Has Merrill Survived the Current Crisis? Analysts Weigh In

Several firms comment on Merrill Lynch (MER) after the company announced an $8.5 billion equity raise as well as a "substantial sale of U.S. ABS CDOs."

- Oppenheimer's Meredith Whitney notes this would reduce MER's CDO exposure by $11.1 billion. While MER has significantly diluted existing shareholders, they applaud this purging of assets as an attempt to cut its losses and focus on stabilizing its platform and righting the franchise towards growth. While MER's stock still sells at a premium to book value and is expensive in the firm's opinion, they believe the stock is getting closer to fairly valued levels as now the hardest work is behind the company.

- Deutsche Bank notes the move increases shares outstanding by an estimated 38% and reduces estimated run-rate EPS from $4/share to $2.80/share but also eliminates most of the worst vintage CDOs, gets cash up front from the monolines (vs. waiting 20-40 yrs.), and keeps book value around $22/share. DB is lowering their price target from $31 to $28 but keeping their Hold rating given an inexpensive valuation.

The good news is that the actual sales can give confidence that it is finally selling assets vs. merely marking them to market. Merrill is also getting ahead of others in getting money from the monolines.

They apply a target multiple of 1.2x to their 2009E book value of $23.

- Goldman Sachs thinks it was undoubtedly a bitter pill to swallow, but they believe management's decision to finally sell the majority of its ABS CDO portfolio and write off its monoline exposure was the right thing to do in order to move the firm forward. Nonetheless, these actions come at a very high cost to existing investors as outstanding shares increase by 38% under the "if converted" method (assuming no exercise of the over-allotment option). Although painful, the firm believes putting these issues largely behind it will better enable the firm to focus on existing business opportunities in the marketplace.

Merrill Lynch currently trades at 1.1x its pro forma if-converted book value of roughly $22. GSCO's new $28.50 six month price target assumes the stock will trade at 1.3x its pro forma if-converted book value in six months.

- Citigroup says that in their view the Merrill franchise has a tremendous amount of earnings power that can be unleashed over time through execution. While the real promise of the new management team at Merrill is the potential to unlock this earnings power, the legacy assets proved to be a year-long detour, but that is now behind it.

This is the first large-scale CDO transaction that is not a distressed sale. Industry participants will likely mark super-senior CDO assets with 2006 and 2007 vintage collateral down to the $0.22 range. Including the financing, Merrill took assets with a carrying value of $0.36 and wrote them down to $0.22, and transferred the risk of declines down to $0.17 to a 3rd party.

Reiterates Buy and $45 target (down from $65 due to dilution) as they expect the sale of highly illiquid mortgage related assets to be a catalyst to refocus on the earnings power of the Merrill franchise. The overhang that has plagued MER for over a year has finally been removed. Furthermore, the capital raised enhances the quality of Merrill's equity base by significantly reducing the preferred component in exchange for straight common equity. MER is trading at 1.1x book despite the credibility of book value being materially higher post reducing the CDO exposure.

Notablecalls: So that's why MER was schmeissed over the past couple of days. I think the stock will see a bounce on this. Trading around book value and around 10x FY09 estimates is where people will likely come in to buy the common.

It's all about survival these days and it looks like MER has made it.

The only downside to the story can now come from earnings. Let's face it - we don't know what MER's real earnings power is.

Comments

[Charlie Str...:]

Both U.S. stock market history and a study have already demonstrated multiple times that forward looking P/E ratios are not useful (which is why I prefer to look at trailing 12 month P/E ratios), and thus MER trading around 10X FY09 estimates does not tell us much.

Disclosure: no position of any kind in MER.

2008 Jul 29 09:36 AM

[ubuy2w:]

What the heck did MER sell to Lone Star at deeply discounted prices. Was it a portfolio of mortgages on a bunch of crack house in Detroit. Even with 100% LTV and sub 500 fico scores a super senior tranche should realize. This must have been a whole bunch of seconds or some other similarly insane portfolio. Stan Oneil you should be ashamed.

2008 Jul 29 02:15 PM

[Kinabalu:]

I'd like to know more about that CDO sale. Super-senior CDOs at $0.22 sounds like a steal. Something does not compute.

2008 Jul 29 08:06 PM

[Maktub:]

If you consider that MER is providing 75% of the financing [retaining (indirectly) 75% percent of the risk associated with the $6.7B purchase price] the real sale price is $.0547 cents on the dollar.

2008 Jul 29 10:31 PM

[Kinabalu:]

After looking at the press release for this CDO sale the only thing clear is that MER is treading lightly on the details. They claim to be carrying $30 billion face amount of these "super senior" securities at $11 billion and selling them for $6.7 billion and taking a writeoff of the $4.4 difference. However they only get $1.7 billion in cash and finance the rest, secured only by the sold CDOs, for an entity with no assets other than the CDOs. Then they claim they reduce their risk exposure by the full $11 billion. To me this is as clear as a bell that the risk reduction is the $4.4 billion writeoff and the $1.7 billion cash for a total of $6.1 billion not $11 billion.

If MER's accountants go along with this the SEC should have two culprits to prosecute, if they could ever figure out what that means.

2008 Jul 29 11:19 PM

[fxtrader07:]

'This is the first large-scale CDO transaction that is not a distressed sale. ...Including the financing, Merrill took assets with a carrying value of $0.36 and wrote them down to $0.22, and transferred the risk of declines down to $0.17 to a 3rd party.'

WTF?? THAT is not a distressed sale??? Gimme a break!
Mer essentially throws away ANY upside after writing down 78% of the assets. In turn, they get some very expensive cash and reduce their remaining exposure by a meager 5% - from 22% to 17% of face value.
In essence, Merill sold the CDOs for 5 cents on the dollar - not 22!!

Imho this allows for but two plausible interpretations:

A) MER is So absolutely desperate in need of cash that it virtually buys 1.7bn in cash by the way of essentially throwing away assets worth at least 4-5 times as much, possibly more. Well. that should tell anyobody in what shape the company is
OR
B) MER actually knows already pretty well that these CDOs are exactly worth ZERO. so instead of losing the entire amount of 6.7 bn, they just lose 5 bn. If that were the case, it spells absoluite DESASTER for a couple of other wallstreet firms and commercial banks!

Given that MER is an established wallstreet house and that they tend to do very stupid risk taking at times, but would not throw away that much of money for a paltry 1.7bn cash, i think that B) is most likely the correct interpretation. If so, the recent July 'bottom' in banking stocks will prove a stemporary as all the others before.
Expect other banks and brokers to follow merill and trying to sell CDO assets for net 5 or 6 cents on the dollar before they get nothing at all from them.

2008 Jul 30 06:11 AM

[ubuy2w:]

I suspect you are right about MER I suspect that the CDO's sold were in fact a CDO created out of lower tranches of sub-prime mortgages basically a portfolio of subprime second mortgages. If this is in fact what was sold my comments about Stan Oneil are changed to you should be tarred and feathered. Any institution which has not wrote these assets to zero should have their mgmt. jailed and their auditors serve as cell mates.


On Jul 30 06:11 AM fxtrader07 wrote:

> 'This is the first large-scale CDO transaction that is not a distressed
> sale. ...Including the financing, Merrill took assets with a carrying
> value of $0.36 and wrote them down to $0.22, and transferred the
> risk of declines down to $0.17 to a 3rd party.'
>
> WTF?? THAT is not a distressed sale??? Gimme a break!
> Mer essentially throws away ANY upside after writing down 78% of
> the assets. In turn, they get some very expensive cash and reduce
> their remaining exposure by a meager 5% - from 22% to 17% of face
> value.
> In essence, Merill sold the CDOs for 5 cents on the dollar - not
> 22!!
>
> Imho this allows for but two plausible interpretations:
>
> A) MER is So absolutely desperate in need of cash that it virtually
> buys 1.7bn in cash by the way of essentially throwing away assets
> worth at least 4-5 times as much, possibly more. Well. that should
> tell anyobody in what shape the company is
> OR
> B) MER actually knows already pretty well that these CDOs are exactly
> worth ZERO. so instead of losing the entire amount of 6.7 bn, they
> just lose 5 bn. If that were the case, it spells absoluite DESASTER
> for a couple of other wallstreet firms and commercial banks!
>
> Given that MER is an established wallstreet house and that they tend
> to do very stupid risk taking at times, but would not throw away
> that much of money for a paltry 1.7bn cash, i think that B) is most
> likely the correct interpretation. If so, the recent July 'bottom'
> in banking stocks will prove a stemporary as all the others before.
>
> Expect other banks and brokers to follow merill and trying to sell
> CDO assets for net 5 or 6 cents on the dollar before they get nothing
> at all from them.
>
>

Feb 01 02:47 PM