Investment Banks: Yellow Flags Ahead

Goldman, Merrill, and Bear Stearns should report healthy earnings this week, but S&P's Robert Hansen thinks their stocks could cool off

Many large investment banks and brokers will report quarterly results this week. Robert Hansen, who follows these stocks for Standard & Poor's Equity Research, recommends that investors exercise caution within these industry groups ahead of the earnings releases.

"These stocks are already up about 10% in 2006, well ahead of the S&P 500 index, because we think investors already expect these companies to report impressive results next week," he says. "The investment banks typically post two or three great quarters followed by a clunker, so the run in the shares could take a breather or even sell off in the near term."


  Despite Hansen's near-term caution, he still likes the fundamentals and thinks the brokerage sector is perhaps one of the most leveraged sub-sectors within the financial services industry to benefit from an expanding economy. Overall, Hansen believes valuations of the investment banks are attractive over the next 12 months.

Hansen favors larger, more diversified companies like Goldman Sachs (GS) and Merrill Lynch (MER), which are both ranked 5 STARS (strong buy).

"This should be a great quarter for the investment banks across virtually all their business segments," Hansen says. "High-margin merger advisory, sales and trading, and stock and bond underwriting all look really strong this quarter."


  Hansen also expects continued strong growth in commission and clearing revenues, as well as higher levels of margin lending, which is getting more profitable as firms continue to raise margin rates in tandem with rate increases by the Federal Reserve.

"We continue to see higher trading volumes from both hedge funds and retail investors, despite concerns that growth could slow," Hansen says.

In addition, Hansen sees increased merchant banking gains and a continued high level of investment activity. The asset management businesses of the major brokerage firms should also post strong results, in Hansen's opinion, given improving equity markets and what he views as strong client inflows.

However, his enthusiasm is tempered by his concerns about rising interest rates, a flattening yield curve, and potentially widening credit spreads, which he expects to affect negatively fixed-income underwriting and proprietary trading revenues in the second half of 2006.


  He thinks the fixed-income market will see challenges in light of a shift he sees away from adjustable-rate mortgages. Also tempering his enthusiasm is increased head count and compensation over the next few years, amid a more competitive recruiting environment.

Hansen recently downgraded the shares of Bear Stearns (BSC) to buy from strong buy, based on valuation and concerns about the company's fixed income business. Hansen expects Bear Stearns to report strong results next week but thinks business could slow in the second half of 2006 should mortgage originations decline and credit spreads widen.

"We still like the company's competitive position but think that Bear Stearns is the most sensitive among its peers to rising rates, given its large fixed income franchise," Hansen says.

Hansen raised his per-share earnings estimate for fiscal 2006 (ending November) to $11.00 from $10.75. In fiscal 2005, Bear Stearns reported profits of $10.31 a share. Hansen raised his fiscal 2007 estimate to $11.50 from $11.00. He believes the company will be aided by merchant banking gains in fiscal 2006 and 2007.

"Bear Stearns probably won't grow as fast as some of its peers, but its valuation still looks attractive at nearly 12 times our 2006 estimate, a discount to peers," he says.

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