Financials melt down

9/22/2008


The shots that took down former bellwethers Merrill Lynch ($19; NYSE: MER), American International Group ($2; NYSE: AIG), and Lehman Brothers ($0.11; NYSE: LEH) were heard around the world.

The Dow Jones Industrial Average plunged more than 500 points on Sept. 15, dragged down by a spate of bad news from some of the best-known financial companies. Stock markets around the world reeled in response to the U.S. meltdown, and the U.S. Federal Reserve and central bankers in Europe and Japan took steps to improve liquidity. However, making cash more readily available treats the symptoms — not the cause of the problems facing the financial markets.

Below are highlights from the three days before the Forecasts went to press. Be aware that these stories are still developing. Plenty of shoes are poised over Wall Street, ready to drop, and we probably haven’t seen the last blockbuster.

■ Merrill Lynch, hampered by extensive exposure to the troubled mortgage market, agreed to sell itself to Bank of America ($27; NYSE: BAC) for $44 billion in stock, roughly $24 per share. Bank of America will exchange 0.8595 shares of its common stock for every share of Merrill common stock. The deal would make Bank of America the world’s largest brokerage, with more than 20,000 financial advisers and about $2.5 trillion in assets under management. Bank of America expects the deal to close in 2009 and begin boosting earnings in 2010. Merrill shares trade at a discount of more than 15% to the proposed deal price, reflecting Wall Street skepticism about whether Bank of America can close the deal. Merrill and Bank of America are rated Neutral.

■ The Federal Reserve agreed to loan insurance giant AIG up to $85 billion for two years — in exchange for an ownership stake of 79.9%. The government stepped in only after efforts to raise $75 billion from a group of banks failed. AIG plans to sell off assets to raise cash. Shares of AIG fell nearly 90% in the four days before the Forecasts went to press. In the six months ended June, AIG posted losses of more than $13 billion. Those losses, coupled with a still-substantial exposure to risky securities, eroded investor and client confidence and sparked downgrades of AIG’s credit rating. AIG is rated Neutral.

■ Lehman filed for Chapter 11 bankruptcy after the Federal Reserve refused to provide financial guarantees for potential buyers, as it did with Bear Stearns in March. Without those guarantees, large U.S. buyers backed off. Lehman agreed to sell its New York headquarters, two data centers, and its North American investment-banking business to British financial titan Barclays ($23; NYSE: BCS) for about $1.75 billion. Lehman and Barclays are not rated.

■ Shares of Washington Mutual ($2; NYSE: WM) plunged when a credit-rating agency downgraded the mortgage lender’s rating to junk status, then jumped the next day on rumors that J.P. Morgan Chase ($38; NYSE: JPM) was in talks to buy WaMu. J.P. Morgan has not commented on the rumors. The New York Times reported that WaMu has put itself up for auction. J.P. Morgan is rated Neutral. WaMu is an Underperform.

With the topple of Merrill and Lehman — and the collapse of Bear Stearns — only two of America’s five largest investment banks from a year ago remain independent. Goldman Sachs ($113; NYSE: GS) and Morgan Stanley ($22; NYSE: MS) claim to be well-capitalized. But so did Bear Stearns and Lehman Brothers, right before the floor fell out from beneath them. Goldman and Morgan posted large declines in August-quarter profits.

■ Goldman’s earnings per share plunged 70% to $1.81. Results topped the consensus estimate of $1.71 per share — but just a month ago, Wall Street expected profits of more than $3.00 per share.  Total revenue tumbled 51%, as investment-banking revenue fell 40% and revenue at the trading and principal investments business dropped 67%. However, the asset-management and securities-services division, which includes lending and other services to hedge funds, notched a 4% increase in revenue. Goldman is rated Neutral.

■ Morgan reported earnings per share of $1.32, down 4%. The consensus estimate was $0.77. One-time gains, strong equity and commodities trading results, and brokerage fees bolstered profits. Excluding one-time items, per-share earnings were around $0.81. Morgan is rated Neutral.

Investment banks face an environment drastically different from the one seen just a year ago. Mergers and private-equity deals have collapsed, and demand for the lucrative specialty investments that contributed to the crisis has dried up. While both brokerages may be better off selling themselves, the list of buyers with the financial strength, management experience, and desire to purchase either Goldman or Morgan is very small. Both companies have said they plan to remain independent.

Investment advice: Please don’t misinterpret the Neutral ratings for the stocks discussed above. Neutral does not mean hold. Most of the stocks discussed above face substantial uncertainty, and we are not confident in their direction over the next year. Bottom-fishing in this area is dangerous, and the Forecasts advises against it. We prefer to stick with our best ideas, the stocks rated Buy and Long-Term Buy. Against that backdrop, a Neutral rating is usually a call to sell a stock and move into another name with more potential.

Oshkosh downgraded
Oshkosh ($12; NYSE: OSK) is being downgraded to Neutral and dropped from the Buy List, reflecting discouraging share-price action and deteriorating Quadrix scores. Despite earning the maximum score of 100 for Value, the stock’s Overall Quadrix score has dropped to 56 from 76 in August. At roughly six times the lowest Wall Street profit estimate for fiscal 2009, the stock appears unduly cheap. But investors are worried about Oshkosh’s debt load, and the markets that Oshkosh serves seem likely to weaken further in coming quarters. With better rebound plays available, Oshkosh does not qualify as top pick for year-ahead gains. Investors tracking our Buy List should sell Oshkosh.

News roundup
Adobe Systems ($38; NASDAQ: ADBE) posted August-quarter earnings per share of $0.50, up 11% and $0.04 above the consensus estimate. Overall revenue increased 4%, aided by a new Acrobat release, while the enterprise business posted record results. Management now targets per-share earnings of $1.99 to $2.01 for the fiscal year ending November, versus a consensus estimate of $1.95. Adobe is a Buy and a Long-Term Buy . . . United Technologies ($63; NYSE: UTX) Chairman George David said that while troubles in the financial sector have spilled over to the industrial economy, he does not expect an abrupt downturn in business. In addition, he said commercial construction orders remain robust, with limited cancellations of big projects. United Technologies is a Buy and a Long-Term Buy . . . Walgreen ($33; NYSE: WAG) made a $75-per-share unsolicited bid for Longs Drug Stores ($76; NYSE: LDG), trumping a $71.50 bid by rival CVS Caremark ($36; NYSE: CVS). Longs operates 521 retail pharmacies, primarily on the West Coast and in Hawaii. Walgreen already has a significant presence in many of Longs’ markets, raising potential antitrust concerns. Citing those antitrust worries, Longs rejected the bid. Walgreen is a Long-Term Buy. CVS is rated Neutral.

Digest
Lockheed Martin ($112; NYSE: LMT) won a contract to provide up to $5.6 billion of wheeled vehicles for the U.S. military. Lockheed is a Focus List Buy and a Long-Term Buy.


Harris ($47; NYSE: HRS) will replace beleaguered brokerage Lehman Brothers ($0.11; NYSE: LEH) in the S&P 500 Index. Harris is a Focus List Buy and a Long-Term Buy.


Bristol-Myers Squibb ($21; NYSE: BMY) may walk away from its $4.5 billion offer to buy the 83% of ImClone Systems ($60; NYSE: IMCL) it doesn’t already own after the smaller drugmaker said an
unnamed suitor had submitted a better offer. Bristol-Myers is rated Neutral.


Dell ($13; NASDAQ: DELL) shares fell on news that the computer maker sees “further softening” in demand for computer equipment. Dell is rated Neutral.


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