Despite some positive signs, the battered subprime mortgage and collateralized debt obligation markets are not ready to return to form just yet, Jeffrey Edwards, senior vice president and chief financial officer at Merrill Lynch & Co. Inc., said Tuesday.
The U.S. subprime mortgage business in particular remains "persistently challenging," Mr. Edwards said during the New York company's second-quarter earnings call. "The environment, when it comes to the subprime business, has yet to fully stabilize. We have worked to mitigate the impact by diversifying our businesses." Related Links
Over the past two years Merrill has increased its stake in the mortgage industry.
In the fourth quarter it made its fourth acquisition in that business, and its first for a U.S. originator, when it purchased First Franklin Financial Corp., a San Jose originator of loans through brokers, from National City Corp. for $1.3 billion.
Since that acquisition dozens of companies that lend to borrowers with low incomes or poor credit have stopped operating or filed for bankruptcy protection, and analysts had tempered their expectations about Merrill's earnings, because of its exposure to the mortgage industry.
However, Mr. Edwards said that his firm's total exposure to subprime mortgages, through direct lending, unsold collateralized debt obligation tranches, and other vehicles, "is limited, contained, and appropriately marked."
For the last six quarters the exposure to the mortgage industry has totaled less than 2% of Merrill's total revenue, he said.
Despite concerns that its mortgage businesses would sap profits, Merrill reported that earnings and revenue increased in the second quarter.
The subprime mortgage area is "only part of our broader business," Mr. Edwards said. "We have many other pistons firing around the world. … The importance of diversification really came through with these results."
Revenue from its structured finance and investments business, which includes mortgage-related activities, declined, but overall revenue from Merrill's fixed-income, currencies, and commodities business increased 55%, to $2.6 billion, Mr. Edwards said.
David Trone, an analyst at Fox-Pitt, Kelton Inc., wrote in a research note, "This was a another strong quarter for Merrill that contradicts predictions of mortgage doom and gloom."
In future quarters he said that he expects Merrill's "significant product and geographical breadth to [continue to] help it overcome challenges in U.S. subprime."
Michael Mayo, a Deutsche Bank AG analyst, wrote, "The quarter showed that Merrill has navigated recent market problems quite well, and that the issues of market concern are not a major driver of earnings."
Merrill's second quarter results easily beat analysts' wary expectations.
Its second-quarter earnings increased 31% from a year earlier, to $2.1 billion, or $2.24 per diluted share, and revenue rose 19%, to $9.7 billion.
Excluding the third quarter of last year, when it recorded a $2 billion one-time pretax gain from the merger of Merrill Lynch Investment Managers with BlackRock Inc., Merrill's second-quarter revenue was its second-highest for any quarterly period. The results also were its highest ever for a second quarter.
The average estimate of analysts polled by Thomson Financial had called for Merrill to report earnings of $2.02 a share on $9.26 billion of revenue.
Jeffrey Harte, an analyst at Sandler O'Neill & Partners LP, wrote in a research note that Merrill "reported what we view as very strong results, which we expect will be viewed favorably, especially given investor concerns surrounding the mortgage and CDO markets in June."
By midday Tuesday, Merrill's shares had declined 0.5% from Monday's close, to $86.92.
The company reported strong results from other business lines. Revenue from investment banking rose 41%, to $1.4 billion, on debt offerings and fees from mergers and acquisitions.
"There are many different areas where we are seeing an increase in risk taking and an increase in client activity to offset weaknesses in any particular area," Mr. Edwards said.
During the quarter Merrill's global wealth management business added $9 billion of client assets, raising its total to $1.7 trillion. The business generated $3.6 billion of revenue, or 5% above Mr. Harte's expectations.
He wrote that both transaction- and fee-based revenue also beat his estimates.
Merrill also continued to follow the growing trend in the investment banking business of looking abroad. It said 61% of its net trading and investment banking business came from outside the United States.
Lehman Brothers and Goldman Sachs Group Inc., which posted their earnings last month, also reported strong international growth. Goldman said that 52% of its business now comes from international markets.
Merrill said that 64% of its second-quarter revenue, and 69.5% of its pretax profits, were generated outside the United States. Mr. Edwards said non-U.S. revenue grew at four times the rate of U.S. revenue.
During the quarter, Merrill's revenue from India more than doubled from the previous quarter, and the company applied for a banking license in Saudi Arabia.
"The theme of non-U.S. growth outpacing U.S. growth will remain intact," Mr. Edwards said. "We continue to invest in our platforms around the world to take advantage of this trend."
Merrill increased its staffing 2.7% from a year earlier, to 61,900 full-time employees. It also reported that turnover among financial advisers remained near historical lows, particularly among its top-producing advisers. Its adviser head count increased 1.7%, to 16,200.
Mr. Edwards said that his company invests heavily in training, so that it will be able to continue to attract and retain top-quality advisers.
