BUYSIDE (cover story), April 2004
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With the No. 1 research departments in equity and debt, Lehman surprises its critics, but how long can the 150-year-old firm justify its top-rated analyst teams in this post-settlement era?


In May 1994, American Express Co. orphaned Lehman Brothers. It had owned the storied investment bank -- established by German immigrants in 1850, a member of the New York Stock Exchange (NYSE) since 1887 -- for a decade. But after selling the Shearson retail brokerage in 1993 (to the Travelers Group, now part of Citigroup), AmEx wanted to get rid of Lehman, too.

Finding no buyers, AmEx spun the eviscerated banking firm off as an initial public offering (IPO). "It traded below book value," recalls an analyst who was part of a team that had considered a Lehman acquisition for a client. "That's a sure sign that the market was debating whether Lehman would actually survive." Indeed, in Sept. 1996 Oppenheimer & Co. (now CIBC World Markets) analyst Steven Eisman recommended Lehman as a likely takeover target. "Either the firm succeeds in improving its equity business...or the firm is sold," the report concluded.

The former turned out to be true, of course. So true, in fact, that in January 2004 BusinessWeek declared Lehman "a deal-making power." What's happened in between? How has the beleaguered bond-specialist firm managed a complete turnaround in the past decade? Will the momentum continue? And perhaps most importantly, what does the new and improved house of Lehman mean for today's institutional investors?


Technically, Lehman Brothers is the investment-banking unit of Lehman Brothers Holdings (2003 gross revenues: $17.3 billion), a public company since 1994. Headquartered in midtown Manhattan (after the loss of its downtown headquarters on September 11, 2001), it has hub offices in London and Tokyo and a network of smaller branches worldwide. Active in equity and debt offerings, its forté has long been fixed-income capital markets. Lehman maintains the bond indexes that have become standard on Wall Street. It serves institutional, corporate, government and, since 2002, high-net-worth individual clients. (Assets under management: $116 billion.) Its 12,000 professionals worldwide underwrite debt and equity securities, offer private placements, provide financial advisory including representing buyers and sellers in mergers and acquisitions, and research, sell and trade not just stocks and bonds but an increasingly broad spectrum of derivatives, foreign-exchange products and commodities. Lehman traders are active on all major exchanges around the world, and the organization has sufficient capital to be a market maker in after-markets.

To be sure, Lehman hasn't entirely steered clear of recent legal scandals. It was one of the 10 firms that agreed in 2002 to a $1.4 billion settlement with New York Attorney General Eliot Spitzer and the U.S. Securities and Exchange Commission to settle claims of misleading investors with biased research. Lehman's share: some $50 million. That doesn't mean it was found guilty of any wrongdoing, however. Other recent Lehman scandals involve an NYSE and National Association of Securities Dealers investigation of whether it illegally allocated shares of IPOs to big and/or potential investment-banking clients.

Yet overall, Lehman's stayed largely above the frays. "Lehman wasn't as badly burned by the bursting of the tech bubble or recent legal settlements as many others," notes Richard Epstein of Boyden Global Executive Search, a New York-based headhunter for the financial industry. "It wasn't as deeply involved in high-tech IPOs."


These days, few would dispute that Lehman is on the rise. Last year's profits rose 74% to $1.7 billion on record net revenues of $8.6 billion, a 40% increase from the year before. Its bond analysts have ranked No. 1 in Institutional Investor Magazine's fixed-income survey for the past three years running. Not surprising, perhaps, considering Lehman "owns all the bond indexes that everyone uses," says David Hendler, an analyst at CreditSights, an independent debt research firm in New York. Still, in 2000 Lehman ranked fifth among bond researchers. Moreover, Lehman's equity squad moved up a notch to the top spot in the most recent stock-analysts roster. Lehman boasted 50 ranked positions. While some analysts may fill more than one position, Lehman's nearest competitor in the poll, Morgan Stanley, held only 36 positions. "Lehman values research as a core of our franchise," says the firm's Director of Global Equity Research Steve Hash. "By developing talent from within and giving it the necessary resources, we've built the top-rated research department and we've done it spending less money than many of our competitors."

Homegrown talent apparently yields loyalty, too. In the past two years only one equity analyst has left to join another sell-side firm, Hash asserts. Though others have doubtless left for other purposes, Lehman's firm-wide turnover rate is surprisingly low. Part of that is because so few have been let go, as compared to other companies. Industry observers note that Lehman didn't overspend on research even at the height of the market, so it hasn't faced the kind of massive reductions that are common on Wall Street nowadays. "Unlike other brokerage firms that had to scale down drastically when equity markets tumbled, Lehman hasn't been forced to cut back dramatically on its intellectual capital," says Richard Bové, an analyst at Hoefer & Arnett, a San Francisco-based brokerage. "It's been able to hold on to most of its talent and build on it. Now it's the strongest research firm on the Street."

That strength comprises 160 senior equity analysts worldwide (85 in the U.S.) who track some 1,600 companies, 1,025 of which are U.S.-based. Most analysts are in the New York headquarters, but others are in San Francisco, Los Angeles, Dallas, Chicago and the District of Columbia. Overseas, the firm's presence includes analysts in London, Tokyo, Hong Kong, Taipei and Seoul. The broad-based large-capitalization equity universe includes 406 of the Standard & Poor's 500 (S&P 500) stock index, representing roughly 92% of that benchmark's market cap. (Lehman itself is part of that index.) "No firm has more U.S. stocks under coverage than we do," notes Research Director Hash.

Indeed, last year the 10 largest research departments on Wall Street tracked nearly 20% fewer stocks than in 2000, as measured by Reuters. In contrast, Lehman's global equity universe shrunk by only 2.7% over that time. "I estimate Lehman's research budget went down about 13% while others' were slashed 30% or even 40%," ventures Brad Hintz of the Sanford C. Bernstein & Co. unit of Alliance Capital Management Holding.

The research product is overseen by a six-member investment policy committee that approves every ratings change and every analyst's ratings distribution at least twice a year. The committee predates the recent regulatory changes. "Our investment policy process has been in place as long as I've been here," says Hash, who joined in 1993 as a senior real estate analyst.

Lehman's decision to emphasize research while competitors turn their backs on it underscores the firm's "commitment to providing premier service to corporate and institutional clients worldwide," says Hash. Some outsiders, however, conjecture that it may be aimed at bolstering the trading business, where Lehman has doubled its U.S. market share in the past three years, or even at attracting more IPO customers without, of course, actually connecting research to banking.


In investment banking, Lehman's gains are also significant. Last year, it jumped two levels to become the nation's second largest underwriter of stocks and bonds, raising $314 billion for clients. Only Citigroup raised more. Globally, however, Lehman is somewhat less impressive. It ranked ninth in debt and equity underwriting fees earned -- $14.4 billion -- as measured by Thomson First Call. It secured a 3.5% share of those fees earned worldwide. In global debt underwriting, it jumped one tier to take fourth place with a 6.9% market share and $339.7 billion worth of sales.

Lehman orchestrated a number of particularly sophisticated underwritings. "It specializes in more complex deals," says Bové of Hoefer & Arnett. For instance, last year Lehman bankers were involved in Detroit-based General Motors Corp.'s $17.5 billion multi-tranche, multi-currency bond and convertible offerings. Both were the largest notes of their kind ever issued.

In mergers and acquisitions (M&As), Lehman's record is similarly distinctive. Last year, it snagged an 18.9% share of the U.S. M&A market, according to BusinessWeek, catapulting 6.2 percentage points from the year before to snag fourth place among M&A advisers, from ninth in 2002. Globally, Lehman was involved in 180 M&A deals with an aggregate value of $147.2 billion when announced (including net debt of target companies), as measured by Thomson First Call -- an improvement from the $131.1 billion worth of M&As worldwide representing 188 deals the previous year.

"Lehman has become the bank of choice for leveraged buyouts (LBOs), split-offs and the like," asserts Hendler of CreditSights. "It's filled a niche in the financial sponsorship market." In the past year, Lehman was active in El Segundo, Calif.-based Hughes Electronics Corp.'s tax-free split off from General Motors and simultaneous sale of 34% of Hughes' outstanding common stock to Rupert Murdoch's Australia-based News Corp. for $19.4 billion. (Lehman was exclusive adviser to News Corp.'s subsequent transfer of its Hughes stake to New York-based Fox Entertainment Group.) Lehman was involved in the second largest LBO since the RJR Nabisco transaction -- New York-based investment firm Blackstone Group's $4.2 billion acquisition financing for TRW Automotive, a Livonia, Mich.-based auto-parts business. In addition, Lehman co-managed (with UBS) the second largest U.S.-based M&A deal announced in 2003 -- the $16.4 billion merger of WellPoint Health Networks, a Sherman Oaks, Calif., managed-care provider, and Indianapolis' Anthem, which supplies healthcare benefits.


Not surprisingly, the buzz about Lehman has been rising -- as has its stock price. Shares of Lehman soared 44.9% in 2003 and another 13.6% this year through early March, outstripping the S&P 500 by 18.5 and 9.7 percentage points, respectively. Even so, it's still trading at only about 1.7 times its book value, which is below average for its peers. But its profit margin at the end of last November, when Lehman's fiscal 2003 closed, was nearing its rivals' at 10.2%. And Lehman's return on equity (ROE) swelled to 15.9%, on a par with its peer group and in fact surpassed the Goldman Sachs Group's 14.9% ROE, as reported by Reuters. Not bad for a firm that lagged its peer average ROE by as much as 11.3 percentage points in 1997. "Management turned a company that was nothing more than a fixed-income house with a large group of commoditized businesses into a veritable power on the Street," says Hintz, of Sanford Bernstein. "Its ROE swelled from single digits to levels where it can compete with the Goldmans and Morgan Stanleys."

Since the 1994 spinoff from American Express and simultaneous IPO, Lehman has been headed by Richard S. Fuld Jr. Fuld, 57, joined Lehman in 1969 as a commercial-paper trader after graduating from the University of Colorado. Four years later he earned his MBA from New York University's Stern School of Business and began moving up in the organization. He became chief executive officer in 1993 and board chairman in 1994. "Dick is a master at understanding the economics of the brokerage industry and, perhaps more important, keeping a team together," affirms Hintz. "He's kept Lehman free of the internal family feuding that's developed on the rest of the Street. His strategic vision is to resurrect the Lehman Brothers of his youth, to put Lehman back on the map as a major institutional firm -- and he's succeeding."

That resurrection entailed a degree of cost-cutting -- compensation and benefits expenses shrank from 50.7% of net revenues in 1997 to 49.9% in 2003. It also meant shifting the revenue mix away from capital-intensive operations such as trading in favor of higher-margin businesses such as investment banking. It also expanded its capabilities in equities, derivatives and convertibles to lessen dependence on bond markets even while "fine tuning" fixed-income operations to "generate higher returns," Hintz says. "What Fuld and his team accomplished is something business school students will be studying for years."

Team spirit is fostered partly by promoting from within and partly by a reorganization that groups bankers -- and, separately, analysts -- by global sector to achieve a sort of cross-fertilization without overlapping areas of expertise. Equity research, for instance, has eight broad industry groups and a separate macroeconomic group. Each group consists of six to 13 senior analysts (most senior analysts have two associate analysts and an assistant) who "share ideas," says research director Hash, "but there is no co-coverage."

The spirit of partnership is also credited with helping Lehman quickly recover after losing its offices on September 11, 2001. It somehow managed to resume bond trading two days later and was the first firm to bring an IPO to the market in the aftermath of the terrorist attacks.


Not that Lehman Brothers is on Easy Street from here on. It's still "rather modest on the equity front," says Hendler at CreditSights, and "a wannabe in M&A," adds Hintz. Especially weak: the IPO business. Last year Lehman arranged only six IPOs globally and earned just $600 million in total fees, down from $3.1 billion in 2002, according to Thomson First Call. It slipped to No. 8 in IPO fees earned worldwide and a 4.2% market share from the previous year's No. 3 and 13.6%, respectively.

Another challenge is satisfying the growing appetite for "prime brokerage" services -- that is, leveraged trade executions and other specialized capabilities required by hedge funds, which represent a rapidly growing share of institutional commissions. Lehman has also never been strong in asset management, though it made a big move in July 2003 when it purchased New York-based wealth manager Neuberger Berman for $2.6 billion -- a purchase it likely couldn't afford five or 10 years ago.

The true test of how well Lehman has changed may come sooner rather than later. The negative stock market performance and low interest rates of the past few years were good for bond markets, Lehman's traditional area of specialty. Last year fixed-income sales and trading accounted for more than half of Lehman's net revenues -- $4.4 billion. Many economists feel a broad reversal is imminent, and recent stock rises would seem to bear that out. How will Lehman fare in an equity-friendly environment? Bové at Hoefer & Arnett isn't worried. "Lehman has a well-defined plan for how it wants to continue to build the business...and it now has the capital to make it happen," he insists. "It's the best-managed brokerage firm in the country."

Hendler might agree. With the memory of nearly going bust in the late-1990s still fresh in their minds, he says, CEO Fuld and company have learned to "hedge their bets."

He may well be right.

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