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Lehman: A Bank In Bondage


Lehman Brothers Inc.'s () third-quarter earnings took Wall Street's breath away. The 74% surge in net income, on a 47% jump in revenues, trounced the estimates of analysts, who declared that Lehman's "exceptional" performance "knocked the lights out." The bank's shares were already riding high: The stock's 34% rise so far this year is twice that of its peers, and its price-to-book ratio rivals that of premier player Goldman, Sachs & Co. (). In fact, the 155-year-old Lehman, long dismissed as merely a bond shop, increasingly finds itself mentioned alongside Goldman as a member of investment banking's "bulge bracket."

But is Lehman really ready for this elite club? Despite its recent moves to grow and diversify, the bank still has some notable voids in its business mix and global presence that it must fill to play in the top ranks. The biggest weakness: Lehman still gets 58% of its revenue -- and, analysts say, 70% of pretax profits -- from issuing and trading bonds. That's down from 63% of revenues in the prior quarter, but it still leaves Lehman as the Wall Street firm most dependent on fixed-income business. Investors are calling for bold moves to expand the equity side of the ledger. "I still see a Lehman that is more dependent on mortgage and credit trading," says managing director Jeff Harte of Sandler O'Neill & Partners LLP, who downgraded Lehman's shares from "buy" to "hold" just before its robust earnings news.

The five-year bull run in bonds was good to Lehman. But now the bank could be vulnerable if rising interest rates scotch debt issuance and trading. "If credit spreads and bond volatility get to a more normal level, Lehman could see very little earnings growth next year," says analyst Michael Hecht of Banc of America Securities (). Indeed, one of Lehman's bond-business rivals, Bear Stearns & Co. (), saw its shares sell off after it announced a slip in fixed-income revenue on Sept 15.

Recognizing the risks, Lehman took advantage of Wall Street's doldrums to hire bankers and make acquisitions, such as the 2003 purchase of mutual-fund manager Neuberger Berman LLC. Its workforce has grown 68% since 2001. "They've had the guts to expand their footprint -- and it really did pay off," says Merrill Lynch & Co. () analyst Guy Moszkowski. Lehman's beefed-up banking team had a hand in such recent megamergers as Sprint's () takeover of Nextel and Chevron Corp.'s () successful quest for Unocal. That clout has paid off in other ways: Equity-capital markets revenue doubled, to $637 million, in the latest period.

But Lehman is playing catch-up -- especially in equity prime brokerage, which caters to the exploding hedge-fund industry. While Goldman, Morgan Stanley (), and Bear Stearns are brokers of first choice for the biggest funds and institutions, Lehman remains a fallback option. "We were a little late to the class," admits Chief Administrative Officer Dave Goldfarb. Hecht puts it more bluntly: "They are nowhere near the top players."

Lehman also comes up short in Asia. The firm captured less than 1% of the Asian-Pacific investment-banking market last year, ranking Lehman a dismal 32nd in debt underwriting and 17th in equity underwriting, according to Dealogic. And it has just 25 bankers in China, where the likes of Citigroup () and UBS dominate.

BEIJING BEACHHEADS

Analyst Moszkowski estimates that Asia will produce a third of Wall Street's revenue growth during the next decade. But the barriers to entry are high, as Lehman learned when its recent aggressive push to fund a broadcasting deal prompted an outcry from Japan's politicians and news media. China is even trickier: Morgan Stanley () and Goldman spent years establishing beachheads for their brokers, traders, and bankers. Lehman's China campaign has been far less ambitious. "Our strategy has been viewing China primarily as an investment-banking opportunity," says Goldfarb, noting that the firm has a "relatively lean" group of bankers in China. "We're constantly evaluating the scaling and sizing of our effort there."

Some investors want to see more. James Ellman of Seacliff Capital, a San Francisco financial-services hedge fund that owns Lehman shares, is keen to see Lehman enter a joint venture with an established Chinese investment bank. That, he argues, would give Lehman entr?e to privatization deals and the continuing expansion of China's equity markets. Following the Neuberger Berman purchase -- which helped catapult Lehman's assets under management from $9 billion in 2002 to nearly $160 billion today -- Ellman favors acquiring overseas asset managers. At home, he wants the firm to get aggressively in front of "megasize" prime-brokerage clients. "Almost anything that would reduce Lehman's fixed-income exposure would impress the Street," says Ellman.

Goldfarb says Lehman won't be rushed. "We're not going to compromise our superior economics to do an acquisition for the sake of acquisition," he says. Given Lehman's strength in emerging from a brutal market shakeout, the firm's managers earned the right to follow their own course. But to play in the bulge bracket, Lehman still has some growing to do.

By Roben Farzad in New York, with Brian Bremner in Hong Kong


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