Sometimes Hedging Isn't Enough (LEH, MER)

By Dean Lundell | September 29, 2007 AAA

Lehman Brothers Holdings (NYSE:LEH) recently surprised the street by beating the consensus estimate of $1.47 by coming in with $1.54 for the firm's third quarter. Lehman's ability to produce that kind of result with these kinds of market conditions is a real tribute to the firm. The surprise results were mainly attributable to three items - controlling expenses, tax rates and managing its hedges.

Morgan Stanley (NYSE:MS) also came out with new quarterly numbers, and it also managed its hedges. However, Morgan Stanley failed to manage its other expenses and it failed to meet expectations. Read on as we examine two major investment banks that have very different results because of their ability or inability to manage basic expenses. (For related reading, check out Surprising Earnings Results.)

Lehman Bros - The Hedges Worked
For the third quarter ended August 31, LEH had net income of $887 million, which was off from the $916 million seen in last year's third quarter and down from the $1.3 billion the firm earned in the second quarter.

For the first nine months of fiscal 2007, LEH had net income of $3.3 billion or $5.71 per share which is up from the $3 billion and $5.09 per share the firm reported a year ago. It is worth noting that 53% of Lehman's revenue originated from outside the United States.

While its Capital Markets segment reported revenue of $2.4 billion for a 14% decrease from a year prior, the Fixed-Income Capital Markets portion of the segment had net revenue of $1.1 billion, down roughly 47% from just a year ago. There were a multitude of problem areas in fixed-income - lower performance from credit and securitized products and substantial marked-to-market reductions in valuations in leveraged loan commitments and residential mortgage-related positions.

The "good" news is that the losses amounted to only about $700 million - it would have been much worse if not for the firm's hedge positions.

The rest of the company's operations did pretty well. The Equity Capital Markets portion contributed $1.4 billion for an increase of 64%, driven by both cash and derivatives. The firm's Investment Banking segment generated $1.1 billion for an increase of 48% and its advisory services more than doubled to $425 million and both equity and debt origination contributed roughly $300 million each.

The firm did an excellent job of controlling non-interest expenses by reducing them to $3.1 billion from $3.6 in the prior quarter, while non-personnel expenses rose incrementally to $979 million from $915 in the second quarter. For the third quarter, Lehman's return on average equity was 17.1% versus 21% in the same quarter of the prior year. (To learn more, see Understanding The Income Statement and Analyzing A Bank's Financial Statements.)

Morgan Stanley - Expense Control Failure
Meanwhile, Morgan Stanley missed the third quarter consensus estimate of $1.54 per share by turning in $1.38. While writing down about $940 million in non-investment grade loan positions and commitments, the damage would have been much worse if not for the hedges the firm employed.

For the third quarter ended August 31, Morgan Stanley reported operating income of $1.48 billion, a 7% decrease from the same period a year ago, but revenues for this quarter were actually up about 13% versus a year ago to $8 billion. The first nine months stood in contrast to the third quarter, with income from operations clocked at a record $6.15 billion, a 41% increase from the prior year. Revenues rose 29% to a record $28.5 billion but non-interest expenses also rose 24% to $19.2 billion.

The firm's Institutional Securities segment contributed an impressive $5 billion in revenue, while its Investment Banking segment saw revenues increase 45% from Q3 2006 to $1.4 billion and continues to have a full pipeline of deals. Its equity sales and trading operations saw net revenues increase by 16% to $1.8 billion, with record results in Derivatives and Prime Brokerage but there were some significant trading losses in quantitative strategies. Meanwhile, the Fixed-Income segment's revenue decreased about 3% to $2.2 billion, as revenues from lower credit products were offset to an extent by gains in interest-rate and currency products.

Morgan Stanley for nine months has a return on equity of 25.5% and that includes a 17.2% rate for the third quarter. The firm's capital stands at $187.5 billion and so far this year has repurchased 42 million shares.

Managing Everything
It is very clear that while hedges can go a long way to limiting damage, that in itself is not enough. One has to keep those expenses in check. To me, this explains why Lehman Brothers was able to beat estimates, while Morgan Stanley was not.

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