| BUSINESSWEEK ONLINE : NOVEMBER 15, 1999 ISSUE | ||||||||
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| COVER STORY
Merrill's E-Battle At a secret site in Manhattan, the financial giant gets an overhaul as it girds for the Internet wars In the bowels of lower Manhattan, in a decidedly low-tech office building, a remarkable--and risky--project is under way. While Merrill Lynch & Co. (MER) has hinted about the project publicly, the venture's offices are top secret. A visitor is told not to disclose the exact location, or take notes, or look too closely at the flow charts posted on the walls. The creative buzz in the large, open room is palpable. The atmosphere is part Wall Street trading floor, part Internet startup. The sprawling space is crammed with rows of casually dressed men and women staring at computer screens. On the walls are blue mathematical symbols scrawled on whiteboards. Toys are scattered around the floor, including a tabletop hockey game and a golf putter. Hundreds of people have been laboring here since April on this project, which still lacks an official name: A sign taped to the wall offers $1,000 to whomever comes up with the best one. ''THEY'RE TOAST.'' The project is nothing less than Merrill's bid to get its mojo back. Like so many other financial services companies, Merrill is under siege from the Internet. The impact is battering its far-flung retail network and its global institutional operation, each of which accounts for about half of its earnings. In parts of its retail business, Merrill faces an 85% compression in its margins, far more than books, toys or computers: $30 and under trades are replacing full-service commissions at $200 a trade. Merrill's huge corporate division, as well as its competitors, are ''panicked,'' says Larry Tabb, director of TowerGroup Securities & Investment Research. The firms are being pounded by the rapid growth of electronic trading systems, which are forcing fundamental, structural changes in the markets. ''Their clients can buy and sell securities at almost the same price as the brokers, and they're not tied to the broker to get to market. It's a small step to [cutting out] the institutional broker. And once that happens, they're toast.'' To deal with this threat, Merrill is building an institutional portal, which is an array of Web sites for corporate clients. Much like a small investor with an E*Trade account, companies will be able to track their holdings and buy and sell a wide variety of stocks, bonds, futures, and options with the click of a mouse. The system is an electronic replica of Merrill's awesome global capital markets businesses, which have 17,000 employees and $6.5 billion in revenues. ''All the things we do, can and should be done electronically,'' says G. Kelly Martin, Merrill's head of global debt markets. ''We are changing the model globally of how an investment bank could run.'' Building an institutional portal is bold and ambitious. It could cannibalize Merrill's existing business. But the move could also give Merrill the fabled first-mover advantage in an important market. The strategy is everything that Merrill was not on the retail side of its business, where the proud firm earned an unwanted reputation as the case study for Internet anxiety by arriving at the online trading party more than two years late. On the retail side, Merrill is playing an aggressive game of catch-up. On Dec. 1, it will go head to head with online market leader Charles Schwab & Co. (SCH) with its launch of Merrill Lynch Direct. For the first time, Merrill will offer $29.95 online trading without a broker. While some of its thunder was stolen by a similar offering announced by Morgan Stanley Dean Witter on Oct. 21, Merrill Lynch Direct may be a big hit. Beyond this, the firm plans to build a major financial services portal. Merrill has little choice but to move aggressively. More than any other company in Corporate America, the brokerage Goliath is feeling the Internet's destructive force. Its raison d'etre as an intermediary, pairing buyers and sellers, is being powerfully challenged. Online equity trading by individuals has jumped from 20% at yearend 1998 to an expected 49% at yearend 2000. ''The brokerage industry is absolutely feeling the pain more than any other industry,'' says Tabb. ''Merrill Lynch, being the largest, most diversified brokerage company, is feeling the brunt,'' says Merrill's new chief technology officer, John A. McKinley Jr. ''It's D-day. We're the first people out of the landing craft.'' The stakes in this conflict are staggering. At risk is everything from the legacies and careers of Merrill's executives to the firm's ability to stay out of the arms of suitors such as Chase Manhattan Bank. At the heart of the battle is Merrill's fight to remain king of the financial hill. According to Harvard business school Professor Clayton M. Christensen, traditional companies such as Merrill are at a disadvantage when a disruptive technology like the Internet blasts through. ''Nobody has the resources of Merrill in the financial world,'' says Christensen, whose message was not lost on Merrill management, which met with him earlier this year. ''They could turn the world upside down,'' he says. But he also believes Merrill is ''swimming against a very strong current.'' Galvanized into action by a tech-driven stock market and its humiliating lapse in letting the competition jump ahead in the battle for the retail online market, Merrill is in the process of remaking itself. It is rethinking every one of its businesses, from research to brokerage to asset management. Says Jerome P. Kenney, Merrill's chief strategist: ''We concluded that the firm has to be converted to an Internet-based firm.'' Chief Executive David H. Komansky puts it a little differently: ''We will take the capabilities of Web technology and use it wherever we can to improve our business life.'' OUTSIDE HIRES. Merrill's strategy is to integrate its new online offering into its existing offline capabilities, its people and offices. To attract more customers, Merrill is trying to unlock the value of its analysts, bankers, traders, and brokers by translating their knowledge and experience into content that can be tapped online. Says Komansky: ''At some point in time, technology won't be the battle. Technology will become ubiquitous. Content will be the battleground.'' There's no question that Merrill is in hyperdrive. In the past year, it has reached outside the insular securities industry to hire: John A. McKinley Jr., from GE Capital, as its first chief technology officer (page 264); Michael B. Packer, who led Simon & Schuster's Internet push, to head Merrill's institutional portal effort; and James P. Gorman, from McKinsey & Co., as chief marketing officer. After years of getting slammed by online brokers' negative ads, Merrill is finally fighting back with its own ads plugging its brokers and its online offerings. Merrill is still paying the price for having an investment bank that trails its competitors in technology prowess. The company has done fewer hot tech IPOs and has no one to compare with Mary Meeker, Morgan Stanley's Internet guru. All of this affects its overall reputation. To expand its technology reach, Merrill is buying stakes in, and forming partnerships with, everyone from Microsoft Corp. to Massachusetts Institute of Technology (table, page 266). It is scrambling to find overseas partners to offer online trading in places such as Japan and Australia. It is not only building the institutional portal but making Merrill Lynch Direct a major financial portal to take on everyone from Charles Schwab to Yahoo! to Microsoft's MoneyCentral. It is getting into new areas, such as e-commerce. And it is dabbling in the media business with the launch of its Global Investor Network, an in-house video news service. But Merrill faces many daunting challenges. Schwab isn't Merrill's only competitive worry. Morgan Stanley Dean Witter's Oct. 21 rollout was formidable, an online account much like Merrill Lynch Direct. Merrill also has to radically realign its costs, because of lower margins. Retail commissions only make up 10% to 15% of Merrill's earnings. But the stock is depressed because of nervousness over potential earnings cannibalization at a time when many investors are paying $29.95 to trade online. Leadership is another concern. With the abrupt departure of President Herbert M. Allison Jr. in July, General Counsel Stephen L. Hammerman and Vice-Chairman John L. Steffens are helping Komansky with the top job. Longer term, it's unclear who will replace the 60-year-old Komansky. Finally, there's the firm's culture, perhaps the most difficult issue of all. Merrill must expunge its image as a Luddite firm. And it must change from a high-cost bureaucracy to a tech-savvy, change-friendly, flat organization that operates on razor-thin margins. If there was one moment when Merrill got religion, it was on Dec. 28, 1998, when Schwab's $25.5 billion market capitalization topped Merrill's $25.4 billion. By almost any other measure, Merrill, a global powerhouse, towers over Schwab (table). Merrill has $11.4 billion in equity vs. Schwab's $1.9 billion; Merrill has $1.5 trillion in assets under management, vs. Schwab's $600 billion; and Merrill has 66,000 employees, vs. Schwab's 17,400. But the market couldn't care less about Merrill's bulk: It judged that Schwab got the Internet and Merrill didn't. ''It ticked me off to a fare-thee-well,'' says Komansky. Adds one insider: ''That was about our manhood.'' Merrill was coming up short by another critical measure. Schwab was increasing assets by 39% in 1998, while Merrill's were growing by only 18%, according to Salomon Smith Barney analyst Guy Moszkowski. Merrill has preached the gospel of asset-gathering, or attracting a customer's assets to one institution, since 1984, when Vice-Chairman Steffens wrote a white paper on the subject. ''That's mother's milk around here,'' says an insider. The moment of truth came at a March meeting of Merrill's executive committee, the 18-man, one-woman committee that runs the firm. Steffens, who oversees Merrill's 17,000 brokers, made an eight-hour-long presentation. His pitch was that Merrill had to offer an online-only account or it would lose too many assets, not to mention the next generation of investors. ''This is the single biggest decision the firm has made,'' says Kenney. Why had Merrill waited so long? One explanation is that Merrill was isolated by its policy of eating its own cooking. Merrill, like other Wall Street firms, requires all of its employees to have their brokerage accounts exclusively with Merrill. The reason is, it's easier to track insider trading if employees can only trade with their employer. The downside was that ''they didn't know personally what was going on in the Net world,'' says one former employee. ''They missed the revolution. They were so disconnected from the zeitgeist of the country.'' BROKER ANGST. Komansky and Kenney say it would have been very difficult to act sooner. The firm had to wait until its brokers had accepted that the online world was here to stay. If Merrill had rolled out online trading in July, 1999, 75% of its brokers would not have supported it. And Merrill stood the risk of having brokers and the assets they manage walk out. Because of the bull market for brokers and the practice of Wall Street firms paying multimillion-dollar signing bonuses, a successful Merrill broker could--and would--change jobs in a heartbeat. That is why it was much harder for Merrill, with its 17,000 commissioned brokers, to embrace the Internet than for Schwab, with its 7,000 salaried brokers. The issue is degradation of earnings and how fast Merrill can go to online pricing without destroying its earnings and losing its sales force. Already, Merrill estimates that Merrill Lynch Direct will cost $1 billion in equity commissions. But Kenney is confident that loss will be more than offset by increased client assets. It would be a Pyrrhic victory for Merrill to hit a home run in low-cost online trading but lose thousands of its best brokers. ''That's the doomsday scenario,'' says a banker close to the company. ''The financial consultants get pissed off and go to other financial services firms or start up little firms.'' The reality is that a number of brokers are in a jam. Brokers can continue to earn their keep by offering good stock ideas or helping pick mutual funds or doing financial planning. Yet many are overpaid order-takers who are not really adding value or who are not Net-savvy. Thomas J. Dorsey, author of Thriving as a Broker in the 21st Century and a former Merrill broker, says that outside of a firm's products, ''an awful lot of brokers really have no value to add.'' Dorsey says these brokers will end up on the Internet service desk, a call center that provides general client support without the one-on-one client relationships that brokers have today. Yet other Merrill brokers believe the firm's new Internet prowess will get them closer to their customers. William J. Belanger Jr., a financial consultant in Merrill's Carmel (Calif.) office, says he functions as his clients' Internet partner, since 80% of his customers use Merrill Lynch Online. Out of 110 online trades done by his clients since June 1, Belanger has advised on all but five, he says. Clients call him about how to best use their points from their Merrill Visa card and how to fill out an online mortgage application from Merrill Lynch Credit Corp. ''This new environment is what it's all about. I suspect I'll have more business,'' he says. Steffens is working overtime to support the brokers. At a gathering of some 100 brokers at Merrill's San Francisco office in September, he said Merrill had no choice but to go online. He talked about General Motors Corp. in the 1960s to drive his point home. The car giant had assumed that consumers would not buy inexpensive Volkswagens or Toyotas. So GM kept making cars with big fins and big profit margins, in effect ignoring a big part of the market. Within years, GM closed 50 to 100 plants and 200,000 employees were fired, says Steffens. And until recently, GM was uncompetitive. ''I didn't want us to be in the same position,'' Steffens told the brokers. ''Telling these clients to go to someone else is not a good idea.'' Merrill's big day is Dec. 1, when the firm rolls out Merrill Lynch Direct (page 258). At least one analyst thinks Merrill has a home run. ''Even in the absence of a financial adviser, at $29.95, with access to the Merrill product suite of research, etc., the business is clearly a better value than Schwab's existing offering,'' says Sanford C. Bernstein analyst Steve Galbraith. To increase customer loyalty, Merrill has launched an elaborate e-commerce offering, unlike Schwab. Merrill has signed on 400 retailers from Barnes & Noble Inc. to eToys to sell through Merrill's portal. The firm wants its customers to do some of their spending via Merrill, ideally with their Merrill Visa signature cards. ''We are trying to build different mechanisms to be able to attract people to the portal--our clients predominantly--and to strengthen the overall relationship,'' says Komansky. DEMAND FOR DATA. And Merrill is also inching into the news business. Its Global Investor Network is hiring broadcast journalists to anchor news reports and do business segments. GIN broadcasts Merrill's morning call, where a group of Merrill analysts talk about the upcoming day--a meeting that used to be open only to institutional investors. Recently, Steve Milunovich came on to say he met with Hewlett-Packard Co. Chief Executive Carleton S. Fiorina and was upgrading the company. With no promotion, GIN is getting 7,000 hits a day, says Frederick Yager, director of broadcast services. His big problem is keeping up with demand for more news and getting it earlier. ''Clients tell me, 'How come we hear about it on CNBC? Why can't I hear it from you?''' asks Yager. The institutional side of the business is facing tremendous uncertainty as well. And the corporate business is far more competitive than the retail side. Many of Merrill's best clients, some 200 to 2,000 top companies, banks, and governments, are already linked electronically to Merrill, as well as to their other brokers. These big institutions can also pick up the phone for personal attention from Merrill traders and salespeople. They get far more access to Merrill research online than do retail clients. And electronic equity trading for institutions is growing fast. At yearend 1998, 26% was done electronically, with that number expected to rise to 44% by 2000. With such powerful clients pushing them, Merrill is buying stakes in the electronic crossing networks, such as Archipelago (table, page 266). This way, as more trading moves away from the New York Stock Exchange and Nasdaq to these electronic exchanges, Merrill will still be a player. It is also participating in multidealer systems, such as TradeWeb, where corporate clients can see Merrill's offerings, as well as those of its competitors. And through its institutional portal, clients can view Merrill's offerings only. Morgan Stanley Dean Witter and Goldman Sachs & Co. are also building institutional portals. ''But they're not as broad as Merrill's and they haven't created a skunk-works environment to destroy their own institution,'' says Tabb. The goal of Merrill's new portal is to expand the company's institutional accounts to some 20,000 middle-market corporations, well beyond its current 2,000 institutional clients. Merrill is not currently serving these companies because it's not cost-efficient to hire conventional salespeople and traders to do so. One major source of new clients could be overseas. Merrill's institutional portal might be popular in countries where corporations are used to using the Internet, such as Sweden and Japan. ''There's no reason why we shouldn't cover every medium to large institution in world,'' says Kelly. Merrill's new portal would enable a corporate treasurer to do most of his or her business with Merrill at one Web site, with one password. Right now, corporate clients deal with many different Merrill salespeople and bankers in each product area and have no centralized way of consolidating their positions and their exposures. ''We're looking to reshape how clients raise and manage money,'' says Michael B. Packer, who heads Merrill's institutional portal effort. It will also deeply affect how Merrill is organized. Right now, Merrill is a loose confederation of territories, from foreign exchange to municipal bonds. Each has its own managers, computer systems, and clients. By rationalizing the products and services on a single system, Merrill is doing what Amazon did to the book market: bringing consistency to a massive variety of individual products. Right now the institutional portal is largely vaporware. And building this system will be far harder than building a retail portal. Corporations make far larger trades and manage much bigger and more complicated portfolios. And while such a system might work in some liquid markets, in other, less liquid markets, electronic trading might flop. The institutional portal raises the same issue as Merrill Lynch Direct: Is Merrill willing to develop technology that could cannibalize its thriving offline role as a broker for big companies? Merrill did take the fairly aggressive step of setting up a separate unit with its own manager, Michael Packer, who has his own profit and loss statement. But Mother Merrill maintains control of the new unit by having Packer ultimately report up the chain of command to Thomas W. Davis, Merrill's head of investment banking and capital markets. SUCCESSION ISSUE. It is Davis' job to integrate the new into the old. For example, Merrill plans to continue doing IPOs the way it always has, but it will also offer clients the choice of an e-tranche, or having a portion of the stock distributed online, says Davis. Right now, Davis is one of four internal candidates vying for the job of president, all of whom are grappling with Internet issues. Jeffrey M. Peek, head of Merrill Lynch Asset Management, is figuring out how to use the Net to distribute Merrill mutual funds. Winthrop P. Smith Jr., who heads Merrill's overseas brokerage business, is busy launching Merrill Lynch Direct overseas. And E. Stanley O'Neal, chief financial officer, must oversee Merrill's continuing profitability in the face of the Internet's downward pressure on margins. Whoever succeeds Komansky will first have to succeed in integrating the Internet into the firm's business. Their collective success or failure will determine how powerful an institution Merrill will be going forward. Already, in October, Merrill's market cap topped Schwab's on seven days. ''This is the beginning of the story, and now we have to make it all work,'' says Komansky. ''A year from now, two years from now, we'll see what we really accomplished.'' By moving forward so aggressively on so many fronts, Merrill will have accomplished a lot. With luck, it might be enough to win this e-battle. By LEAH NATHANS SPIRO _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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 RELATED ITEMS Merrill's E-Battle COVER IMAGE: Inside Merrill TABLE: Merrill's Online Strategy...Has Many Pitfalls TABLE: Leaping into Cyberspace TABLE: Merrill's Web Presence TABLE: Merrill Towers over Schwab... CHART: ...But Schwab's Market Cap Tops Merrill's...And Schwab's Asset Growth Blows Merrill Away TABLE: A Slew of Partners The Architect of Merrill's Digital Future VIDEO: Q&A with John McKinley ``The Winds of Change Are upon Us'' (extended) ONLINE ORIGINAL: Online Brokerage Stocks: Is Their Time Coming Again? INTERACT E-Mail to Business Week Online | |||
