MARKET ISN’T BULLISH ON MERRILL, BUT IT OVERLOOKED ITS WRAP ACCOUNT PLAN: HOUSE SEES SHIFT TO FEES AS STABILIZING INCOME

The stock market did not take kindly to Merrill Lynch & Co.’s announcement the day after Memorial Day that it would offer cut-rate commissions to customers trading online. By week’s end, stock in the brokerage had plummeted 14%, and three top analysts had trimmed their 2000 earnings estimates for the company.

“I’ve never seen a more obvious example of a firm shooting itself in the foot,” says Michael Donofrio, an executive search consultant who places retail brokers.

Still, the conventional wisdom appears to have misunderstood both Merrill’s problems with Internet trading and its strategy. Its move into discounted Internet trading isn’t designed to stem a flight of customers but to capture business already in the hands of its new rivals. It also intends to use the the allure of Internet trading to switch customers to more lucrative flat-fee accounts.

“The customers who are primarily concerned with commission rates have long since migrated to the discount brokers,” observes Raphael Soifer, an analyst with Brown Brothers Harriman & Co.

To be sure, the $29.95 Merrill will charge for no-frills trading is seven or eight times less than what it now charges full-service clients. But the growth of Charles Schwab Corp., E*Trade Group Inc. and other discounters hasn’t come at the expense of full-service firms.

Merrill picked up $9 billion in new brokerage assets during the first quarter of 1999. Another big full-service securities firm, Paine Webber Group Inc., is now taking in $180 million a day in new assets, vs. $30 million a day three years ago.

two-pronged approach

So while Merrill seeks more assets by taking on discounters, it also believes its other initiative could produce more, not less revenue.

On the same day it unveiled the controversial $29.95 commissions for no-frills Web trades, Merrill also announced plans for a new full-service wrap account.

The new account will offer free online trading for an annual fee of up to 1% on stock holdings and 0.3% on cash and bonds. Merrill brokerage chief John L. Steffans has told analysts he expects 30% of commission-paying clients to switch to the new fee-based account by the end of 2001. Two existing wrap accounts, which will be replaced, today account for only 2% of customers.

Right now, the traditional Merrill account produces annual commission revenue equivalent to 0.6% of assets, according to Guy Moszkowski, a stock analyst with Salomon Smith Barney Inc. That means a client with a $200,000 account is typically paying Merrill $1,200 a year in commissions.

On the same portfolio, Merrill’s new flat-fee account will generate revenues equivalent to 0.72% of assets, or $1,440 on a $200,000 account, a 20% increase.

“From Merrill Lynch’s viewpoint, the service package locks the client in, converts commissions to fees, and may even increase revenue relative to traditional trading,” says a recent report by Mr. Moszkowski.

Fee-based accounts generate revenue regardless of market conditions, whereas commission revenue falls off when the stock market declines. This is why publicly held mutual fund companies tend to trade at higher earnings multiples than brokerages. It is also why houses like Merrill and Paine Webber are so eager to move clients from commission-based to fee-based accounts.

“We want to make sure we offer the client the alternative that they want,” says Mark Sutton, head of Paine Webber’s brokerage unit. “But certainly we like it when clients choose to pay via the fee because fee-based revenue is more predictable.”

While every major firm has plans to offer online trading to wrap customers, Merrill and Prudential Securities are the only major firms getting into the pure discount business by offering $29.95 trades. Advertising costs in the online sector have skyrocketed, even as profit margins have shrunk. The danger for Merrill is that Internet brokerage will draw resources away from more profitable businesses.

will brokers go or stay?

Merrill also runs the risk of alienating its brokers, some of whom believe Merrill is threatening their livelihood. Marten Hoekstra, one of Mr. Sutton’s deputies, demurs when asked if Paine Webber will attempt to poach Merrill brokers. Still, headhunters employed by Paine Webber and other major brokerages say they are already working the phones, and they expect Merrill to lose 20% of its sales force this year — twice the normal attrition rate.

“I have never seen so many Merrill brokers out looking,” says one recruiter. “A year ago I wouldn’t have even bothered calling a Merrill broker, but now I’ve got meetings set up with 10 people — all of them top producers.”

That said, Merrill can withstand broker defections better than most. New brokers must sign non-compete agreements that make it extremely difficult to take clients to a new firm. Plus, when a veteran broker defects, Merrill typically retains 60% of his accounts, which is three times the industry average.

“Of all the firms on the face of the earth, Merrill is the only place where you will consistently see clients maintain a relationship even after the broker has left,” says Mr. Donofrio, the headhunter. “People just like to do business with Merrill Lynch.”