Merrill: Your Questions Answered

A very loyal reader writes:

Why did O’Neal defenestrate while Cayne at Bear and Prince at Citi have managed to hang on to their jobs? Is a takeover of Merrill realistic, considering the handicaps of the few firms big enough to do it? Is Merrill stock fairly priced?

Let's take those questions in order.

O'Neal's gone because he had no support: that's the long and short of it. He was good at making himself unsackable, both by posting very impressive financial results and also by more political means: firing anybody who got too powerful, stocking the board with allies. But Merrill Lynch is a firm of brokers, and O'Neal was never a broker, which meant that he could never count on any support within the firm. Indeed, fingers are pointing at Merrill broker Bob McCann as the man who orchestrated the strategic leak to the NYT which triggered O'Neals departure.

Without the support of his employees or executives, O'Neal was forced to rely on his board. But that's where the leak was so smart: it revealed O'Neal's cavalier attitude not only towards his lieutenants (board members are often OK with that) but also towards the board itself. And that's something boards find much harder to stomach. When O'Neal couldn't convincingly explain why Merrill's losses were so big or whether there was any chance of them recurring, the reasons for continuing to pay him his large eight-figure salary diminished to zero. Not only did he have no support within the company, he also seemingly had no control over it, either.

Niether Cayne nor Prince is quite as lonely, in this respect, as O'Neal was. While O'Neal was an outsider to Merrill culture, Cayne is Bear Stearns. And Prince, for the time being at least, retains the support of key lieutenants, chief among them Bob Rubin. But neither is exactly immune from defenestration.

Is a takeover of Merrill realistic? I'd say it depends largely on the new CEO. An insider, like Fleming or McCann, will be much less likely to sell than an outsider like Thain or Fink. And I can promise that there won't be any hostile approaches: if Merrill is sold, it will be sold because that's what the new CEO thinks will be best for the firm and its shareholders.

The who-might-buy-Merrill question is tougher: it would take serious cojones for any banker to attempt a merger of this magnitude in the context of a potentially massive credit crunch. Such a deal would, however, be transformative for anybody who did it, which means that there's possibly a handful of banks who might try. Merrill's US retail presence is unrivalled, and I can imagine that a few big European banks would love it: they are probably more likely suitors than a US shop like JPMorgan Chase or Wachovia.

As for the price of Merrill stock, it's now trading at about $66, which puts it on a price-to-book ratio of about 1.5. But it's entirely possible that Merrill assets including its 20% stake in Bloomberg are worth rather more than the official book value lets on. Reports Peter Eavis:

An influential banks analyst, Mike Mayo of Deutsche Bank, estimates that Merrill is even cheaper when you factor in other assets not fully reflected on the balance sheet. He reckons Merrill trades at 0.7 times his adjusted book value. If potential buyers share Mayo's view, they could swoop in soon.

For the time being, the most likely scenario by far is that Merrill remains independent. As an independent bank, is it worth $66 a share? That depends entirely on your view of the markets and the economy going forward. There's no real reason to believe that Merrill has completely cleansed the Aegean stables of its balance sheet, and if credit markets continue to get worse, it might be a while before Merrill reverts to the kind of profits it has historically made. What's more, there's a very serious risk that credit markets might eventually drag equity markets down with them, which would have a nasty effect on Merrill's bread and butter brokerage operation.

So I'd say that there's a significant downside risk to buying the stock at this level, which probably more than counteracts the upside risk of a takeover bid. On the other hand, if neither of those two things happen, the stock could muddle along quite happily where it is.

To put it another way, the stock might go up, or it might go down, or it might go sideways. You're welcome.

Update: Dana Cimilluca notes that Merrill's Greg Fleming lives to do M&A deals in the banking sector. If the board wants Merrill to remain independent, they might want to choose McCann.