The New Merrill Lynch

Stan O'Neal has made the firm leaner and meaner. Now, he's betting big on trading and other risky ventures

Merrill Lynch & Co. Chief Executive E. Stanley "Stan" O'Neal was always a cool hand in a crisis. He built his career on pulling the world's biggest brokerage out of tight fixes. Whether he was extracting its junk-bond group from the damage caused when the market imploded in 1990 or stanching Merrill's losses from the collapse of the hedge fund Long-Term Capital Management lp in 1998, he invariably came out looking good. His strength: O'Neal, 51, is utterly objective about what needs to be done, and he does it -- however painful it might be.

Right now, that quality is at a premium. Wall Street is still under the cloud of scandal. It will cost Merrill $280 million to settle charges, which it neither admitted nor denied, that it misled investors and helped Enron Corp. cook its books. Federal courts ruled in January that fancy tax-avoidance schemes it sold to clients such as American Home Products, now called Wyeth Corp., were illegal. And it is facing investor suits that could cost it billions. Dealmaking is at a low ebb, and stock market investors are gun-shy in the worst bear market since the Great Depression.

So what's O'Neal doing in this crisis? In the five months that he has been ceo, he has dragged Merrill through more cultural change than it underwent in the previous five decades. O'Neal, a tightly wound 17-year veteran of the firm, openly sneers at the old, comfy "Mother Merrill" culture that tolerated bumbling performance by long-serving execs. In its place, he has established a Darwinian code that encourages managers to take risks and gives them six months to a year to show they can succeed -- or get out. Profit makers get rewarded, not those who just pile up revenues.

O'Neal's management style is a painful break with the past, too. It's a lot more autocratic than that of retiring Chairman David H. Komansky and his predecessors. Already, O'Neal, who has been effectively in control for over a year, has sidelined the sprawling and ponderous executive management committee that once ruled the roost. The operating committee that replaced it is so shrouded in secrecy that even some senior managers don't know exactly who's on it. Insiders say it appears to be mainly a rubber stamp for the torrent of decisions that pours forth from a tightly knit Politburo consisting of O'Neal and three die-hard loyalists: Executive Vice-Chairman Thomas H. Patrick; Arshad R. Zakaria, president for global markets and investment banking; and cfo Ahmass L. Fakahany.

Now, as he steps into Komansky's shoes as chairman on Apr. 28, O'Neal is putting the firm's future on the line with a huge and risky bet that propels it into head-to-head competition with even greater swaths of the financial industry. O'Neal declined to be interviewed by BusinessWeek, but he told investors in January that he aims to build "a new kind of financial-services firm" that redefines Wall Street by offering a far greater range of services, but with far fewer people and an unrelenting focus on profitability. He aims to capture most of his wealthy corporate and private clients' business. "We believe that it is no longer necessary for our clients to maintain a relationship with any other financial-services provider," O'Neal told investors. "Period."

Essentially, he wants to create a financial-services colossus that has both the breadth of a megabank such as Sandy Weill's Citigroup Inc. and the depth -- and trading muscle -- of an independent investment bank such as Goldman, Sachs & Co. It's not that he wants to compete with Citi across the waterfront in retail banking; he's just looking to grab a bigger share of his clients' wallets with services such as checking accounts and mortgages. Because Merrill has a worldwide network of 670 retail offices, most extra revenues from them should drop straight to the bottom line. And he is courting super-rich investors, those with at least $10 million, more assiduously than ever. He's offering them white-glove services while banishing clients with less than $100,000 to two call centers.

What's more, armed with a war chest of $103 billion in capital -- more than either Goldman or Morgan Stanley -- Merrill can greatly ramp up trading of securities on its own account. That's a big change. Although Merrill underwrites lots of corporate and municipal debt, historically, it has left most of the gravy from trading it on the plate for others. Also, O'Neal is making substantial investments in commercial real estate while developing his own hedge-funds-of-funds. "Our business is becoming more capital-intensive," says Patrick.

That means, of course, O'Neal is charging into highly competitive areas. Most banks and brokers are eager to recruit rich individuals as customers. For instance, Charles Schwab & Co. bought New York's U.S. Trust Corp. in 2000 precisely with that goal in mind. But Merrill starts with a huge advantage: In 2002, over 60% of its clients' assets were in accounts of $1 million or more and 27% in those with $10 million-plus.

At least one part of O'Neal's vision -- operating with a drastically slimmed-down roster -- is largely realized. Since 2000, when O'Neal took over the retail business, Merrill has axed 22,000 people, or 31% of the payroll, many of them from its famed "thundering herd" of brokers. Some 6,600 are gone because they served customers with small portfolios who are now handled by 460 agents at the call centers.

The carnage had a huge cost in terms of lost business, but it worked wonders for the bottom line. In 2002, revenues slumped 28%, to $28 billion. Angry investors pulled a net $5 billion from their accounts in the first quarter this year, the first fall in five years. However, according to internal forecasts, Merrill was careening toward a $1.6 billion operating loss in what turned out to be the third year of the bear market. Instead, O'Neal delivered the firm's third-biggest operating profits, which translated into a fourfold jump in net profits, to $2.5 billion, as rivals such as Morgan Stanley and J.P. Morgan Chase saw their earnings wilt. He even managed to top archrival Goldman's $2.1 billion in net profits.

The cost-cutting elixir still seems to be working. In the first quarter, Merrill's earnings were up 27% from the final quarter of last year, coming in at 72 cents per share, 11 cents more than Wall Street analysts expected. Better yet, pretax profit margins perked up sharply, to 20.2% in 2002, from 6.3% the previous year, while return on equity nearly quadrupled, to 11.7% from 2.7%. The result: The stock has jumped 47%, to nearly 42 since hitting a 52-week low last October, nearly triple the 17% rise in the Standard & Poor's 500-stock index. And more analysts rate it a buy than any other investment bank besides Citigroup.

Still, critics contend O'Neal's strategy is flawed. They charge that Merrill's cutbacks are so severe that the firm will be left floundering once the market recovers. "O'Neal took the lead [in slashing staff] in the downturn," says James Mitchell, a Putnam Lovell NBF Securities Inc. financial analyst. "But when things turn around, that could be an issue."

Others say O'Neal is failing to deliver on some key promises he made to shareholders. The CEO said the firm would quit unprofitable lines. But it has remained the top underwriter of short-term debt, a low margin business. Rivals say the firm is chasing revenues to get to the top of the underwriters' rankings. Merrill insists they are no longer a concern.

His detractors shouldn't underestimate O'Neal. He has shown an uncanny knack for turning adversity to advantage ever since he picked cotton as a boy in dirt-poor Wedowee, Ala., in the days of segregated restaurants, theaters, and bathrooms. He put himself through college by working the 4 p.m.-to-midnight shift as a foreman of a General Motors assembly plant. GM paid for him to get an MBA from Harvard. By his late 20s he was working alongside GM's current CEO, G. Richard "Rick" Wagoner Jr., in the Treasurer's office, before leaving to join Merrill in 1986. "He's as smart as it gets," says Bennett Rosenthal, formerly of Merrill's junk-bond group and now a partner at Ares Management in Los Angeles, an affiliate of Apollo Advisors.

Bright he may be, but according to others who've worked closely with him, O'Neal often comes across as insensitive in dealing with people. Stories about his high-handed treatment of colleagues abound. For example, when he became president (and CEO-in-waiting) in 2001, he was far from a gracious victor. One of the losers, Jeffrey M. Peek, then-head of asset management, found out that he didn't figure in O'Neal's future plans from a corporate flack. Last November, about two weeks before becoming CEO, he angered veterans when he, not Komansky, announced the promotion of his buddy Patrick.

Eventually, his lack of people smarts may come back to haunt him. O'Neal regularly offends his investment bankers by commenting both to them and to outsiders that the value of the merger and advisory business is debatable. Such treatment could make it harder for him to keep key staff if Wall Street's palmier days return. Already, 10 senior execs have exited since O'Neal officially became CEO in December, including Robert J. McCann, who retired at age 44 in January after working at Merrill for 21 years. That was just 15 months after O'Neal handpicked him to clean up Merrill's research mess as head of research.

A far bigger preoccupation for O'Neal seems to be that reforms in the wake of the Wall Street scandals have gone too far. "Today's business landscape is dominated by an atmosphere of cynicism and potential retribution; the message seems to be that risk is bad," he told the Greenlining Institute, a minority communities lobby group, in Los Angeles on Apr. 10. "If we attempt to eliminate risk, the result will be, ultimately, economic stagnation or perhaps even economic failure."

So far, the risks O'Neal has taken have given Merrill positive momentum. To maintain it, he must build new high-margin franchises. That's what he's trying to do in Phase II of his top-to-bottom makeover. As he pushes into new businesses or bulks up to critical mass in existing ones, he's starting to hire on a selective basis. In the past 12 months, more than 400 bankers, salespeople, and traders have joined Merrill. The firm has doubled the staff that provides technological support and financing to hedge funds, a business dominated by Morgan Stanley and Bear, Stearns & Co. "Merrill has been aggressively repositioning its business to be in the top ranks," says Johann Wong, vice-chairman, CEO, and founder of hedge-fund watcher HedgeWorld.

In the retail business, O'Neal's battle plan requires remorseless segmentation of customers to ensure that serving them is profitable. That's why those with low account balances were diverted, much to their resentment, to impersonal call centers. Few clients with less than $100,000 in assets generate enough fees to cover the $1,500 that industry mavens say it costs Merrill to assign an investor a personal broker. The more affluent clients, especially if they use Merrill for other services in addition to brokerage, are moneymakers for the firm. Merrill estimates that this group has about $140 billion on deposit with other financial firms. It wants them to shift that cash -- and roll over their 401(k) pension plans when they change jobs -- into Merrill accounts.

The richest clients are the biggest prize of all. Not only do $10 million-plus accounts spin off substantial fees, they're also the natural market for high-margin investment products. Last year, Merrill clients invested $3.1 billion in its hedge-funds-of-funds and private-equity investments combined. O'Neal wants that to rise substantially, along with sales of sophisticated financial products such as futures and exchange-traded funds and fancy derivatives. He is determined to coddle the very rich as much as necessary to keep current clients loyal and win over new ones.

Before O'Neal can convince the rich that Merrill's fancy new funds are worth buying, he still may have to give its plain-vanilla mutual funds another shot in the arm. Since Merrill started to merge funds to bury the dogs, more than half are beating the average 3-year performance for their category. A key but hard-nosed group -- outside financial advisers to whom Merrill would like to sell its funds -- are starting to take notice. On Apr. 21, Jersey City (N.J.) clearinghouse Pershing LLC said it would give the 850 brokerages it serves access to Merrill's mutual funds.

Efforts to expand in investment banking are already paying off. First-quarter revenues shot up 37%, to $2.5 billion, thanks to nearly doubled debt-trading revenues. Operating profits from the sector rose 41%, to $785 million. The firm is also making inroads into so-called block trading to get closer to corporate customers and money managers. It buys large blocks of stocks from companies such as Bank of New York Co., as it did in January, and then sells them to investors. It can lose money if prices move against it while the stocks are still on its books. But it's worth the risk: Banks can make returns on equity of 20% or more, vs. the typical single-digit returns from stock and bond underwriting.

Lending more to favored clients is on the rise as well. In 2002, Merrill granted loans totaling $35 billion, an 80% jump over the previous year, and made commitments to lend another $24 billion, a 60% increase. In this way, O'Neal is taking on power hitters such as Citigroup, Deutsche Bank, and Bank of America by extending credit to win more lucrative jobs from corporations.

Pension rollovers, complex derivatives plays, block trades: How does O'Neal hope to accomplish all this as well as keep his core franchises humming? He's drilling his mantra of discipline, discipline, discipline as far down the ranks as he can. He is also streamlining decision-making by combining divisions and dumping co-heads. On Dec. 3, the firm fused its international and domestic retail-brokerage operations.

Pressure to cut costs is still intense. O'Neal has created special SWAT teams in each business group to sniff out ways to use everything from people to computers and office space better. "[They're] coming up with ideas that involve consolidation or dismantling of processes that are redundant or don't add value," says CFO Fakahany.

Merrill is also pinching pennies by playing legal hardball against more customers who, upset with their losses in the post-bubble market, are suing the firm. Securities lawyers say Merrill is fighting more of the cases rather than settling. And they complain that the firm is also trying to drag out the process by stalling arbitration proceedings. Merrill declined to comment. However, it recently placed classified ads for lawyers to work as temps to help it fight off the barrage of complaints.

For now, O'Neal seems determined to tune out such problems and focus on producing the numbers he needs to declare victory. He outsmarted rivals by anticipating the seriousness of the downturn -- and cutting costs -- much earlier than they did. Now, the big question is whether he can outmaneuver them again when business on Wall Street finally picks up.

The diverse portfolio of businesses he has put in place is designed to enable Merrill both to weather a continuing bear market and benefit from an economic upswing. But that won't do him much good if he fails to win back investors' trust and gain the loyalty of his troops.

There are still people on Wall Street who think Merrill will end up as takeover bait for banks that want a bigger investment-banking presence when business picks up again. Possible suitors, senior merger advisers say, include Bank of America, Bank One, or British-based global bank HSBC. Those rumors will quickly fade if Stan O'Neal succeeds in realizing his vision at Merrill.

By Emily Thornton

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