The brokers' honeymoon period continues. Last Thursday, Bear Stearns (NYSE: BSC) reported third-quarter earnings which were consistent with results announced earlier in the week from Goldman Sachs (NYSE: GS) and Lehman Brothers (NYSE: LEH). In fact, like Lehman, Bear recorded the "third-best quarter [in its history]," not to mention the best Q3 the company has ever had. Earnings per diluted share were $3.02, up 12% year over year and ahead of the consensus estimate of $2.83. Let's see how this was achieved (all comparisons refer to the prior-year quarter, unless stated):
Net revenues (revenues after interest expense) were $2.1 billion, up 17%. Much of this growth was provided by the firm's workhorse Capital Markets segment (up 13%), which accounts for more than three-fourths of total revenues for the nine months to Aug. 31. Within Capital Markets, Institutional Equities (up 31%) and Fixed Income (up 19%) were particularly robust, while Investment Banking suffered a 23% decline, in part because of an unfavorable underwriting environment. It's worth noting that Investment Banking also contains revenues booked from private equity investments. This is a source of significant volatility in results; in the third quarter, revenues from these investments fell to $10 million from $93 million.
In the two remaining segments, Global Clearing Services showed lackluster growth of 4%, while Wealth Management produced a strong quarter, growing 36% (outstripping the 25% increase in Assets under Management). However, part of Wealth Management revenues is performance fees on hedge fund products that aren't "money in hand." The hedge funds are valued at the end of each quarter, and fees are accrued on that basis, but the actual amount Bear Stearns will earn is wholly contingent on end-of-year values, which are subject to considerable uncertainty.
Finally, Bear groups a number of items, including unallocated interest revenues, as "Other." Revenues for this catch-all segment jumped 41% sequentially to $83 million, contributing 22% of the increase in total revenues. Furthermore, the segment accounted for almost 90% of the increase in pre-tax income! CFO Sam Molinaro explained that the main drivers of growth in this segment were higher interest rates, a larger equity capital base, and changes in the value of some of the firm's long-term debt that had to be recognized in earnings under FAS 133. According to Molinaro, the run rate in revenues from "Other" is probably $10 million -- $15 million below this quarter's figure.
Expense growth was only slightly ahead of revenue growth at 19%, with the compensation and benefits to net revenues ratio at 48.1% vs. 47% in the prior-year quarter. Bear Stearns did not disclose its value at risk (a measure of the firm's market risk) for the quarter, but Molinaro asserted that it declined during the third quarter "by a reasonable amount." (Bear's average daily VaR was $34 million in the second quarter.)
Looking forward, Bear Stearns continues to invest to expand its mortgage origination platform, just as its rival Lehman Brothers is doing, and to build its European and Asian operations.
Bear Stearns is a well-run company with a superb mortgage bond franchise, but it is the least diversified of the major investment banks (known collectively as the "bulge bracket" in I-banking speak), both geographically and in terms of its business lines. Furthermore, given the narrow valuation range that Bear and its four closest peers currently occupy (see table below) and the potential sector risk I alluded to here, none of them look particularly compelling to me -- especially after last week's run-up. For investors who want exposure to investment banking, I'd recommend a look at "universal banks" such as Citigroup (NYSE: C) or Income Investor picks JPMorgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC) instead. These banks have solid investment banking franchises that complement other, more stable activities (retail and commercial banking, for example) and seemingly attractive valuations to boot!
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Earnings Growth (Est. 5 years)
|
P/ BV
|
Forward P/ E
|
|
Bear Stearns (NYSE: BSC)
|
11.0%
|
2.0
|
10.0
|
|
Peer Group (1)
|
13.2%
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2.3
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10.6
|
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Range for the five companies (Peer Group + Bear Stearns)
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11.0% - 15.0%
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1.8 - 2.4
|
9.5 - 11.2
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(1) Based on closing prices on 09/15/06 for a peer group containing Goldman Sachs, Lehman Brothers, Merrill Lynch (NYSE: MER), and Morgan Stanley (NYSE: MS). Average P/ BV and P/ E multiples are weighted by market capitalization. Average Earnings Growth rate is unweighted.
For further Foolishness:
Goldman Sachs is a
Motley Fool Inside Value
watch-list stock. Bank of America and JPMorgan Chase are
Income Investor
recommendations.
Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.
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