Merrill Lynch & Co., preparing for its biggest expansion since the 1990s, plans to buy a mortgage lender, triple its corporate investments and increase trading bets to boost shareholder returns that trail those of rivals.
Merrill's top managers spent the past six monthsdetermining how to spend "excess capital," ChiefAdministrative Officer Ahmass Fakahany said in an interview lastweek. The New York-based firm, which has the world's biggestnetwork of brokers, decided against expanding by buying aconsumer bank, he said.
"What's new is an increased emphasis on building ourinstitutional business," said Fakahany, 47. "When I saymortgage origination will take capital, that's because itrequires an acquisition."
Fakahany declined to identify potential targets. Thebiggest independent U.S. mortgage lenders include CountrywideFinancial Corp., Ameriquest Mortgage Co. and IndyMac Bancorp Inc.
While Merrill is benefiting from rising stocks and recordcommodities prices, Goldman Sachs Group Inc. and Lehman BrothersHoldings Inc. are reporting faster earnings growth. Goldman,which depends on half as many employees to produce about thesame amount of profit, last month passed Merrill as the world'sNo. 1 securities firm by market value.
Chief Executive Officer Stanley O'Neal limited Merrill'sgrowth by cutting more than 20,000 jobs after the bull marketended in 2000 and keeping acquisitions to less than $1 billion.Rivals including New York-based Goldman took bigger riskstrading and investing.
Missed Market
"We just wish we had the clairvoyance to retool thecompany earlier so we could take advantage of a market that'squite robust," Fakahany said.
Merrill's return on equity, a measure of how effectively itreinvests capital, is the lowest of the five biggest Wall Streetfirms. Its first-quarter ROE of 19.1 percent, excluding anaccounting change, was half Goldman's 38.8 percent and trailedNew York-based Lehman's 26.7 percent.
Shares of Merrill rose 80 percent during the past threeyears, while Goldman's and Lehman's more than doubled. Merrill'sstock fell 74 cents to $76.51 in New York Stock Exchangecomposite trading yesterday.
"They're behind in some important businesses, likecommodities and fixed-income trading," said Jeff Harte, aChicago-based analyst at Sandler O'Neill & Partners LP, whorecommends clients buy Merrill shares. "They need to close thegap not only to generate returns, but to maintain themselves asa viable competitor."
Excess Capital
Merrill hasn't been as bullish about spending since thelate 1990s, when then-CEO David Komansky acquired Mercury AssetManagement Plc of the U.K. for $5.3 billion and Canada's MidlandWalwyn Inc. for $810 million. He opened a Japanese brokeragethat eventually cost the firm hundreds of millions in losses.
Unlike Lehman and Goldman, Merrill didn't accelerate thepace of capital investments after cutting costs in 2001 and 2002,said Morgan Stanley analyst Chris Meyer. He figures Merrill hasthe most excess capital of any investment bank.
"I'm not dispelling the need to be compared to those twobecause we should and we do ourselves," said Fakahany,Merrill's vice chairman in charge of strategy and one of sevenexecutives who report to O'Neal. "We really need to keep doingwhat we're doing. The problem is we haven't been doing it aslong as some of these other people."
Energy Trading
Merrill made up some ground with the $800 million purchaseof Entergy-Koch LP's energy-trading unit in 2004. With 280 newcommodities employees, Merrill entered the markets for naturalgas, fuel storage and weather derivatives. Derivatives arefinancial instruments derived from assets such as stocks andbonds or the outcome of an event.
Lehman's expansion into the home-loan market made it one ofthe top mortgage-bond underwriters and led to a 67 percent surgein fixed-income sales and trading revenue from 2003 to 2005,more than double Merrill's pace.
Lehman acquired five mortgage lenders in 2003 and 2004,adding 3,300 employees. It originated $85 billion of residentialmortgage loans and bundled $133 billion into bonds during fiscal2005, both increases of more than 30 percent from 2004. Merrillsaid it generated a "cash inflow" of $58 billion turning homemortgages into securities last year.
"Building a mortgage capability is a priority," saidFakahany, who was promoted from chief financial officer in March2005. "You can't just build it out of thin air."
Merrill is having "dialogues" with companies it may buy,he said. A mortgage lender would be what Merrill considers a"bolt-on" acquisition, not a "transformational deal."
Mortgage Stocks
Shares of Countrywide, the biggest U.S. mortgage originator,gained 18 percent in the past year. That gives the Calabasas,California-based company a market value of $25 billion -- morethan one-third of Merrill's.
IndyMac, based in Pasadena, California, rose 19 percent inthe past 12 months. Closely held Ameriquest is closing all ofits retail branches to focus on online lending. Otherindependent mortgage lenders include New Century Financial Corp.of Irvine, California, and Melville, New York-based AmericanHome Mortgage Investment Corp.
Merrill also intends to dedicate more capital to trading,with the majority going to proprietary bets in fixed income,Fakahany said. Strategies for equities such as statisticalarbitrage, in which banks of computers determine whethersecurities are cheap or expensive, also are a priority, he said.
The firm plans to triple its investments in other companieswithin two years, either by partnering with clients orleveraged-buyout firms, Fakahany said. Merrill's purchases inthe past 14 months include stakes of about $500 million each inHertz Corp., Rexel SA and Bank of China.
'A Misperception'
"There's a misperception out there that because of ourcapital strength there's a need for capital to go somewhere, tobe used in some transformational transaction," Fakahany said."That's not the case."
One deal Merrill explored was a takeover of North ForkBancorp of Melville, New York. O'Neal, 54, met with North ForkCEO John Kanas last year. Fakahany said Merrill was interestedin North Fork's GreenPoint mortgage unit. The talks broke offand Capital One Financial Corp. agreed to buy the bank for $14.6billion.
In addition to a mortgage lender, Merrill is looking forbrokerages similar to Advest Group Inc., a Hartford,Connecticut-based firm with 500 financial advisers, Fakahanysaid. Merrill acquired it last year for $400 million. He saidMerrill also is interested in teams of traders and specializedcompanies with "bank-like" products.
International Expansion
Expanding investment banking in Europe and Asia, whereMerrill's revenue is growing faster than in the U.S., is anotherpriority, Fakahany said.
Merrill's latest deal was the February agreement to swapits money-management unit for 49.8 percent of New York-basedBlackRock Inc. to form the biggest manager of bond funds.
"There is more of an onus on them to prove themselvesbecause they didn't have a good track record on acquisitions,"said Morgan Stanley's Meyer. "You can't deploy capital thatquickly. It requires confidence to deploy it successfully,otherwise you start swinging for the fences."
If Merrill can't find suitable investments, it can alwaysincrease dividends or stock buybacks.
"We just renewed our buyback program by another $6 billionand we haven't even finished the first one," Fakahany said."We're not shy to do it again."
