Bullish on Bear Stearns
By Robert Hansen, CFA
We at Standard & Poor's believe leading investment-banking and securities trading firm Bear Stearns (BSC ; recent price, $74), has weathered the financial-services industry slowdown remarkably well, largely due to its strong fixed-income franchise and prudent expense management. We think it has a strong competitive position within its industry and view the shares as attractive compared to peers and the S&P 500-stock index. Bear Stearns carries S&P's highest investment recommendation of 5 STARS, or buy.
Our 12-month target price is $100, which is 13 times our fiscal 2004 EPS estimate. Although Bear Stearns has traded at an average p-e of 9.5 over the past 10 years, we think the multiple can expand as it demonstrates consistency of earnings during an adverse fixed-income cycle.
Bear Stearns serves corporate, government, institutional, and individual clients through offices in several cities across the U.S. and in international business centers such as London and Hong Kong. Overseas sales accounted for 9.1% of the total in fiscal 2002.
The outfit operates in three segments: capital markets, global clearing services, and wealth management. The capital markets unit (77% of fiscal 2002 revenues) comprises the fixed income (38%), institutional equities (22%), and investment-banking (17%) businesses. The fixed-income business, which caters to institutional clients, focuses on mortgage-backed and asset-backed securities, corporate and government bonds, municipal and high-yield bonds, foreign exchange, and fixed-income derivatives.
The institutional-equities business includes domestic and international sales, trading, and research in areas such as block trading, convertible bonds, OTC equities, equity derivatives, and risk arbitrage. Revenues in this group have declined less than the company's peers since 2000. The international equity sales and trading business returned to profitability in fiscal 2003. Results at Bear Wagner Specialists have been hurt by lower volumes, reduced volatility, and decimalization, but remains profitable and has grown market share since fiscal 1999.
The third and final capital markets subgroup, investment banking, helps clients raise capital, provides strategic advice and guidance on mergers and acquisitions, and engages in merchant banking. Bear Stearns underwrites equity, investment-grade debt, and high-yield debt products. The company is particularly strong in asset-backed securities, mortgage-backed securities, and municipal bonds. Within investment banking, Bear Stearns has focused on cross-selling products in order to deepen client relationships.
In December, 2002, Bear Stearns and other leading investment banks entered into a $1.5 billion agreement to settle allegations that their research was tainted with conflicts of interest and misled investors. Its share of the settlement was $80 million. The banks also agreed to make organizational changes to reduce conflicts of interest in their research departments.
In our view, the diversification of Bear Stearns' businesses across fixed income, equity, and clearing operations has contributed to increased earnings consistency. Furthermore, we believe that diversification within the fixed-income business since fiscal 2000 beyond mortgages and high yield will result in more stable operating earnings going forward.
Recently, the fixed-income unit had 13 businesses, each with annual revenue of over $100 million, which is up from two in fiscal 2000. We estimate that over half of the revenues in the mortgage department are not highly sensitive to either interest rates or fixed-income origination levels based on the revenue contributions from the EMC/MAX (purchasing and servicing distressed loans), ARMs (adjustable rate mortgages), and ABS (consumer mortgage) businesses. We think both the EMC and MAX businesses will benefit from an improvement in employment levels from the economic recovery that we expect.
FOCUS ON VOLUME.
Within Fixed Income, about 75% of the revenue growth in 2003 came from nontraditional mortgage products, including credit, interest rate, consumer mortgage, and distressed mortgage, which we think illustrates the improved diversification.
In our view, the Institutional Equities group has gained market share since 2000 due to its focus on Prime Brokerage (primarily hedge fund) and commitment to research. We expect strong revenue growth in fiscal 2004 from hedge-fund clients, which we estimate generate more than 30% of Bear Stearns' total equity commissions. We are impressed that the international equity sales and trading business returned to profitability in fiscal 2003 given difficult industry conditions.
Bear Stearns has focused on increasing its market-making volumes and keeping inventories of securities held low in order to generate consistent returns, rather than on proprietary trading. We're impressed that it hasn't had a trading loss on any day in the first half of 2003 and has the lowest standard deviation of quarterly trading revenues among its peers over the 30 quarters through the second quarter of 2003.
Bear Stearns, in our view, takes a long-term approach in allocating its resources in order to capitalize on market opportunities and generate sustainable and profitable growth. For example, it has allocated capital to its highly profitable merchant-banking unit. Although merchant-banking results are quite volatile, we view the unit as a core business for Bear Stearns and don't exclude gains and losses from our operating estimates.
We forecast that revenue growth in the investment banking, PCS, and global clearing services will significantly offset the projected decline we see in the fixed-income business in fiscal 2004. We expect a modest decline in the fixed-income origination business next quarter, particularly in collateralized mortgage obligations, as a rise in interest rates in the third quarter of 2003 leads to a reduction in consumer mortgage activity, which leaves fewer loans to be packaged and sold by Bear Stearns.
We expect revenue to recover modestly in the institutional-equity business in fiscal 2004, while margins remain depressed. We see significant growth in several of Bear Stearns' businesses including interest rate products, distressed debt, high-yield underwriting, credit derivatives, international fixed income, private client services, and prime brokerage.
We believe that charges for regulatory judgments and increased legal expenses are likely in fiscal 2004, given ongoing regulatory inquiries, but we view them as one-time, nonrecurring events. We forecast earnings per share of $8.35 in fiscal 2003 and $7.50 in fiscal 2004, up from $6.47 in fiscal 2002. We expect Bear Stearns to use its strong free cash flow to pay dividends and repurchase common shares in fiscal 2004.
Our Standard & Poor's Core Earnings analysis suggests that our fiscal 2003 EPS estimate of $8.35 would be reduced by 38 cents if stock options were expensed. Our fiscal 2004 EPS estimate of $7.50 would be reduced by 37 cents for similar stock option expenses.
We think Bear Stearns has a strong competitive position within its industry and recommend buying the shares. We believe the stock trades at a significant discount to its peers due to concerns about a slowdown in the company's fixed-income business, which generated the majority of its revenue in fiscal 2003. However, with the shares recently trading at a p-e of 9 times our fiscal 2003 EPS estimate, we think the valuation more than accounts for this risk.
The shares have gained 24% year-to-date, which is slightly higher than the gain for the S&P 500-stock index, but lags behind its peer group, which has advanced about 40%. Our 12-month target price of $100 represents a multiple of 13 times our fiscal 2004 EPS estimate.
Although Bear Stearns has traded at an average p-e of 9.5 over the past 10 years, we think the multiple should expand as the company demonstrates consistency of earnings during an adverse fixed income environment. We also believe that the multiple should expand, given its impressive return on equity vs. its peers, broader analyst coverage, and increased management visibility.
We also view as positive the very cautious risk-management policies and Bear Stearns' reluctance to make large proprietary investments, which we think will minimize losses on dealer positions or hedges on its origination pipeline. We believe our target multiple is conservative relative to the company's peer group and the overall market.
DRESSED FOR SUCCESS.
In our view, our investment thesis has several risks. These include unfavorable interest rate trends, compliance with regulatory matters, competition, counter-party credit risk related to trading with other institutions, and Bear Stearns' principal exposure on proprietary investments, which could result in losses on dealer positions or hedges on its origination pipeline.
Despite these dangers, we believe Bear Stearns has established policies and procedures to succeed in the market. We think its customer focus, prudent expense management, and stock repurchases illustrate its shareholder focus. In particular, we find management's equity interest in the company to be a positive, which should align shareholders' interests to maximize return with those of management.
Analyst Hansen follows stocks of asset managers and brokers for Standard & Poor's