If only: Invariably, the most frequently repeated comments about Merrill Lynch & Co. begin with these two words. If only Merrill Lynch got its act together, if only it could realize the potential of its mammoth franchises.

Merrill has always taken great pride in its size. It is the largest U. S. underwriter, employs the most retail brokers, and holds more individual assets -- $413 billion -- than any other U. S. financial institution. Merrill's bottom line, though, has been far less awesome. Powerful but awkward and overweight, the firm was hobbled by a costly, bloated bureaucracy. Its senior executives were widely regarded as among the least imaginative and venturesome on Wall Street.

The consequence was a return on equity and a stock price that lagged far below those of rivals. The huge stock market bonanza of the 1980s never trickled down to Merrill's shareholders. In early 1989, with its stock trading at $18, vs. today's $56, a group of investors assembled a preliminary bid for the firm. The group, led by former Merrill executives with support from a Japanese securities firm and a U. S. financial firm, disbanded when such executives as former Merrill chief Donald T. Regan turned down their offer to head the takeover bid.

SEA CHANGE. Today, there are clear indications that Merrill is remaking itself. Led by Chief Executive Officer William A. Schreyer, 63, an ebullient, unpretentious, former stockbroker, and heir apparent Daniel P. Tully, 59, who is president and chief operating officer, the giant firm is busily trying to abolish its lax, free-spending culture. In the last two years, Merrill has cut costs by well over $400 million, reduced its head count from 48,000 to 37,000 -- largely by getting rid of managerial and support staff -- and divested itself of several underperforming divisions.

More fundamentally, the firm is pushing employees to focus on profits instead of size. Merrill has installed internal controls and risk-management systems, eliminated superfluous management layers, and is taking a more disciplined approach to its businesses, a move that could permanently lower its hefty cost structure.

Signs of Merrill's transformation abound. In the first three quarters of 1991, the company earned a record $525 million, more than it ever made before in an entire year. Virtually all Wall Street firms, of course, are reaping the revenue benefits of the buoyant stock market. But Merrill is doing better than most in transforming volume into profits. From a year ago through the third quarter of 1991, Merrill has boosted its return on equity to 20% from 6% and its margins from 2.6% to 7.7%. In the third quarter of this year, its costs as a percentage of revenues were 87%, the lowest of all large retail brokers except Dean Witter Reynolds Inc. Says Schreyer, who became CEO six years ago, "What's different this time is we've streamlined the organization."

At a time when the credit ratings of numerous financial institutions are being downgraded, Moody's Investors Service on Nov. 8 upgraded Merrill's long-term debt to A-1. What convinced Moody's is that Merrill has lowered its cost structure, probably for good. "There really does appear to have been a cultural shift from emphasizing market share to a bottom-line focus," says Moody's Christopher Mahoney. "We have a much higher degree of confidence that they can perform well in bad markets."

Merrill has done much to insulate itself against market reverses. It has successfully shifted away from volatile brokerage commissions toward dependable fee income, mainly by accumulating a huge cache of customer assets, which are growing at a steady 10% a year. That push began in the late 1970s, when the firm pioneered the Cash Management Account, a combination CD, checking, and brokerage account. Merrill brokers used this to attract money that they could then direct into an assortment of Merrill investment products, such as mutual funds. Merrill Lynch Asset Management Inc., one of the largest mutual-fund operations, has $120 billion in assets, up from less than $80 billion in 1988.

Merrill is currently benefiting from low interest rates, which are causing many customers to move their money from short-term money-market funds into higher-yielding long-term bond funds. The firm earns both a onetime sales charge when the money is moved and profits from the slightly higher management fee on the bond funds. A 10% shift of the roughly $130 billion that Merrill customers have in short-term funds would buoy Merrill's earnings by about $120 million, estimates analyst Alison Deans of Smith Barney Harris Upham & Co.

At a time when creditworthiness is next to godliness, Merrill has amassed a formidable $11 billion capital base, the largest of any broker. It has been steadily reducing such high-risk assets as bridge loans, and it has among the highest ratios of equity to net assets of any brokerage.

Schreyer's efforts to boost Merrill's competitiveness have been helped by the travails of its rivals. The firm, once accident-prone, is now almost as notable for what it didn't do wrong as what it did right. Caught with a portfolio of ailing bridge loans, First Boston Corp. had to be bailed out by parent Credit Suisse. Merrill had far fewer such losses. After Drexel Burnham Lambert Inc. went under, Merrill became the No. 1 issuer of junk bonds, though the market has shrunk. Shearson Lehman Brothers Inc. appeared to upstage Merrill when it bought E. F. Hutton in 1988 and doubled its broker ranks. "We were viewed as stodgy, and Shearson was viewed as bold," says John L. Steffens, Merrill executive vice-president. Hutton, though, was a costly black eye for Shearson. Merrill picked up a lot of business when Salomon Brothers Inc. became enmeshed in a Treasury bond bid-rigging scandal. "It helped us when a few of the 'bulge-bracket' firms stumbled," says Jerome P. Kenney, Merrill executive vice-president.

CLEAN-NOSED. Merrill has also managed to maintain a clean image at a time when many firms have been sullied by charges of wrongdoing. The Securities & Exchange Commission is currently investigating whether Merrill illegally parked bonds for a Florida insurer in the mid-1980s, which Merrill denies. And along with all primary dealers, Merrill is under scrutiny for possible collusion in Treasury issue auctions. But the firm not only avoided being implicated by the Levine-Boesky-Milken scandals but got favorable publicity for helping the SEC. Credit goes to Merrill's strict compliance department, its extreme image-consciousness, and top management's basic philosophy. Long before Warren E. Buffett was telling Salomon employees to watch their ethics, Schreyer's mantra has been, "no one's personal bottom line can ever be more important than the reputation of the firm itself."

Despite recent achievements, many Wall Street executives think the firm's financial results are simply a windfall from the robust stock and bond markets. They refuse to believe that Merrill's management has changed much. A good deal of the skepticism is directed at Schreyer. In fact, over the past few years Schreyer has become much more effective. But the constant lack of respect gives Merrill executives fits. "I've never met a group of people so determined to prove their critics wrong," says Scott Offen, an analyst at Fidelity Investments, a major Merrill stockholder. "They keep shouting and no one's listening. They have disappointed people for so long."

There's no denying that. For years, Merrill's strengths have been obscured by its predilection for overspending and undermanaging. During the 1980s, it pulled out all the stops. To overcome its inferiority complex in investment banking and break into the big leagues, it paid top dollar for talent. Schreyer recruited a raft of big names (all of whom are now gone) to broaden its management ranks, including Courtney Jones, former treasurer of General Motors Corp., as chief financial officer. Its biggest embarrassment was signing long-term leases in 1984 on two costly headquarters buildings in lower Manhattan, when one proved to be enough. Most of the 2.2 million square feet in extra space has been sublet, but 170,000 square feet are still empty.

The low regard for cost control manifested itself in less spectacular ways. Employees remember sending packages to each other between floors by United Parcel Service. Bond traders got $12 a day, which has since been pared to $6, for a take-out lunch. Merrill's trading floors, featured in the movie The Bonfire of the Vanities, are probably the largest and most expensive on Wall Street. Traders' desks were piled high with the latest computers and screens, some of which they never used.

REFORMS. Schreyer and Tully shouldered much of the criticism for these excesses. "They were the ones that got the blame, and they should get the credit," for the improvement, says Regan. Both allowed lieutenants to build separate fiefdoms without holding them accountable for results. And they were lax in installing operating controls, which resulted in one of Merrill's few visible disasters during the 1980s: a mind-boggling, one-day trading loss of $377 million in April, 1987.

That certainly got Schreyer's attention. But it wasn't until the crash later that year that he pushed the panic button. Merrill found itself stranded with shrunken revenues to support its enormous cost structure. Schreyer commenced an extensive series of reforms. "The institution doesn't change. The people change, because they become more experienced and they learn from their mistakes," says Merrill General Counsel Stephen L. Hammerman.

First, Schreyer insisted that Merrill beef up its risk-management procedures. The firm installed Daniel Napoli, a former bond trader, in a new position of senior vice-president responsible for monitoring risk firmwide. Instead of being under the thumb of a powerful trading chief, Napoli reports directly to Tully and sits on the executive committee. Merrill has also scaled back trading for its own account. Today, about 85% of trading revenues come from less risky trading for customer accounts.

Merrill is forcing managers to run their divisions more like freestanding businesses. Managers are accountable for all the costs of their divisions. The firm is also systematically putting units under the microscope. At the end of every quarter, in what the firm calls a "burden of proof" process, Merrill reviews from two to five of its businesses that are not meeting budgets and are earning less than a 15% return on equity, Schreyer's overall goal for the firm. Merrill has exited about 15 businesses including Fine Homes International, formerly Merrill Lynch Realty, most of its Family Life insurance business, and its clearing business, Broadcort Capital.

Merrill has scaled back significantly overseas. It cut costs 40% in London since 1988 and now makes a market in 30 British stocks, instead of the 120 of a year ago. It sold its Canadian retail brokerage and pulled out of Australia, paring 20 global sales offices down to 11. Domestically, Merrill has drastically cut branch-network costs. It is reducing 14 nationwide operations centers to 2. That will trim 1,200 employees and 400,000 square feet of space, saving $85 million by 1992.

SALARY FREEZE. The firm now forces the heads of its six operating divisions -- debt trading, equity trading, investment banking, retail brokerage, asset management, and insurance -- to pick up the total costs of the support staff. The results of 'dedicating' these costs was impressive: a whole tier of support personnel was eliminated and expenses, notably in human resources and the controller's office, were reduced dramatically.

Despite the strong stock market this year, Merrill instituted a salary and head-count freeze throughout most of the firm, and managers have been directed to shift people from slow to more active areas. "Ninety percent of my time was spent downsizing and reconfiguring. It's not a hell of a lot of fun," says David H. Komansky, executive vice-president in charge of equity. "But I'm just not going to add head count. I don't want to get into a position where we're the biggest at the top of the market. It's too painful."

Merrill is also giving greater power to line managers. The executive management committee, a 13-member entity that runs the firm, had been dominated by staff executives who ran such support divisions as legal, operations, and finance. Now it is guided by the heads of the firm's six profit centers.

The firm is restructuring the compensation system to get employees to think more like owners. Managers' base pay and bonus are now based in large part on the revenue of their divisions less controllable costs, such as staff, space, and operational support. And more pay is in stock. Senior managers get 20% to 50% of their compensation in restricted stock, with the pace of vesting linked to Merrill's ROE. The more senior the managers, the more stock they get. "Close to 80% of my net worth is invested in Merrill stock," says Herbert M. Allison, Merrill's chief financial officer.

Despite the improvements, Merrill still has major weaknesses. Despite years of effort, the profitability of its large investment-banking operation still is lackluster. Merrill did not begin building its capital-markets capabilities until the late 1970s. The firm became the No. 1 underwriter of all debt and equity in 1988. Yet that hasn't translated into the top slot in profitability because Merrill dominates mostly the low-margin, commodity end of the underwriting business. For example, Merrill is the ranking debt underwriter, where fees are half a percentage point of the underwriting. But in the initial public offering market, where fees run 6% to 7% of the principal amount, Goldman is by far the leader.

Merrill has had mixed success breaking into the high-margin mergers and acquisitions business. Often, other firms get the call when companies are planning complex restructurings and refinancings. One reason is that Merrill's bankers still don't have the long-term relationships with corporate executives that generate such business. "The juicy deals in terms of profits, where you need the ear of the CEO and CFO, Merrill is not there," says an industry analyst.

Another reason is that for all of the streamlining, Merrill remains much more bureaucratic than most competitors. This is a major drawback in a business where profitability relies so heavily on speed and innovation. It also hampers Merrill in attracting and keeping good people. "Merrill Lynch is a company which only tolerates entrepreneurs," says a former Merrill employee.

DEEP CUT? Longer term, Merrill faces fiercer competition for individuals' assets, as banks and mutual funds go after this lucrative market. On the institutional side, Merrill must contend with more powerful banking rivals, such as J. P. Morgan & Co. And to stave off global financial giants, it must boost its worldwide presence. Merrill has a successful investment banking presence in Europe and Japan and a thriving retail brokerage operation in Japan. But its international presence is deficient, and it may have cut too deeply.

But perhaps most important, it must maintain its hard-won stress on organizational discipline and cost-control. Old habits die hard. Observers note the firm's compensation costs are moving up again, although it is hiring more brokers than support staff. They also note the annual bash for Merrill's top producers will still be held overseas in Barcelona instead of in a more modest domestic locale. Dean Eberling, a Shearson analyst, sums up the challenge: "They have gotten some religion. Whether they're born-again, I don't know."

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