All Eyes on Lehman

For the past couple of quarters, Lehman Brothers (NYSE:LEH) has been overshadowed by Goldman Sachs (NYSE:GS) come earnings season. On Wednesday, the firm reversed that trend, reporting results that hold up well compared to those of its larger rival. Lehman's healthy numbers bolster the notion that broker-dealers have come through a difficult environment relatively unscathed during the third quarter.

Net income for the quarter was $916 million, or $1.57 per share on a diluted basis. The latter represents a 7% increase year over year, beating the consensus estimate of $1.49 per share. Let's break the numbers down to see how this was achieved (all comparisons refer to the prior-year quarter unless stated):

Net revenues (revenues less interest expense) were $4.2 billion, up 8%, thanks to a relatively strong performance from the firm's dominant Capital Markets segment, where net revenues increased 13%. Capital markets contributed almost 70% of total net revenues over the first nine months of this year. However, the segment contracted 8% compared to the second quarter, and this slowdown was more pronounced in fixed income, the firm's bread-and-butter activity. Investment banking net revenues fell 11% despite a good showing in debt underwriting, and investment management net revenues increased 18%.

On the cost side, the ratio of compensation and benefits to revenues was 49.3%, unchanged from the first half and slightly lower than that for the third quarter. Meanwhile, the firm's risk profile, as measured by its average VaR (value-at-risk, an estimate of maximum loss on trading positions at a given confidence interval), was "in-line with the second quarter," according to CFO Chris O'Meara.

Looking ahead, O'Meara said that Lehman's investment banking pipeline is at a record level in terms of fees. Furthermore, the firm is expanding its mortgage activity outside the United States with new mortgage origination platforms in Japan and Korea. While I applaud any initiative to increase the geographical diversification of revenues, these illustrate the firm's dependency on its fixed-income capital markets activity, which represents almost half of total net revenues. Beyond this firm-specific risk, investors should also be aware of a potential Sword of Damocles hanging over the entire sector:

Judging from the table below, Lehman's valuation is in line relative to its four closest peers: Bear Stearns (NYSE:BSC), Goldman Sachs, Merrill Lynch (NYSE:MER), and Morgan Stanley (NYSE:MS). In absolute terms, these P/Es look pretty modest. But this masks the cyclical nature of investment banking, an industry heavily dependent on the business cycle.

Over the last couple of years, broker-dealers have been operating in an extremely favorable environment, both for corporate profitability and interest rates. That helps to explain Lehman's return on average common shareholders' equity of 19.5% on a trailing-12-month basis, compared to a 17% annual average for the five-year period from 2001 through 2005. Both Goldman and Lehman announced robust deal pipelines this week, but if their profitability keeps slowing down, it's not clear whether the firms' recent share-price gains will be sustainable. (As of Thursday afternoon, Lehman shares were up more than 8.5% for the week!)

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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.