Merrill Brings Home the Bacon

With the financial markets having found their footing in the third quarter, and with competitors Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) having reported great earnings last month, Merrill Lynch's (NYSE:MER) solid third-quarter performance came as no surprise. However, I'd caution investors to harden themselves against the siren song of broker-dealers' record results -- these businesses are cyclical and subject to numerous risks. This highly profitable sector, which exhibits robust growth, commands relatively low multiples compared to many other industries. Credit Suisse's (NYSE:CS) recent disclosure of a $120 million third-quarter loss on Korean equity derivatives is a timely reminder of why. (In the following discussion, all comparisons refer to the prior-year period, unless stated.)

Before one-time gains from the merger of Merrill Lynch Investment Managers (MLIM) and BlackRock (NYSE:BLK), Merrill achieved record earnings of $2 per diluted share, besting the consensus estimate of $1.74 and adding up to a 43% increase over the prior-year quarter. This was achieved on net revenues of $7.9 billion, up 19%. Although Merrill's earnings release is detailed and comprehensive, it's worth noting that the pro forma earnings weren't adjusted for $300 million in tax carrybacks that added $0.31 per share (as described in the CFO's prepared remarks). Once these gains are stripped out, diluted earnings per share are $1.69, "only" a 21% increase instead of 43%.

All three segments -- Global Markets and Investment Banking (GMI); Global Private Client (GPC, Merrill's wealth management arm); and Merrill Lynch Investment Managers -- performed well, and compensation expenses were contained, with the compensation and benefits-to-net revenues ratio at 48%.

On capital allocation, the board authorized a new $5 billion share repurchase program, which means the firm now has $6 billion in dry gunpowder for buybacks. Based on the Oct. 20 closing price of $84.18, this equates to 71 million shares, nearly 8% of the common shares outstanding at the end of the third quarter! Merrill Lynch also made several acquisitions to expand its mortgage origination business, both domestically, with the $1.3 billion purchase of First Franklin (NASDAQ:FFHS), and abroad. This new push in mortgage origination puts Merrill Lynch on a collision course with Lehman Brothers (NYSE:LEH) and Bear Stearns (NYSE:BSC).

Conversely, Merrill isn't showing the same commitment to the prime brokerage and hedge fund arena, in which it lags behind traditional rivals Goldman and Morgan Stanley. Nine years ago, when it acquired Mercury Asset Management for $5.3 billion, Merrill blazed a trail by giving asset management its rightful place among the activities of an integrated investment bank. Although the completion of the BlackRock merger shows the firm is still a leader in traditional asset management, it doesn't appear to have the same appetite for hedge fund strategies. So much for the good, you might say, if you believe the hedge fund industry has topped. However, while mid- and lower-tier funds will likely be squeezed from a lack of scale, a recent study co-authored by the Bank of New York (NYSE:BK) estimated that the demand for hedge funds from institutional investors will triple to more than $1 trillion by 2010. Hedge funds are a permanent and increasingly mature part of the capital markets, and they will continue to require the services that prime brokers provide. As a result, I think Merrill's reticence has a very real opportunity cost. As far as the third quarter is concerned, though, there is no question that this bull brought home the bacon.

Sizzling hot further Foolishnes:

• Morgan Makes It Four of a Kind
• Goldman Shines On
• Merrill's Bull Stampeding

Goldman Sachs is a Motley Fool Inside Value watch-list stock.

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.