FOOL PLATE SPECIAL
An Investment Opinion
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The deal will boost the number of Nasdaq and over-the-counter (OTC) stocks in which Merrill makes a market from 650 to more than 8,000. Perhaps more notably, it makes the financial institution the world's number-two Nasdaq market maker -- Herzog, with about 8% market share, came in after Knight-Trimark (Nasdaq: NITE) and Charles Schwab's (NYSE: SCH) operation.
How do market makers work? We'll revisit an old Fool article: They act "as the broker's broker in matching buyers and sellers. Moreover, when there is no buyer for a stock that is being offered for sale, the market makers purchase it themselves to keep the markets liquid. For each trade, the market makers charge a spread, the difference between the purchase and sale price, with the general rule being that the more liquid the security, the smaller the spread... Sometimes [the] spreads are quite significant, to take into account the increased risks inherent in these securities."
Many traditional brokerages have shunned the market-maker business in recent years, but Merrill, noting increased trading volumes and the advent of electronic trading technology that has improved the profitability of the business significantly, has taken a big step back into the fray with the purchase of Herzog. The acquisition is expected to be immediately accretive to Merrill's earnings, though how much wasn't reported.
To get a picture of the financial dynamics of the business in a high-volume environment, one might consider Knight-Trimark's gross margins over the last three full years. (The company doesn't have a gross margins line item on its balance sheet: We added commissions and fees to net trading revenue and then subtracted payments for order flow, execution and clearance fees, communications and data processing and professional fees.)
At Knight-Trimark, which has perhaps a 20% market share in Nasdaq and OTC trades, gross margins have absolutely ballooned since the end of 1996 from 52.3% at the end of 1997 to 68.9% in December. Clearly a business that relies so heavily on volume to drive profits carries with it some inherent risks, but that's apparently a risk Merrill was willing to assume more of as it moves to offer even more services.
The company already offered some such services, but not on so nearly broad a scale and this will allow the company to handle more -- if not all -- its clients' Nasdaq transactions internally. According to reports, the company has recently farmed out about one-fourth of its trading execution orders, some of those to Knight-Trimark.
And so at least two other questions arose today. First up was what the deal might mean for Knight if it were to lose some of the business it was getting from Merrill. A spokesman for the brokerage told Bloomberg, "We intend to continue and strengthen the relationship with Knight and do not intend to scale back the volume of execution business we send to Knight," and the market maker's shares were flat as lunchtime neared. The last two months haven't been easy, though.
Also looming was whether the acquisition was a vote of no confidence for the emerging business of Electronic Commerce Networks (ECN), essentially a fully electronic market-making application that matches orders rather than requiring the likes of Herzog to buy and sell sells with their own funds. At least one analysts pooh-poohed the threat of ECNs to traditional market makers, but many a brokerage -- including Merrill -- includes in its investments a stake in one young ECN or another.
And the long-term picture will almost certainly be driven by technology rather than tradition, whatever the form the technology might take -- even Merrill's own analyst presentation detailing with the deal said as much.
"[The] Nasdaq is developing into a two-segment market: full-service and low price/discount," the report said. "Narrowing spreads and price improvement requirements are pressuring profitability. Technology [is] rapidly enabling [a] wide array of trading options all chasing liquidity ... [and] volume will migrate to [the] best execution/liquidity solutions."
Related Links:
Merrill Lynch Web page
Merrill Lynch discussion board
Bear Stearns' Bearish Outlook on Knight, Fool on the Hill, 2/4/00
Herzog Heine Geduld
Merrill Lynch analyst presentation (click on "Investor Information" and scroll down)
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Fool UK
