Rising Profits Are Bound to Fall for Most I-Banks
Revenue composition will determine whose earnings are shaky or steady.
Many investment banks reported robust earnings during the last couple of quarters. Earnings outperformance was based on a tripod of contributors: a broad-based rally in asset prices, a partial recovery in investment banking revenues, and strong fixed-income trading revenues. Although these earnings weren't the result of accounting gimmicks, they are of questionable quality for other reasons and may prove transitory. We believe that the worst has already passed for investment banks in this cycle, but we also believe that most investment banks will likely stumble on their earnings before a sustainable earnings uptrend establishes itself.
Higher Revenues but also Earnings-Quality Issues
Investment banks' asset management and principal investment-related revenues have done well during the last couple of quarters, but the two revenue lines lead to different conclusions regarding future earnings. Asset management revenues are generally calculated as a percentage of assets under management, while principal investment revenues are generally the markup in the value of investments, and to an extent securities inventory, that an investment bank bought using its own capital. It's no mystery why these revenue lines did well as just a brief glance at the lineup of Morningstar indexes shows a year-to-date broad-based rally across asset classes. We believe earnings of investment banks with large asset management revenues as a percentage of their total, such as Lazard (LAZ), should fare relatively better than companies that may have received earning boosts from gains, such as Jefferies (JEF) and Greenhill (GHL). This is illustrated in the following tables.
Michael Wong does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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