Saturday, 22 September 2007

A first look at broker's earnings

This week saw 4 US broker's report 3Q07 earnings . Let's have a look at how they fared:

Lehman Brothers (LEH)
Earnings declined 1.9% to $1.54 a share, in 3Q07 from $1.57 a share a year earlier, beating analysts average forecast of $1.48 a share.

While fixed-income trading revenue fell 47% to $1.06 billion in the quarter, Lehman reported gains of at least 33% in equity trading, investment banking and money management.

Lehman took a one-time charge of $44m for restructuring the mortgage business after cutting about 2,000 mortgage- related jobs. They still have some $6.3 billion of subprime-mortgage assets on their books and by some estimates Lehman may have to fund around $16 billion of loan commitments to leveraged buyouts at a loss because investors are reluctant to buy that type of debt.

Richard Bove of Punk Zeigel pointed out that Lehman achieved the better than expected result after cutting compensation costs by $500m and reducing tax expense by about $75m. Bove argues the latter is unsustainable going forward.

Kevin Depew at Minyanville noted that LEH didn't reveal the split among trading asset levels. That is between level 1 assets, which are highly liquid and therefore have easily observable market prices, level 2 assets which are kind of liquid and level 3 assets which aren't very liquid at all. Still confused? Read point 2 and associated links here. Nor did they adjust any of their loan commitments to reflect potential credit market issues.

So what can we say about Lehman's 3Q07? I think Kevin Depew put it best:
Bottom Line: The standoff continues as Lehman pulls back the curtain to reveal the fact that there's a curtain hiding the earnings wizard. Thanks!

Morgan Stanley (MS)
On to Morgan Stanley - the company's earnings dropped 17% to $1.44 a share, compared to $1.75 a share in the year-ago period. Analysts polled by Thomson Financial had expected the firm to earn $1.54 a share in the quarter. Revenue at the firm rose 13% however loan write-downs in the quarter cost it $940 million. The company stated that:
losses of approximately $940 million (were) due to the marking-to-market of loans as well as closed and pipeline commitments. These losses reduced third-quarter earnings per share from continuing operations by approximately 33 cents a share. The markdowns reflect the illiquidity created by current market conditions."
A little more transparency here. Morgan Stanley also noted that the current difficulties in credit markets will take a couple of quarters to work through.

Bear Stearns (BSC)
Earnings slumped 61% to $1.16 a share, down from $3.02 a share, earned in the same period a year earlier. Net revenue declined 37% to $1.33 billion. On average, analysts polled by Thomson Financial had been looking for the company to generate earnings of $1.78 a share on revenue of $1.64 billion. Bear Stearns said fixed-income net revenue plummeted 88% to $118 million in the latest quarter.

Roughly $450 million of Bear's $700 million write-down came from cuts in the value of mortgage assets such as MBS and collateralized debt obligations (CDOs), with the other $250 million of Bear's write-down was related to commitments that the bank made to finance leveraged buyouts and other debt-fueled acquisitions.

The company still had $7.6 billion of leverage finance commitments at the end of August, down from $20.8 billion at the end of May.

Like all the other brokers Bear experienced strong growth in trading income as expected given the volatility in financial markets. The company also said it had upped it's share-repurchase program from $2 billion to $2.5 billion.

In other news Bear Stearns sought a stay of proceedings to appeal the bankruptcy ruling that went against them on Aug. 30. Remember Bear tried to claim bankruptcy in the Caymans as a foreign entity thereby gaining exemption from US creditors.

Thankfully the judge recognized the brazenly fraudulent act and ruled against them. Bear must file for bankruptcy before the end of this month but will get a hearing on September 24th to appeal the decision. Hopefully the judge throws it out with the contempt it deserves.

Then the lawsuits can begin. How much are they liable for? A number totaling in the billions of dollars no doubt. Such lawsuits could present far bigger problems than faltering earnings. A buyout or even Chapter 11 is still very much a possibility for BSC.

Goldman Sachs (GS)
The market darling didn't disappoint posting earnings of
$6.13 a share for 3Q07, up 88% from $3.26 a share in the year ago period. Analysts polled by Thomson Financial had, on average, expected Goldman to earn $4.35 a share. The result including a $900m gain from the disposal of Horizon Wind Energy.

Goldman said in its earnings commentary that "significant losses" on subprime loans and securities were more than offset by gains on short mortgage positions. Credit products included a loss of $1.71 billion, or $1.48 billion net of hedges, related to non-investment grade origination activities.

The firm said it wrote down about $1.5 billion of leveraged buyout loans, net of hedges and fees.
The firm also said it wrote down some mortgages, but that was offset by gains from short positions, or bets that the value of mortgages would fall.

The bank said that at the end of the third quarter it had about $42 billion in unfunded leveraged loan commitments on its books, and about $10 billion of unfunded commitments.

Goldman said revenues from its financial advisory business grew 64% in the quarter, and helped generate record revenue of $2.15 billion in its investment-banking unit whilst the company commented that merger and acquisition activity remained strong.

In othe news on Friday Goldman and KKR abandoned their $8 billion takeover of Harman International Industries Inc., maker of Infinity and JBL audio equipment, citing a decline in the firm's performance.

The sale agreement would require the buyers to pay the company a so-called break-up fee of $225m should they refuse to proceed with the transaction, unless they can show a severe decline in the company's business. Obviously Goldman and KKR are trying to weasle their way out of this one on that basis. Expect more of this type of behaviour as more deals fall over.

What does it all mean?
Two companies were worse than expectations while the other two were better. A couple of points to bear in mind. Whilst MS gave the most candid assessment of the medium term outlook no-one was willing to give any solid guidance going forward.

It may have sounded strange that Goldman announced strong M&A activity given that LBO activity has all but dried up. However remember that the fiscal 3rd quarter for these companies covers June, July and August. Two of those months saw business as usual. Problems didn't really kick until August.

4Q07 results will be more interesting to see how these companies do in a more subdued M&A and structured credit environment. Also of note is that whilst GS earnings growth looks impressive, their 3Q06 number was quite low at $3.46 which subsequently jumped to $7.01 per share in 4Q07. I suspect it will be a lot tougher for GS to post earnings growth of any kind in 4Q07.