue to benefit from the fallout of the recent mergers at the large-cap wire houses," KBW says.

At their worst, regional firms still do better -- or not as bad -- as the big guys. Just check the 12-month performance of the giants vs. Stifel, SWS and Raymond James Financial ( RJF). At their best, regionals can outperform Warren Buffett.

That last description belongs to Stifel Financial, the St. Louis-based financial holding company for the Stifel Nicolaus brokerage.

On a split-adjusted basis, Stifel's stock was up28% for the 12 months ended Feb. 5. The S&P 500 was down about 37%. Buffett's Berkshire Hathaway ( BRK.A) was off 36%.

Over a five-year period, Stifel's stock has nearly tripled, while Berkshire Hathaway is slightly in the black and the S&P 500 is definitely in the red. The big-shot investment banking firms don't come close to Stifel, and neither do the financial supermarkets.

"Stifel is one of the best mid-market investment banks," says Michael Wong, an analyst at the independent research firm Morningstar.

With investment operations "that won't fall off a cliff," the worst thing Wong can say about Stifel is that its stock is "a bit overvalued." Morningstar's three star-rating (out of five) means its fairly valued by the firm's standards.

Since the middle of this decade, Stifel has made several acquisitions to bolster its financial advisory efforts and expand its geographic reach. It also bought a small bank in 2007, but banking represents a small portion of its revenue.

Expansion has "artificially" depressed margins, says Wong, noting that Stifel has capitalized on the bloodshed at big investment banks by hiring more advisers. During the first nine months of 2008, Stifel added 140. And on Feb. 12, it reported October-December earnings per share of 72 cents, excluding one-time items, which beat the Wall Street average estimate of 57 cents. Revenue of $228 million topped the consensus of $219 million, according to Thomson Reuters.

So how long can Stifel be called "regional?" Formerly known for its Midwest focus, Stifel now operates in 36 states and the District of Columbia. It has three European offices.

Dallas-based SWS has even less Wall Street coverage (two sell-side analysts) than Stifel (four sell-side analysts). It's stock gained 24% for the 12 months ended Feb. 5. It's five year-return isn't as good as Stifel's, but who's arguing with a split-adjusted gain of about 80%?

SWS just released October-December results in which earnings per share of 33 cents beat estimates by 6 cents. Revenue rose to $100 million vs. $72 million for the same period in 2007, thanks partly to a brokerage acquisition.

"We believe that revenue and EPS growth will likely be driven by acquisition," says a recent report by Keefe Bruyette & Woods.

SWS feels confident enough to avoid TARP money. "It's our opinion that we can keep the Bank well capitalized without the risk and uncertainties of the terms for accepting the government money," CEO Donald Hultgren told analysts during a Feb. 4 conference call. (Stifel Financial isn't seeking TARP money either). SWS subsidiaries include Southwest Securities, SWS Financial Services and the banking unit Southwest Securities FSB. The company operates in 50 states.

SWS could be under pressure for the rest of 2009 and 2010 due to the recession's impact on investors in general and to the fear that the Texas economy will weaken, says KBW. That would hurt SWS's bank subsidiary, municipal finance business and its commissions.

"With energy prices well below their peak levels of 2008, we believe that the state's economy will begin to weaken and could present concerns for SWS's businesses," says a mid-January KBW report maintaining a market perform rating. KBW's analysts don't own shares, but their firm has had a recent noninvestment banking relationship.

Raymond James Financial is larger, with market cap of $2.4 billion, than Stifel and SWS combined. It can brag that it beat the big guys and the S&P 500 over the last 12 months, but its stock was still down about 20%.

However, it recently reported earnings per share of 52 cents for the October-December quarter, beating the Wall Street consensus of 35 cents, according to Thomson Reuters.

Earnings per share rose 11% vs. the same period in 2007 even though net revenue fell by 3% to $664 million for the company's first quarter. From Jan. 20, the day before the announcement, through Feb. 5, the stock was up about 42%.

"We avoided most of the direct damage through our conservative business practices" for the fiscal year ended Sept. 30, Thomas James, the chairman and CEO of the St. Petersburg, Fla.-based company, told analysts in January.

However, the first quarter reflected "an increasing weakness in our private client group, our largest business segment."

As befits a company with a diverse portfolio of services, Raymond James was able to offset declining retail commissions and fees with rising investment banking revenue from merger-and- acquisition fees. The company also enjoyed a big jump in the fixed-income revenue.

Despite the strong showing, "numerous industry headwinds persist that should pressure earnings in coming quarters," says a recent report by Devin Ryan of Sandler O'Neill & Partners.

Ryan has a hold rating on the stock, as do the handful of other analysts following the firm. The analyst doesn't own shares, and the firm doesn't have an investment banking relationship.

"We continue to look for signs of stability in the credit and equity markets to become more constructive on the earnings outlook and on Raymond James Financial's shares," Ryan adds. "We expect material upside will exist for both in a more normal market."

And like many of its peers, Raymond James Financial requires a reworking of the term "regional" brokerage. It does business in every state, many Canadian provinces and several other countries.

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