Merrill Remains In The Media Glare

This seems to be the unofficial Merrill Lynch/Stan O'Neal week in business media. The attention just won't stop.

First it was the $5B of CDO writedowns early this month. Then last week's disclosure of another $3B worth of losses. Then the weekend's rumors of Merrill CEO Stan O'Neal's imminent firing.

Now, we learn from one of the several Wall Street Journal articles about Merrill and O'Neal this morning, that he retired from Merrill. He wasn't fired.

Thanks for the hair-splitting distinction. Yet another reason for Merrill board members to either resign, change their names, or do anything else to hide their identities as this pathetic example of corporate governance continues at the stricken financial services giant.

The back page of today's Journal, C14, contains this line from the breakingviews.com fluff,

"Directors can rectify that when naming a successor with a more tightly-worded employment contract- one that actually penalizes the boss financially if the firm posts losses."

That's comforting to read. It echoes my own thoughts in this post, yesterday,

"However, as I watched CNBC report on the two-day long travail at Merrill, while the board ostensibly negotiated with O'Neal on some sort of monetary compromise that would allow the former to appear to be prudent trustees of their shareholders' interests, another idea occurred to me.

Why didn't Merrill's board, and, for that matter, the board of any publicly-held, financial services sector company, require a new CEO to sign an agreement which states performance and event conditions under which the CEO is eligible to lose all but an agreed minimum amount of money if s/he is dismissed from, or resigns, the CEO post?

Honestly, this seems like a pretty obvious clause, now that I see how badly O'Neal damaged Merrill. Think about that.

The truth is, the nature of financial service firms is such that a CEO, or, as I've written recently, here, any senior executive, can play the 'heads I win, tails you lose' game all too easily by risking the shareholders' equity.

In this regard, financial service companies are a bit different than those in most other sectors. Pumping growth at a financial services firm often leads to simply taking more risk.

In order to help a CEO own the responsibility for not allowing this to happen, why not simply make all deferred CEO compensation over an amount with which the board would not be embarrassed to have a loss-inducing CEO leave, subject to revocation and loss, in the event of certain conditions.

These conditions could include the occurrence of loss, as reported on financial statements, exceeding, either annually or cumulatively, a stated amount. Or perhaps a percentage decline in total return, adjusted for the S&P500 Index.

By making a new CEO aware that extreme losses and failure would not result in loss of the post with substantial financial rewards, such a candidate would probably be more cautious when running the company."

So the Journal's piece reinforced my own idea, but with none of the detailed thought my post provided. I think I'm on to something. As I said to my partner at lunch today,

"How long will it be before we read that Heidrich & Struggles has advised Morgan Stanley or Lehman to add such a clause into their new CEO's employment contract?"

Of course, there's much speculation on who will succeed Stan O'Neal as Merrill's CEO. By now, it's pretty clear that Larry Fink passed on the privilege of trying to run Merrill.

I've pasted the Yahoo-sourced five-year chart of Merrill's and the S&P500's prices nearby. It's clear that Merrill has barely outperformed the index over the entire period, and only briefly outpaced it, in late 2003 and parts of 2006. Then it began falling in the early months of this year. You can see by optical inspection that just in the price series alone, never mind the total returns, Merrill's stock has had quite a bit more volatility over the period, for not much more return than the S&P.

As my partner and I discussed the Merrill situation, I offered this analysis. Were I to be invited to a Merrill board meeting to review the company's options, I would offer this recommendation:

It's time to break Merrill up, return what cash or equity can be gained for a sale of the parts to the shareholders. Quite simply, Merrill no longer needs to exist, in an economic sense.

Question: What is the (one) innovation for which Merrill Lynch is most famous, when did it occur, and who chaired the firm when it occurred?

I won't divulge the answer right away. It's at the end of this post. However, let me give you a clue- it's been quite some time since this event.

And that is sort of my point. Merrill hasn't been consistently superior to the Index for a long time.

As the nearby Yahoo-sourced price chart of the S&P500 Index and Merrill since 1977 depicts, Merrill has outperformed the index, but fitfully so. Merrill lost all its advantage from 1977 to about 1991. Then, if you draw a line along the bottoms of the troughs in Merrill's stock price, you see that its effective rise over the index was much less steep than it appears for the 1990s. It gave back quite a bit in 1998, and then in the early years of this decade.

As we used to do back at AT&T when assessing the attractiveness of our businesses, and Warren Buffett similarly approaches investments, ask yourself the following question:

"If someone left me $20B, would I start a Merrill Lynch from scratch now?"

Doubtful. Merrill is the only remaining independent retail 'wire house,' or brokerage firm, from before the Big Bang. Shearson, Paine Webber, Bache, Dean Witter, EF Hutton, are all gone. Merged, consumed by banks, or defunct.

It's a fair question to ask just what unique value or skill set Merrill now possesses. It bought its investment banking parts, and they remain second-rate, compared to the 'white shoe' firms.

I don't know of anyone who has an active Merrill retail account who isn't basically old or unsophisticated. It's not a growth market.

Here's another perspective. Stan O'Neal began to pump his fixed income group for growth soon after rising to the top of Merrill. He behaved dismissively toward the brokerage head, McCann, while replacing the existing bond executives and growing that business.

Why? We have to assume that O'Neal believed that the necessary growth would not come from Merrill's vaunted retail brokerage corps. Instead, he felt obliged to undertake a riskier strategy involving origination, securitization, trading and holding of increasingly-lower-quality mortgage securities.

If that doesn't tell you something about Merrill's supposed unique "strength," nothing will.

No, I think if I were advising the Merrill board now, I'd advocate selling the brokerage unit to one firm, and the capital markets piece to another. Perhaps spin the asset management unit back to shareholders as a standalone unit, from which BlackRock could buy the remaining 49%, if it so chose.

And, finally, we come to the page 2 Wall Street Journal article entitled, "Is There a Second Act for O'Neal After Merrill?"

George Anders begins his column by comparing O'Neal to Abraham Lincoln and Richard Nixon.

That's an insult to the two former Presidents.

Lincoln only lost a Senate race. He didn't blow out a major company, nor hold and lose a major office.

Nixon was an accomplished foreign policy wizard and political survivor before his fall from grace. He merely waited, plying his foreign policy craft, for time to pass and his credentials to bring him back out of disfavor.

Even Bob Nardelli, whom Anders mentions, only failed to profitably grow Home Depot. He didn't seriously torpedo the place with billion dollar losses. And Nardelli is credited with actually creating value at GE for years prior to that.

Stan O'Neal seems, from the reports I've read, to have been mostly a politically astute executive who accomplished more by adroit maneuver at Merrill than he did by stellar solo performance. Other than a few brief years of profit growth, now tarnished by the ensuing risk and losses of that growth, there hasn't been a lot for people to point to in O'Neal's defense.

While Anders contends that it's just rich white males who merit a second chance, I don't think that's necessarily true, either. My own ex-CEO at Chase, Bill Butcher, never really rose again after being knifed by his lieutenant, Tom Labrecque, and tossed overboard for the LDC losses. Bill was given the American Enterprise Institute over which to notionally preside, but nobody ever accused him of being an especially insightful or standout businessman to start with. Good natured and well-intentioned? Sure. But at best, an organizational man of his era, more suited to administer a mature corporate loan business than provide vision to a large commercial bank during times of radical change.

Stan O'Neal reminds me of Butcher in that regard. Capable of administering internal businesses and climbing the Merrill ladder, but unequal to the task of leading the firm to consistently superior performance, once installed as CEO.

Even though he may have $160MM to bring to the table, I'm not sure O'Neal will find many offers to join private equity or hedge fund firms. More likely, he may just bankroll himself as a targeted private investor and shun the spotlight for a few years.

By the way, here's the answer to my earlier question regarding Merrill's innovation.

Answer: The Cash Management Account, or CMA, in 1978. Don Regan was chairman of Merrill Lynch at the time, just prior to his departure to serve as Ronald Reagan's Treasury Secretary.