Selling shares would be extra pricey for Merrill

By Dan Wilchins - Analysis

NEW YORK (Reuters) - Merrill Lynch & Co Inc MER.N agreed to financing terms in December and January that could end up costing the bank nearly $4 billion if it tries to issue equity now.

The onerous cost of issuing equity makes Merrill Lynch much more likely to sell assets, analysts said, and explains why Chief Executive John Thain said recently the company would consider selling its stakes in Bloomberg or BlackRock if it needed more capital.

"They'd have to pay through the nose to raise equity now. It just wouldn't be a good deal," said Matt McCormick, analyst covering financial stocks at Bahl & Gaynor Investment Counsel in Cincinnati.

U.S. commercial and investment banks are broadly raising capital after recording more than billions of dollars of write- downs and credit losses. Merrill Lynch is no exception -- it has recorded more than $30 billion of write-downs since the third quarter of 2007.

Analysts forecast the bank will take up to another $6 billion of write-downs when it reports second quarter results next week, which could force the bank to raise additional capital.

Any capital the company raises now would follow big transactions in December, when Merrill sold up to $6.2 billion of common stock, and January, when Merrill sold $6.6 billion of convertible preferred stock.

But both deals had an unusual feature: If Merrill Lynch raised equity at too low a share price in the future, the December and January investors, which included Singapore state fund Temasek and Korea Investment Corp, would be reimbursed with either cash or more shares.

For the December capital increase, those provisions kicked in for equity sold below $48 a share, and for the January deal, for equity sold below $52.40 a share. Merrill would have to sell more than $1 billion of equity to trigger the provision for the January offering.

With Merrill's shares having closed on Friday at $30.36, down more than 40 percent since the January financing, any share issuance now would require nearly $4 billion of reimbursement in cash or shares, according to an analysis by Reuters. In the case of the January deal, the reimbursement would come in the form of additional shares when the convertibles change into equity.

(For more on the mechanics of the analysis, as well as an interactive calculator, please click here: tinyurl.com/552jgj)

Several investors checked the analysis, but Jessica Oppenheim, a spokeswoman for Merrill Lynch, declined to evaluate it.

FUTURE PROFITS

Selling high-quality assets is not usually a company's first choice when raising capital, because strong assets can be a source of future profits. If a company does sell pieces of itself, it usually focuses on pieces that will have the least impact on future earnings.

Bloomberg seems to fit the bill there -- the 20 percent stake, which Thain said in a recent call was worth about $5 billion to $6 billion, is not part of Merrill's main business.

But selling all or a portion of the 49.8 percent stake in BlackRock, worth about $10 billion at current market prices, would be less desirable because the asset management company is more closely related to Merrill's main business, analysts said. Merrill, which essentially sold its investment management business in 2006 for a big stake in BlackRock, distributes BlackRock funds through its brokerage.

"Now you're damaging the future earnings power of the company," said Bill Fitzpatrick, equity research analyst covering financial stocks at Optique Capital Management in Milwaukee.

FEW OTHER OPTIONS

Other options are limited. Companies looking to issue equity-like capital without issuing common equity can sell securities that have characteristics of debt and equity, known as "hybrid instruments."

But that option may not open to Merrill Lynch now, judging by a recent comment in a Moody's Investors Service statement.

The credit ratings agency said Merrill's percentage of hybrid instruments in its capital structure is more than 25 percent of total equity capital.

"This means that Merrill would need to increase common equity to improve capital ratios under Moody's framework," the rating agency wrote in a statement in April.

If issuing securities is unpalatable, selling assets may be the only option left, analysts said.

"Among its current options, selling the BlackRock or Bloomberg stakes is the least unattractive," said Michael Holland, founder of Holland & Co, which oversees more than $4 billion of investments.

(Editing by Andre Grenon)