Friday, January 18, 2008

More 'Smoke & Mirrors' at Merrill Lynch

Merrill Lynch & Co. (MER-$49.45) reported a fourth-quarter net loss of $9.83 billion, or $12.01 a share, significantly above the consensus deficit of $4.93 a share forecasted by analysts in a Thomson Financial survey.

The fourth-quarter loss included $12.4 billion in net write-downs on U.S. collateralized debt obligations (CDOs), sub-prime and residential mortgage-related securities. Flowing through the investment bank’s income statement, too, were negative credit adjustments of $3.1 billion to reflect
tainted hedges with bond insurers.


At the end of the fourth quarter 2007, the balance sheet still held $30 billion of senior Asset-Backed Securities (
ABS) CDO at year-end (post write-downs)—of which a significant portion is collateralized with 2006 mortgages!

On its earnings call, management attempted to minimize this exposure by positing that $14 billion, or 46.7%, of the ABS was hedged with financial guarantors. Big deal—bond insurers are currently under review for possible event of defaults (related to failure to hold required levels of over-collateralization) and subsequent rating downgrades (which means that additional credit valuation adjustments might be forthcoming in the 1H:08).

An additional concern, in valuing the $30 billion in gross exposure still in ABS CDOs, the Company--we believe--is using ‘smoke & mirrors,’ for these securities are nothing more than contrived financial instruments, rarely traded.

CFO Neslson Chai said, “I think where the book is marked right now reflects as of December 31 as best we could where we think those positions were. And as you know, under
FAS-157, everything was level three. We triangulated around a bunch of different modeling assumptions and a lot of obviously external metrics to come up with what we thought was the right range, if you will.”

[Ed. note. Management would prefer that investors focus on its net exposure in ABS CDOs, which fell to $4.8 billion at year-end, from $15.8 billion at the end of the third quarter 2007.]

Commercial Real Estate and Leveraged Finance

On the commercial real estate and leveraged finance front, within Merrill’s commercial real estate business, aggregate net write-downs totaled approximately $230 million for the fourth-quarter, driven by spread widening and market illiquidity. Within leveraged finance, net write-downs of approximately $126 million were recorded with respect to these financing commitments.

After the current-quarter’s writedowns, net exposures related to commercial real estate (excluding Merrill Lynch Capital) and leveraged finance commitments totaled approximately $36 billion.

On the conference call, Chairman & CEO John A. Thain concurred on the pricing sensitivity of the commercial real estate portfolio to the overall economic environment, but said: “given where we are, given the types of properties that they are, given the structure of those deals, we’re very comfortable that these things are conservatively marked [$18.0 billion commercial real estate portfolio].”

A concern remains that deteriorating U.S. economic and market conditions could spread to theses business segments, leading to substantial impairment charges in coming quarters.


Equity-linked trading and Wealth Management remain two bright spots for the Company.

Equity Markets net revenues increased 23% from the prior-year quarter to $2.2 billion, driven by the global build out of the equity-linked platform and substantial growth in client volumes and asset balances.

Global Wealth Management recorded fourth quarter net revenues of $3.6 billion, up 12 percent year-over-year, reflecting growth in transaction volumes and fee-based revenue.

Equity redeployment and aggressive balance sheet management have gotten a good reception from credit rating agencies, which all affirmed their bond ratings today. However, at the end of the fourth quarter, book value per share was $29.37, down from $41.35 at the end of 2006.

John A. Thain has promised improved
risk management—delivering on that promise would do much to improve stockholder confidence.

Well, I hope you guys help us get credit in our stock price because as you all know, if you simply put a multiple on the earnings out of the wealth management business, you basically get the market value of the whole company, so I assume that you all will help by telling how cheap our stock is. ~ CEO John A. Thain

Unfortunately for Messer. Thain, save for
takeout rumors, brokerage stock investors rarely price their holdings using a sum of the parts valuation.

In our view, despite the 48.2% drop in the Company’s market valuation in the last year, now is not the time to do contrary buying in Merrill Lynch. At a multiple of 11.1 times consensus FY ‘08 estimates of$4.50 a share (on average), the stock of Merrill Lynch carries market risk, selling at a 38.7% premium to its peer (investment banking) multiple of 8 times earnings.

At 1.7 times tangible book value, the stock of Merrill Lynch is priced at a premium multiple to its peers, too (mean, 1.4 times).

The 10Q Detective believes that the Company understated asset impairment charges in the fourth quarter, and we believe that the stock will underperform the market as rising levels of non-performing assets continue to adversely impacting 1H:08 profitability.

Editor David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

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