Lehman Brothers F4Q06 (Qtr End 11/30/06) Earnings Call Transcript

Dec.14.06 | About: Lehman Brothers (LEH)

Lehman Brothers Holdings Inc. (LEH) F4Q06 Earnings Call December 14, 2006 11:00 AM ET


Shaun Butler - Investor Relations

Christopher M. O'Meara - Chief Financial Officer, Executive Vice President


Daniel Goldberg - Bear, Stearns & Co.

Guy Moszkowski - Merrill Lynch

William Tanona - Goldman Sachs

Glenn Schorr - UBS

Michael Mayo - Prudential Equity Group

Douglas Sipkin - Wachovia Securities


Good morning and welcome to the Lehman Brothers fourth quarter earnings conference call. All participants have been placed on a listen-only mode until the question-and-answer session.

(Operator Instructions)

I would now like to turn the call over to Ms. Shaun Butler, Director of Investor Relations. Thank you, you may begin.

Shaun Butler

Good morning and thank you for joining us. Before we begin, let me point out this presentation contains forward-looking statements. These statements are not guarantees of future performance. They only represent the firm’s current expectations, estimates and projections regarding future events. The firm’s actual results and financial condition may differ, perhaps materially, from the anticipated results, financial condition in any such forward-looking statements. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are difficult to predict and beyond our control. For more information concerning the risks and other factors that could affect the firm’s future results and financial conditions, see risk factors and management’s discussion and analysis of financial condition, the result of operations, and the firm’s most recent annual report on Form 10-K and quarterly report on Form 10-Q as filed with the SEC.

This presentation contains certain non-GAAP financial measures. Information relating to these non-GAAP financial measures can be found under selective statistical information, reconciliation of average common stockholder’s equity to average tangible common stockholder’s equity, and gross leverage and net leverage calculations in this morning’s earnings press release, which has been posted on the firm’s website, www.lehman.com, and filed with the SEC in a Form 8-K, available at www.sec.gov.

With that, let me now turn the remarks over to Chris O'Meara, our CFO.

Christopher M. O'Meara

Good morning. Thank you, Shaun. Good morning. Happy Holidays and thank you for joining us for our fourth quarter and year-end update. As you have seen in this morning’s press release, we have reported another quarter of extremely strong results. In fact, this was our best revenue quarter ever, driven by record performances in our investment banking and investment management business segments, along with robust results in our other businesses and record revenues in Europe.

This also marks the fourth consecutive quarter that our revenues have exceeded $4 billion. The increased breadth and scale we have built, the broader diversification we have achieved in our businesses and regions, and the strong productivity we are seeing from our growing base of people all contributed to this performance.

Underpinning these results was a favorable market environment, where business momentum picked up throughout the quarter. Although GDP growth continued to slow in most major economies over the period, global equity markets rose 6% in local currency terms during the quarter, due to better-than-expected corporate profitability, a decline in oil prices, and the market’s anticipation of the end of the federal reserve interest rate tightening cycle.

In the U.S., the S&P hit a six-year peak and the Dow hit an all-time high. European markets also rose during the period, with many hitting five-year highs. Global equity trading volumes rose approximately 5% compared to the prior quarter, and in the fixed income markets, the yield curve in the U.S. and the U.K. further inverted, while it flattened in the Euro area and Japan.

Interest rate actions by central banks remained fairly benign over the period. In the U.S. and Japan, central banks kept interest rates unchanged due to moderating economic growth, while both the Bank of England and the ECB each raised rates once during the period. In the U.S., signs of slowing growth and weaker housing data caused treasuries to rally.

Investor activity remained high, creating significant liquidity in the markets, and the search for incremental yield caused credit spreads to tighten during the period, most notably in high yield.

In investment banking, both M&A and underwriting activity were strong, driven by improved valuations and lower volatility. On a sequential basis, announced M&A volumes rose 40% in the market. Equity underwriting volumes increased by 55%, and debt underwriting grew by 20%. The volume of announced M&A transactions in calendar year 2006 is now at an all-time record, due in large part to increased financial sponsor activity.

In asset management, flows remained solid across major asset classes. So overall, a favorable backdrop for the markets and for the overall level of capital markets, investment banking and asset management activity.

Given these constructive conditions, we posted record net revenues for the quarter of over $4.5 billion, up 23% from the comparable period last year, and up 8% from last quarter’s level.

Net income was just over $1 billion, up 22% from the year-ago period and up 10% from last quarter.

Diluted earnings per share was $1.72, our second-highest level ever, up 25% from the year-ago period and up 10% from last quarter.

This strong financial performance once again illustrates the significant momentum that we have established in our franchise and our ability to translate that into a higher level of earnings. If you examine our business units that were the biggest gainers this quarter, they were all areas where we have made considerable investments over the past years, and we have continued to improve the overall level of client-related revenues, as evidenced by increases in our fee-based businesses and capital market sales credits.

Now let me review each of our three business segments.

Starting with our investment banking segment, we posted record revenues of $858 million in the quarter, up 5% year over year and up 18% from last quarter. Our pre-tax income for this segment was $135 million.

Our advisory services revenues totaled $256 million, down 7% from the year-ago period and up 31% from last quarter. This represents our second-highest level of revenues for this business.

For the quarter, our volume of completed M&A transactions totaled approximately $71 billion. We advised on several notable transactions that closed during the quarter, including Golden West’s sale to Wachovia, Thermo Electron’s merger with Fisher Scientific, West Corp’s acquisition by Thomas H. Lee, and Abbey National’s sale of its life insurance business to Resolution plc, among others. We are currently advising on three of the top four announced transactions for 2006.

In equity origination, our revenues increased to $224 million in the quarter, our highest quarter of the year, up 7% from last year and up 22% from last quarter. As I noted earlier, there was a noticeable pick-up in the equity origination market during the quarter, as the markets resumed a steady rise on lower oil prices and double-digit increases in corporate profitability.

For the quarter, our lead managed volumes increased significantly to over $9 billion, and we increased market share during the period. Our volume increase was most noticeable in IPOs and convertibles.

Moving on to fixed income origination, our revenues were $378 million, up 14% year over year and up 9% from last quarter’s level. This represents our second-highest level of revenues in this business. The strength in debt underwriting emanated from several sources. Clearly, low absolute rates, tighter credit spreads, and ample liquidity prompted issuers to take advantage of attractive financing conditions. This was most notable in high yield, where volumes were driven by both sponsor related and strategic M&A.

Our investment grade volumes rose significantly from the sequential quarter, increasing slightly more than the industry, as borrowers remained opportunistic and in some cases, accelerated 2007 refinancings into the current period, or termed out commercial paper.

The hybrid market was revived from the clarity that the National Association of Insurance Commissioners provided. We remain a market leader in this hybrid business.

In structured finance, we underwrote such innovative transactions as a cell-tower securitization for SBA Communications, a mortality linked bond for AXA, and triple-X reserve monetizations for Genworth and Banner Life.

We have significant momentum in the investment banking business and our pipeline remains strong. At quarter end, our M&A volume pipeline was $348 billion. Our equity origination pipeline was $17 billion, and our debt origination pipeline was $58 billion.

Away from M&A and underwriting fees, we have continued to grow our banking revenues by providing additional services to our clients, including transaction related derivatives and foreign exchange, structured solutions, such as whole business securitizations to finance M&A transactions, liability management generally, and accelerated stock repurchase transactions for clients, among other transaction types.

Moving on to our capital market segment, we posted revenues of over $3 billion, up 28% from the year-ago period and up 7% from last quarter. This represents our third-highest revenue level ever for this segment. Our pre-tax income for this segment was approximately $1.2 billion.

In the fixed income component of our capital market segment, we posted revenues of over $2.1 billion, up 31% from the year-ago period and up 6% from last quarter. This represents our second-highest revenue level for this business and the fourth consecutive quarter where our revenues have exceeded the $2 billion mark. Once again, the depth and breadth of this diversified global set of businesses was evident during the period, as strong results in certain asset classes and regions helped to offset softness in others. We continue to benefit from our client-focused business model, as our customer activity reached the highest level of the year.

Tightening credit spreads had a positive impact on our credit products businesses, leading to a stronger origination market, an active secondary market, and positive absolute and relative returns across the spread sectors. During the period, high grade spreads tightened four basis points and high-yield spreads tightened 17 basis points.

Our high-yield business posted record revenues due to stronger customer activity, improved market conditions, stable credit quality, and improvements in sectors such as airlines and autos. The search for incremental yield again generated strong investor demand for these products. High grade trading flows also benefited from a heavy origination calendar.

Results in our residential securitization businesses remained solid in relation to the sequential quarter, but were down a bit versus last year’s same quarter, despite the challenges from the U.S. housing market.

Our origination volumes for the period were essentially flat to last quarter. However, our securitization volumes increased over $41 billion for the period. We posted solid results for our non-U.S. mortgage business, including the completion of our first residential securitization in Japan from self-originated product. We have also begun to originate loans through Campus Door, the student loan originator that we recently acquired, and our pending acquisition of Capital Crossing will add to our small business commercial loan sourcing going forward.

In our commercial real estate business, revenues were solid, although down from both benchmark quarters. During the period, we securitized over $7 billion of commercial real estate loans. Results on our interest rates product business and foreign exchange were negatively impacted by a decline in market volatility to near-record lows.

Moving over to the equities component of our capital market segment, our revenues were $900 million, up 22% from the year-ago period and up 8% from last quarter’s level. This represents our second-highest level for this business as well.

As I noted earlier, the market environment was constructive, as global valuations and volumes rose during the period compared to the prior quarter, supported by positive investor sentiment and buoyant M&A activity. We realized our second-highest revenues in our execution services business, as we are seeing the return on our investments in electronic trading which contributed to the increase this period.

We realized record revenues in our convertibles business, as clients were more active with valuation improvements in both equities and bonds. A strong origination calendar also bolstered the secondary markets in converts.

In our prime broker and financing businesses, our results remain strong. We continue to grow this unit by adding new clients and growing balances with existing clients. In 2006, we added over 100 clients and increased balances by approximately $58 billion, as we improved our share with clients in traditional and synthetic products, as well as in the statistical arbitrage space.

Our revenues in equity derivatives improved slightly from last quarter’s levels, as our share continued to increase in flow derivatives, but also in structured products and derivatives-based solutions for our corporate clients. Client activity in this market has continued to grow despite lower levels of volatility over the period.

We also saw an increase in revenues from our merger arbitrage business during the period and lastly, we realized depreciation from our private equity investments of approximately $70 million for the period, slightly higher than both benchmark quarters.

Moving to our third segment, investment management, we posted record revenues of $640 million, up 26% from the year-ago period and up 6% from the previous record we set last quarter. Our pre-tax income for this segment was $163 million.

For the asset management component of this segment, we reported revenues of $368 million, up 39% from the year-ago period and up 5% from last quarter. This equals our previous record for this business, set in the first quarter of 2006.

Results in asset management were driven in part by an increase in assets under management across all asset classes and businesses, including a strong performance by our Neuberger Berman platform.

We ended the quarter with a record level of assets under management, $225 billion, as we realized net inflows of $10 billion and market appreciation of $8 billion during the quarter. Over the course of the quarter, we continued to expand our product set within asset management, including:

  • New CDO structures;
  • A series of alpha funds that represent the repackaging of Neuberger and Lincoln funds for non-U.S. investors;
  • The successful launch of our $1.6 billion co-investment private equity fund; and most recently
  • Our announced agreement to acquire H.A. Schupf, a $2.5 billion money manage, which we expect to close later this month.

So great momentum in this business.

In private investment management, which encompasses our high net worth client distribution business, we realized record revenues of $272 million, up 11% from the year-ago period and up 6% from the previous record we set last quarter. Within this business, equity-related revenues increased versus last quarter, while fixed income activity remained robust, as we continued to see strong productivity from our growing high net worth sales force.

Now let me briefly review the results on our non-U.S. businesses. For the quarter, we realized non-U.S. revenues of over $1.5 billion, up 7% year over year and down 3% from last quarter’s levels. This represents 34% of firm-wide revenues for the period.

Europe and Asia have contributed 37% of total revenues for the full year, which is consistent with last year, and we do expect the proportion of our non-U.S. revenues to continue to grow over time as a result of the new initiative spending that we have been directing to these regions over the last few years.

In Europe, we posted record revenues of approximately $1.2 billion, up 28% year over year and up slightly from the previous record set last quarter. This represents our fourth consecutive quarter of revenues over $1 billion in Europe. Sequential increases in investment banking and investment management were partly offset by a decline in capital markets.

Revenues in investment banking in Europe rose sequentially on higher advisory, debt underwriting and equity underwriting revenues, where we demonstrated particular strength in high yield and structured products.

In our European capital markets business, our fixed income revenues were a record, with strength in real estate and credit businesses. Equities capital markets had a solid performance, but was down from a very strong third quarter. Revenues in investment management in Europe rose, partly as a result of the launch of six additional funds in the period and increased private investment management activity.

In Asia, we posted revenues of $381 million, down 11% versus last quarter. While we continue to see opportunities and strong results in de-stressed restructurings, we have focused on building a client-facing business and for the quarter, we realized our highest level of client revenues.

In fixed income capital markets in Asia, declines in interest rate products and real estate were partially offset by increases in credit products. As we mentioned on our call last quarter, we recently launched mortgage platforms in both Korea and Japan, and as a result, securitized product revenue improved versus both prior periods.

As I noted before, we completed our first residential mortgage securitization in Japan, while in Korea, our origination activity has picked up and we plan to begin securitizations there in the first half of 2007. We are looking to further broaden our geographic footprint in the region in the securitized product space.

In terms of investment management initiatives during the quarter, we entered into a $180 million joint venture with IBM to focus on investing in mid-stage to mature, public and private companies in China across industry sectors.

Moving briefly to expenses, for the quarter, we posted a compensation-to-revenue ratio of 49.3%, a level consistent with the ratio we posted for the first nine months of 2006. As we continued to invest throughout the year, adding top quality talent to the firm, as I mentioned, throughout the year, so our investment program was not limited to the beginning of the year. We continued to invest throughout the year.

Over the period, our headcount rose 5%, to approximately 26,000. For the quarter, our non-personnel expenses totaled $809 million, up approximately 8% from last quarter’s level, driven by the continued investment we are making to grow the firm.

Business development and professional fees increased, primarily due to recruiting and training costs associated with the mid-year round of initiative spending. Additionally, increased technology expenses reflect our continued build-outs in fixed income and securitized products, along with infrastructure development in Asia.

For the period, non-personnel expenses as a percentage of revenues were 17.8%, in line with our full year 2005 ratio.

Taking all this into account, we reported a pre-tax margin of 32.8% for the quarter, our effective tax rate was 32.5%. Return on equity for the quarter was 22.3%, and return on tangible equity was 27.6%. So overall, an extremely strong performance for the quarter across our businesses and regions.

What this quarter’s results demonstrate first and foremost are the depth and breadth of our product capabilities, where we continue to benefit from our client-activity driven business model, as well as the overall growth of our client franchise, where we are serving more clients in more asset classes than ever before. Our commitment to growth is evidenced by building capacity and scale in the businesses and regions with the most rapid fee pool growth.

Now let me make a few comments about our balance sheet. Over the period, our stockholders’ equity increased to approximately $19.2 billion. Book value per share increased to $33.87, up 18% since the beginning of the year, and we ended the quarter with a net leverage ratio of 14.5 times. Our average value at risk increased during the quarter as we continued to grow the franchise and saw opportunities to put our capital to use in the markets, and over the course of the quarter, we repurchased approximately 13.8 million shares at an average price of $74.06 per share, bringing our full-year stock repurchases to 52.9 million shares.

Now I would like to make a few comments about our full year results.

Our 2006 net revenues were a record $17.6 billion, representing a 20% increase over our prior record last year. In fact, the firm has grown its full-year net revenues by approximately $3 billion for each of the last three years.

Net income and EPS for 2006 were at all-time highs of $4 billion for net income and $6.81 per share of EPS, up 23% and 25% respectively from the prior year.

Our pre-tax margin for the year increased to a record 33.6%, and our return on equity increased to 23.4%. Return on tangible equity was at 29.1%.

We are extremely pleased with this performance, especially since these record results were broad-based. All three of our business segments and each of our regions generated record full-year revenues.

Given what we have achieved as a franchise in 2006, our momentum as we go into 2007 is considerable. Our business is driven by our people, and as I noted earlier, we ended the year with a headcount of approximately 26,000 people, up over 13% year over year. This gives us significantly more capacity to expand our global client base while increasing wallet share with our existing clients.

This momentum extends to each of our businesses and regions as we continue to expand our geographic footprint, improve the firm’s ability to cover important segments of our client base, and enhance our product capabilities.

In investment banking, we have made substantial strides. Our volume of M&A completions increased 13% year over year and our announcements in 2006 were up approximately 40%. The breadth of our investment banking franchise has increased dramatically, as evidenced by our completion of 64 transactions, with fees in excess of $10 million over the course of the year.

Geographically, we have added significant scale in Asia, made key appointments in Europe, and most recently extended our presence to India, Canada, and the Middle East. We have established formalized banking groups for hedge fund coverage, pension solutions, insurance solutions, and a cross-divisional joint venture to cover financial institutions, all to better address important sectors of our client base. Importantly, we enter 2007 with a volume and fee pipeline that is higher than where we entered 2006.

In capital markets, our momentum also continues, as demonstrated by our increased market share, as well as our top rankings in surveys that evaluate overall quality and trading sales and research capabilities.

In equities, we have continued to focus on growing our wallet share with more customers and our client revenues increased substantially this year. We have continued to build our capacity and capabilities in derivatives and in prime services, as these businesses become even more important components of our revenue growth.

Our international footprint remains strong, with over 50% of our revenues in equity capital markets continuing to be generated from outside the U.S. over the period.

In fixed income, we realized our eighth consecutive year of revenue increases, including record fixed income revenues outside the U.S. We continue to see significant growth opportunities for our fixed income franchise and we are aligning our resources accordingly.

For example, we are expanding our origination and securitization platforms into different asset classes around the globe. We are building greater scale in Asia, including building out India, and we are further developing our capabilities and risk solutions, energy and commodities, insurance and middle market lending.

In fixed income, we have also become a market leader in product innovation, with our development of constant proportion debt obligations and the Exum Ridge and [AVIV] programs being recent examples.

In investment management, we continued to build our platform globally and our growth in assets under management is largely from net inflows. We have continued to expand our product offerings as we raised $2.8 billion in new private equity funds. Alternative investments currently represent 9% of our year-end assets under management, and we are looking to grow this proportion further.

In 2006, we made considerable progress in Europe, launching a total of 15 funds over the course of the year, and our internal synergies have never been better, as we sourced 55 investment banking transactions from investment management clients in 2006, while our investment banking and capital markets clients referred approximately $5.6 billion of client assets into our asset management products. So despite our strong results and the tremendous growth we have realized to date, we continue to identify numerous opportunities to drive future growth of the franchise.

Now, a few brief comments on our outlook.

We remain confident in our organic growth prospects. This is further reinforced by our positive view of the markets in 2007. First, our outlook is for the global economy to grow 2.8% in 2007, a slower rate than was realized in ’06 but still a level that continues to provide a favorable underpinning for our sector.

Furthermore, we expect the interest rate outlook to remain fairly benign, with the fed on hold throughout all of next year, the ECB and the Bank of England raising rates one more time, and the Bank of Japan prepared to hike rates gradually. Despite our projection for slower growth, our view is that corporate profitability will remain resilient and we are looking for corporate earnings globally to grow by 7% next year versus 14% in 2006.

Strong profitability has helped corporate balance sheets to remain very strong, with approximately 10% of total balance sheet assets representing cash on hand, and clearly a robust corporate sector is very important to our business, since it gives corporations a higher degree of flexibility for M&A, buybacks, dividends, and so forth.

Aside from corporate cash on hand, there have been other ample sources of liquidity in the marketplace in 2006. Financial sponsors are sitting on an estimated $325 billion or more of un-invested capital that has been raised. Cash consideration on completed M&A has recycled over $2 trillion back into the capital markets in 2006, and corporate share buybacks have added another $78 billion to the marketplace in 2006 globally.

This massive pool of liquidity has benefited both the markets and conditions within our industry in 2006, and we expect more of the same in 2007. We expect the bond markets to remain range bound in 2007 and credit spreads to trade fairly tightly. Our view is that the global equity market indices will rise about 12% in 2007, with:

  • Japanese equities rising 18%;
  • The U.S. and Europe, ex the U.K., rising 12%;
  • Asia, ex Japan, rising 10%; and
  • The U.K. increasing by 8%.

So we expect additional growth in capital markets activity next year.

Given the health of corporations, the higher level of un-invested capital among financial sponsors, the growing amount of assets being managed by hedge funds, and positive valuations, we expect further increases in investment banking activity in 2007. We expect announced M&A volumes to grow by another 15% in 2007 after increasing by 30% in 2006.

Similarly, our view is that equity origination will also increase by another 10% to 15% next year, and we project that debt origination will remain fairly flat, relative to the peak levels issued in 2006.

The quickening pace of regulatory change could also serve as a catalyst for capital markets activity next year. Pension reform in the U.S. and Europe, Basel II, Regulation NMS on the New York Stock Exchange, MiFID or Markets and Financial Instruments Directive in Europe, and penny pricing increments for U.S. options are all issues that will come into pay in 2007.

We also see the forces of disintermediation continuing in 2007. For example, in the current year, Asia and Europe combined have accounted for half of completed and announced M&A volumes, 68% of equity issuance, and 48% of fixed income underwriting volumes. All of these percentages are up significantly from the past.

The non-U.S. component now accounts for approximately 58% of total capital market outstanding, up significantly over the last five years, and providing another important element of growth. Going forward, a generally favorable environment with plenty of opportunities for us as we continue to grow our franchise.

In conclusion, we believe our franchise has tremendous momentum. We have continued to consistently post strong results. Our franchise now incorporates significantly more people covering more clients and more products in more geographies. Our expectation is that this broadening in capacity will serve us well going forward. Our outlook remains positive. We believe we will continue to benefit from the favorable secular forces that are driving growth for both Lehman’s and the industry as a whole.

Now, I will be happy to take questions.

Question-and-Answer Session


(Operator Instructions)

Our first question is coming from Daniel Goldberg. You may ask your question and please state your company name.

Daniel Goldberg - Bear, Stearns & Co.

Yes, good morning, Bear Stearns. Could you talk about, you gave us the levels of the investment banking pipeline by area, but I guess if I look back to the prior quarter, it seems like each of them fell sequentially. Is that correct? If it is, could you just maybe give us a little bit of color there?

Christopher M. O'Meara

Yes, let me give you a little color. We had a terrific, as you can see that has come through in the revenues in the fourth quarter, we executed a lot of the pipeline that was in the third quarter. We replenished that to some extent, but the third quarter pipeline was a little higher than it is in the fourth quarter. What I was comparing to was the fourth quarter of last year versus the fourth quarter of this year, so sort of how we entered 2006 versus how we are entering 2007. Let me give you the numbers for that.

I mentioned that the equity pipeline is at $17 billion at the end of this year. That was $19 billion at the end of last year. Debt pipeline is $58 billion at the end of this year. That was $51 billion at the end of last year, and the M&A pipeline is $348 billion at the end of this year. That was $236 billion at the end of last year.

Daniel Goldberg - Bear, Stearns & Co.

Okay, that is helpful. In terms of value at risk, you did mention that -- I think that was you said slightly up. Any way to quantify that, or anymore color there?

Christopher M. O'Meara

On average, looking at the historical simulation, model-based value at risk, our average value at risk was $48 million, and that is up from $38 million on average for the third quarter. That is in both fixed income, a little more in fixed income than equities. Within fixed income, the key places that are up a bit, one is in energy and one is in our high yield business as we continued to build that out and see terrific activity in it.

Daniel Goldberg - Bear, Stearns & Co.

Okay. On the investment management side, you showed some real solid assets in management organic growth. Do you see the composition changing? It looks like, year over year, less of the assets are fixed income and I guess more are money market and alternative. How should we think about that mix going forward?

Christopher M. O'Meara

There are -- it depends on where the clients want to rotate their assets, but in general, when we look at them, we see that there are opportunities for us to grow each of these categories, and so the rotation of them is really within our private asset management business, because for example, we have Lincoln Capital, which is our fixed income asset manager. That is not something that has product that gets rotated around. People invest in that platform because it is a terrific fixed income money manager.

But I think that as you look out, you will see each of those growing. We have had very good performance across the board and we are expecting to attract additional assets next year in all of them.

The one thing that we talked about is about trying to increase the proportion of our assets under management that is in the alternative space. We have a terrific track record. We have had great growth in our private equity. We have offered a lot of additional funds over the past couple of years, and our track record is terrific, so we are expecting to continue to grow that out and have that become a bigger portion of the total as time ticks on.

Daniel Goldberg - Bear, Stearns & Co.

And the percentage of non-U.S. assets in the 225?

Christopher M. O'Meara

Of non-U.S. assets in the 225? It is hard to say that because we do have international funds that are managed here in the U.S., by Neuberger, for example, but our assets under management outside the U.S., that are actually managed outside the U.S. are relatively small. That is a business we are building out. We have indicated that we are at the early stages of a build-out of that business.

I do not have that information right in front of me, but it is a very small percentage relative to the total at this point, but that will be growing.

Daniel Goldberg - Bear, Stearns & Co.

Okay, thanks a lot.


Thank you. Our next question comes from Guy Moszkowski. You may ask your question and please state your company name.

Guy Moszkowski - Merrill Lynch

Thanks. Merrill Lynch. Good morning. Some of your competitors have had fairly significant positive operating leverage driven really by merchant banking gains in some areas. Obviously that is a business that you are in, and you talked about new fundraising that you have done. Maybe you could give us a feeling for where you are in the cycle of harvesting gains from existing funds and what we might be able to think about under decent market conditions during 2007 there.

Christopher M. O'Meara

We are an investor in our own private equity funds, so we have about $2 billion in aggregate of the firm’s money invested in those funds, and those are coming up to maturity. We have been growing out that business over the past couple of years, making those investments, so those investments are along the stage of producing revenues, and we are seeing what I think is pretty consistent revenue generation on a quarter-by-quarter basis that is coming out of those funds. It may not be consistent from each fund, but when you have a diversified set of funds, and we do, we have real estate, merchant banking, LBO merchant banking, sort of middle market. We have venture capital. We have CDOs. We have MLPs and various other -- we have fund of funds, fund of private equity funds and various others.

We are seeing a diversified portfolio of assets producing revenues over the cycle. I think as we pick that up in conjunction with the continued growth of the equity base of the firm, we will see that gradually increase. But I think the revenues that we posted today for the quarter, the $70 million, is kind of in the range of what I would expect to get going forward.

Guy Moszkowski - Merrill Lynch

Okay, thanks for that. You did say one thing that was slightly counter-intuitive about how the commercial mortgage business appears to have weakened year over year and sequential quarters, even as the residential business actually is better. Maybe you could give us a little bit of color for what is going on in that market and why it produced that result.

Christopher M. O'Meara

Right. There are a couple of things going on inside of that. One is the commercial mortgage lending and securitization, which has held in quite strongly. The other piece is where we take principal positions, which are the minority of the business but always have been part of the business, in commercial opportunities, commercial real estate opportunities. The revenues generated from that business were down versus the periods that we are comparing to.

Guy Moszkowski - Merrill Lynch

That is just a matter of lumpiness and timing of realizations?

Christopher M. O'Meara

Yes, we believe so.

Guy Moszkowski - Merrill Lynch

Your net leverage, as you pointed out, is up about a multiple point from where it has run most of the year, about 14.5 times. You also mentioned that the VAR was up fairly meaningfully from last quarter. Overall, should we view that as a statement of your degree of level of confidence in some of your trading opportunities over the next six to 12 months versus what it has been during most of this year?

Christopher M. O'Meara

I think on the leverage point, the 14.5 times net leverage is modestly higher than what we have been setting as our target. That really has to do with the -- the increase in that is in liquid assets. That really has to do with us building out our prime brokerage business, where we have margin lending, well-protected margin lending to our clients and that is a user of net balance sheet. So it is a relatively low-risk part of what we do and it is just an eater of balance sheet. We believe we should not constrain ourselves around that business, because it is one of the low-risk businesses. Whether you take it in the form of a margin debit or the form of a securities borrowed or a reverse repo, we think about them similarly. I think there is sort of a technicality there.

I would not say that we have changed how we are operating the business by looking at that statistic.

Guy Moszkowski - Merrill Lynch

So it really is not reflective of the same thing that is going on in the increase of the VAR?

Christopher M. O'Meara

No, and when you look at the increase of the VAR, I think we have run quite a low VAR over time and we do see opportunities here as we get into more businesses. We think that certainly our equity base can support a VAR of what we have posted here, and probably some more. So we do believe we still have some excess equity available in the system to continue to put to work.

Guy Moszkowski - Merrill Lynch

Thanks very much, Chris.


Thank you. Our next question comes from William Tanona. You may ask your question and please state your company name.

William Tanona - Goldman Sachs

Goldman Sachs. Just a couple of quick questions. I think first, you guys obviously keep highlighting international mortgage opportunities. Could you give us a sense as to what percentage of your mortgage business now is derived from outside the U.S. versus in the U.S.?

Christopher M. O'Meara

It is becoming an increasing percentage. We do not disclose that. We think about our mortgage business or our securitization business as being very broad. So as I mentioned, with the Japan build out, we are seeing that start to get up and get some traction. Korea has gotten very good traction very quickly. Haven’t done any securitizations yet there, but expect to.

As you know, we have built out our U.K. mortgage platform and we now have a platform in the Netherlands. The other points I mentioned is outside of residential mortgages, where we have a student loan operator now. We are acquiring this company, Capital Crossing, that is in the small business finance or commercial finance area. We also have an operator out in California, Lehman Small Business Finance, that we have had for a while that is ramping up -- all of those businesses are growing and are going to be providing lift for us in the securitization business.

Without giving you specifics around what is outside the U.S., recognize that it is a growing proportion of what we do and we intend to keep growing.

William Tanona - Goldman Sachs

Thanks. If I look at the revenues that you guys generated all year, you have been pretty consistent across all four quarters. But if I look at some of the non-comp expenses, we have seen some pretty significant ramp-ups from say the first quarter to fourth quarter. You have more or less seen your operating leverage not increase as dramatically as we have seen in past years. Is that significantly a part of the build-up that you guys are trying to attempt to do outside of the U.S., or is there something else going on there? How should we think about that going forward?

Christopher M. O'Meara

I think there are two pieces to that. One is when you are building in places that you do not exist already, so whether it is in India or in a business that you are not in, for example, energy for us, where we have been building those businesses. It is not just adding scale to an existing infrastructure. You have to rebuild an infrastructure to some extent.

So it is partly that and it is partly the headcount growth that we have experienced over the course of this year, seeing all of the great opportunities that we see in our business model. We did undertake to invest a significant amount. I mentioned in the remarks that our investment program that we had in 2006 was not something that we stopped after the first four or five months. We continued to invest in new opportunities and adding people on to the platform right throughout the whole year.

When we look out for non-comp expenses, I do think as we look forward and we see in 2007, our expectation is to continue to add talent into this organization, so we would expect our headcount to grow again in 2007. So if you look at the non-personnel expense total in the quarter of $809 million, I think that is sort of our starting point. If you just took that and said that is the starting point from which we expect to use that as a base of expenses, and then we are going to grow our headcount, and with that additional headcount, we will be seeing additional non-comp expenses coming into the system, because whether it is technology or additional occupancy, we will be seeing all of that coming in -- recruiting, training, all of the things that make it go.

We do expect to get operating leverage from it, but in situations in which we are building in places where we are not, we are going to have to put that infrastructure in place before we are able to realize operating leverage.

William Tanona - Goldman Sachs

That is very helpful. Lastly, in terms of prime brokerage, I know you guys had put out an initiative for a lot of your middle market sales force, to try to incent them to go after the prime brokerage business for you. Would you say that a lot of your growth in prime brokerage is coming from the smaller, mid-tier accounts? Or have you won any kind of major mandates on that front? How has the success of that program been for the middle markets effort?

Christopher M. O'Meara

It has been terrifically successful across the board, so it is not limited to small firms or middle firms. It is really across the board. Also, it is across regions, so when we think about prime brokerage, we may tend to think about the U.S., but this offering exists in Europe and Asia. When you think about the percentage growth in balances that we have experienced, we have actually experienced percentage wise a higher level of growth in the more recent period outside the U.S. than inside the U.S. So it is really across both regions and across hedge fund types.

William Tanona - Goldman Sachs

Great, thanks.


Thank you. Glenn Schorr, you may ask your question and please state your company name.

Glenn Schorr - UBS

UBS. Just on the allowance and derivative land, have you moved away from 02-3, early adopter on FAS-156? Was it a contributor in the quarter or the year?

Christopher M. O'Meara

The FAS-157, we likely will be adopting it, it is a first quarter event for this year, so the 02-3 paradigm has come out of play with the beginning of this year. We are on the new program, so 02-3 is not going to be in effect in 2007 and going forward.

Glenn Schorr - UBS

Does that mean anything that was in that allowance or unrealized bucket would flow through in the first quarter of ’07?

Christopher M. O'Meara


Glenn Schorr - UBS

Has it been much of a contributor in terms of realizing gains this quarter or throughout the year as you approach that deadline?

Christopher M. O'Meara

No, I think as you look at what that standard calls for is that you need to have observable inputs around market data in order to recognize revenue and so, consistent with that standard, there are some items that just did not meet that threshold. As a result, there will be some amount of revenue that gets taken into opening retained earnings for the firm in the first quarter, but that amount, I would not view that as being a highly material amount. But that is a positive to opening retained earnings in 2007.

Glenn Schorr - UBS

I heard you mention the higher leverage ratio in your remarks, but was there an explanation or is that just taking advantage of opportunities in the market?

Christopher M. O'Meara

It is really around the prime brokerage business, and it is, you will see the balance sheet at some point, it is the increases in our assets are in liquid instruments, be they global, governments and agencies, or the margin debits associated with the growth of our prime brokerage business. So it is low risk, highly liquid assets that are growing.

Glenn Schorr - UBS

Then, I believe Lehman has upped the equity component for people of MD level and above this year. I happen -- easy for me to say as an outsider -- I happen to like it and I think it is what has worked well for Lehman over time, as employees are empowered. But I am curious to ask why the change now? It was kind of big already. Is there an accounting benefit? Does that help you grow as you attract new people?

Christopher M. O'Meara

Well, we have always had a culture of ownership. As you know, the firm, the employees in the firm own about 30% of the equity equivalence in the firm. We agree with you that we have seen that as a powerful aligner of the interest of the employees with the shareholders.

We have toggled between -- I don’t want to give you the percentages, but we have changed the percentages of equity that we have given in people’s pay over time. This year, we ticked it up a bit but I would not consider that a real significant item.

Glenn Schorr - UBS

Okay, thanks very much, Chris.


Thank you. Our next question is from Mike Mayo. You may ask your question and please state your company name.

Michael Mayo - Prudential Equity Group

Prudential Equity Group. How much do you have in all-in investment spending? We see the non-comp expenses, but some of these people you are hiring very strategically. How does that total investment spending figure compare to say a quarter or a year ago?

Christopher M. O'Meara

Well, we do not disclose the total amount, but I will tell you that the amount that was invested in 2006 is our highest ever, and it is up from what we had in 2005 and all periods before.

Michael Mayo - Prudential Equity Group

Is it self-funding now? If not, when do you expect it to be self-funding?

Christopher M. O'Meara

Well, on that point, over time, as we grow out these new areas that we are growing out and bring those up to maturity, then we would expect that to be self-funding and as a result of that, over the long term we would expect to get some operating leverage out of the comp line. That is something that is obviously something we are watching constantly. We are making decisions along the way, along the course of the year around the investment, but it is something that over time, we would expect to have the opportunity to get operating leverage from the comp line.

Michael Mayo - Prudential Equity Group

If you think of investment spending along the shape of a U, are you still at the bottom point of that? You are not benefiting a whole lot yet?

Christopher M. O'Meara

I would characterize that, Mike, as it really depends on what it is you are investing in. There are certain investments that pay off more quickly, and we have a mixture of those that pay off more quickly, where you are hiring sales people who come in with clients, bankers obviously take longer, and new region or new product build-outs take even longer.

I would think that each year you look out, you want to get the returns. We track and monitor and make sure we are getting the returns from the investments that we are making, but then we make the next series of decisions around growth for the future. In 2006, we saw great opportunities and we were able to attract great players onto the platform.

Michael Mayo - Prudential Equity Group

How much of the investment spending is outside the U.S.? What percentage?

Christopher M. O'Meara

A very healthy percentage. We had a disproportionate amount. If you think about 2006, we had a disproportionate amount of our investment spending in Asia, so Asia had the highest percentage of, relative to their size, additional spending that went into that system.

The outside the U.S. in aggregate was greater than inside the U.S. on an absolute basis. We are growing outside the U.S. in different products within our existing footprint and then adding to the footprint, both in geographies, for example, in India, and also in new products, as I mentioned energy, where our energy build-out is not just a U.S. business for us. We have that in each of our three regions.

Michael Mayo - Prudential Equity Group

Of the 13% increase in headcount year over year, how much of that was outside the U.S.? Is that also more than the U.S.? How much more?

Christopher M. O'Meara

Yes, outside the U.S. -- let’s say it this way. Outside the U.S. was double-digits and inside the U.S. was single-digits.

Michael Mayo - Prudential Equity Group

I guess this all leads to a question about the margin. Does this all mean that your margin outside the U.S. is quite a bit less than what you have in the U.S.?

Christopher M. O'Meara

We do not disclose that particularly but that is a safe assumption, but it is something that is, what we view as a temporary phenomenon just because of the investment spending. You can almost sort of see that. If you carve that out, you see terrific profitability. If you add that in, and you still see very good profitability outside the U.S., but it is a little lower than in the U.S.

Michael Mayo - Prudential Equity Group

You expect that to get back up what, in like a year or two?

Christopher M. O'Meara

Yes, I would say as time ticks on here, we are going to continue a pretty significant investment program in Asia this year. We will continue to build out Europe, so as we look forward into the future, I think the back-end of what you said feels right.

Michael Mayo - Prudential Equity Group

Lastly, for all this investment spending, more headcount growth outside, more investment spending, the non-U.S. revenues did not do well this quarter, at least. What has happened this quarter?

Christopher M. O'Meara

Yes, Europe revenues were a record, so we had very good performance in Europe, and the Asia build-out, where we are really trying to adapt our business model to be more of a client-centric business model versus an opportunistic business model that we have had in the past, that was not a full service client model. That is something that we have been working on for the past couple of years and we will continue to make those investments.

The Asia performance was lower than it has been, but I do think that there is a little lumpiness in it. I do not think that is indicative of how it is going to operate looking forward.

Michael Mayo - Prudential Equity Group

Thank you.


Thank you. We have time for only one more question. Douglas Sipkin, you may ask your question and please state your company name.

Douglas Sipkin - Wachovia Securities

Thank you. Good morning, Chris. Just a question on your guidance for fixed income origination. Just hearing your comments about the amount of untapped cash that the private equity sponsors still have and your prospects for, forecast for 20% M&A. Doesn’t it seem like fixed income origination will probably be higher this year? Is there an element of conservatism in that forecast, or is there something else that I am missing?

Christopher M. O'Meara

That is a great point. We would say it is going to be in the range of the aggregate amount of debt that was issued this year, but our folks who look at that say it really does depend on the level of M&A, and if that M&A number is higher, than that debt financing would be higher as well.

Douglas Sipkin - Wachovia Securities

Okay, terrific. Thanks a lot.

Christopher M. O'Meara

Thank you. I guess we are wrapping up. Thanks again for joining us today, everybody. We look forward to speaking with you next year and we wish you a happy holiday season. Take care.


Thank you. This concludes today’s conference. Thank you for participating. You may disconnect at this time.

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