Clouds follow Merrill's brokerage business
NEW YORK (Reuters) - Retail brokerage has been the silver lining to Merrill Lynch's dismal earnings recently, but the outlook for even that business is increasingly stormy as the economy slows.
Weaker retail brokerage profit is itself bad news for equity investors, but there's an added negative: income from the business is a key source of support for Merrill Lynch's debt ratings, and a downgrade could be painful for the bank.
For now, the company's retail brokerage is still performing well -- it recorded second quarter net revenue of $3.4 billion, while writedowns brought the investment bank's net revenue to negative $5.3 billion.
But historically, when unemployment rises and equity markets fall, it takes investors only one or two quarters to start pulling funds from their brokerage accounts, said Brad Hintz, analyst at Sanford C. Bernstein in New York.
"(Merrill Chief Executive John) Thain right now is in the midst of a perfect storm in his institutional businesses and unfortunately, right now the clouds are gathering for his retail business," Hintz said.
In Merrill's second quarter results, the company said profits in its private client business, the largest in the U.S. by number of advisors and assets under management, were down 3 percent on the same quarter last year. Net new money from clients was down by $5 billion, the company's first negative quarter in five years.
The company said the outflow reflects seasonal income tax payments and the departure of a significant institutional retirement client due to a merger, but analysts think more outflows are coming.
"There's every indication that the retail investor is backing away from the market," said Bill Hackney, managing partner at Atlanta Capital Management Co.
Investors are putting more money into U.S. taxable money market funds, according to the Money Fund Report, with taxable money market fund balances rising nearly 3 percent so far in July. Those rising balances signal that even if investors are not withdrawing money from their brokerage accounts, they are favoring products that tend to be less profitable for brokerages than stock investments.
Retail brokerage is a business with relatively high fixed costs and low variable costs. When markets are improving, that's a real positive -- as trading volume increases, profits can rise much faster than revenue. But when trading volume decreases and clients withdraw money, profits can drop quickly while costs persist.
It is hard to tell just how severely this slowdown will hit Merrill's brokerage because the scale of the economic downturn is uncertain, said Hintz.
The retail brokerage is seen as a key support to Merrill's share price: last month analysts estimated the wealth management business to be worth at least $25 billion, compared to Merrill's market capitalization of about $27 billion. The bank's stake in investment manager BlackRock (BLK.N) is worth about $14 billion at current market prices, which implies a negative valuation for Merrill's investment bank.
Merrill spokeswoman Selena Morris declined comment.
MERRILL'S RATING
Ratings agencies are watching the business closely for signs of weakness.
"In this environment, we'd expect sales and business to decline because we're in a recession," said Eileen Fahey, analyst at Fitch Ratings in Chicago.
"It's a great diversifier, and it's a great source of funding," she said.
Fitch rates Merrill at "A-plus," the fifth highest level, and one notch above where Moody's Investors Service and Standard & Poor's rate the company.
A downgrade by S&P or Moody's could make it more difficult for the company to borrow in short-term debt markets known as commercial paper markets, and could force the company to post more collateral.
On a call with journalists last week, Chief Executive John Thain said a further downgrade would "have a significant impact" in terms of collateral, meaning it would cost the bank more to trade with other institutions.
Moody's has a "stable" outlook on Merrill's ratings, signaling that a change over the next 12 to 18 months is relatively unlikely. S&P has a "negative" outlook, indicating that it is more likely to cut Merrill over the next two years.
Whether or not Merrill can break even in the second half of 2008 will be a key determinant in whether the bank can stabilize its credit ratings, S&P analyst Scott Sprinzen said earlier this month.
