Bull/Bear Report: No "Bull" for Merrill Lynch

The craziness that was Lehman Brothers (LEH) and the subsequent collapse of Merrill Lynch (MER) resulted in my selection of MER as our stock of the week late in the day last Friday.

With so much uncertainty in the market, I figured our InvestorPlace Blogs community could weigh in on where MER was heading. At a minimum I was hoping to gauge some sentiment on a difficult to value company in a very difficult situation.

I had no idea how crazy things would become. During the weekend we saw our government draw a line in the sand with respect to bailouts. At the same time, LEH frantically chased down a partner that could help it survive.

No such luck. All potential partners backed away given the toxicity of LEH balance sheet. With no government assurance for help, there really was no incentive to step up to the plate.

Any interested party could simply let LEH fail and then buy whatever assets, the good assets on the cheap. And that is exactly what transpired right down to Barclays stepping in to buy some assets after the LEH declaration of surrender.

With the writing on the wall, MER felt the pressure to do a deal itself. Knowing that it would not be wise to wait until the shorts attacked the stock on Monday, MER entered into a definitive sale agreement with Bank of America (BAC).

The deal of a lifetime as BAC's CEO claimed in announcing the deal. So with that there was no more LEH and no more MER.

No sense to continue our query of bloggers. BAC and MER did our work for us setting the price of MER before we all had a chance to chime in.

One blogger did offer some insightful commentary on Merrill Lynch. Get his take and my opinion when you read the rest of this week's "Bear Report".

It is interesting to note though the activity of the rest of the week. Amazingly the turmoil did not end with the MER deal. There were more fireworks to come.

American International Group, Inc., as suspected, was closer to the brink than anyone could imagine. So real was the threat of failure and so horrible the consequences thereof, the government reversed course.

The Federal Reserve stepped in and essentially took over the company with a loan that included a major equity stake in the company. And that wasn't the only news from the government.

Today, we get word that a resolution trust like government entity may be formed to buy all bad assets from banks and financial institutions. No deal has been announced yet let alone the need approvals from Congress, but the potential of a massive rescue lifted the market like a rocket ship.

Hmmmm? I wonder if MER may be rethinking its position. If the government has become so generous, it may have been possible to keep MER independent.

Oh well, I wonder if MER shareholders can sue to collapse the deal with BAC. Oh never mind.

The following is a very insightful analysis of MER and the challenge of dealing with an uncertain market:

Russ of RD's Picks

Last week's big decline in Merrill Lynch (MER) share price makes it worth a look. Significantly, it is now trading nearly 25% below the last 'smart money' issue price of $22.50. So far, I believe every financial firm that's raised capital by selling common stock has gone on to trade below the issue price. Please comment if you're aware of an exception. To summarize Merrill's capital raise, I've copied the pitch from my Motley Fool CAPS underperform rating entered in late July.

Monday, 28 July Merrill Lynch (MER) announced they were raising $8.5 billion of new capital in a stock offering and selling off a portfolio of CDO securities for $6.7 billion.
The CDO's had been carried on the books at $11.1 billion, that was after being marked down from an original value of over $30 billion. Merrill also financed 75% of the sale, so they netted something like $1.7 billion with some type of paper for the balance.
The stock placement will be 380 million shares priced at $22.50. There are 985.4 million shares outstanding before the new issue. That's nearly a 28% dilution for current shareholders. There is also a conversion of some convertible preferred stock from earlier capital raise that's tossed in the mix, so the dilution may even be a little higher.

Particularly disturbing in this case is that the CEO had stated that Merrill was in good shape and wasn't going to need to raise capital fairly recently.

Analysts expect MER to return to profitability next quarter, however MER has under performed expectations for the last two quarters. Yahoo shows 1.53 billion shares outstanding and the company listed tangible assets of a little over $16 billion at the end of Jun. Factoring in the new capital raise and loss on the CDO sale announced in July, tangible assets would bump up to about $20 billion. The share count appears to include the dilution. That gives a tangible book value of $13 per share and would have MER trading at a price-to-tangible book value ratio of 1.3. I believe Merrill's assets are in better shape than many other financial firms because they did go ahead and sweep out a lot of the trash; that doesn't mean the trash is all gone.

MER is paying a high yielding dividend, but if they don't start logging profits soon the payout will need to be cut.

If I did the math right, MER is trading at a premium for a company with uncertain prospects. Financials that are weathering the credit crunch well and are positioned to make fire sale acquisitions deserve premium valuations; I don't think MER is in that category. At the other end of the spectrum, MER is too expensive to attract high risk, speculative investors or deep value hunters.

Bottom line, I think MER is expensive for a company with an uncertain future. I also don't like that they announced the last capital raise so soon after Mr. Thain had publicly stated they wouldn't need one. The smart money track records in financials have not been good to date, so I'd like to see either some profitable quarters or a much larger discount to Temasek's purchase price before considering joining them as a MER shareholder.

[Edited to add: Never mind; disregard this post. Just saw the news that BAC is buying MER for the ridiculous price of $29 per share. Overpaid for Countrywide, now over paying for Merrill Lynch.]

We now know that MER was indeed worth more than what it traded for before the deal with BAC. What we don't know is what MER would be worth had they survived the week. Seeing what shares of other companies did in the wake of a potential massive government rescue.

It does make one wonder.

Jamie Dlugosch
Executive Editor, InvestorPlaceBlogs

by The Freshman |  09/19/08  |  Stocks: BAC, LEH, LEHMQ, MER,