Alexandria, VA (June 11, 1998) --With Merrill Lynch's (NYSE: MER) numbers fresh in your mind, let's take a closer look at the company's financials and see what we have. I've written too many times that I treat it as equivalent to a large bank, given that it engages in some of the same lines of business as companies like Citicorp (NYSE: CCI), Chase Manhattan (NYSE: CMB), Bankers Trust (NYSE: BT), and J.P. Morgan (NYSE: JPM), not to mention the capital markets operations of all the mega-regional banks. With over $350 billion in assets on the balance sheet, not even counting over $1.5 trillion in client assets and assets under management, this company is a Deathstar. The banks are afraid of it, too. It can do pretty much whatever a bank can except get bailed out it goes bankrupt (and I wouldn't even count that out, given the "too big to fail" doctrine that we say doesn't exist in the country but does).
With its huge set of assets, it's a wonder the company's equity is valued at $36 billion. Well, actually, it's not a wonder. It's due to the fact that the company has nearly $50 billion in long-term debt. However, if we look at the deposits at banks as debt, which it is in form if not fact, Merrill's enterprise value (market cap - cash + debt) would be above that of big banks, but still in their ballpark. Looking at the company's leverage picture, there's only a certain price that investors will pay for the company's net assets. Compared to the large banks' assets-to-equity ratio in the 15 range, Merrill has a virtual sliver of equity supporting its assets. With an assets-to-equity ratio of about 40, it takes only one large mistake or a couple small mistakes for the equity interests of the company to be eaten. If equity gets munched, that means the stock's value gets munched.
When looking at the leverage of a company, though, you can't just go on the face value of the ratios. While you can't get inside the balance sheet to examine all the assets and a company's entire loan portfolio, you should consider certain things when it comes to a company's effective leverage. First, we see that there is over $100 billion in pretty liquid securities on the balance sheet. A small proportion of that is made up of risk-free assets -- federal government securities -- while there's a bunch of corporate debt, preferred stock, equity, some asset-backed securities, and other things that trade in liquid markets. A market crash would hurt the value of a good deal of these securities, but it's not like office buildings going under. Liquidation of these assets could be done instantaneously, if need be.
Then there's another $100 billion in customer receivables and short-term loans (receivables under re-sale agreements). These are all assets that turn into cash within three to 90 days and are backed in good part by collateral. We also see another $29 billion in margin loans, which again are collateralized, plus $28 billion of actual collateral on the balance sheet. In the sense that we're talking about collateral here, you don't actually have to go out to foreclose on someone's house and then attempt to sell it on the market. The collateral that Merrill can collect if a customer "deadbeats" on them is often securities held in "street name." If the customer screws up, Merrill liquidates their account. The problems in collecting the security on a second mortgage made at 125% of the equity value of a house are totally different. Similarly, try operating as a credit card lender, when actual gross write-offs reached 6% of receivables in much of the industry last year. A credit card issuer gives you months to take care of your problem -- Merrill can by law freeze your equity if you don't perform on an obligation after three days.
So, in this vein, we have to consider that the company's business model and rights it has under government regulations allow it a huge advantage in its ability to lever up the balance sheet and support many more assets than a bank can.
The price it pays is that in a great market, Merrill Lynch generates a 0.67% return on assets. That's a poor performance that wouldn't create too much of an excess return to shareholders in the banking world. ROA is a function of asset turnover and net margins, as you remember. Not including goodwill amortization in net margin, the company runs at a 12.54% net margin and an asset turnover of less than 5 1/2%. Multiplying ROA by leverage gets us to ROE2 (or return on equity with goodwill amortization taken out of the expense base and goodwill left in the asset base). So, here we see 0.1254 net margin2 * 0.538 asset turns * 39.84 average assets/average equity = 0.26878, or ROE2 of 26.88%.
That's a great return on equity, especially for a company so large. On a risk-adjusted return basis, though, one has to weigh those results for the price being paid. Like the big banks, Merrill Lynch gets cheap every once in a while. But as a secular trend, large financial services companies have seen huge increases in their market multiples. That, along with growth in the business, has been where shareholder returns have come from over the last couple years. That can't continue indefinitely, though, and will definitely reverse course at some point. But I have no idea when that will happen.
Over the long-term, Merrill Lynch's growing global franchise and dominant market position make this a company that should be considered by investors. Unfortunately, the company doesn't have a DRIP, which you might want to take up with Merrill Lynch. I wanted to take a look, though, and examine how much Merrill's financials represent those of a big bank. Because it doesn't have a DRIP, it can't by definition be in our portfolio (at least not yet!). But it is an interesting company worthy of a look for individuals nonetheless.