Financial Services: Fattening Up

Despite rising interest rates, Merrill Lynch reported a stellar second quarter. And it's not the only firm with strong earnings growth

Never mind wars, oil spikes, and rate hikes: The bull keeps charging ahead. Merrill Lynch (MER) said on July 18 that it raked in record net revenues of $8.2 billion during the second quarter, 29% more than the same quarter last year and 2% more than the first quarter of 2006. Net earnings during the second quarter amounted to $1.6 billion, or $1.63 per share, up 44% and 43%, respectively, from the year-ago quarter.

Chief Executive Stan O'Neal's recent success leading the giant brokerage underscores how well financial-services firms have performed this year, even as the U.S. economy faces stiffening headwinds in the form of rising interest rates and a gradual strengthening in inflation (see, 3/15/06, "Goldman's Golden Haul"). The jury is still out on what happens in the coming months.

"This is definitely a period of peak earnings" for financial-services firms, says Philip Guziec, an analyst at the investment research firm Morningstar. "They've been firing on all cylinders."

Merrill Lynch earns the lion's share of its business from managing retail customers' assets, making it less sensitive to interest rates than financial-services firms that depend more heavily on lending and investment banking. But even those firms have fared well so far, as they continue to make money in areas such as trading. The New York investment banking firm Bear Stearns, for example, reported $4.30 billion revenue in the quarter ended May 31. Revenue from its fixed-income businesses grew 44% to $1.167 billion as of May 31.


  Citigroup (C) is another case in point. On July 17 the bank reported net income for the second quarter of 2006 of $5.27 billion, up 4% from the same quarter in 2005. In spite of emerging markets' tumble in recent months, Citigroup managed to make money in areas such as global debt underwriting and trading services. It also opened corporate and investment banking offices in Kuwait and Dubai. The bank increased its fixed-income and equity-markets revenue by 51% and 30%, respectively.

"When equity and debt valuations are high, every aspect of investment banks and brokerages perform well," says Morningstar's Guziec. "Both equity and debt and markets have been healthy so far this year." Indeed, in spite of all the recent geopolitical and market turmoil, the Standard & Poor's 500 Index only dropped by 1% year-to-date as of July 14, after having been in positive territory for the bulk of the year. Financial-services companies are down an even smaller 0.1% on the index.

Of course, it remains anyone's guess what happens next, as pundits battle over when and by how much the Federal Open Market Committee will raise interest rates next, energy prices soar, and stock markets grow more volatile. The relatively flat year-to-date performance for the S&P 500 financial-services stocks masks the fact that they have lost 2.7% of their value during the past 13 weeks as investors grow increasingly fretful. But they've still fared slightly better than the overall index, which shed 4.1% during the same period.


  Dave Ellison, chief investment officer of FBR Mutual Funds, says he isn't fazed by the recent market turmoil. He's keeping his two financial-services sector funds exposed the same way they have been for years, with about 60% of his holdings in firms that mainly do business with retail customers and 40% in institutional-oriented ones. (He says he prefers to stay away from commercial lenders because their financial information is more complex and hidden, while banks that do business with consumers have relatively straightforward balance sheets.)

Ellison plans to keep his fund exposure the same during the coming months, too. "I'm waiting for the interest rate thing to play itself out," he says. When he gets more clarity on what happens next to the housing market and the yield curve, then he'll make some decisions, he says. "But the underlying issue is that if you own companies that are generally well-run and focused on profitability, you don't have to go home and go crazy."

There is more news to digest before the final verdict on the second quarter can be delivered, with upcoming results from other big industry players such as JPMorgan (JPM) on July 19 and Wachovia (WB) on July 20.

JPMorgan's business competes with Citigroup's, but it's more dependent on corporate investment banking. "JPMorgan should certainly benefit from continued strength occurring within the investment banking area, as well as among corporate borrowers to a greater degree than Citigroup," says Morningstar analyst Craig Woker. He expects the company to have "healthy bottom-line growth." For now, it looks like the good times will continue for Merrill and the rest of the financial-services club.

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