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NOTE: Please confirm through your own research any numbers on which you are to make a buy, sell or hold decision. Monthly Sector Summary Since the May update, 2004 EPS estimates have increase for UBS [1 cent] WB [1 cent]. C's 04 EPS estimate fell a penny. At month end, the year-to-date sector price losses went from -0.35% to -1.14%, 04 EPS growth estimates were stable at 15.85%, and yields fell from 3.34% to 3.18% due to a decrease in BAC's dividend. Banks & Rising Rates Meg Richards, Associated Press 6-18 Whenever Wall Street is worried about rising interest rates, the market almost automatically sells off banking stocks, in the belief that higher rates will hurt their future earnings. But analysts say tightened rates don't necessarily spell doom for all banks. Sweeping changes within the industry have made banks larger, more diverse and more sophisticated at managing risk, including interest rate fluctuations. In some cases, rising rates might even boost profits. Because all banks are built differently, it's wise to evaluate these stocks on a case by case basis. The most rate-sensitive financial stocks are typically regional banks, consumer credit card companies and firms heavily dependent on residential mortgages. Companies like this, such as Washington Mutual., National City Corp. and Countrywide Financial Corp., benefited greatly from the recent refinancing boom, when homeowners rushed to take advantage of historically low rates. Now, left with the more mundane business of servicing those mortgages and with little prospect of another profit spike, their earnings are likely to flatten or fall over the next year or two. Larger, more diverse financial institutions will fare better as rates rise. They're more likely to have moved assets to short-term securities in anticipation of the eventual rate hike, which will boost their bottom lines. In addition, banks that offer more products and services are likely to derive a higher percentage of income from fees and transactional costs - everything from insurance, brokerage and checking account charges to the $1.50 you pay whenever you use their automatic teller machines. The improving economy is also likely to work in the big banks' favor. During good times, the demand for commercial loans goes up as businesses look to expand. Unlike residential mortgages, which are often fixed at a low rate, commercial and industrial loans are usually adjustable, meaning they are repriced as rates rise. From a bank's perspective, they're a better investment. In a recent study of the industry, Collyn Gilbert, senior bank analyst with Ryan Beck & Co., identified a high percentage of fee income and a bigger proportion of commercial and adjustable rate loans as two important factors for determining how well a bank is positioned in a rising rate environment. "Now is a good time to own a Citigroup, a large, diversified financial corporation," Gilbert said. "They're much more sophisticated and less subject to volatility." If you're looking to invest in smaller companies, she said, you might focus on those with a higher concentration of commercial loans, because that's the segment of the economy that is expected to improve, and that's the portion of their loan portfolio that will be repriced as rates rise. There's another factor at play in the current market, as well: The rise in merger and acquisition activity has helped regional banks hold up more than they might otherwise, because investors are betting they'll be snapped up by bigger firms. So far this quarter, the financial sector is down 2.2%, while regional banks are up 1.1%. "You'd normally expect the regional banks to sell off when interest rates are about to rise, but so far in the second quarter they're outperforming the sector as a whole," said Jeff Kleintop, chief investment strategist for PNC Financial Services Group in Philadelphia. "That's absolutely related to merger speculation." Month Ending Sector Summary Since 5-28, the year-to-date sector price losses fell from a decrease of 3.72% to a decrease of 3.63% and 04 EPS growth estimates fell from 30.40% to 28.34%. Over the same time period, EPS estimates rose for BSC [10 cents], GS [3 cents], LEH [16 cents], and MWD [2 cents] and fell for AMTD [7 cents], BEN [1 cent], MER [1 cent], SCH [4 cents] and TROW [a penny]. Schwab Cuts Fees Craig & Zuckerman, WSJ 6-02 To attract more customers, Charles Schwab last week announced plans to slash prices for some online stock trades. The firm says the move, aimed in part at narrowing the pricing gap between Schwab and discount online brokers Ameritrade and E*Trade, will help it attract customers while costing Schwab just 2% to 3% of its revenue over the next year. But the move has rattled investors, who suspect the pain may be worse than Schwab is predicting. Their concern: The company may not attract nearly as much new business to offset the price cut. Making matters worse, Schwab shares remain expensive, despite dropping more than 30% in the past eight months. And with the stock market hitting weakness, and the company struggling to boost earnings and still trying to figure out how best to compete with rivals, some investors are concerned a turnaround isn't around the bend. Although the stock market is up sharply in the past year, and individual investors have returned to the market, Schwab has missed out on much of the spoils. While Ameritrade and E*Trade are both up about 50% in the past year, Schwab shares are pretty much flat, in part because its bloated cost structure has hurt profit. While Ameritrade wins kudos as the low-cost broker, Schwab continues to try to make headway in this area. Last week, Chief Executive David Pottruck, who became sole CEO early last year when founder Charles Schwab stepped down as his co-CEO, warned that the revenue fall could result in more staff reductions. Since the second quarter of 2001, the company has seen its staffing levels fall almost 25%, to 16,900 at the end of March, its most recent quarter. "As we begin to identify the necessary changes and reset priorities, we have to be realistic that some jobs will be eliminated," he wrote in a memo to Schwab employees. It has been a rough few years for Schwab, which has implemented a variety of strategies in an attempt to bring down the huge cost base left over when the booming trading volumes of the late 1990s slowed. In an attempt to wean itself off the online-fee business, it has been trying to transform itself into a full-service broker such as Merrill Lynch. In 2000 it bought U.S. Trust Corp, which caters to wealthy clients. It also launched Schwab Private Client to attract high-end customers who pay fees based on a percentage of assets rather than per-trade. It also has added stock research to its product mix, and to compete with Ameritrade and E*Trade, it bought an electronic trading platform in 2000 that caters to highly active traders. Several years after it launched many of these initiatives, Schwab has yet to show that it can significantly boost profit. Except for the quarter ended March 31, Schwab has taken charges to cover costs associated with items like restructuring or acquisitions in each of the last 11 quarters. Goldman Sachs Q2 Earnings Susanne Craig and Randall Smith, WSJ 6-22 Goldman Sachs posted strong quarterly results despite a challenging bond environment and trading losses in a key division. Morgan Stanley's profit more than doubled thanks partly to its fixed-income and commodities trading businesses. Goldman's net income rose 71% to $1.19 billion, or $2.31 a share, for its second quarter ended May 31, from $695 million, or $1.36 a share, a year earlier. The total is second only to Goldman's first-quarter results, when the firm reported net income of $1.29 billion. Net revenue, or revenue minus interest expense, rose 38% to $5.51 billion from $3.99 billion in the year-earlier period. Revenue in the previous quarter was $5.93 billion. The firm handily blew through estimates of analysts, who were predicting Goldman would earn $1.95 a share, according to information provider Thomson First Call. Many analysts were expecting Goldman's revenue to dip more than it did, thinking that rising interest rates would dent the demand for bond trading and underwriting, which has provided a big boost to Wall Street earnings in recent quarters. Goldman did see its revenue from bond-related businesses, including currencies and commodities, fall 10% from the first quarter to $1.89 billion, but this is still above the $1.65 billion it logged a year ago. Goldman Chief Financial Officer David Viniar said that even if interest rates continue to rise this year, he doesn't think that will translate into a big drop in bond-related revenue, largely because the business is more diversified than it was 10 or 15 years ago. "I don't subscribe to the belief that the [bond] world is going to end because rates are going up," he said today. "The environment could be a little tougher though, but still OK." Overall, Mr. Viniar said the near-term outlook is still uncertain for businesses like investment banking and trading, but with the prospect of economic growth he remains optimistic longer term. While Goldman managed to post strong bond results, its equity arbitrage traders, who attempt to profit from placing bets on price discrepancies of similar securities trading on different markets, had a tougher quarter. This division, Mr. Viniar said, barely managed to eke out of a profit after making bad bets with the firm's cash on a number of deals. "Over time this has been a great business for Goldman Sachs," he said. "But positions go the wrong way sometimes." Equity trading, the division that houses equity arbitrage, posted a profit of $351 million, down 21% from the year-earlier quarter and 63% from the previous quarter. Elsewhere, Goldman appeared to have less trouble. Revenue in its investment-banking division was $953 million, up 45% from a year earlier and up 25% from the previous quarter. And revenue from trading and principle investments, which includes equity trading and bond revenue, was $3.63 billion, up 35% from the year-earlier, though down 12% from the previous quarter. The firm also reported a $561 million unrealized gain from its investment in financial concern Sumitomo Mitsui Financial Group. Goldman, one of the street's biggest risk takers, saw its "value at risk" figure, an average figure for the quarter indicating what it could lose in a day because of bad market conditions, rise 17% to $69 million from a year earlier. This, however, is slightly lower than the preceding quarter. This number has been rising steadily for a few years now and is up from just $28 million in the fourth quarter of 2000. Morgan Stanley's Q2 Earnings Susanne Craig and Randall Smith, WSJ 6-22 Morgan Stanley said its fiscal second-quarter profit more than doubled to $1.22 billion, or $1.10 a share, topping analysts' estimates of $1.06 a share. Within its business of dealing with institutional investors, Morgan's fixed-income sales and trading revenue not only rose 43% from the second quarter of 2003, it also rose 11% from the first quarter of 2004, despite a rise in interest rates that has hurt bond-related results at some other firms such as Goldman and Lehman Brothers Holdings Inc. Morgan's net in the quarter that ended May 31, 2004 fell slightly from $1.23 billion, or $1.10 a share, in the first quarter of 2004. Net for the second quarter of 2003 was $599 million, or 55 cents a share. Morgan Stanley's net revenue rose 32% to $6.65 billion in the latest quarter from $5.05 billion in the second quarter of 2003; it also rose 7% from $6.24 billion in the first quarter of 2004. Quarterly pretax income in institutional securities more than doubled to $1.13 billion compared with the second quarter of 2003, and doubled to $132 million in the individual investor group, which includes the firm's brokers. Pretax income rose 71% to $209 million in investment management, but fell 1% to $298 million in credit services, which contains the firm's Discover credit-card business. Analyst Daniel Goldberg of Bear Stearns noted that while Morgan Stanley's investment banking revenue grew 19%, driven by a 40% increase in advisory fees and 31% higher fixed-income underwriting revenues, margins declined from the first quarter in each business except investment management. Although the firm said its broker headcount fell by 110 to 10,722 in the quarter, marketing and business development costs rose 5% to $263 million from the second quarter of 2003. For the first six months of the year, Morgan said its net rose 63% to $2.45 billion, or $2.21 a share, from $1.5 billion, or $1.37 a share, in the first half of 2003. First-half net revenue rose 23% to $12.89 billion from $10.52 billion. Merril Lynch Expects only 9% Profit Rise Jed Horowitz, Dow Jones Newswires 6-30 Merrill Lynch is likely to be a victim of the calendar when it reports later this month that second-quarter earnings grew more slowly than at its Wall Street rivals, some analysts and investors said. Merrill's fiscal quarter ended in June, when the bond trading gains that fueled Wall Street profits for more than a year fizzled and retail investors abandoned stocks. Rivals Morgan Stanley, Goldman Sachs, Lehman Brothers and Bear Stearns avoided the June slide in reporting results that beat expectations last month because their fiscal second quarters ended in May. Merrill Lynch is expected to report that earnings rose 9% to $1.10 a share in the second quarter, according to the average forecast of 20 analysts surveyed by Thomson First Call. That's well below the gains of 100% and 70% reported last month by Morgan Stanley and Goldman Sachs, respectively, and half of the gains at Lehman and Bear Stearns. The results for those companies were burnished in March - in their second quarters - when revenue from bonds and other fixed-income securities soared as investors and mortgage buyers shifted their portfolios in anticipation of a Federal Reserve rate rise, said Prudential Equity Group analyst David Trone. Merrill's March bond bonanza, on the other hand, was booked in its first quarter, when it earned a record $1.3 billion, or $1.22 a share. "The annual summer slowdown appears to already be in full force on Wall Street as several macro indicators for U.S. brokerage stocks witnessed a deceleration in June," Goldman Sachs analysts, led by Jim Hoeg, wrote in a recent report. That report also reduced Goldman's estimate of Merrill's second-quarter earnings by seven cents, to $1.10 a share. The report cited both the absence of March trading revenue and a decline in retail stock trading. Merrill's almost 14,000 brokers had to contend with individual investors' distaste for the stock market in June, a factor much less important to Goldman Sachs, Bear Stearns and Lehman, which have few or no retail branches. Share volume on the New York Stock Exchange and the Nasdaq Stock Market reached their lowest levels in June since at least January while online brokers such as Charles Schwab said daily trades from their customers plummeted in May and June. Like Goldman Sachs, Prudential was one of several firms that trimmed second-quarter and full-year earning forecasts for Merrill last week, citing lower retail commissions, trading and investment banking revenue. Goldman still rates Merrill outperform, saying its full-service rival's return on equity should beat most other firms because of its diversified revenue sources as fixed-income trading profits deteriorate. The Legg Mason Outlook Allison Krampf, Barrons 6-29 In recent year, shares of Legg Mason have performed well in all types of markets.The stock of the Baltimore-based money manager and investment bank is up 42% in the last 12 months, easily beating the industry, when most other financial services stocks have been treading water in anticipation of rising interest rates. What's been Legg Mason's secret? A diversified asset management strategy. The company offers both growth- and value-oriented stock funds, as well as bond funds of all flavors, to institutional and retail investors alike. Today, Legg Mason owns some of the best-performing assets in the mutual fund world. Since 2000, its assets under management have more than doubled, to $286 billion, from $112 billion. It is currently the 26th largest U.S. asset manager. Legg Mason's business had grown both organically and through acquisitions. For example, since 2001, when it acquired small and micro-cap value manager Royce & Associates, Royce's assets under management have tripled to $18 billion. Western Asset Management, an acquisition from the 1980s, is a leading fixed- income manager, too. But all this probably won't be enough to help the stock rise. As assets under management balloon, high double-digit earnings growth rates are harder to come by. Even self-described fans of the stock are watching Legg Mason carefully, wondering whether it already has fully priced in an economic and stock market recovery. Legg Mason's well-known units include Barrett Associates, a New York City money manager for wealthy individuals, which it acquired in 2001, and the $14-billion Legg Mason Value Trust mutual fund, headed by legendary portfolio manager Bill Miller. Asset management (or investment advisory and related fees) has grown to an estimated 63% of net revenue this year from only about 17% in 1994, according to Legg Mason's annual report. Right now, almost two-thirds of Legg's assets under management are in fixed income, which generate lower fees than equity products (which comprise the remainder of sales). And while both equity- and bond-market rallies have helped Legg Mason register impressive results since last March, those days may be numbered. In 2003, Legg Mason's earnings grew by 24%, and they surged another 46% in 2004. But Thomson First Call's consensus expects a slower 15% annual growth over the next five years, probably because of lower expected returns in equities and fixed income. The shares fetch roughly 17x Wall Street's earnings estimate for the fiscal year ending next March, a premium to Legg Mason's projected long-term annual earnings growth. Legg Mason also is selling at 3.9x book value, above its median 3.4x book over the last five years, according to Thomson Baseline. Home Page Factoids Previous Update
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