Salomon Steps Into The Daylight
Salomon Brothers Inc. Chairman Deryck C. Maughan is back from the heart of darkness. Beset by managerial turmoil in 1995, he was barricaded in his Manhattan office night and day for months, black circles under his eyes, reluctant to take time out even for a haircut. His managing directors were defecting to rival firms or dividing into hostile factions. These days, in the hallowed tradition of Wall Street's edgiest firm, he arrives at work "ready to bite the ass off a bear," as predecessor John H. Gutfreund liked to say. Maughan says he has won "a mighty struggle for the soul of the place."
Indeed, Maughan is well on the way to making a new Salomon--managerially, culturally, and financially. And he is making a dramatic strategic bet that goes sharply against Wall Street's current conventional wisdom. Noting white-shoe Morgan Stanley merging with retail-rich Dean Witter Reynolds, and Bankers Trust buying out Alex. Brown & Sons, he says he wants none of it. Merging Salomon with a retail firm would put it in a game Salomon would surely lose, the resilient 49-year-old Brit explains: "We're not going to be panicked into believing we need a retail arm. If we dance with the elephants, we're going to get stomped."
Boss Robert E. Denham, 51, who heads parent Salomon Inc., sees it the same way: "We really have no retail, don't intend to, and we don't view that as a problem that needs fixing." The two are banking on a three-year alliance with Fidelity Investments announced in January to provide the retail distribution they need to win underwriting deals without the cost and culture clash of operating their own retail brokerage.
"ON A ROLL." Instead of the McDonald's of finance, Solly aims to become the Four Seasons, serving prime fare to the institutional market--namely, a select group of pension funds and corporations. Using the proceeds of its hugely profitable proprietary trading group, it is spending heavily to expand its equity and debt underwriting and mergers-and-acquisitions businesses globally. Denham and Maughan's goal: maintenance of a 15% average return on equity, less reliance on volatile trading profits, and, ultimately, a much higher stock market valuation. They want to transform a transaction shop known mainly for its bond-trading acumen into a top-tier investment bank.
Their strategy is certainly nothing new: Salomon has been trying for years to become a global institutional investment bank, with only mixed success. Nevertheless, its recent recovery is fostering a new, more favorable appraisal of Denham and Maughan. The firm has rebuilt its tattered institutional equity department. It has gone to No.5 from No.13 in a customer survey of research-analyst quality since 1992, and to No.5 from No.12 in equity underwriting, according to Securities Data Corp. In m&a, it has gone to No.7 in 1996 from No.5 in 1995. In the bond business, Salomon is No.1 in secondary trading volume and has moved up to No.2 from No.6 in corporate debt underwriting.
Salomon's results still swing wildly, thanks to house accounts trading. But client businesses have started to smooth out the numbers. While first-quarter profits were down 44% from a year ago, to $173 million, because proprietary trading profits slumped, investment banking and equity revenues were up 89%. "Salomon is on a roll," says analyst Michael A. Flanagan of Financial Service Analytics in Philadelphia.
Ironically, Maughan's success may make the firm more attractive to suitors. After going nowhere for years, the stock has jumped in recent months on takeover talk. "The majority of the gain was the halo effect from the Morgan-Dean Witter deal," says Gregory Jackson of the Yacktman Fund, a Solly investor. On Apr. 1, unconfirmed rumors that Deutsche Bank was in talks to buy the firm boosted the stock $4 per share.
Maughan and Denham have many naysayers. Some say Salomon won't be able to raise its return on equity--or its p-e--unless it expands into retail financial markets or asset management, businesses with higher returns. "The name of the game is increasing shareholder value. I don't see how their strategy does that," says one rival. Nor is it clear that Salomon can sustain the huge expense of expanding globally in highly competitive businesses when the markets turn down, as they inevitably will.
Others believe Salomon would be better off concentrating on its most profitable business: proprietary trading of interest-rate products. As one ex-Salomon exec puts it: "Why pay $1 billion of overhead to generate $50 million of earnings [from client businesses] when you could do $400 million or $500 million in earnings from proprietary?"
It's not that simple, say Denham and Maughan. Salomon's proprietary trading exposure is at an optimal size, and throwing money at it would bring on too much risk. The better growth prospects are in customer businesses, where they hope to grab market share. Contrary to what critics say, Salomon might benefit from a Wall Street downturn, since proprietary trading, if handled adroitly, should hold up and continue to fund growth. "We might well be able to stick with our plan longer than any other competitor," says Denham.
Most of Salomon's detractors would agree that Denham and Maughan have come a long way. They were vilified in 1994 when they tied compensation to the firm's overall results rather than to individual performances. Tough fixed-income markets and poor risk-management results led to a $660 million loss in 1994. For billionaire Warren E. Buffett, the 18.5% owner of Salomon who had installed them, a $1 billion investment was at risk. Internal strife forced them to scrap their pay scheme after six months. Today's compensation plan returns to fabulous individual payouts--proprietary-trading boss Shigeru Myojin made $31.5 million in '96. "Our top people are better paid today than under the previous regime," says Maughan. But he says that it is fairer because mediocre performers don't get as much. Salomon Brothers' ratio of compensation to expenses was 58% in 1996, compared with 73% at Lehman Brothers and 65% at Morgan Stanley.
BIG MO. Much of Denham and Maughan's momentum dates from a little-noticed management coup. In spring, 1995, as the firm's turmoil reached a peak, Maughan cut its operating committee from an unwieldy dozen to five. The aim: end years of nasty infighting and de-balkanize the firm by making top brass accountable for overall performance. Maughan's critics say the move shows he can't manage strong-willed leaders of the type who made Salomon great in the 1980s. Still, morale has improved dramatically since the change, and the territoriality that has always characterized Salomon's management appears to have given way to a group consensus.
Nowhere has Maughan's approach brought greater change than in equities, where headcount has more than doubled, to 1,100, in five years. The chief builder: Rodney B. Berens, a veteran manager recruited in 1992 from Morgan Stanley & Co. at a time when Salomon's main U.S. equity business was trading for its own book. Berens helped reel in deals such as last year's $1.2 billion stock offering for mfs Communications Co. and restored Salomon's research team. More than half of Berens' hires have been in Europe, Latin America, and East Asia. While global diversification is pricey, Berens says it's his best insulation against a U.S. bear market. "If U.S. volumes are down but Japan and Europe are good, you're all right," he says. For now, though, U.S. profits are subsidizing growth overseas.
Berens is bullish on the Fidelity deal. Salomon promises the fund giant a 10% slice of all its stock offerings, as well as access to research, in exchange for distribution. When Salomon took San Antonio-based ilex Oncology public in late February, Fidelity culled its massive database for 8,000 likely targets for the $30 million deal. It pinpointed buyers, including wealthy Texans and doctors. ilex emerged with a 20%-plus retail shareholder base, besting the 15% typical of biotech initial public offerings.
In building up investment banking, veteran telecommunications dealmaker Eduardo G. Mestre is going head-to-head with Goldman Sachs, Merrill Lynch, and Morgan Stanley, making progress difficult. Yet Salomon is known for its strong franchises in telecommunications, financial services, media, and natural resources. Mestre, a Harvard Law School grad who bills himself as a "player-coach," also extols Solly's quantitative bent toward financial models over flashy presentations. But the division is weak in other key industries such as technology and health care, and it suffers from relatively small scale. Like Berens, Mestre has expanded headcount to 1,100, up 38%, in the past five years, including 23 new managing directors since the beginning of 1996.
The mood is more defensive in Salomon's core bond-trading business, partly because of the wary instincts of its new leader, Thomas G. Maheras. Just 34, the onetime Chicago Mercantile Exchange runner has been tempered by two major firestorms. After becoming senior trader on the high-yield desk in 1989, he won kudos for his performance in volatile markets. And when the mortgage-backed securities desk got caught long with a huge inventory as the bond market crashed in early 1994, Maheras was tapped to unwind the mess. His versatility in moving from credit-risk-oriented junk to math-intense mortgage analysis contributed to his ascension, in spite of his youth and inexperience in trading government securities.
Since taking over on Jan. 1, Maheras has extended a push into bond underwriting, where Solly had lapsed as it focused on trading. While spreads are lean, Maheras figures the firm needs to be among the top three in new issues to keep a high profile among corporate decision-makers. After a few benign years for bonds, Maheras expects U.S. Federal Reserve tightening and European monetary union to bring volatility, so he's strictly enforcing risk parameters and keeping exit strategies up to the minute. He's adding 50 staffers in loan syndications, Japanese government bonds, and other growth areas.
STABILITY. Maheras' duties could expand. As head of Salomon's biggest business, he is Maughan's most likely successor from within. But no one's counting Maughan out. In fact, critics say Maughan has entrenched himself by nurturing a fuzzy-cheeked set--epitomized by Maheras--who will need years of seasoning to vie for the ceo job. Maheras predicts Maughan will be around for a long time because "he's just starting to have fun."
Indeed, Salomon looks surprisingly stable at the top these days, considering its dire condition three years ago. Denham, tarred as a do-nothing dilettante through much of his tenure, says he and Maughan have developed a smooth working relationship that could continue indefinitely. The uncontroversial nature of a board transition this year--four directors retiring, two newcomers being added--underscores the stability.
As for Warren Buffett, he's reducing his interest, but he isn't out of the picture. Last year, Salomon underwrote a note issue that over time will shrink the stake of Buffett's Berkshire Hathaway Inc. holding company. And for each of the next three years, Buffett has the option of cashing out big chunks of his Salomon preferred. Buffett watchers believe he'll slowly reduce his holdings. The Oracle of Omaha is silent on his investment plans in Berkshire's annual letter to shareholders. He is expected to stand behind Denham and Maughan, even though his withdrawal indicates he sees higher returns elsewhere. Says analyst Peter Russ of Shelby Cullom, Davis & Co.: "I don't think he's ever going to pull the plug on those people."
Salomon, in sum, remains a bet on the come. Its record is so spotty that investors have greeted its recent accomplishments warily. "I got tired of the mea culpas. In the five years it took them to find their stride, their competitors moved to the next level," says Russ. Even the Fidelity deal may have a limited payoff: Retail customers haven't gobbled up follow-on offerings of other stocks with nearly the same gusto as they gulped down the ilex ipo. It's clear Salomon has rebounded from the dark days of 1995. But even more than its better-diversified and more stable rivals, the test of Solly's strategy will be how it weathers a market downturn.