More Mergers Mean Bouncing Boutique Banks

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There has been a striking rebound in merger announcements since Labor Day, and some of those deals imply renewed availability of debt financing for acquisitions. That's a very bullish sign for the market generally, but especially for boutique investment banks that focus on M&A advisory work.

Bulge-bracket investment banks such as Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) should win higher market share, but boutique firms Lazard (NYSE: LAZ), Greenhill & Co. (NYSE: GHL), and Evercore Partners (NYSE: EVR) should see the biggest impact on earnings per share (EPS).

Until recently, the main bullish argument for these stocks was that they stood to earn nice fees advising on restructuring bankrupt companies during the downturn. They still may, but now instead of the main course, restructurings may just be gravy on a feast of mergers.

While merger activity may not come roaring back to peak levels immediately, it has likely bottomed. Despite the strong market performance since March, valuations remain relatively attractive for acquirers, and if the market for debt financing is really thawing, then we should see a nice bounce in transaction volume (i.e., more deals!).

These stocks aren't the cheapest names in the still-battered financial sector. Price-to-earnings ratios based on 2010 estimates range from Lazard's 18 to Greenhill's 31, with Evercore in the middle at 23. That's a big premium to JPMorgan Chase's (NYSE: JPM) P/E of 14. However, a sustained rebound in merger activity may drive up the "E" in those P/Es.

Key concerns
Of course, Lazard just had some bad news with the unexpected death last week of its chief executive, Bruce Wasserstein. Lazard is far from a one-man show, but Wasserstein's loss may be felt at least in the short term.

At Evercore, the key concern has to be the company's historical reliance on huge transactions among a fairly small list of large clients. As a result, Evercore's results may be even more feast-or-famine than its peers'.

Greenhill doesn't have either of those problems, but you pay for it at 30 times 2010 estimates. Notably, though, those estimates assume 26% earnings growth versus 2009. That may seem high, but estimates for Lazard and Evercore already assume earnings double. Hence, it's easier to envision dramatic upward revisions to Greenhill's estimates.

Next milestones
All three companies should report third-quarter results in the next couple of weeks. Evercore and Lazard report on Oct. 28, while Greenhill has yet to schedule its announcement. While M&A activity in the past quarter was very weak, investors should watch managements' body language on the state of their deal pipelines, the appetite for acquisitions (which will likely vary widely from industry to industry), and the availability of financing.

More on M&A boutiques:

• Good Moves in Bad Times
• Was I Wrong About Investment Banking Bonuses?
• A Goldman Opportunity