Investment bank Merrill Lynch (NYSE:MER) led off its second-quarter earnings release by claiming "very strong net revenues, net earnings and earnings per diluted share for the second quarter of 2007." Year over year, the bank's revenue rose 19% to $9.7 billion, while earnings per share increased 37% to $2.24.
The results could help bring some pep back to the investment banking sector. Last month, though Lehman Brothers (NYSE:LEH) reported positive results, competitors Bear Stearns (NYSE:BSC) and Goldman Sachs (NYSE:GS) weren't able to similarly wow investors with their earnings. And the situation at Bear's pair of struggling hedge funds certainly hasn't helped investor confidence.
Business segments, take one
A look at the business segment breakdown shows impressive results across the board. Merrill's global markets and investment banking (GMI) division showed 36% higher revenue than the prior year. Each of the three sub-segments -- fixed income, currencies, and commodities; equity markets; and investment banking -- showed positive revenue growth.
Merrill's other major segment, global wealth management (GIM), showed good, though lower, revenue growth. Its two sub-segments, global private client and global investment management, were up 13% and 119%, respectively, year over year.
Business segments, take two
Looking a little further into the earnings release, though, you can find another breakdown of Merrill's revenue generation that paints a somewhat different picture. Year over year, this second revenue classification shows principal transactions, which produced $3.5 billion of revenue and were up 201%, as the primary driver of the bank's results. As defined in Merrill's 2006 10-K, principal transactions are the realized and unrealized gains from trading and investing activities in which Merrill acts as a principal.
The second revenue breakdown also shows good results from commissions and investment banking, which gained 16% and 26%, respectively. On the other hand, Merrill's revenue generation from fee-based activities, consolidated investments, and its "other" category -- which includes private equity investments and mortgage sales -- was down a collective 26% compared to last year.
Why this matters
This doesn't mean that Merrill didn't have the great quarter it claims it did. But many investors are concerned with the "quality" of the revenue generation. Investors tend to more highly value revenue and earnings that are more predictable and repeatable, since they give a better sense of what the company can produce in the future.
Though the principal transaction revenue is certainly money in the bank for the firm, it's generally considered a less reliable revenue source than, say, fee-based revenue. This disparity between growth in principal transactions and other revenue sources is likely the reason that Merrill's stock lost 1.4% Tuesday while all three major indices were up.
Looking out at the rest of the sector, the savvy performance of Merrill's traders also doesn't tell us much about what we can expect from JPMorgan and Citigroup, both of which report later this week.
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Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...
