Shaking Up Merrill

Stan O'Neal is reinventing the Wall Street icon. He hardly has a choice

The low hum of cranes clearing away tons of rubble from Ground Zero reverberates through Stan O'Neal's art deco office in the north tower of New York's World Financial Center. From his 32nd-floor window, the new president of Merrill Lynch & Co. (MER ) can see the south tower, where the firm occupied 19 floors until Sept. 11: Broken windows are boarded up, and debris lies all around it. But O'Neal, the first Wall Street executive to move back to the center of the financial district, has little time to ponder the disturbing view. "At the end of the day, we're about the business of conducting business," says O'Neal, who made the decision to move back. "This is where we do it."

Returning to the corporate headquarters is not just a matter of appearances or an act of bravado, the chance for a recently appointed, and relatively unknown, leader to assert himself. No, for O'Neal, it was an imperative. Almost as soon as he was named president of Merrill in July, the 50-year-old executive began an aggressive overhaul of the financial icon. It was no time to be working on the fly, without a real office, without even his senior executives nearby. (They joined their employees in sites scattered from midtown Manhattan to Princeton, N.J.)

Even though he's a 15-year veteran of the company, O'Neal was unknown to many inside Merrill before his appointment, which made him heir apparent to Chief Executive David H. Komansky. Now they're finding out what execs who have worked closely with him already know: Stan O'Neal may keep a low profile, but he is a force to be reckoned with. One of his first acts as president was to drive off two of his three chief rivals for the job, one of whom was the son of a founder. Even Komansky seems a diminished presence since O'Neal's appointment. Many believe the board of directors has lost faith in Komansky. And for all practical purposes, O'Neal is running Merrill. In fact, he has been almost since July.

O'Neal, who stands to be the first African American to run a major investment bank and one of the only Merrill chiefs never to work as a broker, faces formidable challenges. Merrill embodies the problems of businesses that grow to excess, that come to prize bulk before profitability. It's America's biggest brokerage and one of the nation's top three investment banks. Perhaps no other firm had been so associated with the bull market, with clients ranging from retired shopkeepers to multibillion-dollar pension funds. In less than a decade, it made 19 acquisitions, paying top dollar for several.

It also spent generously, some would say extravagantly, on employees and clients. Low-level managers traveled in chauffeured cars to appointments, and investment bankers enjoyed concierge services on Merrill's tab. The firm advised wealthy clients on everything from how to help their kids cope with money to how to purchase a private jet. Some perks may have been wasteful, but in the heady days of the bull market, no one particularly cared.

But then the go-go '90s ended, and Merrill's fortunes quickly changed. Today, both its profit margins and return on equity trail those of rivals. That's bad news for any company, but for one of the last remaining independent firms on Wall Street, it's especially worrisome. Corporate clients around the globe are demanding capital-intensive services, and increasingly commercial-banking powerhouses are happy to provide them--at cut-rate prices. That's forcing investment banks to offer their services at a discount while also raising their capital requirements. And it has led to a spate of mergers that are forcing investment banks into the arms of megabanks, such as J.P. Morgan (JPM ) and Chase or UBS and PaineWebber.

DIFFICULT TIME. O'Neal's choice is clear: He can either boost performance and be an acquirer or risk watching Merrill be swallowed by a better-run rival. The firm's stock price has already fallen 31.7% this year. By comparison, Citigroup's shares have slipped only 9% and J.P. Morgan Chase's are down 18%. In an Oct. 17 report, Salomon Smith Barney financial-services analyst Guy Moszkowski predicted that if O'Neal can't bring Merrill's profit margins in line with the pack, the board of directors may push O'Neal to sell, perhaps as early as 18 months from now. O'Neal says that kind of talk is "crap." The board declined to comment.

Making the situation even more risky, O'Neal is attempting to bring Merrill into line during a time of great economic and political uncertainty. Trading is slow, mergers and acquisitions are few, and initial public offerings are on hold. Merrill is expected to earn only $2 billion on net revenues of $22 billion this year, 39% less than in 2000. Further complicating matters is the fact that he will be redirecting businesses while many of his senior staff are just settling in to new jobs: By the end of the year, only five of the 24 members of his executive management team will be in their same positions.

O'Neal is unsparing in his assessment of Merrill's problems and unsentimental about change at the 87-year-old firm. Indeed, his overhaul of Merrill Lynch will involve nothing less than abandoning the company's mission to be all things to all clients around the globe. O'Neal is determined to double up resources in areas that are high-profit and chop unflinchingly where making money is harder. "That means being properly positioned in the markets we want to be positioned in," says O'Neal. "It also means not expending resources on those things that will not ultimately produce the growth and profits we want to achieve."

That's a watershed for Merrill. Its brokers, who once brought Wall Street to Main Street, are now focused squarely on courting the rich, those with $1 million or more to invest. Merrill's investment bankers will concentrate on select industries where their relationships are strongest: financial services, power and energy, telecom, and technology. Overseas, it will mean retreating from mass retail ventures in Japan and Europe to focus on high-margin wealthy clients. All this with fewer people: O'Neal plans to lay off some 10,000 employees, or one of every six.

CULTURE SHOCK. O'Neal's plans to transform the Merrill culture are just as ambitious. He says the new Merrill will be a meritocracy where talent, not seniority, rises to the top. He intends to put an end to the firm's benevolent "Mother Merrill" culture and its civil-service mind-set. "I don't like the term. I've never used it," he says. "I don't think it's realistic in a 70,000-person organization spread out around the world."

The kind of change O'Neal envisions is always disruptive. Similar undertakings have brought others, like Jacques A. Nasser at Ford Motor Co. (F ) and Durk I. Jager at Procter & Gamble Co. (PG ), to grief. For some, O'Neal's pace is too quick, his timing is off. (Shouldn't he have paused longer after September 11, they ask.) Already, the three other executives who ran Merrill's key businesses have been replaced. With this much turmoil, other executives are sure to depart. "Any time you make this many changes in a down market, it raises the risk premium associated with the company," says Henry McVey, securities industry analyst at Morgan Stanley.

Merrill simply can't afford to behave as if it were still 1999. Today, the company devotes fully 54 cents of every dollar it takes in to employee compensation, compared with an estimated 49 cents at Goldman, Sachs & Co. (GS ) and 52 cents at Morgan Stanley Dean Witter & Co. (MWD ) To keep up with those rivals, Merrill also has to boost its return on equity and profit margins. Merrill earned only a 9% return on its equity in the third quarter. Morgan Stanley got 15%, Goldman 10%. And Merrill posted a relatively weak 13% operating profit margin, while Goldman Sachs recorded 21% and Morgan Stanley 17%. O'Neal has vowed to build margins to 24% by 2003.

To get there, he has ordered his managers to reduce their expenses to 1998 levels. "I think O'Neal is conscious of the things we look at in the investment community as far as expense control and meeting earnings targets, and he's pretty serious about it," says James K. Schmidt, manager of John Hancock Financial Industries Fund, which had about 6% of its $535 million in Merrill shares as of Sept. 30.

O'Neal's dress rehearsal for his current job came last year, when he ran Merrill's brokerage operations. Merrill had plenty of accounts, but most were under $100,000--an increasingly unprofitable niche. O'Neal's solution: He cut the payroll by 13% and slashed the level of personal service for those small accounts. Then he focused on bringing in high-end private banking with $1 million or more in assets.

CALM AND COLLECTED. The strategy worked. While some of those ordinary clients fled, most stayed--and Merrill says it doubled the amount of revenue per dollar of assets in their accounts and reduced operating costs by $800 million. And after an initial outcry from brokers worried about their future and resentful of a boss who didn't come up through the ranks, O'Neal won some respect. "There were many in the organization who said, `How can anyone who has not sat in our chairs have the wisdom and the experience and the skills to lead the organization?"' says Augie Cenname, a broker in Columbus, Ohio. "Stan has proved those people wrong."

Success always makes people more popular. But even so, O'Neal is still more respected than liked. And he's no Komansky, who describes himself as "a back-slapping, gregarious person." O'Neal is cerebral, reserved, and supremely calm. After fleeing the World Financial Center on Sept. 11 with the 9,000 employees in the building at the time, O'Neal set up at Merrill's "command center" 15 blocks away. He let nothing escape his attention, from the firm's open trading positions to securing desks for everybody. He kept his sense of humor, too. At one point, O'Neal turned to a group and said: "Remind me again why I wanted this job?" But when it came time to move back to headquarters, O'Neal didn't get around to letting everyone know. Many employees heard the news when he announced it on television.

Some employees describe O'Neal as an "enigma." He gives little away and admits that he shuts down in meetings when he believes someone is just telling him what he wants to hear. However, "there are other times when it's clear exactly what I think of a subject," he says. O'Neal's closest confidantes are James P. Gorman, who joined Merrill from consultant McKinsey & Co. and is now head of the U.S. brokerage operation, and Thomas H. Patrick, chief financial officer and the most likely candidate for chief operating officer.

To hear Komanksy tell it, their partnership is clicking. "You don't want to slink out the back door thinking you left the place a mess," he says. "My most important function is to provide the kind of guidance that will put Stan in the position to be the best CEO that Merrill Lynch has ever had." But some insiders believe Merrill's board could ask Komansky, who became CEO in 1996, to retire as early as next year instead of in 2004, when he turns 65. They also say the board forced Komansky to select a successor earlier than he planned to and overruled his first choice, Jeffrey M. Peek. Komansky denies it: "I see the next 10 years as being very different from the past. A change of style, a change of points of view, is critical." Board members declined to comment.

O'Neal certainly sees the world through different eyes than many at Merrill. For starters, he was raised on a subsistence farm in Alabama, and then in a housing project in Atlanta. In Alabama, he walked a mile to school, a shack with a potbelly stove. In Atlanta, his father, who worked on an assembly line for General Motors Corp. (GM ), struggled to feed his wife and four children on less than $50 a week. It was he who encouraged Stan to attend college. O'Neal alternated six-week stints in the factory in Doraville, Ga., with six weeks at a GM-sponsored college in Detroit until he got his degree. From there, he went on to Harvard Business School, rose to assistant treasurer at GM, and became an investment banker at Merrill at age 35.

WORKAHOLIC. In the '70s, GM was full of driven would-be executives, but even so, O'Neal stood out. He moved from entry-level analyst to director level in the treasurer's office in three years. "That's about as fast as you can do it," says John D. Finnegan, chairman of General Motors Acceptance Corp. and a former colleague. A workaholic from the start, O'Neal often remained in the office until 10 p.m. "He worked hard to take himself to the next level," recalls Louis R. Hughes, former president of GM International Operations, who hired O'Neal. "He had a very large Afro American haircut. He got conservative very quickly." He lost his Southern drawl fast, too. But "he was proud of the fact that he had started at the bottom," says Sandy Robertson, founder of investment bank Robertson Stephens, who dealt with O'Neal during his GM days.

He could size up an opportunity quickly as well. When O'Neal sensed the balance of power shifting away from the finance staff at GM, he followed his mentor, former Treasurer Courtney F. Jones, to Merrill. There he joined the ranks of investment bankers he knew from working on acquisitions of Electronic Data Systems Corp. (EDS ) and Hughes Electronics Corp. (GMH ) There was another reason O'Neal was ready to move on: He feared GM would become a victim of its own success, bogged down by high costs, low quality, and massive overcapacity. "I was concerned I would wake up 10 years hence and be very successful in a context I was not entirely happy with," he says. In August, O'Neal became a member of GM's board.

O'Neal hadn't been at Merrill for more than three years when he was made head of the firm's high-yield bond business. After Michael R. Milken's Drexel Burnham Lambert Inc. blew up in 1990, O'Neal led a group of young vice-presidents on a sales drive to win over new clients. The group debated high-yield bond structures while shooting baskets in O'Neal's office. (The hoop has since been replaced by elegant Shona sculptures from Zimbabwe.) The effort paid off: Merrill climbed to No. 1 and remained either first or second in junk bonds until O'Neal was promoted to lead the entire capital-markets businesses in 1995. After he left, Merrill slid steadily to No. 8. "I never took Stan on a pitch where we didn't win the business," recalls Bennett Rosenthal, now a partner at Ares Management in Los Angeles, an affiliate of Apollo Advisors. "He was obsessed with being No. 1."

What most distinguishes O'Neal from his colleagues, though, is his calm. He's stern, but few have seen him shout at his staff or throw a tantrum. "The more pressured the situation, the cooler he gets," says Raymond McGuire, an investment banker at Morgan Stanley who used to work with O'Neal. When hedge fund Long-Term Capital Management collapsed in 1998, O'Neal, then Merrill's chief financial officer, steered the firm through a severe liquidity crunch without hesitation. Afterward, O'Neal put a funding program in place to ensure that Merrill would never be caught off guard again. Consequently, when markets fell after the September 11 attacks, the firm had plenty of access to cash.

Still, well into his career at Merrill, O'Neal was relatively anonymous. That changed when Komansky brought him in to revamp U.S. retail brokerage operations in February, 2000. O'Neal was an unwelcome replacement for popular veteran John "Launny" Steffens, and Merrill's brokers were not shy about expressing their contempt. In one of O'Neal's first big meetings, he was sitting next to Steffens when a broker asked: "And who are you?" O'Neal answered: "Launny's apprentice." That broker wasn't alone in giving him a hard time in public settings. "They would ask, `How can you lead our business when you have never even sold a stock?"' recalls Gorman, who worked with O'Neal at the brokerage.

And, of course, O'Neal set off a real furor when he began to overhaul operations there. O'Neal believed he had inherited a fundamentally flawed business. Expenses were spiraling as Wall Street firms fought over top brokers. Worse, Merrill was struggling to deliver the same service to clients with $100,000 to invest, who make up 67% of Merrill's accounts, as it did for multimillionaires. But the reality was that providing that kind of service to small fry cost too much. Meanwhile, a new breed of individual investor who was looking for cheap trades, not advice, was increasingly turning to discounters such as Charles Schwab & Co. (SCH )

PROFIT FIRST. Just months into the job, O'Neal laid off 2,000 employees and changed the lineup of executives to help him break down the walls between sales, marketing, and products. O'Neal segmented the business so that the rich get to talk to their own brokers and everyone else deals with a general call center. That way, small-time clients were guaranteed to receive a call from a Merrill representative at least once a quarter, yet Merrill didn't have to pay high-priced brokers to make them. At the other end of the spectrum, he devoted considerable resources to winning clients with at least $1 million to invest. Of course, there's not a competitor around that's not going after the same market. But Merrill estimates that the numbers of ultra-rich, now 7.2 million strong worldwide, will grow by 8% annually over the next five years. And there's no one firm that dominates. Like other businesses, the U.S. brokerage is being tested: In the third quarter, both earnings and revenues were down compared to a year ago.

As president and CEO-designate, O'Neal will have to draw on all of his resources. His first challenge will be finessing Merrill's retreat from recent initiatives in Europe and Japan that never lived up to their promise. The firm had hoped to expand its reach down to small investors. In April, 2000, Merrill and HSBC (HBC ) announced a joint venture to offer online investment advice to retail investors worldwide. The arrangement was generally viewed as a prelude to a possible merger between the two. But it never amounted to much, and O'Neal may ditch it.

When Merrill bought Japan's fourth-largest brokerage, Yamaichi Securities, after Yamaichi went bankrupt in 1998, the firm figured it could easily win over the average "salaryman" who kept his money in savings accounts. It hasn't happened. O'Neal plans to pull back, even though "the Japanese business is on track to break even in 2002," says Winthrop H. Smith Jr., who used to run the international brokerage business and was a contender for O'Neal's job. He announced his retirement in early October after O'Neal removed him from his position. Retail operations in Japan and Europe have accounted for a $180 million loss for Merrill annually. "Spending more money on a flawed business model will not correct the fundamental problem," says O'Neal.

What he hopes to spend money on is expanding banking services for foreign clients with at least $1 million to invest. Sound familiar? G. Kelly Martin, the new president of international private-client services, believes operating margins of at least 15% are possible even in the downturn. In the third quarter, the business posted a $40 million pretax loss.

O'Neal wants to apply the same profit-first principle to Merrill's asset-management business. Before, Merrill's aim was to offer a wider choice of funds than its competitors, at whatever the cost and whatever the profit margin. Now, Merrill Lynch Investment Managers wants to boost its profit margins from the teens to around 30% by selling more of its higher-fee mutual funds. "Five years ago, an asset in the door was a reasonable goal because every asset was profitable," says Robert C. Doll, who became head of Merrill Lynch Investment Managers after Peek resigned in October. O'Neal also hopes Merrill brokers will sell more of the company's own mutual funds, though that may be difficult since as a group they offer very average returns. Now, about 30% of brokers' sales are Merrill funds. O'Neal would like to see that share grow to 50%.

As for the investment bank, O'Neal is convinced Merrill can expand its highly profitable equity-trading capabilities. He also wants Merrill to be as much of a player in interest-rate, derivative, and foreign exchange trading as it is in debt and equity issuance. "We have the greatest cash equity franchise in the world," he says. "Why can't we have the greatest equity derivative franchise? We should. We can. We will."

O'Neal may talk tough, but he is leading Merrill through an unprecedented transformation during a time of intense uncertainty in markets and economies around the world. He may be as calm as ever. But his employees are on edge, and he and his executives are on notice. If he can't fix Merrill, someone from the outside may get the chance.

By Emily Thornton in New York, with Anne Tergesen in New York, David Welch in Detroit, and bureau reports

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