Capital Markets
ASSUMING COVERAGE
The Day After Tomorrow
Herein, we assume coverage of the brokerage sector. Our investment conclusions:
■
Buy Brokers Selectively. Given the need for financing/strategic advice and
important role as financial intermediaries, we see a return to core strengths for
the U.S. brokerage industry. We believe there is light at the end of the tunnel for
the strongest firms to be profitable and gain market share as we exit the cycle.
We view brokerage stocks as early cycle recovery plays and while there will be
material changes this time around (i.e., regulation, funding) and the stocks have
rebounded in the new year, we still see selective opportunities to make long-term
investments. Top Picks: Goldman Sachs (GS), Blackstone Group (BX).
■
Investment banking—expecting a three-year recovery to trend-line. Current
investment banking activity levels remain depressed—revenues are 15% below
trend-line. We push off our expectations for a return to trend-line sometime in
2010. While investment banking contributions may be more tepid, increased
counterparty risk post-crisis should drive healthier spreads and more
concentrated trading market share for the strongest survivors.
■
Growth opportunities. Market share gains in agency businesses, principal risktaking
for those institutions with healthier risk appetites and a track record of
performance, distressed investing opportunities.
■
Is capital adequacy an issue? For Goldman Sachs and Morgan Stanley, we
think both have adequate capital given aggressive efforts to reduce assets and
leverage, diversification and shoring up of funding and the benefit of government
aid in helping to bridge the liquidity/financing gap. While balance sheet hotspots
remain (i.e. real estate, private equity, leveraged loans), we believe both overall
improving market conditions and vast government intervention efforts (i.e., TARP,
TALF, PPIP) should help to heal wounds further over time.
■
Returns on equity. Coming out of the cycle, we expect industry ROEs to
normalize at 12-15% with the opportunity to expand to high-teens for the best-inclass
franchises coming out of the cycle—we do not expect a return to historical
peak returns (30%+) nor do we believe current stock valuations (about half the
historical averages on book) call for that magnitude of recovery.
■
Key risks to our call. Overall macro conditions, impact of government
regulation, unsecured financing prospects and continued legacy asset exposure.
■
How we want to be positioned in the sector. Our top pick within the brokerage
sector is Goldman Sachs; we also recommend shares of Blackstone Group.
Given strong year-to-date outperformance and our more tepid growth/profitability
expectations, we downgrade shares of Morgan Stanley to Neutral. We now rate
Lazard (previously Outperform) and Greenhill Neutral given our outlook for a
broader M&A recovery to be later-stage in nature and relative valuation
prospects within our coverage universe

Table of contents
Investment Summary 2
Investment Thesis: Buy Brokers Selectively 2
How to Be Positioned in the Sector 2
Summary of Our Estimates and Target Prices 2
Where We Are Versus History 5
Reshaping the Competitive Landscape 7
Continued Rise of the Boutiques 8
Principal Investing—Still Opportunities For Those With the Appetite 8
Business By Business 10
M&A/Financial Advisory 11
Fixed Income 14
Equities 15
Retail Brokerage 16
Asset Management 18
Changes Coming Out of the Cycle 20
Regulation 20
Funding/Capital Costs 20
Customer Behavior—Increased Savings Rate? 22
ack to Basics Investing 23
Five Signs of a Potential Recovery 24
1) Continued Credit/Fixed Income Market Healing 24
2) Return of the Securitization Market 24
3) Improved Transparency/Alleviation of Counterparty Risk 25
4) Completion of Financial Services Sector Recapitalization 26
5) Success of Government Programs 26
Asset Levels/Marks 28
Capital 31
What’s Happened to Book Values? 31
Funding and Balance Sheet Sizing 31
Leverage and ROEs 32
Capital Ratios 33
Capital Management 33
Valuation 35
Where Are We Versus Historic Valuations? 35
The Stocks 38
How to Be Positioned in the Sector 38
Summary of Our Estimates and Target Prices 38
Goldman Sachs Group, Inc. (GS) 39
Assuming Coverage with an Outperform Rating 39
Goldman Sachs 40
Our Thesis 40
Our Estimates 40
Well-Diversified Earnings Stream 40
Track Record of Delivering Franchise Value 40
Solid Distressed Investor 41
Reversal of Spread Widening Gains Not a Material Headwind 41
What is Book Value and Where’s It Going? 42
Valuation 42
Risk Factors 42
More Detail on Our GS Earnings Outlook 43
Morgan Stanley (MS) 48
Assuming Coverage with a Neutral Rating 48
Morgan Stanley 49
Our Thesis 49
Our Estimates 49
Strategic Initiatives 49
MS Smith Barney JV Helps Diversify Revenues 49
What is Core Trading Earnings Power? 50
Reversal of Spread Widening Gains a Potential Material Headwind 50
What is Book Value and Where’s It Going? 51
Valuation 52
Risk Factors 52
More Detail on Our MS Earnings Outlook 53
Lazard Ltd. (LAZ) 58
Assuming Coverage with a Neutral Rating 58
Lazard 59
Our Thesis 59
Our Estimates/Scenario Analysis 59
Restructuring Represents Buffer to Advisory Revenues, But Not a Full Offset 60
Asset Management Making Positive Traction 60
Valuation 62
Risk Factors 62
Greenhill & Co. Inc. (GHL) 63
Assuming Coverage with a Neutral Rating 63
Greenhill 64
Our Thesis 64
Our Estimates 64
Continued Strategic Hiring Helping Drive Revenues... 64
… While Still Maintaining Solid Margin and Return Prospects 64
A Look at the Current Environment 65
Valuation 66
Risk Factors 66
Blackstone Group (BX) 67
Assuming Coverage with an Outperform Rating 67
Blackstone Group 68
Our Thesis 68
Our Estimates 68
Ample Capital to Deploy 68
Well Positioned for Financial Advisory & Restructuring Share Gains 69
Paid to Wait—Stress Testing the Distribution 69
Valuation 70
Risks Factors 70
Appendix A: First Quarter Activity 76
Underwriting and M&A Activity 76
Trading and Brokerage Activity 81
League Tables 89
Appendix B: Detailed Disclosures 94
Appendix C: U.S. Government Policy Initiatives 110
Appendix D: Executive Officers and Board of Directors 113