Brokerage Deals: Just Looking, Thanks
Another day, another brokerage-firm rumor. Lately, Baltimore has been abuzz with whispers of imminent takeovers. It is home to Alex. Brown & Sons Inc., which just agreed to be sold to Bankers Trust Co. In the shops and restaurants at Harborplace near the small financial district of this old Chesapeake Bay city, takeover talk has centered on Legg Mason Inc., a well-regarded regional brokerage firm. "We've been sold about 12 times in the last week," jokes Raymond A. "Chip" Mason, Legg Mason's chief executive.
Many analysts, indeed, foresee a wave of brokerage takeovers by large financial institutions that will fundamentally reconfigure Wall Street. And many banks are raring to buy brokers now that the Federal Reserve has liberalized its guidelines. But despite this seeming forward momentum, there may be fewer brokerage deals than the rumormongers expect. The main reason: price. Brokerage stocks are trading at record levels, and sticker shock is discouraging many buyers. "A number of people are balking. They're having a visceral, negative reaction," says one banker.
VOLATILE. The Alex. Brown deal was a clear tipoff of the new world of valuations. The price tag was $1.9 billion, including $200 million in payouts to keep senior executives. That is three times book value--a measure of the value of the assets on its books--or almost twice what Alex. Brown was trading at in the weeks prior to the deal, says Michael Flanagan, a securities industry analyst at Financial Service Analytics. Historically, brokerage stocks have traded at 1.1 to 1.2 times book value when they are out of favor and 1.75 to 2 times book when they are in favor, says Oppenheimer & Co.'s brokerage analyst Steven Eisman. Indeed, the rule of thumb for brokerage stocks is to buy them when they are trading at one times book value and sell them when they reach two times book. "These stocks are at very high valuations," says Sallie L. Krawcheck, a securities industry analyst at Sanford C. Bernstein & Co. (table, page 144).
The issue of price has been causing many would-be suitors to focus on whether book value is really the most appropriate way to price brokerage firms. Most businesses are usually assessed in terms of earnings. But Wall Street has traditionally favored the book value method of valuing brokerage houses since their earnings are extremely volatile and hard to predict.
Oppenheimer's Eisman is recommending Lehman Brothers Inc. and Bear, Stearns & Co. because their price-to-book values haven't appreciated nearly as much as the other stocks in the group. And Eisman believes Lehman and Bear Stearns are takeover bait.
Others consider earnings a better way to value brokerage stocks. "Some firms are evolving to have less volatility inherent in their earnings. Those with more stable earnings deserve a higher reward," says Peter Davis, a Booz. Allen & Hamilton Inc. consultant. The best example is Merrill Lynch & Co., the firm with the highest valuation outside of Charles Schwab & Co. It is currently trading at 2.6 times book value and a price-earnings ratio of 13.5, which is the top of its own historical range and considerably higher than the other brokers. This is because Merrill's earnings are more diversified than its competitors'.
BIG UPSIDE. Even using earnings, though, most brokerage stocks are fully valued. For example, Krawcheck's valuation analysis of PaineWebber Inc. is derived by assigning different p-e ratios to its various businesses. She calculates that PaineWebber's commission brokerage business has a p-e multiple of 12.6 and that its asset management has a p-e of 15.5, which is a discount to what independent asset managers trade at. Weighing those, she arrives at a total p-e of 11.5, or a share price of 37. This compares to an average p-e for PaineWebber in the 1990s of 9.6 and a current p-e of 10.9. PaineWebber stock traded at 35 on May 14, and Krawcheck believes that any takeover premium is already reflected in the stock price. Krawcheck is recommending Morgan Stanley, Dean Witter Discover & Co. because the combined firm has the most upside earnings potential.
High prices aren't the only impediment to deals. "Price is the least important factor," says Donald A. Moore Jr., vice-chairman of Morgan Stanley Group Europe. "Strategic fit is No.1, cultural fit and the ability to manage is No.2, and price is No.3."
In some cases, special circumstances militate against a deal. Not only is PaineWebber fully valued; the firm could be tough to acquire. PaineWebber is tightly controlled by its chief executive, Donald B. Marron, who has been CEO for 17 years. Marron has said he wants to keep the firm independent and perhaps make acquisitions. Despite conventional wisdom that PaineWebber is too small to survive on its own, it may hold out longer than expected. "Don Marron's got board support. He can do it," says one banker.
Donaldson, Lufkin & Jenrette Securities Corp. is another brokerage that banks frequently salivate over because of the attractiveness of its equity and junk-bond underwriting business. Theoretically, DLJ would be a good fit with a bank such as Chase Manhattan or even J.P. Morgan, given their investment banking ambitions. Street sources say DLJ has held talks with NationsBank Corp. and National Westminster Bank PLC in the past year. But there is a major obstacle: DLJ's compensation agreements, which are rich even by Wall Street's stellar standards. DLJ partners participate in the considerable profits generated by the firm's large leveraged-buyout funds. This payout system would be hard for any bank to swallow. "It's a great company," says a banker. "The stumbling block is their compensation system."
Most buyers, thus, may wait for a major slump in brokerage stocks before pursuing purchases. Until then, rumors will vastly outnumber actual deals.