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Merrill Lynch & Co. Inc. (MER)

Q3 2006 Earnings Call

October 17, 2006 10:00 am ET

Executives

Jonathan Blum - IR

Jeff Edwards - CFO

Analysts

Daniel Goldberg - Bear, Stearns & Co.

Mike Mayo - Prudential Equity Group

Glenn Schorr - UBS

William Tanona – Goldman Sachs

Prashant Bhatia - Citigroup

Douglas Sipkin - Wachovia Securities

Jeff Harte - Sandler O'Neill & Partners

Meredith Whitney - CIBC World Markets

Presentation

Operator

Good morning and welcome to the Merrill Lynch third quarter 2006 financial results conference call. (Operator Instructions) I would now like to turn the call over to Jonathan Blum, Head of Investor Relations. Please go ahead.

Jonathan Blum

Good morning, and welcome to Merrill Lynch's conference call to review third quarter and first nine months 2006 results. The following live broadcast by Jeff Edwards, Chief Financial Officer, is copyrighted to Merrill Lynch.

Statements made today may contain forward-looking information about management's expectations, strategic objectives, growth opportunities, business prospects, investment banking pipelines, acquisition synergies, anticipated expense levels and financial results and other similar matters. Such forward-looking statements are not statements of historical facts and represent only Merrill Lynch's current beliefs regarding future performance, which is inherently uncertain.

Investors are cautioned not to place undue reliance on such statements, which speak only to the date on which they are made and which may be impacted by a variety of factors Merrill Lynch cannot control. Merrill Lynch generally does not undertake to update these statements to reflect the impact of subsequent circumstances or events. Investors should consult Merrill Lynch's reports filed with the SEC for any additional information, including risk factors specific to Merrill Lynch's business described in the Company's 2005 annual report on Form 10-K.

Investors should also read the information on the calculations of non-GAAP financial measures that are included in today's earnings release and posted on Merrill Lynch's investor relations website, www.ir.ml.com, where an online rebroadcast of this conference call will be available today at approximately 1 pm Eastern Time. Now I'll turn the call over to Jeff.

Jeff Edwards

Thank you, Jonathan. Good morning to all of you on the call. I am pleased this morning to report very strong third quarter results at Merrill Lynch, including strong year-on-year revenue growth, reflecting the successful implementation of our growth strategies; record EPS on both a GAAP and adjusted basis; ROE of 35.3% or 22.5% excluding the net gain from the BlackRock merger, bringing our year-to-date ROE on this basis to 20.2%, the highest in six years.

During the third quarter of 2006, Merrill Lynch generated record GAAP net revenues of $9.9 billion, up 48% from the third quarter of 2005 and 21% from the second quarter of 2006. Adjusted to exclude $2 billion in one-time revenues associated with the completion of the combination of Merrill Lynch investment managers and BlackRock, total revenues for the third quarter would have been $7.9 billion, still a record for a fiscal third quarter despite a considerably more challenging market environment than in the first half of the year.

Adjusted revenues were also 19% higher than the strong third quarter of 2005, as all three business segments increased net revenues over the year-ago period. On a sequential quarter basis, adjusted revenues declined 3%, reflecting both environmental and seasonal factors. Excluding the net impact of the BlackRock combination, adjusted net earnings for the third quarter of 2006 were $1.9 billion and EPS were $2 per share, up 41% and 43% respectively from last year; and also up 19% and 23% from the second quarter of 2006.

Adjusted earnings and EPS were impacted by a tax benefit in the quarter, as pre-tax earnings of $2.4 billion were up 22% from last year and up slightly from the second quarter, and were higher than in any other period.

The third quarter adjusted pre-tax profit margin was 29.8% and the adjusted return on average common equity was 22.5%, up over 5 percentage points from the 2005 third quarter. Book value per share was $40.52 at the end of the quarter, up more than $3 sequentially and 17% higher than the 2005 third quarter.

Our quarterly results concluded a record first nine months for 2006. Excluding the impacts of both the BlackRock merger and the one-time FAS 123 R related compensation expenses we incurred in the first quarter of 2006, adjusted net revenues of $24 billion were up 25% from 2005, while adjusted pre-tax earnings increased 36%. Adjusted net earnings and EPS rose 40%, and ROE of 20.2% improved by 4.5 percentage points.

As I mentioned at the onset, the environment during the quarter was characterized both by the typical seasonal slowdown that frequently impacts business in July and August, as well as a continuation initially of the clear decline in activity levels that had begun in mid-May, triggered by greater market uncertainty around interest rate policy, economic outlook and geopolitical concerns. By the end of the third quarter, many of these concerns had receded to a degree.

In a moment, I will discuss our results in more detail. But first, I want to highlight four important themes that have driven our record YTD results and positioned us to extend our strong performance in the quarters and years ahead.

The first is consistency of our growth as we capitalized on specific initiatives and market opportunities across the franchise, demonstrating the benefits of diversification across channels, products and regions. Global Markets & Investment Banking, or GMI; Global Private Clients, or GPC; and Merrill Lynch Investment Managers, or MLIM each reported higher quarterly and YTD revenues than in the comparable periods for 2005, as well as pre-tax earnings if you exclude the one-time compensation expenses from the year-to-date comparison.

Within GMI, Debt Markets -- which has been renamed Fixed Income, Currencies & Commodities or FICC -- Equity Markets and Investment Banking all showed similar strength, increasing both quarterly and year-to-date revenues over 2005. Likewise, revenues from each of our three major regions, Americas, Europe, Middle East and Africa, and the Pacific Rim have all grown both for the quarterly and year-to-date periods.

The second major theme that was present during the third quarter was we made significant progress across a number of important strategic initiatives. Most visible, of course, is the transformational combination of MLIM and BlackRock, which was completed on September 29th. We now own just under half of what we believe is the most exciting growth platform in asset management today and we have every confidence that the newly combined BlackRock team will rapidly capitalize on the complementary strengths of these tremendous franchises.

But this past quarter, we saw a number of other important strategic developments as well. We announced the acquisition of First Franklin, to materially increase our presence and scale in mortgage origination. We hope to close that transaction by year end, subject to regulatory approvals. We agreed to take a minority stake in D.A. Capital and committed some of our own capital to their funds, an important step in enhancing both our returns and our presence in the hedge fund space.

We also announced a strategic alliance with Portware, the creation of levels and the formation of bids, all of which enhance our electronic execution capabilities in the cash equity space. We agreed to acquire Tat Yatirim Bankasi in Turkey, which provides an important platform to expand this fast-growing market.

We added Freedom Funding to our mortgage origination business in the U.K. and made a majority investment in Peninsula Capital, the start-up mortgage origination business in Korea. We agreed to acquire Equity Methods, a leader in equity award reporting, forecasting and valuation services that will enhance GPC's retirement platform.

Over the past three years, we have announced more than 30 acquisitions and other strategic investments or alliances spanning a broad range of our businesses. These in-organic initiatives, in aggregate, have made an important contribution to our financial success and our ability to source and execute these transactions is now a core competency across the firm.

The third theme is international growth, which continues to be an important accelerating engine of out-performance as our expansion plans outside the U.S. gain traction. I'll discuss this further in each business segment but for the firm overall, non-U.S. revenues contributed 37% of our total for both the quarter and the year-to-date, the highest contribution they've ever made.

In summary, our significant stream of investments in key growth and diversification initiatives are on track and producing results. While many of these investments have yet to fully mature, many are already contributing to current performance; in some cases, significantly.

The fourth major theme is our continued success in attracting and retaining top talent, which will also be critical in driving future growth. For example, for the year to date and including acquisitions, our GMI businesses have added more than 200 directors and managing directors and another 300 vice presidents, heavily weighted toward our non-U.S. operations. These hires, like the significant number we added last year, will expand our capabilities in key product areas and enhance our coverage of key clients.

GPC once again increased its FA census during the quarter by 180 FAs, bringing the YTD net increase to 540, with considerable success in recruiting against our primary competitors. Creating an inclusive work environment that truly functions as a meritocracy and develops leaders is one of our most important initiatives, because it will drive the success of our employees and ultimately our firm.

Now for some more specifics on our performance by segment. Any year-to-date comparisons I make will exclude the one-time compensation expenses from the first quarter of 2006.

GMI generated record revenues for our fiscal third quarter, despite the more uneven tone of the environment compared to the third quarter of 2005. The impact of diversifying our portfolio of businesses as a result of our investments proved critical to GMI's performance against that backdrop. GMI's third quarter net revenues were $4.4 billion, 21% higher than the third quarter of last year and down only 4% sequentially. The regional story in GMI remains one of out-performance in non-U.S. markets.

EMEA, our second largest region in terms of revenues, saw increases in every major product compared to the third quarter of last year. For the year to date, GMI's net revenues from both EMEA and the Japan/Asia-Pacific regions are up more than 40%. Revenues from India are now making a meaningful contribution to GMI's results, following our acquisition of a consolidating stake in our joint venture there earlier this year.

Third quarter pre-tax earnings for GMI were $1.5 billion, up 13% from the prior year quarter, driven by the strong revenue growth. The pre-tax margin was 33.2% compared with 35.4% in the year earlier period, due primarily to higher expenses associated with investments being made across the business, as well as the absence of the litigation reversal that benefited the 2005 period. Pre-tax earnings were down just 2% on a sequential basis.

Looking at GMI's third quarter net revenues by business line, FICC net revenues set a new quarterly record at $2.1 billion, up 26% from the third quarter of 2005 and 23% from the second quarter of 2006. Both year-on-year and sequentially, the increase in net revenues was primarily driven by commodities and credit products, more than offsetting declines in principal investments, rates and foreign exchange. The strong results in commodities are particularly notable as we set a quarterly revenue record that nearly doubled the prior record, driven by strong trading results in both natural gas and power in both the U.S. and Europe, as well as significant revenues from structured transactions.

Turning to equity markets, net revenues increased 26% from the third quarter of 2005 to $1.5 billion, as higher revenues in private equity, cash trading, proprietary trading and equity financing and services more than offset a modest decline in equity-linked trading. Sequentially, revenues declined 20% from the particularly strong second quarter, as a modest increase in the cash equity trading and proprietary trading revenues was offset by declines in most other groups. The private equity business, which was coming off a record second quarter saw its revenues decline by more than half.

Clearly, the market downturn that we began to experience midway through the second quarter continued to negatively affect both activity levels and trading opportunities through most of the summer. We continue to take steps to position our equity markets platform for further growth in electronic execution, portfolio trading and prime brokerage, as well as enhancing our already leading capabilities in areas of strength, such as cash and equity-linked trading.

In Investment Banking, we generated net revenues of $783 million, just ahead of the strong prior-year quarter on increased advisory revenues. Revenues were down 20% sequentially due to more typical summer seasonality and the timing of certain transactions around quarter end. YTD, Investment Banking revenues remain at a record level, reflecting continued progress in building coverage across regions and strengthening our product capabilities.

Once again, the strength of our franchise was evident in Advisory revenues, which for the quarter were down 12% sequentially but up 65% from the third quarter of 2005. This is now the sixth straight quarter where we have increased Advisory revenues year-over-year, clear evidence of our success in enhancing our strategic dialogue with our core client base.

Debt origination revenues decreased 17% from the record third quarter of 2005 and 10% from the second quarter of 2006, as overall issuance in the market was lower versus both periods. Equity origination revenues, clearly the most impacted by the unevenness in the markets and the resultant lower activity levels, were down 12% year on year and 39% sequentially.

Our dialogue with clients continues to be vigorous. Our pipeline ended the quarter at a new record level, with particular strength in Advisory and Debt Origination and increases overall in each of our major regions. Thus far, fourth quarter conditions for execution of this pipeline appear to be more positive than those we experienced in the third quarter.

On a nine-month basis, total GMI net revenues were a record $13.5 billion, nearly matching the full year total for 2005 and up 30% from the first nine months of last year. Similarly, pre-tax earnings were $4.5 billion, up 29%.

Now GPC, which continues to implement its strategy of growing its base of highly productive financial advisors, attracting client assets into the diversified total Merrill platform, increasing the contribution of annuitized sources of revenue and taking targeted steps to expand its non-U.S. business. GPC net revenues of $2.8 billion were up 5% from the third quarter of last year as higher asset-based fees and net interest revenues more than offset lower transaction and origination revenues, which reflected more typical summer seasonality than in the 2005 period. Sequentially, revenues declined 7%, driven by transaction and origination revenues due largely to the absence of the unusually large origination transactions in the second quarter, as well as seasonally lower client activity levels.

Asset-based fee revenues were relatively flat as the impact of lower market values at the beginning of the period when fees for many of these products are calculated, was largely offset by net inflows into these products. Net interest was down slightly.

Pre-tax earnings of $611 million, up 4% year on year, with a pre-tax margin of 21.6%, down slightly. Sequentially, pre-tax earnings were down 13% and the pre-tax margin declined by just over a point.

Year-to-date growth better reflects the momentum of the franchise with net revenues up 12% and pre-tax earnings up 26% from the first nine months of 2005. These pre-tax earnings are higher than GPC has reported for the first nine months of any previous year.

Outside the U.S., GPC continues to make targeted investments for growth. Our joint venture in Japan gained momentum in its first full quarter of operations and of the 180 net new FAs we hired in the quarter, more than 25% joined GPC's operations outside the U.S., including places such as India, Europe and the Pacific Rim.

Our global total FA headcount has now reached 15,700. We continue to have success recruiting financial advisors from competitors and importantly, retaining our current FAs. Turnover among our most productive FAs continues to be near historical lows and our recruiting efforts have been active but disciplined.

Client assets flows in GPC remained positive even in the seasonally slow third quarter amidst mostly challenging markets. Assets and products that generate annuitized revenues ended the quarter at $578 billion, up 17% from a year ago, driven by market appreciation and net inflows. Third quarter net inflows into annuitized revenue products were $7 billion, bringing the year-to-date total to $30 billion, and total net new money was $14 billion in the quarter and $39 billion YTD, up 8% from a year ago. Total client assets ended the quarter at $1.5 trillion.

Finally, MLIM. This business turned in another outstanding quarter, even as it completed its combination with BlackRock. The merger impacted both revenues through the one-time gain, and both comp and non-comp expenses through one-time costs. These items, which were recorded in the corporate segment, as well as the impact on firm-wide tax expense, can be seen in attachments 3 and 5 to our press release. Going forward, our share of earnings net of both expenses and taxes from our investment in BlackRock, will appear as revenues on our income statement.

For MLIM, record third quarter net revenues of $700 million were up 54% from the third quarter of 2005 and 11% from the second quarter of 2006. Pre-tax earnings were $284 million, up 75% and 18% respectively from those periods. The increases over both prior periods were driven by higher average long-term asset values, driven in part by robust net inflows. Year on year, higher performance fees and consolidated investments revenues also contributed. MLIM's pre-tax margin of 40.6% was more than 5 percentage points higher than the 2005 third quarter and more than 2 points higher sequentially, as operating leverage was strong and spending was lower in certain areas in anticipation of the merger.

Firm-wide assets under management just prior to the quarter end closing of the merger, were $598 billion, up 14% from a year ago. Despite tougher market conditions for much of the period, MLIM's third quarter net inflows were a solid $1 billion as inflows in EMEA, Pacific and America's retail driven by both equity and liquidity products, were partially offset by outflows in the EMEA institutional channel. MLIM also continued to generate strong relative investment performance during the quarter, particularly for longer-term assets.

MLIM has strong operating and profit momentum going into the merger with BlackRock and we only expect bigger things to come as we enter this exciting new phase in our commitment to the asset management space.

That wraps up my discussion of the segments. Now I will return to the consolidated income statement, beginning with expenses. My discussion of expenses and expense ratios will exclude the effects of the MLIM BlackRock merger and were relevant the impact of one-time compensation expenses incurred in the first quarter.

First, compensation. The ratio of compensation expenses to net revenues for the third quarter was 48.0%, bringing the year-to-date comp ratio to 49.0%. Despite the significant hiring I discussed earlier and with many of those hires not coming off leave until the second half, we've still been able to reduce our year-to-date comp ratio by 50 basis points. While we continue to accrue appropriate awards to attract and retain high-performing people, we remain disciplined in managing this key part of our cost base.

Moving on to non-compensation costs. These rose 20% from the 2005 third quarter to $1.8 billion but declined 4% sequentially. Non-comp expenses were 22.2% of revenues, up from 22.0% in the 2005 third quarter. In the third quarter of last year, non-comp expenses benefited from the Allegheny settlement, which reduced the non-comp to revenue ratio in that period by nearly a point. Otherwise, the year-over-year increase was attributable to higher overall activity levels, consistent with the expansion of the business as well as consolidated investments expenses.

Looking sequentially, most operating line items did not move much and we did not have as much minority interest expense as we did in the second quarter. We continue to exercise cost discipline while investing for the future. Year to date, the ratio of non-comp expenses to net revenues is 21.7%, down nearly 2 percentage points from the 2005 period.

Now turning to the effective tax rate. The effective tax rate for the third quarter was 26.2% compared to 30.5% in the second quarter and 28.9% in the third quarter of 2005. Excluding the impact of the MLIM/BlackRock combination, the tax rate would've been 17.8%, reflecting the benefit arising from carryback claims we foreshadowed in our recent 10-Q filings. This benefit of just under $300 million added $0.31 per share. Were it not for that item, the rate excluding the impact of the BlackRock merger would have been about 30%.

At this point, including the complex impact of the BlackRock merger, we anticipate our fourth-quarter tax rate to fall in the 32% to 34% range, subject to considerable variation, depending on geographic mix of businesses and other factors.

I also want to update you on capital management. As we grow our business, we continue to carefully balance increases in book value per share with further improvements in ROE. Our third quarter book value was $40.52 per share, up 9% from the end of the second quarter and 13% for the year to date. Third quarter ROE was 22.5%, adjusting for the BlackRock combination; and year-to-date ROE, excluding both the merger and the impact of the one-time compensation expenses, was 20.2%, up 4.5 points from the same period last year, and again, was the highest in six years.

Our primary goal in capital management remains supporting investment in growth initiatives. At the same time, we continue to actively manage excess capital through share repurchases and dividends. In the third quarter, we repurchased 18.3 million shares for $1.3 billion. This brings our year-to-date repurchases to 86 million shares for $6.3 billion, up 64% and 112% respectively from the same period in 2005. Our third quarter average diluted share count is down 3% sequentially and is the lowest we have reported since the first quarter of 2003, more than 14 quarters ago. The period end share count is the lowest in 15 quarters. Today, we also announced that our Board of Directors had authorized a new $5 billion share repurchase program, bringing our total capacity to about $6 billion. At this point, we expect to be more active repurchasing our stock in the fourth quarter than we were in the third.

In concluding, I would like to express how proud we are of our record financial results for the quarter, achieved despite the less than exuberant environment that we have weathered resiliently since the middle of the second quarter; how delighted we are with our strategic progress, particularly the closing of the MLIM/BlackRock transaction and continued execution of bolt-on initiatives; how pleased we are with the additions we have made to our talent pool; and most importantly, how confident and excited we are in the future opportunities we see in front of us.

Activity levels have picked up since the end of the summer but are not as consistently robust across businesses as they were during the first 4.5 months of this year. While the fourth quarter is also typically a seasonally slower one, we are encouraged by our growing backlog. We also remain confident in the long-term secular growth story unfolding globally, and the opportunities that story presents to us in each of our business lines and regions.

Thus, we enter the final quarter of 2006 with strong momentum. Against this backdrop, we must continue to execute successfully on our growth strategy, maintain discipline over costs and capital, and create a vibrant and dynamic environment to allow our talented people to excel. Now I will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Daniel Goldberg - Bear Stearns.

Daniel Goldberg - Bear Stearns

Good morning, Jeff. Can you give us a little bit more detail on the FICC revenues, which I believe were record in the quarter? You gave us some of the products that were outperforming. Any sense of the magnitude of how much by product? Any more detail would be very helpful.

Jeff Edwards

Sure. It was clearly a very strong quarter in FICC, a new record. As I said in the speech, the primary drivers there were commodities and credit. I think the important point to make in commodities is that there was real breadth to the strength there. It was both natural gas and power, it was Europe and the U.S., it was both trading and structured transactions. We continued to invest to build out other products, oil, coal, metals, expansion in Asia, and we think these will become more additive next year.

So there are still opportunities for us to both grow the core business as we did this quarter and grow additional add-on businesses as well.

Credit was really quite strong, broadly I would say. Client activity was somewhat mixed but spreads tightened from the second quarter. There were good results in distressed emerging markets, derivatives. Our CDO business continues to be extremely strong. Overall, it was our second-best quarter there.

I think the last point to make about FICC is if you go back to the second quarter, we were really talking about different strengths in the quarter. It was a very strong quarter for our GPISF, principal investing and secured finance, as well as FX. I think an important point here is the benefits of the diversification that we have seen in that platform as we have built out different legs, so that in different quarters there are different pieces that can produce the results.

Daniel Goldberg - Bear Stearns

Then you mentioned offsetting some of that good performance was a decrease on the interest rates and the FX in particular. Any more color there?

Jeff Edwards

Rates, it was certainly a tougher quarter as the environment in the U.S. continued to be characterized by a relatively flat yield curve. Rates were up in Europe and so it was just generally a more challenging market than we saw previously. Similarly, FX. I think it was just a quieter quarter. Some of that is seasonal.

Daniel Goldberg - Bear Stearns

In terms of the capital management, you said the pace of buybacks should increase in the fourth quarter. How should we think about that? I think you had been slowing down those going into the third quarter. Is that a sign that there are not other areas to realize that capital in terms of investments outside the U.S.?

Jeff Edwards

I think capital management has been one of our most important themes of the year. We have bought back, as we mentioned, $6.3 billion so far this year so it's clearly a very large increase. I think now with the MLIM/BlackRock transaction being completed, we expect to be able to increase that pace somewhat from the third quarter, more similar to a pace we saw earlier in the year. We will continue to deploy that capital, of course, in organic initiatives and inorganic initiatives. We have some transactions coming up so we will be redeploying that capital broadly. But you will see, at this point, we believe, an increase in buybacks as well.

Daniel Goldberg - Bear Stearns

Would you say $2 billion to $3 billion in terms of capital usage would be appropriate?

Jeff Edwards

I guess I would say that we will see an increase from the third quarter levels and to a level more comparable to earlier in the year.

Daniel Goldberg - Bear Stearns

In terms of the BlackRock integration and closing, maybe you can just give us a little bit more color there. Obviously, with the Citi/Legg Mason transaction probably not going as smooth as possible, maybe just comment there on the integration and maybe also tie in the flows of only $1 billion, which I think was a bit disappointing during the quarter.

Jeff Edwards

First of all, I would say that the flows, I think you have to understand the context. The retail flows continue to be very strong. That was somewhat offset by a decline on the institutional side. That is not unexpected, I would say, as we have seen some managers look to manage their overall concentration of managers. But our pipeline on the institutional side remains very strong.

I think the integration process has gone extremely smoothly. It was a complex integration, but it was completed in a very timely manner and the businesses are off and running.

Operator

Your next question comes from Mike Mayo – Prudential Equity Group.

Mike Mayo - Prudential Equity Group

Can you elaborate more on the non-U.S. growth? You said non-U.S. is 37% for the firm. What is it for GMI?

Jeff Edwards

Well, overall, GMI YTD is over 50% outside of the U.S. The strongest areas of growth, as I mentioned in the call, you've seen EMEA growing in GMI over 40% and you have seen over 40% growth YTD in the Japan/Asia Pacific regions as well.

Mike Mayo - Prudential Equity Group

Do the backlogs follow that pattern? How much of the backlogs are outside the U.S. versus in the U.S.?

Jeff Edwards

Yes, the backlogs for investment banking are up in all three regions at this point.

Mike Mayo - Prudential Equity Group

Can you comment on China? China has been called a frenzy for the paper today and you are certainly involved there. What is happening there?

Jeff Edwards

Yes, I think China has been a very important market for us for quite some time. Certainly from an investment banking standpoint, there have been a number of important transactions and there continue to be important opportunities for us there as well.

Growth in China, I think, will come from both our ability to expand on the global market side, further growth in investment banking and private client as well. So, I certainly would not want to comment on any pending transactions. I think I will leave it there.

Mike Mayo - Prudential Equity Group

Lastly, what has been your average private equity gain for the last several quarters? What would you consider normal and what was it this quarter?

Jeff Edwards

Private equity is, as we said before, going to be lumpy. We highlighted it in the second quarter, where it was a record. It was up this quarter from the same period last year, but it was down by more than half from the second quarter. It will move around, that's the nature of that business. Overall, it continues to be an important opportunity for us to grow.

Operator

Your next question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

Question, if you can help deconstruct the book growth. It grew by something in the range of $3.20. You have the BlackRock gain and you have the tax benefit, which is in the range of half of that, but it still grew by more than I would have thought, give the buyback in the quarter. So I don't know if there's something in there that I can't see, related to the comp plan or something?

Jeff Edwards

If you think about what the contributors are to book value per share of growth, there is the earnings, there is the impact of the comp plans that come into effect, which includes option exercise, of course. Then you have some deduction for dividends and for the buyback. As you point out, there was a contribution for BlackRock certainly this quarter as well.

Glenn Schorr - UBS

Process of elimination then, I would say that the comp plans were the difference in my math.

Jeff Edwards

That would be the right conclusion.

Glenn Schorr - UBS

Just trying to get a bigger than a breadbasket type of comment of how you think about comp flexibility as we head into year end, I'm sure your employees are psyched that revenues are up 35% year to date, nine months, and headcount is up 4%. Now there have been changes in headcount in terms of the ones out the door and the ones in the door. How do we think about that, because it feels like you have some flexibility, obviously, depending on the fourth quarter revenue environment?

Jeff Edwards

Yes, well, one important point to make is as you think about our headcount, recognize that a very significant number of employees, over 2,300 ended up moving out of our headcount and over to BlackRock. Of course, they are expecting some compensation as part of their year as well. So keep that in mind.

Look, I think at this point, we feel we are appropriately accrued. Where we end up for the year is very hard to say. It will depend on the ultimate business conditions of the quarter. It will depend on competitive trends in the industry. We have added a lot of employees. There has been a clear strategic decision on our part to invest for future growth by adding employees, and yet we are feeling very good that, at this point, we have been able to bring down the comp ratio by 50 basis points. Where it ends up for the full year at this point, I can't really speculate.

Glenn Schorr - UBS

I appreciate it, Jeff.

Operator

Your next question comes from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

Not to hop on the Merrill Lynch/BlackRock thing too much, but just how should we think about the mark-to-markets on those securities, for one? And then how should we think about the tax treatment of those earnings at the corporate level? I know you gave a guided tax rate, but is that inclusive or exclusive of that?

Jeff Edwards

In terms of the first part of the question, the question on mark-to-market, we're going to account for this under the equity method going forward so you will see our share of their after-tax earnings appear as revenues for us going forward. We will be subject to some double taxation, so there will be a tax item associated with that as well. That is included in that estimated tax revenue.

William Tanona - Goldman Sachs

Okay, so essentially the high end of the 32% range is inclusive of that, whatever the share of gains you have on the BlackRock?

Jeff Edwards

It is. Again, just to be clear, I want to make sure I was clear on the first part of your question, we are not marking to market these securities going forward on our balance sheet.

William Tanona - Goldman Sachs

Understood.

Jeff Edwards

It’s the equity method.

William Tanona - Goldman Sachs

Great. Then in terms of the equities business, obviously, you had record private equity gains last quarter. You had some private equity gains this quarter but you mentioned that they were half of what they were last quarter. Obviously, we don't know what that exact amount is. But it still looks like even if you exclude private equity from both quarters, your overall equities business was up on a sequential basis. Is that true? And if so, can you tell us where that strength was on a sequential basis?

Jeff Edwards

It wasn't true on a sequential basis. It was true on a year-on-year basis. So if you look at the business overall, I think the first point to make is that given those conditions in the equity markets, we are extremely pleased with how that business performed in the quarter.

On a year-on-year basis, we really saw good growth outside of private equity in the cash business, the proprietary trading business, and the equity financing and services business. We saw a modest decline in the equity linked business. On a sequential basis, not surprising given the seasonality, most of those areas were down, but we were up in both cash, equity trading and proprietary trading on a sequential basis.

William Tanona - Goldman Sachs

Okay, that's helpful. Thanks.

Operator

Your next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

Hi. You talked about the nice growth you continue to see in terms of FA headcount, I think up 540 for the year. Can you give us a feel for how much of that is experienced hires from competitors versus trainees? Also, can you tell us how you're dealing with the aggressive recruiting environment?

Jeff Edwards

The environment does continue to be aggressive. I think discipline is critical in this type of an environment. That has been a hallmark, I think, of our actions over the last couple of years as these periods of intensity flare up.

The most important part of that really is to create an environment that is conducive to FA's doing business so that they can recognize the benefits of doing business at Merrill Lynch. From our standpoint, that's involved aggressive investment in technology and systems, in support, in order to make this platform and environment the best. I think that has been an important part of our ability to deflect that environment.

Overall, I don't have a breakdown for you exactly in recruited versus relatively new hires, but I would make the point that among the recruited, we have had good success really against our largest, most important competitors on a net basis. As we continue to have low turnover, that allows us to focus more on those competitive hires as opposed to new hires.

Prashant Bhatia - Citigroup

The driver behind the growth in leverage, it looks like the long-term debt was up roughly $20 billion during the quarter. Should we interpret that as really just getting more comfortable with taking more risk in the franchise?

Jeff Edwards

The funding strategy has a number of elements to it. Certainly our focus on long-term debt this quarter is part of an overall plan, over the course of the year, to support the growth in the business broadly. We also have decided to term out some of our funding. You can see commercial paper was down a little bit for the quarter. We felt it was an appropriate environment for us to take advantage of market conditions.

Prashant Bhatia - Citigroup

Is that a trend we should probably see continue?

Jeff Edwards

You know, without predicting exactly where it will end up, we'll certainly continue to issue long-term debt to support the growth of the business. But I think we'll take advantage of specific opportunities in specific markets on an opportunistic basis. So exactly as to where we'll end up for the year at this point, I would not predict.

Operator

Your next question comes from Douglas Sipkin - Wachovia.

Douglas Sipkin - Wachovia Securities

Just two questions and I apologize if they've already been asked and answered. I just got onto the call. First, I think you guys highlighted on BlackRock that potentially the transaction was going to allow you to free up a couple of billion dollars of capital. Am I to assume that the reauthorization is probably something to do with that, or is this more just a function of normal reauthorization?

Jeff Edwards

The first point would be that we absolutely did highlight that the BlackRock transaction would allow us to free up capital. As we think about deploying that capital, our first focus is on organic initiatives. As you can see from the progress we have made during the year, we continue to have very attractive organic opportunities going forward.

We also have opportunities to redeploy capital into acquisitions, and we have been more active on that front in the third quarter as well and we'll need to fund that. But, yes, there is certainly a component of that that also goes into our thinking around the long-term capital management and our overall equity capital base.

As a result of the repurchases we've made through the first three quarters of the year, we were down to $1 billion on our previous authorization. This now gets us back up to $6 billion.

Douglas Sipkin - Wachovia Securities

Your common equity looks like it was up about 7%,. How much did your tangible go up from this transaction, tangible equity capital, roughly?

Jeff Edwards

The tangible common will certainly go up considerably more as a result of the elimination of goodwill associated with our MLIM businesses, which resulted from the Mercury acquisition. So you'll see quite a significant increase in tangible book, because the overall goodwill will go down by more than $4 billion for the quarter.

However, you do have to remember that there is a meaningful amount of capital that we will certainly want to attribute to this investment as well, as we consider how to fund it going forward.

Operator

Your next question comes from Jeff Harte - Sandler O'Neill.

Jeff Harte - Sandler O’Neill

Good morning, nice quarter. A couple of questions to hopefully wrap up with. One, you talked about the investment banking backlog of pipelines, and it's good to hear that those are strong and up, though the road from backlog to completion can vary quite a bit. How much more favorable do you get a feel for the current capital markets environment being as far as the backlog actually turning into revenues? I’m looking versus the prior quarter when it was quite a bit more challenged environment.

Jeff Edwards

I think the third quarter you had both a challenged environment and a seasonal slowdown. I would say at this point that the markets do appear to be considerably more constructive for execution of that pipeline, so I think we're optimistic about that going forward here.

Jeff Harte - Sandler O’Neill

You've made a lot of investments recently, which you highlighted earlier. Then there is also talk about the ROE and returns on capital. Do you have any kind of a timeline in mind when you make investments? What I'm trying to get at is you have been growing assets as you've made investments; is there any kind of a specific timeline you target as to when we can expect those investments to be more productive and maybe start seeing asset turns increase?

Jeff Edwards

It depends on the business. Just to be clear, some of the investments that we have made over the last several years are clearly highly productive and are important contributors in every way to our turnover, our return on equity, even as we believe we can continue to grow them. Others will take longer and others are just shorter in terms of how long we have been invested in those strategies.

So there's no specific timeline where you can say there is a cookie cutter for each investment. Each depends on the nature of the business, the markets around it, what the opportunities for synergy are and how easy it is to achieve those.

But from our perspective, the important part here is that we create a pipeline of these opportunities that will continue to drive our future growth, and that is where we are.

Operator

Your next question comes from Meredith Whitney - CIBC World Markets.

Meredith Whitney - CIBC World Markets

Good morning, Jeff. I'm trying to understand your commodities business better, and I appreciate the diversity comment that you made earlier but in terms of continuity of the revenue contribution, it was not significant in the first quarter, as you guys said, or the second quarter. I'm just wondering whether there was a trading opportunity on the short side in the gas business this quarter that was the material difference? And then how to look at that business from a continuity perspective going forward.

The next question, you guys had said that your global opportunities are strong. I wanted to get an update on your Japan private client business.

Jeff Edwards

Well let's deal with the first one, commodities. Commodities, like many trading businesses, will experience some volatility. It was certainly an important contributor to our growth throughout all of last year. The quarterly results, this is clearly the strongest quarter that we have had in commodities this year, in fact, our strongest ever. So there will be some pattern to that. The important part is that it is part of a broader fixed income business and you will see different legs of that platform perform better in different quarters.

But overall, there is a secular opportunity here that continues to grow as we build it out. It was not just a natural gas opportunity. There was very significant opportunity on the power side also that we were able to capitalize on. It wasn't just a trading opportunity. We saw very significant structured transactional revenue as well, driven primarily out of Europe. So there was good breath to that business.

The key there for us now is as we continue to grow those core businesses that have been a part of that platform, we will continue to invest in and, therefore, build the related commodities revenues and platforms in oil, coal, and other products. Sorry, the second part of that question again?

Meredith Whitney - CIBC World Markets

The second part was an update on your efforts in Japan.

Jeff Edwards

I think we have got good momentum there. The first observation is that at this point we have had, I think almost 1,000 new accounts opened. It has generated something like $400 million in net new money at this point. Our pipeline of new opportunities remains very strong there. So I think that business is off to a great start in its first full quarter.

Operator

Your next question comes from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

Great. And I apologize if you answered this in the interim, but on the non-comp side, obviously we had a bunch of non-comp expenses because of BlackRock. We're going to be losing some non-comp expenses because of BlackRock. We don't necessarily know what the mix of comp to non-comp is. Can you give us a sense of what we should assume for the run rate in the fourth quarter here, or what it would have been excluding those items? So that way we can kind of make our best guess estimate as to what to expect going forward.

Jeff Edwards

The non-comp ratio, I think the best way to think about it is in, I want to say it is attachment 3, we break out what that looks like ex the impact of the BlackRock merger. So we have stripped them out and it was just over 22% for the quarter. Going forward, we have seen some seasonality to the non-comp expenses in the fourth quarter over the last few years. At this point, it's hard to say whether that will occur again.

The most important philosophy I would say from our standpoint is we recognize the need to increase non-comp expenses as we grow our businesses but we want to do it in a disciplined way and therefore make sure that we drive down our non-comp ratio over time as we are able to grow revenues. That's been an important part of the story so far this year, where we are down materially from the first nine months of last year. We would hope if the environment is conducive, to continue to be able to do that.

Operator

Ladies and gentlemen, let me now turn the call back to Jonathan Blum for some final remarks.

Jonathan Blum

Thank you. This concludes our earnings call. If you have further questions, please call investor relations at 212-449-7119. Fixed income investors should call 866-607-1234. Thanks for joining us today. We appreciate your interest in Merrill Lynch.

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Source: Merrill Lynch Q3 2006 Earnings Call Transcript
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