MERRILL LYNCH

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MERRILL LYNCH Co Inc (NYS)

• FIBB sector Victor (P), Ian (SL), Diana, Jason,
  James, Feliks

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Company Profile

• Holding company that provides numerous products
  and services primarily to the US and also world
  wide.
• Services include broker-dealer, investment
  banking, wealth management, advisory, asset
  management, insurance, lending services, and
  other related products.
• Activities are grouped into three main segments
• GMI (Global Markets and Investment banking)
  most profitable segment, with activities
  including MA advisory and underwriting for
  corporate clients.
• MLIM (Merrill Lynch Investment Management)
  provides financial products such as mutual funds
  and separately managed accounts clients include
  individuals, small businesses, corporations,
  financial institutions, governments, and
  government agencies.
• GPC (Global Private Client) offers investment
  advisory, broking, and depository services for
  clients financial needs

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Industry Analysis

• The financial services industry is extremely
  competitive and highly regulated
• This industry, and tied directly to global
  financial markets, is influenced by numerous
  unpredictable factors economic conditions,
  monetary and fiscal policies, the liquidity of
  global markets, international and regional
  political events, acts of war or terrorism,
  changes in applicable laws and regulations, the
  competitive environment and investor sentiment.

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Threat of new entrants

• Heavily regulated industry that requires immense
  intellectual capital for a firm to operate within
  it.
• This is an industry in which name and prestige
  carry a lot of weight, and its very difficult
  (almost impossible) for a no-name firm to enter
  the market, gain market share and maintain it.
• The intensifying consolidation throughout the
  industry would further make it difficult for new
  firms to enter the market.
• However, established firms from other areas in
  finance have begun entering the market (ie
  Citigroup), and have started to chip away at
  Merrills market.

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Bargaining power of buyers

• In general, firms and corporations are paying
  less for financial services, such as MA
  advisory, than they did in the past,
  demonstrating that buyers today are more price
  setters than price takers.
• Buyers are very concentratedMerrill must work
  hard to keep clients, and this results in the
  aforementioned observation.
• However, in terms of private investors (relevant
  to Merrills Wealth Management division), buyers
  are far weaker than big company clients.

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Threat of substitutes

• In general, the financial services industry does
  not face a threat of substitutes from other
  industries.
• The products Merrill provides are only provided
  by competing banks.

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Bargaining power of suppliers

• Merrill, as well as all firms in the financial
  services industry, are built on talented
  employees, experienced management, and commercial
  prowess.
• The primary suppliers Merrill is concerned with
  are simply its employees, and because of the way
  the employment market in the financial services
  industry works, the bargaining power of its
  suppliers is fairly moderate, and its effect on
  the actual industry is negligible (yes, this even
  includes 100 million bonuses for executives).

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Intensity of rivalry among competitors

• Clients no longer keep their business with one
  firm they are more willing to shop around and
  take their business with them.
• Commercial and investment bank consolidations
  have also increased the competition for
  investment banking and capital markets business,
  due in part to the extension of credit in
  conjunction with investment banking and capital
  raising activities.
• Also, some financial services companies have
  begun offering one-stop service for all of a
  firms financial needs.

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Source of growth - 1

• Diversification of revenues across geography and
  classes

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Source of growth - 2

• Focus on fee-based activities, with more
  consistent returns
• Acquired firm focusing on natural gas and
  electricity trading to diversify for difficult
  financial markets this firm, Entergy-Koch, is
  the third in its field for power, natural gas and
  weather derivative trading
• Investment managers in Europe seen as strong area
  of growth their services have been popular
• Private wealth managers in Europe have increased
  their pretax earnings

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Quality of growth - 1

• Quality diversification into Europe and Asia
  should forge loyal relationships with more small
  investors
• Equity markets in Europe and Asia have higher
  expectations for revenue
• 30 of revenues from outside the U.S.

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Quality of growth - 2

• Could extract more income from fixed income
  trading, acquisition of trading firm could help
  this situation

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Strategy - Macro review I

• Macro review divided into three principle
  sub-groups Global Markets and Investment Banking
  (GMI strong albeit not dominant player in IB
  coverage, historically strong across diversity of
  trading platforms), Global Private Client ("GPC"
  reputation as best business in kind FAs are
  dominant in output, performance measures), and
  Merrill Lynch Investment Managers ("MLIM"
  basically mutual fund business with decent
  overall results). Overall approach has aimed to
  diversify revenue streams across businesses,
  regions, and within asset classes. MERs
  objective is to deliver superior returns to
  shareholders over the long-run given across a
  variety of market conditions. To achieve goal,
  key strategic objectives include

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Strategy Macro review II

• diversifying revenue growth streams on a global
  scale by increasing investments in fee-based
  revenues (as opposed to interest or lending based
  revenues) in a variety of financial product
  groups
• maintaining an strong operating discipline
  through a focus on optimal resource allocation
  the deployment of our people, financial,
  technical and other resources into areas that
  offer the most attractive returns and growth
  opportunities
• rigorous capital management essentially MER
  considers the equity capital necessary to support
  the risks and needs of its businesses and
  accordingly assigns each business an amount of
  equity that reflects the risks of that business,
  both on and off balance sheet.
• Diversification of liquidity and funding sources
  maintain alternative sources of funding so that
  all debt obligations maturing within one year can
  be repaid when due without raising new unsecured
  debt or requiring the liquidation of business
  assets ensures that sufficient long-term debt
  and equity capital are in place to fund the
  firms assets, commitments, contingent
  obligations and regulatory capital needs.

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Strategy Key business drivers in 2004

• GMI continued emphasis on diversifying revenue
  sources in both fixed income and equity trading,
  and selectively increasing proprietary trading in
  certain asset classes has recently acquired a
  commodities trading business ? provides MER
  leading position in commodity markets both
  domestically and abroad. Also built out global
  principal investing and secured finance
  (organic), mortgage-backed trading and
  securitization (acquisition), clearing and
  electronic trading platform businesses
  (acquisition) future plans include further
  acquisitions for commodities, equities, prime
  brokerage, forex, and leveraged finance
  platforms. In IB, key hires were made to
  strengthen consumer/retail and industrials
  coverage
• GPC demonstrated benefits of revenue
  diversification, asset annuitization and growth
  in financial advisors (FAs) in a year subject
  to uncertain market conditions. Investment in
  training and retention of FAs remains top
  priority
• MLIM generated strong investment performance
  while focusing on broadening distribution of
  products and maintaining operating discipline
  key areas for future growth include further
  expansion of U.S. non-proprietary and
  institutional long-term channels and European and
  Asian third-party retail distribution channels.

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Profitability (using information from historical
10-ks and morning star)
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Profitability comps (2004)
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Cash flow (using information from historical
10-ks)( in millions)
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Financial Health - 1
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Financial Health Comps (2004)
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Valuation 1 valuation comps
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Valuation 2 An alternative Approach

• An examination and explication of the valuation
  models employed by sell-side analysts would prove
  more useful both in terms of thinking about
  Merrills margin of safety and allowing the
  audience to gain a better understanding of
  alternative valuation approaches commonly
  employed for financial institutions.
• Historically, the preferred ratio to use in
  valuing a brokerage stock has been price-to-book
  value. Book value benefits from the fact that
  brokers mark their positions to market every day,
  and their assets are highly liquid. SP
  NetAdvantage Industry Report

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Valuation 2 An alternative Approach Morgan
Stanley

• Emphasis on fact that MER has benefited the least
  from FI bull market in recent years, thereby
  making it a good defensive bid in the case of
  negative earnings revision from a pullback in
  fixed income trading environment
• Given washed out retail sentiment, typically
  marks a good contrary indicator of when to buy
  MER typically interesting correlation between
  index tracking retail investor sentiment
  (currently at a low) and best time to buy MER
  (when index has bottomed)
• 12 Month price target on Merrill of 60
  currently trades in low 50s uses two pronged
  valuation methodology residual income and
  divisional-sum-of-parts analyses historical
  price/book ratios imply currently undervalued by
  about 26
• Sum-of-parts valuation approach (next slide)
• 2004A 2005E 2006E
  2007E

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Valuation 2 An alternative Approach Morgan
Stanley

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Valuation 2 An alternative Approach Bear
Stearns SSB

• SSBs DCF model derives 12 month value of 73 for
  MER assumes cost of capital at 11, ROE at 15
  terminal multiple of 1.9X model is driven by ROE
  expectations based on earnings estimates.
• Further emphasis on compelling price/book value
  of 1.6x as they trade at 15 discount to peer
  group median of 1.9x attributable to lower than
  average ROE of 16, but forward expectations
  remain favorable

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Bull Case

• 4 billion dollar share buyback 25 increase in
  dividend
• Steady and solid revenue drive from its GMI
  business
• Feasible strategy Revamped retail business
  international expansion
• Time to buy relatively undervalued BV, recent
  sharp pull back and record-low retail investor
  sentiment (Typically a good contrary indicator)

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Bear Case

• Lower than average ROE
• Recent equity market downturn
• Inherent nature of the market volatility and
  various legal risks

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Recommendation

• Merrill Lynch is trading at an approximate 15
  discount to the peer group median of 1.9x book
  value. Also, the combination of a wider product
  mix and stringent cost controls should allow
  Merrill to perform well under various market
  conditions. We believe that Merrill Lynch knows
  how to create shareholder value and, for this
  reason, we advocate a MODERATE BUY this time