Merrill: Is Stan the Man?

In a tough market, O'Neal's strategy is on the line

Almost a year ago, when America's No. 1 brokerage was reeling from a 41% decline in earnings, E. Stanley O'Neal looked like the man with all the answers. Merrill Lynch (MER ) Chairman and CEO David H. Komansky had barely finished installing O'Neal, formerly the head of Merrill Lynch & Co.'s U.S. private client group, as his new president and de facto successor when O'Neal began to overhaul the financial icon. Known as a ferocious cost-cutter, he quickly shuttered loss-making operations in Japan, reduced Merrill's head count by 10,000--16% of the payroll--and pushed rivals for the top job out the door. Indeed, O'Neal moved so aggressively that he fueled rumors that Komansky would be forced to retire ahead of schedule: In February, he set up a management committee to run the brokerage that didn't include the chief executive.

However, it turned out that O'Neal needed the boss more than he imagined. When New York State Attorney General Eliot Spitzer charged Merrill with issuing misleading research in April, Komansky shot back into public prominence, sparking speculation both inside and outside the firm that he was trying to reassert himself. Insiders say the affable Komansky, a former broker who loves to schmooze with clients, was brought in to repair damage in the delicate negotiations after the tightly wound O'Neal balked at Spitzer's initial suggestions for settlement terms. Merrill denies this. "There was no difference of opinion at any time between the two as to how to proceed in the negotiations," insists company spokesman Paul W. Critchlow. "Komansky is very comfortable with their relationship and partnership."

Either way, it's clear that Merrill desperately wants, and needs, to move on. Insiders are betting that O'Neal, 50, will be promoted to CEO this year to signal that a new era has begun at Merrill. Komansky, 63, is expected to stay on as chairman, although it's not sure he'll last until his preferred retirement date in 2004.

For Merrill to truly rebound, O'Neal needs to prove that he can fix the firm. And that's quite a challenge. Merrill's stock price has fallen 24% since he became president, wiping about $9 billion from its market value. The damage to the firm's reputation from Spitzer's investigation and the brutal competition for sparse equity offerings and mergers are making it more difficult for O'Neal to convince investors that he can finesse a strong comeback. And there's a chance that Merrill will soon lose its top-gun status as the firm with the most brokers in America.

Time may not be on O'Neal's side. Some analysts believe he may have only a year in which to prove his makeover is working. "I think the next step the board would take if O'Neal can't sort it out might be just to sell Merrill," says Guy Moszkowski, financial-services industry analyst at Salomon Smith Barney. "That's ridiculous speculation," says Critchlow. "The board will give him whatever time is needed to move the company forward."

O'Neal's turnaround plan is very simple. He wants Merrill to be the most profitable brokerage, not the biggest. So, he's axing low-margin operations such as underwriting short-term debt and retail brokering in Canada to plow freed-up capital into more lucrative businesses. The aim: boost Merrill's pretax profit margin to 24%, up from its present 19.9%, by next year.

So far, the results of his revamp are mixed. Although revenues for the first quarter fell 21% from a year ago, O'Neal limited the slide in pretax margins to just one percentage point. But some of that reflected onetime revenue gains from the sale of $101 million worth of businesses. And while all investment banks have been forced to scramble for business since the bust in technology stocks in the spring of 2000, Merrill is losing ground in such profitable lines as advising on mergers and acquisitions and underwriting junk bonds. Merrill remains the No. 2 underwriter of global debt and equity even though its market share dipped to 8.7% through June 5, down from 10.6% in 2001. The firm has fallen to No. 6 among the ranks of advisers on announced mergers, with a 15% market share, down from the No. 2 position with a nearly 30% share in 2001, according to Thomson Financial. "While Merrill has shown margin improvement, it's too early to say definitively how the pie will end up being split when it begins to grow again," says Diane B. Glossman, securities-industry analyst at UBS Warburg.

The firm's hallmark retail brokerage business, which accounts for about one-third of its earnings, hasn't been spared, either. Merrill's client assets in the U.S. failed to grow in the first quarter while rival firms such as Charles Schwab Corp. (SCH ) collected $15 billion.

That's bad enough. But an even greater hurdle may be in store for Merrill. In the wake of O'Neal's staff cuts, Merrill may soon lose its bragging rights as the country's biggest broker. Competitors such as Salomon Smith Barney (C ) and Morgan Stanley Dean Witter & Co. (MWD ) have been racing to train more brokers, while Merrill has shed them in the last two years. "At some point, our numbers will cross," says John H. Schaefer, head of retail brokerage operations at Morgan Stanley. "Potentially, even within a year."

It may sound like a macho squabble of little real consequence. But what's at stake is the permanent loss of the lead Merrill has enjoyed since the 1940s. Its legendary Thundering Herd of bullish brokers recruited more clients--and raked in more assets--than those of its competitors. Apart from spinning off lucrative commissions and management fees, Merrill's unmatched breadth is also a key to winning even more profitable underwriting from companies that want to be sure that their stock and bond issues are sold to the greatest number of clients.

Merrill insists that it doesn't feel threatened. The firm argues that its brokers are much more productive because they manage $1.2 trillion in client assets compared with, for example, $588 billion at Morgan Stanley. "The number of advisers is minimally relevant to us," says Bob Mulholland, a managing director in Merrill Lynch's U.S. private-client group. "We're much more interested in the quality."

But rivals are not sitting still, either. Salomon Smith Barney's brokers manage roughly as many assets per head as do the brokers at Merrill. And Morgan Stanley believes that by rolling out new services it can boost assets under management to $1 trillion over the next five years, if not sooner. At the same time, some analysts expect that Merrill's brokers will find it harder to sign up new customers and garner new assets since Spitzer has damaged the credibility of the firm's analysts.

O'Neal isn't interested in listening to excuses from the firm's troops. On May 21, the day of the settlement with Spitzer, he told analysts that he's still aiming for 24% margins next year, a goal that the firm set in 2000. "The fact that they have the same margin targets in a much more challenging revenue environment speaks volumes about the cost-cutting opportunities and O'Neal's progress," says Mark Constant, a securities-industry analyst for Lehman Brothers Inc.

Neither O'Neal, nor Merrill, can afford for his strategy to fail. There is no longer any obvious replacement for him. And Komansky doesn't want the responsibility of turning around the company. Asked on May 21 about the potential fallout from Spitzer's investigation on Merrill's financial goals, Komansky replied: "Thankfully, that's going to be pretty much Stan's headache." O'Neal politely laughed at the time. But it may turn out to be no joke.

Corrections and Clarifications "Merrill: Is Stan the man?" (Finance, June 17) incorrectly said that Salomon Smith Barney brokers manage more assets per head than those at Merrill Lynch & Co. in the U.S. In the first quarter, Merrill brokers averaged $84 million each, vs. $78 million at SSB. Also, Merrill now calls its brokers "financial advisers."

By Emily Thornton in New York

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