Previewing 2007: BlackRock

BlackRock's (NYSE:BLK) merger with Merrill Lynch's (NYSE:MER) asset-management unit transformed the investment adviser from a fixed-income-focused manager to a broad-based industry leader. Industry observers cheered the deal, expecting that BlackRock's highly-regarded CEO Lawrence Fink would improve the generally mediocre performance of the former Merrill funds, while using the resources of a bigger firm to develop new business opportunities. The merger closed in September, so it's a good time to consider BlackRock's outlook for 2007.

BlackRock reported in its recent third-quarter earnings announcement that the integration of the Merrill unit was proceeding smoothly. But the process of combining these two complex organizations is still in the early stages, and problems may still emerge. Legg Mason (NYSE:LM) preceded BlackRock with a similarly transformative transaction when it acquired the asset management unit of Citigroup (NYSE:C). Legg Mason's stock, however, has fallen by nearly 19% this year because of disappointing investment returns from certain Legg Mason-advised funds and concerns about whether the firm has been reaching the performance milestones set out in its merger plan. Based on the example of Legg Mason, as well as the high expectations that surround BlackRock, investors should expect BlackRock's stock price to be highly sensitive to any bad news in 2007.

The relative market performance of asset managers tends to correspond closely to the direction of the net flows of their assets under management. Accordingly, investors should keep an eye on the effectiveness of BlackRock's distribution system in 2007. In particular, a change in the volume of BlackRock funds sold through Merrill Lynch's broker network would help validate or raise doubts about the promise of the recent merger.

BlackRock now manages more than $1 trillion in client assets, making the firm one of the world's largest asset managers in terms of assets under management. At a recent share price of $145, the stock trades at richer multiples than many of its competitors. The expected earnings growth built into those high multiples must be satisfied by strong net inflows of client funds. Over the long term, international clients will be an increasingly important source of new assets under management. In the short term, BlackRock must be able to point to progress in expanding all distribution channels in order to justify the current premium in its share price.

In 2007, investors should gain more clarity about the success of the Merrill merger and BlackRock's long-term prospects. That increased clarity could easily expose operating challenges that the market doesn't seem to anticipate. Investors might find BlackRock to be a disappointing investment next year after the firm delivered such a healthy 35% total return year to date.

Further Foolishness:

• Merrill Brings Home the Bacon
• The Year's Best Financial Stocks

Check out the other companies featured in "The Motley Fool's 2006 in Review and 2007 Preview" special.

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Legg Mason is an Inside Value recommendation.

Fool contributor Michael Leibert welcomes your feedback. He does not have a position in the stocks of any of the companies mentioned above.