Drip
Portfolio Report
Wednesday, April 8, 1998
by Dale Wettlaufer
([email protected])
ALEXANDRIA, VA (April 8, 1998) -- Since the DRIP Port's look at the financial services industry is converging with the major news event of the year in financial services, today we'll again join our other coverage on that merger and its aftermath. Back with our regular programming tomorrow!
Fool on the Hill: More on the Citigroup Aftermath
Yesterday, in looking at the aftermath of the Citicorp (NYSE: CCI) - Travelers Group (NYSE: TRV) agreement to join forces to form a galactic financial services powerhouse, we returned to one of our favorite questions -- "What is a Bank?" In the two-month look at the financial services sector we're conducting in the Drip portfolio, the question of the nature of banking has come up a number of times. That's because the nature of banking has transcended the typical bread-and-butter lending function and has evolved into banks concentrating ever greater amounts of institutional resources into developing numerous lines of business: transaction facilitation, fiduciary lines of business, asset management, raising capital, data processing, and financial engineering.
Besides the data processing, which has been a natural by-product of banking, these business lines have all been traditionally the domain of securities firms. In particular, both Merrill Lynch (NYSE: MER) and American Express (NYSE: AXP) have emerged as the largest virtual, nonbank banks. One doesn't see Merrill jumping up and down to get into commercial lending -- it already took the juice away from commercial banks with the explosion of money markets in the 1970s and 1980s. Commercial lending isn't the most profitable line of business unless a bank is heavily into highly leveraged transactions, which the mega-regionals such as NationsBank (NYSE: NB) are.
Right now, Merrill takes a slight pinch off the top of the money market transactions it facilitates for corporations, either through the trading process or the origination of commercial paper. Granted, commercial banks do this as well, but Merrill's thrust in the equivalent of commercial lending is in light-on-capital money market transactions while commercial banks maintain capital-intensive commercial lending activities on a very large scale.
In highly leveraged transactions, or basically buyouts, takeovers, and debt-financed recapitalizations, Merrill is nearly dwarfed by Chase Manhattan (NYSE: CMB), which is a leading commercial lender in this area. Including contingent commitments, Merrill's exposure here is nearly $1 billion while Chase last year along committed over $1 billion in new exposure. Here again, though, Merrill participates in raising capital for corporation and government entities as an underwriter and syndicator of debt rather than as a retainer of risk for its own account. In securities underwriting, Merrill Lynch is nearly 2.5 times bigger than Chase. With market share anywhere from 13% to 16% in debt and equity, Merrill generated underwriting and M&A advisory fees of $2.75 billion last year compared with Chase's $1.14 billion.
In asset management, Merrill pulled away from Chase in terms of sheer size last year, as its acquisition of U.K. money manager Mercury Asset Management added $167 billion to assets under management, which finished the year at $446 billion. Chase, one of the largest bank asset managers, had $155 billion in assets under management at the end of the year. No competition for Merrill there. The real kicker, and this is the one that really ticks off the banks because so much of it came out of their deposit bases in the age of inflation, is Merrill Lynch's $1.2 trillion in client assets. This asset base doesn't have to turn all that often for Merrill to make money on it. The pure float that it generates for Merrill averaged around $20 billion last year, creating net revenues of up to $1.14 billion or more with virtually no credit risk to Merrill Lynch.
Having in excess of $1 trillion in client assets would make any bank CEO salivate because they know that those assets don't resemble a bank's loans. Those assets are readily liquid, which means that margin lending is a highly controllable risk where collateral can be easily liquidated in the case of nonperformance on the margin loan. Those assets are also like a huge pinata hanging there, waiting to be swatted by Merrill's financial consultants. Converting a client's capital into an annuity is the coup de grace on this particular pinata because it not only means a huge commission for the financial consultant (aka broker), but it's also a great source of funds for the firm, especially for older folks who might go onto the great beyond in the year after annuitizing assets.
Banks know this is something they can't do. Sure, they can entice more money out of their customers, but part of the battle is already won at Merrill because the client's assets are already there, all ready to be converted. A bank isn't going to come to you and suggest turning your mortgage into some other financial product. Luckily for the banks, though, asset-backed securities markets came along in the 1980s, letting them partially accomplish a higher turnover of loans. That doesn't solve the whole problem of keeping a relationship going, which good brokers know is the key to profitability rather than doing quick-buck moves on their clients.
Overall, though, Merrill is a bank in its financial model. The amount of capital needed to generate $1.9 billion in earnings is staggering. In fact, on a return on average assets (ROA) basis, Merrill Lynch's 0.771% lags by nearly 63 basis points, or by a magnitude of 55%, the average ROA of 1.4 for the 14 companies in our universe of large bank holding companies and integrated financial services giants. Looking again at the breakdown of return on average equity, we can see where Merrill's ROE comes from.
To refresh your memory:
Net Income Avg.Assets Revenues ROE = ------------ x ---------- x ----------- Revenues AOE Avg. Assets
(AOE is average owners' equity)The above components are net margin, leverage, and asset turnover.
Merrill Lynch generated net income of $1.867 over revenues of $15.67 billion, for net margin of 11.9%, below the average net margin of 20.9%. Average assets divided by average owners' equity equaled 33.22 at year-end 1997, better than twice the average for our 14-company universe. The higher the leverage, the higher the potential ROE. Finally, asset turnover was 6.2%, 35 basis points above our composite average. Therefore, the DuPont ROE model on Merrill looks like this:
ROE = 11.9% x 33.22 x 6.2% = ROE of 24.53%. This is 7.58 percentage points better than the average company in our universe. Because customers tend to stay a long time, Merrill Lynch can leverage itself up like a super-bank. Its assets-to-equity ratio is twice that of other big banks, though the company can throttle back its leverage with swaps and derivatives for a lower effective leverage ratio.
Merrill doesn't want to hook up with another financial company unless the deal is really sweet, because it's essentially already a bank. Why would it want to enter into a stiffer regulatory environment overall as a bank holding company when it already has more latitude than that. As a bank, it couldn't operate with the leverage it does. The lines of business that the banks are entering are those that Merrill already operates in. Not vice versa. Merrill Lynch has no incentive to change things at the moment, since it is already the bank of the future that can gather customer assets, perform a full array of financial services for wholesale and retail customers, and operate on a global basis. Few partners bring much more to Merrill, though a deal is always possible. Merrill will probably be conducting some fill-in acquisitions in specialty finance niches such as specialty insurance. A blockbuster universal bank merger is possible, but not likely, for Merrill Lynch.
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