BUYSIDE (cover story), October 2003

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THE BIG 6 : PART ONE

Recent Draconian Changes Earn Praise and Enmity

The Embattled Bull

BY BEN MATTLIN

In September 2003, Merrill Lynch & Co. was sounding more and more like a Charles Dickens novel. For the Wall Street powerhouse known far and wide for its raging bull logo, it was either the best of times or the worst. Merrill's stock had skyrocketed to an eye-popping 45% year-to-date while the Standard & Poor's 500 benchmark advanced 16.3%. In the most recent quarter, Merrill posted $1 billion in net earnings, its second-best quarterly earnings in history. And its quarterly pretax profit margin was the highest in a quarter-century.

Yet the media kept shining a spotlight on the dirty laundry -- rampant turnover among the top brass, widespread layoffs and office closings, and a controversial new CEO who was making a lot of enemies. "Merrill Lynch appears to be in disarray from top to bottom," asserts Jacob Zamansky of Zamansky & Associates, a New York litigator that's pressed several successful claims against Merrill Lynch on behalf of investors. "They really need to clean up their act to restore investor confidence and trust."

What's the truth? Perhaps more importantly, what does it all mean for institutional investors?

Though the answers seem fluid and highly subjective, no one disputes the fact that Merrill Lynch has changed dramatically over the past few years. In the past two years alone it sacked 23,000 employees -- a third of its total workforce. Its sales force, which had once numbered more than 20,000 brokers is down to 13,300. Trimming the fat, says management. But critics charge it's cut off an arm to fix a hangnail.

In research, Merrill maintains a top-notch squad of some 440 equity analysts and 80 economists, strategists, and technical and quantitative analysts spread across 19 countries. Altogether they monitor more than 2,300 companies in 27 industries. No single industry is considered an area of special emphasis. There is no particular research "style" or "philosophy"; value- and growth-oriented investors are served equally, and analysts come from a diversity of backgrounds. As a group, they came in second in last year's Institutional Investor All-America Research Team (the 2003 ranking won't be announced until October) and third in The Wall Street Journal's 2003 Best on the Street survey, down a notch from the preceding year.

Yet five years ago, when Merrill took first place in the II rankings for the 17th time, it boasted more than 700 stock researchers tracking 1,500 companies in 27 countries. With fewer analysts collectively covering a larger universe of companies today, it's no wonder the pressure is on.

Much of that pressure now is on ensuring research objectivity. In May 2002, Merrill Lynch became one of the first Wall Street firms forced to pay out $100 million in a legal settlement with New York Attorney General Eliot Spitzer. This followed a long, embarrassing investigation that unearthed derogatory internal e-mails and made Henry Blodget, the firm's former Internet analyst, a poster child (along with Salomon Smith Barney's Jack Grubman) for alleged conflicts-of-interest. Then a U.S. Senate subcommittee accused Merrill investment bankers of helping Enron misstate profits. Merrill staffers were also implicated in illicit partnerships with Enron ex-CFO Andrew Fastow, and in the Martha Stewart insider-trading scandal. To date, the firm has not been found guilty of any wrongdoing and maintains its innocence, but the damage to its reputation has been done. (Merrill Lynch was contacted for this article but declined multiple requests to participate.)

RADICAL RESTRUCTURING

The house that Charles Merrill and Edmund Lynch built in 1914 to "bring Wall Street to Main Street" is still a vibrant force, to be sure. With some $1.4 trillion in assets under management and revenue in 2002 of $28.25 billion, the publicly held New York-based corporation maintains offices in 36 countries. It's active in underwriting debt and equity deals, advising on mergers and acquisitions, providing wealth management through its Global Private Client Group, and running mutual funds and other asset management services through its Merrill Lynch Investment Managers.

Taking the lion's share of credit -- or blame, depending whom you ask -- for the recent downsizing is Ernest Stanley O'Neal, Merrill's CEO since December 2002. O'Neal, who turns 52 in October, is known as a tall, elegantly-attired fiscal conservative. He joined the firm in 1986 as an investment banker and has been at various stages its chief financial officer, brokerage head and president. He's eliminated underperforming sales operations in South Africa, Canada, Australia and Japan, as well as hundreds of U.S. retail branches. He's also rumored to have eased out former investment-banking president Arshad Zakaria in August and ex-executive vice chairman Thomas Patrick in July, both men once considered cost-cutting allies and key members of O'Neal's inner circle. Their departures are officially dubbed retirements.

"It's become Mr. O'Neal's show," says Zamansky, the attorney. "Rather than looking for quality people, Merrill Lynch is looking for yes-men."

Nevertheless, the scaled-down Merrill Lynch is undeniably more efficient than it was only a few years ago. During 2002, when the overall headcount was slashed by 11% and total sales dropped 27% from 2001's intake, the firm's net income grew 339% year-over-year to $2.5 billion.

THE O'NEAL DEAL

Beyond reducing expenses, O'Neal has changed the very philosophy of Merrill Lynch. The investment banking operations had enjoyed an 11-year reign as the biggest and most active in the world, as measured by the "league tables" -- an industry ranking system derived from the number and dollar value of banking deals managed over a 12-month period. Not bad for a firm that didn't even have investment banking until the late-1970s, under the stewardship of Donald Regan, another fiscal conservative. But O'Neal isn't especially interested in that kind of glory. So Merrill will no longer pursue investment-banking deals regardless of their profit margin.

Last year, too, the number of Nasdaq stocks the firm makes a market in was slashed by 75%, in favor of more profitable aftermarket activities. Similarly on the brokerage side, O'Neal has instituted a policy of basing compensation on the account size, rather than per trade. Larger accounts pay larger execution fees.

The message is clear: Go for the bigger, more profitable transactions. Forget about "Main Street."

This might seem odd given O'Neal's own humble origins. He reportedly grew up on an Alabama cotton farm, the grandson of a former slave. At 12, his family moved to Atlanta when his father got a job at a nearby General Motors Corp. plant. O'Neal worked part-time on the GM assembly line while in college. After earning his MBA from Harvard University in 1978, he took a position in finance at GM's New York offices. From there he was recruited to join Merrill Lynch.

RETOOLING RESEARCH

Research, too, has been restructured under O'Neal's leadership, though admittedly in response to legal settlements and new regulations from the Securities and Exchange Commission. The goal is plainly to clean up allegedly tainted research and regain investor confidence. Accordingly, analysts' compensation is now based not on investment-banking incentives but on "an evaluation of how the analyst's insights and recommendations benefit investors," company literature states. Again, Merrill's media relations office refused to comment or explain.

Analysts report directly to the company vice chairman, who at this writing is Robert McCann, the former research director who left early this year and returned in August to his new title. They do not report to the head of investment banking or any other individual business group. The firm has also launched a Research Recommendations Committee to review all ratings changes and appointed a Research Compliance Monitor to oversee how analysts arrive at their conclusions. The ratings nomenclature has been simplified, too, with all covered stocks receiving either a "Buy," "Neutral," or "Sell."

Not surprisingly, reaction to these modifications is mixed. "Things have gotten a lot better, but they're not where they should be yet," says Charles Hill, research director at ratings tracker Thomson First Call, referring to Wall Street research generally. Hill is one of many market participants who praise the greater degree of disclosure now required by law -- especially, he says, the fact that every research report must now reveal how many Buys, Holds and Sells analysts have within their total universe of current recommendations.

This is important, he adds, because before the regulation was enacted the average percentage of sell ratings on Wall Street "never exceeded two percent, and that's not realistic even in a bull market." Now, Hill observes, "it's running between 10% and 11%, and the majority of large firms have anywhere from 15% to 26% sells." Granted, brokerages may be afraid to recommend too many stocks these days, considering recent volatility. Hill acknowledges that ratings distribution varies with market swings and other economic conditions, but maintains he'd distrust any research department with fewer than 10 sells to every 100 buys.

Any research department, that is, like the one at Merrill Lynch.

Merrill, Hill attests, is among the minority of firms with an unrealistically low percentage of Sell ratings. "I can't remember their Sells ever going as high as a double-digit percentage of ratings," he notes. "They're in the mid-to-high single digits -- and certainly have not joined the majority of big brokerages."

In fairness, many factors could explain the low proportion of sells. Hill concedes that only promising companies tend to get coverage in the first place. Still, as for why Merrill would lag behind its Wall Street rivals in its ability or willingness to use the Sell rating, Merrill wasn't available for comment.

ANALYSTS UNJUSTLY ACCUSED?

Other Merrill watchers defend the analysts. "They're not supposed to be financial advisors," says James Sheehan, an adjunct scholar at the Competitive Enterprise Institute, a Washington, D.C., public-policy think tank. Financial advisors, he maintains, have a "fiduciary duty to be cautious and try to maximize clients' returns, but research analysts produce reports for sophisticated institutional investors. It's a different calculus." When analysts encounter companies that deserve a Sell rating, they're "as likely to drop coverage as issue a Sell," Sheehan points out. That's because their job is to identify the best companies, those that are going to succeed in business and appreciate in value, not to oversee or advise portfolios, he stresses.

Sheehan allows that it's a "natural tendency" for people who lost money when the tech bubble burst to want to blame someone else. But analysts, he says -- even the infamous Blodget -- are victims of unjust "scapegoating." After all, while Blodget was touting overly ambitious dot-coms, many corporations were exaggerating earnings and creating unrealistic expectations. Fund managers and others were discarding tried-and-true valuation methodologies in the belief that the New Economy demanded new standards. The Internet frenzy caused novice investors and old pros alike to throw caution to the wind.

CEO O'Neal would probably agree. In April 2003, when Merrill paid an additional $200 million penalty for its share of a 10-firm $1.4 billion settlement to ensure research honesty and objectivity, O'Neal reacted in an essay printed in The Wall Street Journal. It said in part, "To teach investors...that if they lose money in the market they're automatically entitled to be compensated for it does both them and the economy a disservice."

Then again, in the weeks that followed, Attorney General Spitzer strongly decried such statements for displaying a complete and utter lack of remorse.

MORE CHANGES NEEDED

Even some who applaud Spitzer's efforts say Merrill Lynch hasn't yet gone far enough to clean up its research. Attorney Zamansky highlights individual investors who have access to research reports though few of them "really understand the rating system or the recommendations," he says. "Merrill must institute a system of plainer language that clearly states the potential risks of every investment and requires the brokers to educate and advise their customers better." In truth, for accounts under $1 million, Merrill calls its brokers Financial Advisors, a subtle variation launched in March 2001 of the old Financial Consultants, which was established in 1984. It's a misnomer, charges Zamansky. "They need to advise their brokerage clients more fully and honestly," he insists.

On the institutional side, one bond investor who spoke on condition of anonymity bemoans the paucity of insightful, value-added research. "Many of my old sell-side colleagues have left. There's been considerable attrition and a new, younger set has come in," he reflects. Not that some of those neophyte analysts aren't smart and hard-working, the investor adds, but they lack an experienced perspective.

What's more, the revolving door of human resources means an end to many long-held client relationships. For investors who rely on familiar analysts and sales reps the way some people go to the same doctor most of their lives, this may be the largest problem for O'Neal's trim and efficient Merrill Lynch. The loss of client relationships, a cost that's hard to measure in dollars, may prove the fatal flaw of the restructuring plan.

A former star of Merrill's fixed-income research roster who was pushed out last November doubts Merrill cares very much about its investor-clients anymore. He, too, wishes to remain unnamed. He points to how Merrill, like many of its competitors, recently combined much of its investment-grade and high-yield bond research. "They claim it's what the clients want, but it's obviously a financial decision," he avows. "If you can find one fixed-income investor who feels better served, you'll probably win the Pulitzer."

Indeed, Merrill's fixed-income team of 120 analysts slipped considerably in Institutional Investor Magazine's investor polls over the past two years. As a group they finished 10th in 2003, an ignominious drop from last year's fifth place, which in turn was a plunge from second place in 2001.

THE WORST MAY BE OVER

Yet past disappointments aside, many Merrill clients optimistically declare the worst is over. "The analysts who had conflict-of-interest problems were poorly managed and poorly trained," says Robert Olstein, president and manager of the $1.6 billion Olstein Financial Alert Fund, in New York. "That's all gone now. It's been corrected."

An expert in financial disclosure and reporting practices, Olstein credits the intervention of new regulations and legal settlements with effecting significant improvements in how analysts are supervised and how they are coached to evaluate companies and ferret out inaccuracies and other hidden problems. He also credits CEO O'Neal. "That's exactly what's needed," says Olstein, of O'Neal's reorganization and management shakeup. "A new direction, a new structure, and they've done it very well."

In fact, he's such a fan of the new Merrill Lynch that he's become a shareholder. "I bought it at $30," he boasts. By mid-September the shares were trading at $54.

Olstein concedes there's no guarantee ethical lapses won't occur again, at Merrill or elsewhere, but for the time being Olstein is bullish. "Wall Street is more honest and ethical today than I've ever seen it," he declares, "and I've been in the business for 35 years."