By Michael Wong
Article originally published on 12/7/09
Many investment banks reported robust earnings during the last couple of quarters. Earnings outperformance was based on a tripod of contributors: a broad-based rally in asset prices, a partial recovery in investment banking revenues, and strong fixed-income trading revenues. Although these earnings weren't the result of accounting gimmicks, they are of questionable quality for other reasons and may prove transitory. We believe that the worst has already passed for investment banks in this cycle, but we also believe that most investment banks will likely stumble on their earnings before a sustainable earnings uptrend establishes itself.
Higher Revenues but also Earnings-Quality Issues
Investment banks' asset management and principal investment-related revenues have done well during the last couple of quarters, but the two revenue lines lead to different conclusions regarding future earnings. Asset management revenues are generally calculated as a percentage of assets under management, while principal investment revenues are generally the markup in the value of investments, and to an extent securities inventory, that an investment bank bought using its own capital. It's no mystery why these revenue lines did well as just a brief glance at the lineup of Morningstar indexes shows a year-to-date broad-based rally across asset classes. We believe earnings of investment banks with large asset management revenues as a percentage of their total, such as Lazard (NYSE:LAZ), should fare relatively better than companies that may have received earning boosts from gains, such as Jefferies (JEF) and Greenhill (NYSE:GHL). This is illustrated in the following tables.
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Recent quarters have been like Period 1--markets are rising and investment banks, like our sample company, have recognized higher asset management revenues as a result of higher AUM and recognized principal investment gains from marking up the securities they own. However, when the markets are flat as in Period 2, our company will still generate a steady level of asset management revenues while principal investment gains will disappear. The lack of principal investment gains will actually likely cause a sequential drop in earnings if our company recognized gains in the prior period. In the event that overall markets decline as in Period 3, asset management revenues will decrease somewhat, but our company would recognize principal loss. During these three periods, our sample investment bank recognized $875 of asset management revenues and $0 of principal investment gains, even though both AUM and principal investment/securities positions at the end of Period 3 are the same as the beginning of Period 1. This is why we prefer companies that derive more revenues from asset management than principal investment gains because the quality of earnings is better.
Economic Recovery Good for Underwriting, Advisory Revenues
The primary cause of the rebound in asset prices, belief of an imminent economic recovery, also led to a rebound in traditional investment banking lines such as underwriting and financial advisory. Third-quarter investment banking revenues were up 50% to more than 100% from their fourth quarter of 2008 or first quarter of 2009 trough at many investment banks. Although we were skeptical of the underwriting revenues in the second quarter, as we believed everyone was rushing to raise capital during what was, at the time, a questionable brief window of opportunity, a sustained economic recovery should create an uptrend in investment banking revenues. That said, we forecast that 2009 investment banking revenues will still be approximately 40% lower than their 2007 peak at many investment banks and that it will be several years before those lofty heights are seen again.
Good Economy Could Hinder Trading Profits
Although improving economic conditions and the unfreezing of the capital markets were a boon for underwriting revenues, they actually cast a shadow over future fixed-income trading revenues. Furthermore, this shadow could be rather dark as cash fixed-income trading has arguably been the most important driver of the recent outperformance of investment banks; multiple investment banks reported record-breaking trading revenues.
Even after adjusting for write-downs and debt-valuation adjustments and even if you disregard companies where 2008 revenues were weak or the income line contains other revenues besides cash fixed income, the year-over-year increase shown in the table above is clearly abnormal. Fear, volatility, and constrained investment bank balance sheets were primary contributors to the increased fixed-income trading profitability. Many investment banks exhibited a sequential decrease in fixed-income-related trading revenues from the second to third quarter of this year as those contributing factors started to abate. As prospects for an economic recovery are ever brighter, the risk premium that investment banks were able to earn on fixed-income trading has begun to shrink. A decrease in fixed-income profitability started last quarter, and we don't expect the downward trend to reverse until normal fixed-income trading revenue levels are reached once again. In a conference call, the chairman and CEO of Piper Jaffray (PJC), Andrew Duff, anticipated that fixed-income sales and trading revenues in a normalized environment could be 50% lower than their second quarter of 2009 results.
Recent results of investment banks have been good, but they were a result of likely transitory tailwinds that led to the relatively poor quality of earnings. Of the tripod of sources that have supported investment bank earnings, we believe outsized investment gains and fixed-income trading revenues should be petering out while underwriting, financial advisory, and asset management revenues will hold fairly steady or increase. The net effect on most investment banks will be negative, as principal investment and trading revenues have generally been a larger percentage of revenues. For example, FICC and principal investments accounted for approximately 60% of Goldman Sachs' (NYSE:GS) net revenues, principal transactions were 40% of Morgan Stanley's (MS) net revenues, and principal transactions were 55% of Jefferies' net revenues after mandatorily redeemable preferred interest in the third quarter. If even just one leg of the tripod buckles and nothing takes its place, recently elevated earnings will fall.
Earnings May Hold Up for These I-Banks
We do believe there are several investment banks that are less likely to stumble on earnings because of their revenue mix or special circumstances. They are Evercore Partners (NYSE:EVR), Lazard, and Stifel Financial (NYSE:SF). Evercore derives the bulk of its revenues from mergers and acquisitions and restructuring advisory. The unfreezing of the capital markets and more positive economic outlook should lead to more M&A activity. The aftermath of the financial crisis still needs to be cleaned up, so restructuring advisory is still likely on the increase for several quarters. Lazard also generates the bulk of its revenues from M&A and restructuring advisory, but also has a sizeable asset management division. We believe Stifel Financial may avoid an earnings dip, as its recent acquisition of some UBS wealth-management offices in the U.S. could replace the lost revenue from a likely fixed-income trading revenue decrease. Although we believe these companies' earnings may outperform those of their peer group in the near term, please look at their respective Analyst Reports to see if we believe they're currently attractive on a long-term basis.