Merrill Mauls Morgan Stanley in Brokerage Titan Clash

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Sallie Krawcheck of Bank of America
Sallie Krawcheck oversees Merrill Lynch as president of Bank of America's wealth unit. Photographer: Jin Lee/Bloomberg

In the clash of the two largest U.S. brokerages, Bank of America Corp.’s Merrill Lynch is generating more profit with fewer people than the business Morgan Stanley formed by buying a controlling stake in a venture with Citigroup Inc.’s Smith Barney.

Merrill Lynch, acquired by Bank of America in 2009, produced $315 million more profit from its brokerage in the first half than Morgan Stanley with 2,900 fewer financial advisers, according to company filings. Its pretax profit margin, 16.7 percent for the same period, is more than double Morgan Stanley Smith Barney’s 7.8 percent.

The worst financial crisis in 70 years shook the brokerage landscape, catapulting Morgan Stanley from fifth-largest to first by client assets and enabling Bank of America to acquire industry leader Merrill Lynch. The advantage wielded by Merrill stems from a simpler integration and from pushing clients into deposits and other products as individual investors fled stock markets, analysts said.

“Merrill Lynch long ago led in banking, financial planning, insurance, and they are the more diversified firm,” said Charles Roame, managing principal of Tiburon Strategic Advisors, an industry consulting firm in Tiburon, California. “It will win the banking-integration bet. Morgan Stanley will not catch them.”

Gorman, Krawcheck

The job of catching up falls to Morgan Stanley Chief Executive Officer James P. Gorman, 52, who ran Merrill Lynch’s private-client group from 2001 to 2005 and spearheaded a shift to higher-wealth customers. He must now compete with a company still benefiting from that strategy.

To help him, he has three Merrill veterans. Morgan Stanley Smith Barney’s president, Charles D. Johnston, began his career as a financial adviser at Merrill Lynch, and Andy Saperstein, who runs the brokerage’s U.S. operations, was recruited from Merrill by Gorman in 2006. Gorman, who became CEO in January, also hired former Merrill Lynch investment bank head Greg Fleming to lead asset management.

Their chief rival is Sallie Krawcheck, 45, who oversees Merrill Lynch as president of Bank of America’s wealth unit. She’s now going head to head with Smith Barney, which she led from 2002 to 2004 and in 2008 when she worked for Citigroup.

“We’ve got the leadership position, but we can’t rest,” Krawcheck said in an e-mail. “Staying focused on the clients, meeting the needs and demands that have come out of the downturn and leveraging the competitive advantages of Bank of America will keep us ahead.”

Gorman declined to comment. A spokesman for Morgan Stanley, Jim Wiggins, said the firm likes its position.

‘Leading Position’

“The Smith Barney deal enabled Morgan Stanley to go from subscale to a leading position in wealth management overnight,” Wiggins said. “There are great synergies with our institutional businesses, and we have a clear, multiyear plan to grow the profit margin as we integrate two large franchises.”

There may be more at stake for New York-based Morgan Stanley, which got 36 percent of first-half net revenue from wealth management, than for Bank of America, which relied on the Merrill Lynch brokerage for 10 percent of net revenue.

The firms manage about the same amount of client assets -- $1.4 trillion at Merrill compared with $1.5 trillion at Morgan Stanley -- and have comparable revenue: $6.4 billion in the first half at Merrill and $6.2 billion at its competitor.

Broker Revenue

They part ways on profit and revenue per broker. Merrill earned $675 million from its brokerage business in the first half, while Morgan Stanley Smith Barney reported profit of $360 million. Each of Merrill’s 15,142 brokers brought in $836,000 on average on an annualized basis compared with $682,000 for Morgan Stanley’s 18,087.

Pretax margin at Morgan Stanley’s wealth-management unit slumped to less than 10 percent this year from 17 percent in 2007, in part because the firm spent more to recruit brokers to replace those who left over concerns about the company’s future, said Daniel Arbeeny, managing principal at CMF Partners LLC, a New York search firm.

“Morgan Stanley came really close to being pounced on, so a lot of people fled for safety,” Arbeeny said, referring to the period after the collapse of Lehman Brothers Holdings Inc. in September 2008, when Morgan Stanley’s stock dropped 78 percent before the firm received investments from Mitsubishi UFJ Financial Group Inc. and the U.S. government.

‘Not Going as Well’

Morgan Stanley had 11 percent fewer brokers as of June 30 than when the Smith Barney merger was announced in January 2009. Revenue per adviser remains a third higher than before Gorman arrived in 2005, though down from a peak of $811,000 in 2007. Johnston said last month that attrition among the firm’s brokers had dropped to “record lows” since the joint venture closed.

Morgan Stanley, the nation’s sixth-largest bank by assets, is pushing back its target to achieve a 15 percent profit margin, Chief Financial Officer Ruth Porat, 52, said on a July 21 conference call with investors. She blamed the delay on weak market conditions, including the May 6 crash that unnerved many investors. The brokerage’s profit margin fell in the second quarter, when it had a $5.5 billion outflow of assets.

The merger with Smith Barney “is probably not going as well as they originally thought,” said Douglas Sipkin, a New York-based analyst at Ticonderoga Securities, who has a “neutral” rating on Morgan Stanley. “They have pushed out their margin targets, which they blame on the markets. But I’m skeptical of that excuse because stock prices are still a lot higher than last year.”

Simpler Integration

Merrill Lynch has also shed brokers. It had 16,000 in September 2008 when the deal with Charlotte, North Carolina- based Bank of America was announced. Bank of America had about 2,000. Krawcheck, recruited by former Bank of America CEO Kenneth D. Lewis in August 2009, has stanched fears of a continuing exodus by adding about 150 brokers in the past year.

The large size of Merrill Lynch compared with Bank of America’s brokerage unit made the integration simpler than Morgan Stanley’s, which was a combination of two similarly sized operations, said Guy Manuel, founding partner of CBM Group Inc., a New York consulting firm.

Morgan Stanley reported about $200 million in one-time integration costs in the first half. Gorman said in February that the brokerage would have $450 million in integration costs this year, after $280 million in 2009. He said he expects a minimum of $1.1 billion in cost savings at the unit by 2011.

‘Natural Referral Flow’

Merrill also has a lead in pushing more jumbo mortgages and other banking products to existing customers. It has 800 bankers assigned to persuade brokerage clients to move money to Bank of America, the largest U.S. lender by assets, resulting in 80,000 sales of banking products in the second quarter compared with 35,000 in all of 2009, according to a regulatory filing in July.

Providing banking services to clients also helps increase profit margins as advisers are paid a lower percentage of the revenue generated from that business than from brokerage transactions or asset management. Merrill reported more than four times as much first-half net interest income -- the profit made on the spread between interest paid on client deposits and that received from loans and other assets -- as Morgan Stanley Smith Barney did.

To close that gap, Morgan Stanley hired 100 bankers to offer loans and deposit products to brokerage clients. The unit will be run by former Wachovia Corp. executive Cece Stewart, 52, and may quintuple its ranks by the end of 2011, a person with knowledge of the strategy said in June.

Retail Investors

“There’s more of a natural referral flow that would exist at Bank of America and Merrill Lynch,” said Douglas Ciocca, managing director at Renaissance Financial Corp. in Leawood, Kansas, which manages $2 billion in assets. “Every one of the wealth-management studies would dictate that up to a certain point, the more you’re able to do for your clients, it’s directly proportional to their loyalty.”

Merrill’s net-interest-income advantage will decline in importance as stock market returns accelerate and investors hold less cash, said Dennis Gallant, president of Gallant Distribution Consulting in Sherborn, Massachusetts.

Morgan Stanley Smith Barney may outperform Merrill when retail investors become more active in the bond and equity markets and asset prices increase, Ciocca said. The firm had a 21 percent market share in managed accounts, which often charge fees based on asset levels, compared with Merrill’s 17 percent, according to Cerulli Associates, a Boston-based consultant.

‘Rock-Star Advantage’

Retail investors had 52 percent of their investments in stock funds and individual equities, 24 percent in bond funds and bonds and 24 percent in cash in July, according to a survey by the American Association of Individual Investors, a nonprofit investment-education group in Chicago. That compares with a historical average of 60 percent in equities, which often produce higher margins for brokerages.

Krawcheck, who is based in New York, has kept a low profile at Bank of America compared with her stint at Citigroup, where she often made headlines, said Mindy Diamond, president of Diamond Consultants, a Chester, New Jersey-based executive search firm for the brokerage industry.

“We talk to zillions of Merrill advisers all the time, and her name never comes up,” Diamond said. “It’s very different at Morgan Stanley, where Gorman absolutely has a rock-star advantage. Many advisers are staying there because they respect him so much.”

After Grubman

Gorman, an Australian, was named to lead a restructuring of Merrill’s famed “thundering herd” of brokers in 2001. He cut the number of brokers by one-third over two years, closed a quarter of the firm’s retail branches and shifted its focus to the wealthiest clients. Pretax earnings in the global private-client group Gorman headed rose to $2.2 billion in 2005 from $1.5 billion in 2003, filings show.

Krawcheck, who grew up in Charleston, South Carolina, was hired by Citigroup in 2002 to restore Smith Barney’s reputation after analyst Jack Grubman was accused by the Securities and Exchange Commission of publishing biased research to win business for the firm’s investment bank. He was later banned from the markets and paid $15 million in penalties and disgorgement. Smith Barney’s net income rose 12 percent in 2004 to $891 million from the previous year and topped $1 billion in 2005 and 2006.

When John Mack recruited Gorman to turn around Morgan Stanley’s brokerage in 2005, the firm’s brokers were each generating an average of $490,000 in revenue compared with $766,000 at Merrill and $556,000 at Smith Barney. Gorman helped close that gap, which shrank further after the joint venture.

Independent Advisers

Neither Gorman nor Krawcheck can afford to slip. Wells Fargo & Co., the third-largest full-service U.S. brokerage and an industry leader in cross-selling, has almost as many brokers as Merrill and oversees $1.2 trillion in client assets. The fourth-largest U.S. broker by client assets, Zurich-based UBS AG, is run by Robert McCann, Gorman’s boss at Merrill from 2003 until 2005.

The firms also face competition from independent online brokers such as Charles Schwab Corp., which has $1.4 trillion in client assets, and closely held Fidelity Investments.

Merrill Lynch and the combination of Morgan Stanley and Smith Barney have lost market share since the start of the financial crisis. The firms controlled 25 percent of the industry assets under management in 2009, down from 32 percent in 2007, figures compiled by Cerulli Associates show.

Registered independent advisers, known as RIAs, and regional broker-dealers such as Royal Bank of Canada Corp. have taken some of that share, increasing their percentage of assets to 32 percent from 28 percent in 2007, Cerulli data show.

“Competing in this world is much different than it was in the 1980s and the 1990s, especially building a business,” said Anthony DeChellis, head of Credit Suisse Group AG’s private banking Americas business, who said his unit’s profit has doubled in the past three years. “Clients are getting better at choosing the firms where they can get the best advice and the best guidance.”

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