Lehman Brothers: So Who Needs to Be Big?

Little Lehman, with profits and revenues rising, is the bright spot in a dark financial-sector picture

Richard S. Fuld Jr. was exultant. At 6:30 p.m. on June 19, the CEO of Lehman Brothers Inc. (LEH ) arrived at the Museum of the City of New York for a glitzy black-tie event that Wall Street insiders had speculated neither he nor the firm would be around to honor--Lehman's 150th anniversary.

Earlier the same day, Lehman had upstaged rival Goldman, Sachs & Co. (GS ) by posting an impressive 14% rise in second-quarter net income vs. the same quarter in 2000, to $430 million. Goldman posted a painful 24% decline. Lehman managed to trump Goldman largely because of its strength in trading and issuing debt. It received record fees of $265 million for debt issuances. But Lehman was also reaping the rewards of building up its small equities business: it more than doubled its market share in equity issues to 7%, while its Nasdaq trading volume jumped 80%, vs. 32% for the industry.

Lehman is challenging Wall Street's conventional wisdom that big is beautiful. Its market cap is a puny $19 billion, vs. $50 billion for Merrill Lynch & Co. (MER ) and $71 billion for Morgan Stanley Dean Witter & Co. (MWD ) The firm's strong results also buck the belief that investment banks need to bulk up via a merger, such as that between J.P. Morgan and Chase Manhattan Corp. (JPM ) in September, 2000, in order to lend money to companies to win deals.

HELP WANTED. Instead of trying to turn Lehman into a behemoth, Fuld, 55, has stuck to making it the nimblest and most cost-efficient operator on Wall Street. And he's been doing so since Lehman--then worth $1.5 billion--was spun off from American Express Co. (AXP ) in 1994, ending the failed marriage of Shearson Lehman Hutton Inc. And the strategy is working: Fuld has delivered returns on equity in excess of 20% for nine straight quarters. "If we compete on size, it doesn't make a whole lot of sense. For us, it's about being the best operator," says Fuld.

Now, Lehman is hiring while big rivals are firing (box). Lehman wants to boost its headcount by as much as 13%, to reach 13,000. Fuld plans to spend $300 million this year, much of it to attract top talent, after spending $600 million last year when Lehman hired 525 people in its equities business alone. And it is swelling its client roster as companies see their old advisers swallowed by behemoths. That's enabling Fuld to snag more profitable deals, leaving big-ticket but low-margin deals to the biggies. "I'm thrilled when I see the banks fill their balance sheets with less profitable deals, because over time, we're going to drive a higher return on equity," Fuld says.

Lehman's current performance is the payoff from the tough measures Fuld started after Lehman's split from AmEx. In the following three years, he pruned 800 of Lehman's 8,500 employees as part of a drive to strip $250 million from costs. Fuld also dumped low-margin lines such as commodities trading.

Fuld, who started with the firm as a commercial-paper trader in 1969, has been able to make employees feel like owners of the firm. He put an end to a bitter war over compensation and strategy between the firm's bankers and debt traders, some of whom were nicknamed Moonies because of their loyalty to Fuld. "Anyone who refused to drink the Kool-Aid was summarily executed," recalls a former banker. Fuld gave employees a greater stake in the firm by distributing stock to 35% of employees, up from 4% in 1994. Then he sent a strong message that teamwork would count by paying everyone on Lehman's executive committee the same: $8.5 million in salary and bonus last year. "When we line up with a customer, it's about how we approach them as a team. It's not about lone rangers. Lone rangers don't live long," says Fuld.

ROCKS AHEAD. Lehman still has a long way to go to reach its goal to become one of the top three advisers for all of its clients. It still trails many rivals in equity and debt issuance. And its merger-and-acquisition fees slid to $128 million in the second quarter, down 30.1% from $183 million in the previous quarter. "We have tons of work to do," says Fuld.

Once Lehman was at risk because it was too small. Now the danger is that, as it gets bigger, it could become more like the rest of Wall Street. Credit Suisse First Boston industry analyst Joan Solotar warns that it will be tough for Lehman to keep its expenses under control as it expands in a rocky market. Other analysts seem to agree. They're forecasting a 20% decline in Lehman's third-quarter earnings, vs. a 27% drop at Morgan Stanley and 37% at Goldman, according to First Call Corp.

Lehman's improved situation could also make it an alluring takeover target. Shareholders might love that. But the firm's top execs, many of whom harbor bitter memories of working under the yoke of AmEx, are not enthusiastic. "We're not very interested, frankly, in being run by someone else," says Joseph M. Gregory, chief administrative officer. However, if Lehman can stay nimble as it gets bigger, it could be well on its way to its next big birthday bash.

By Emily Thornton in New York

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