As Salomon Stock Surges With Bond Rally, Prospect of Profit Is Humbler Than in Heyday
May. 26, 1995
Has Salomon Inc., the battered bond powerhouse, finally turned the corner?
That's what Wall Street is betting on. In the past month, Salomon's stock has zoomed 17 percent as investors have snapped up shares amid a big bond-market boom. Salomon's gains have far eclipsed the 8 percent rise in brokerage stocks and the 2.6 percent jump in the Dow Jones Industrial Average during that time.
The recent rally in Treasurys has helped Salomon, no doubt. Salomon lives and dies trading bonds. But the rationale for the big price jump is that with Salomon's steep leverage and the Street's biggest bond inventory, the firm must be minting money. Indeed, during the 1993 bond-market boom, Salomon earned a record $827 million.
But those who have rushed in may be in for a shock. People at Salomon say the firm isn't likely to rack up the eye-popping profits investors are accustomed to during good times. That's because the firm has pared its inventory and is taking far less risk than it once had.
``If the earnings aren't likely to be as exciting as in the past because the firm is taking less risk, profitability is going to be lower and valuation is not going to be as high,'' says David Dreman of Dreman Value Management, Jersey City, N.J., which manages $1.6 billion and whose funds own a small Salomon stake.
Everyone agrees it's been rough sailing for Salomon this past year. Stung by a sudden rise in interest rates and embarrassing trading gaffes, Salomon posted its first ever annual loss in 1994. Morale hit rock-bottom after management unveiled a pay plan that would cut the base pay of Salomon executives by as much as 65 percent. The move sparked the defection of more than two dozen Salomon bankers and traders.
Though Salomon insiders say management still faces several problems, including devising a more palatable pay plan, investors are more focused on the bond-market bang.
There is one wild card: Salomon's prospects as a takeover candidate. The talk on Wall Street recently is that Salomon is attracting suitors as varied as Germany's Deutsche Bank and insurance giant American International Group.
Maurice Greenberg, AIG's chairman, says the rumors of his firm making an investment in Salomon are unfounded. Spokesmen for Deutsche Bank and Salomon won't comment.
Some Salomon investors believe Deutsche Bank and Salomon would make a powerful fit. Deutsche Bank's triple-A credit rating would be a boon to Salomon, enabling the big bond-trading firm to lower its funding costs by hundreds of millions of dollars. That's important now, because Salomon's senior-debt rating has been downgraded to Baa-1 from single-A-3, adding as much as $50 million to its annual funding costs.
Still, even such a marriage might cause cultural clashes, hampering any immediate stock gains, some money managers say.
``I think a foreign bank would have a very difficult management task with Salomon,'' says James Gipson, portfolio manager of the $300 million Clipper Fund of Beverly Hills, Calif., who recently sold his remaining Salomon stake.
Others say foreign banks that already have an active presence in the U.S. would have to cross enormous hurdles to acquire a major U.S. investment bank before the Glass-Steagall Act, which restricts securities sales by banks, is repealed.
Technically, banks can set up securities affiliates to engage in securities underwriting, but only 10 percent of the revenue can come from ``ineligible'' activities such as bond sales.
Thus, if Deutsche Bank were to acquire Salomon, it would most likely have to rejigger its balance sheet, refocusing its trading activities, for instance, outside the U.S., Wall Street lawyers say.
With Salomon's stock trading roughly 23 percent above its book value of $33.22 a share, Mr. Dreman says Salomon is ``cheap enough that someone may look at it'' as a takeover candidate.
But that prospect still isn't enough to lure Mr. Dreman.
``I think the takeover prospects are in the price. I would look at it if it wasn't in the price,'' he says, adding that he might consider nibbling at the stock if it moved into the low-30s.