MERRILL LYNCH BULLS AHEAD IN THIS MARKET, FIDELITY AND SCHWAB GET THE HEADLINES, BUT UNHERALDED MERRILL IS THRIVING. DAN TULLY INTENDS FOR THE PROFITS TO KEEP ROLLING IN, WHATEVER THE MARKET DOES.
(FORTUNE Magazine) – ON WALL STREET'S sloppy playing field, no team has made a more surprising comeback in blocking, tackling, and most important, in scoring than Merrill Lynch. What was once a fumbling squad of beefy, slow-footed dullards has become a lean powerhouse consistently running up big-point totals against hapless opponents.
So it's not surprising that at the head of this team stands Daniel Tully, a great admirer of Penn State football legend Joe Paterno. Tully, a street kid from Queens now transformed into a burly, snow-topped CEO, likes to praise pal Paterno for exalting dogged teamwork over individuality. He loves that Paterno doesn't let his Lions wear nametags on their jerseys or stars on their helmets, and would strangle any smart-ass who pranced to celebrate a touchdown. For Tully, who downs lasagna at Paterno's regular postgame house party, business is like a Penn State charge, a mighty human wedge that--play after play--grinds out three yards and a cloud of dust.
Tully is the Paterno of Wall Street. In a field full of hot dogs, he's developed a winning formula based on Marine-like discipline and no-frills cooperation. And it works. Merrill's total client assets grew 24% last year, to $703 billion, and it still dwarfs not just Charles Schwab ($182 billion) but even much vaunted Fidelity ($548 billion).
It has a galaxy of 160 in-house mutual funds covering everything from Asian stocks to junk bonds. It perpetually combats Goldman Sachs for first place in equity underwriting, and it trades an astounding 11% of the shares on the big board and Amex.
All that's the domain of Dan Tully, who's so far from being a silk-stocking manager that he once warned his traders that if they broke his rules, he'd break their legs.
As befits a CEO who prefers beer to Perrier, Tully has chosen as his heir apparent and sidekick David Komansky, a massive, ruddy-faced extrovert who grew up in a tenement and never graduated from college.
Tully's not just set on being the biggest. He's intent on revolutionizing what a brokerage firm can do for you. Dan Tully wants to reorder the sloppy financial lives of the Great Disorganized Elite. America's yuppies, now approaching both age 50 and success, will pay a premium price for sage financial guidance they can't easily get from a Schwab, he reckons. In place of the old "have I got a stock for you" brokers, Tully is training a new generation of soft-sell advisers to restructure your portfolio, plan your estate, and whip up minor miracles, like an interest-only mortgage for your new ski chalet.
Along the way, he makes solid profits in good times and bad. Credit Tully for tackling bloated pay and banishing excessive risk taking, two problems the slick investment banker types either don't acknowledge or can't seem to solve. Too often Wall Street firms--Salomon Brothers, for instance--resemble star-studded NFL teams that never make the playoffs. Paychecks are sumptuous even when results are not. Traders gamble on the spectacular big play, roaming for interceptions or lofting too many bombs. The result is a profit picture that zigzags like a quarterback scrambling to escape a sack.
In a world of Gordon Gekko look-alikes, it's hard to imagine a more unlikely crew of reformers. A homespun extrovert, Tully wears corny neckties and likes to hand out tiny lapel pins depicting the Merrill bull to everyone from clerks to finance ministers. He didn't leave Merrill's sales office in Stamford, Connecticut, till age 44. Like Tully and Komansky, his president, many of Merrill's top people are ex-stockbrokers who began knocking on doors in the suburbs. The brass boast few MBAs and no trophy wives. They'd cheer for the Knicks, Budweiser in hand, as soon as serve on the boards of opera or ballet companies. It's their ball field camaraderie that impresses Paterno: "They're just regular street guys. Tully does what I do in coaching: He's great at getting a lot of people to share the same values."
Tully inherited a one-of-a-kind franchise. Most firms specialize, either in institutional business, catering to corporations, governments, and big investors like pension funds--Morgan Stanley, for example--or in selling stocks, bonds, and mutual funds to the broad public, a Schwab, say, or a Fidelity. Merrill Lynch not only straddles the two worlds but dominates them both. Taking stocks and bonds together, Merrill is the world's largest underwriter, and it boasts the largest sales force in the business, blanketing America with 13,000 brokers serving 4.5 million households.
But for Tully, bigness isn't an end in itself; generating a strong, stable stream of profits is--whatever the market conditions. That's a radical change from Merrill's boom-to-bust tradition. High in animal spirits, Merrill Lynch always excelled at growing. But wayward expenses waxed as fast as revenues. Those heavy costs made Merrill's bottom line vulnerable to the wrenching ups and downs in the securities markets.
TULLY'S GAME PLAN is two-fold. First, he's taming Merrill's once-wanton fixed costs. A case in point is rent, a huge expense item for brokerage firms. By consolidating a dozen computer centers into two and moving back-office staff from expensive places like New York City to Jersey City, Denver, and Jacksonville, Tully has actually cut real estate costs by $25 million since 1991. In the same period, he's added only about 7% more brokers, squeezing the new recruits into existing offices and demanding that each broker handle far more business.
Second, Tully is rapidly raising revenues, but he's pushing for a business mix that's stable, not volatile.
That's no easy task. By its very nature the securities business is highly cyclical, driven by unpredictables like interest rates, stock prices, and the economic outlook. That's the reason investors penalize the stocks of Wall Street firms with low P/E multiples. The jolts are especially severe in the institutional business. At Merrill, investment banking revenues soared in 1993 as companies floated stock to expand their businesses and refinanced expensive debt from the 1980s; they slipped 32% in 1994, then rose slightly last year. Result: a shifting plank under earnings.
For Tully the solution is to balance the profitable but erratic institutional wing with steady revenues from retail. Then, even in a down year for investment banking, Merrill can post solid profits. When the institutional side prospers, earnings explode. To provide the ballast, Tully is building an ever-rising mountain of assets in brokerage accounts and mutual funds. Those assets generate two types of revenue. The first is Merrill's staple: upfront, one-time commissions from selling stocks, bonds, and mutual funds. The second is the fabric for its future: fees--chiefly from managing clients' money--that pour in year after year. Customers pay Merrill annual or monthly charges for money market funds, 401(k) plans, and trust accounts. The richest source of fees is Merrill's panoply of proprietary mutual funds, into which its clients have funneled $181 billion. Merrill and its brokers divide a 4% or 5% commission for selling a fund; then the firm charges an average annual fee of 0.5% or so for managing it.
Unlike the tumult in investment banking, the flow of fees and commissions is fairly predictable. Typically, Merrill can count on collecting almost 1% on its total client assets, or about $6 billion last year. And Merrill is great at growing that hoard.
The big growth for Merrill is an ever-increasing annuity of $3 billion in fees. That came to 30% of its last year's net revenues, enough to cover about two-thirds of its fixed costs. "There's great comfort in that," sighs Tully. As a result Merrill's earnings are not only bigger, but less wobbly. In 1995, for example, strong growth in fees helped compensate for a rocky start in investment banking. Consequently Merrill earned $1.1 billion on net revenues of $10.3 billion, posting pretax margins of 17.5% and a strong 20% return on equity.
To Tully's chagrin, the market hasn't taken much note. Since Tully took charge in 1992, the stock has jumped about 120%, to around $54 a share, but Merrill still sells at a lackluster ten times earnings, about the same as its more erratic competitors like Salomon. Even when Merrill announced a fourth-quarter profit surge, its stock actually dropped half a point. Tully has a lot at stake; he himself owns nearly $30 million in Merrill stock and options on 1.7 million shares. (He has never sold as much as one share of Merrill stock.)
So he sees a matchless opportunity to hoist its price by further fattening his pet cushion, fee income. By the year 2000, Tully wants $1 trillion in client assets, up over 42% from the current $703 billion, and enough to generate fees that would cover every dime in fixed costs, like salaries, rent, telephones, and computers.
If that comes to pass, the day that Merrill opens for business in the next century, every dollar from commissions or investment banking, after bonuses, will drop straight to pretax income.
There's no better way to grasp the new Merrill than to understand Dan Tully's blend of smooth blarney and fiery will, flamboyant salesmanship and accounting rigor. Son of a steamfitter, Tully grew up in the tough neighborhood Woodside, in Queens, New York, a working-class mosaic of Irish and Jews, blacks and Italians. In his teens he spent evenings as a copy boy for the Daily News, riding the subways to deliver ads from stores in Brooklyn, say, to the offices in midtown Manhattan, reading his schoolbooks between stops. The system worked so well that the E train became his study-hall-on-wheels. The family's cramped, noisy apartment made it impossible to do homework there. So on weekends Dan studied underground all day, shuttling from Queens to the Bronx and back again.
On the streets of Queens, his temper and tenacity earned him the sobriquet "Donkey Dan." Tully parlayed his fast fists and tart tongue into a powerful role: the picker who chose a stickball team from kids on the street. Usually there was such a throng of candidates that only half could play. It was then that Tully discovered the rewards of doing favors. "I'd often choose a kid who couldn't hit but hadn't played in a few days," says Tully. "Later on you might need that guy to help you with your math or take your place as an altar boy. But I also loved to win."
Tully retains that hunger. His intensity comes wrapped in flamboyant Irish-American. His ancestors, he proudly announces, hail from a hamlet appropriately named Moneygall. His idea of a great vacation is squiring his wife and 16 children, in-laws, and grandchildren around Ireland in a special van. Tully greets friends and customers with a broad comic brogue and has been known to croon "Danny Boy" to a roomful of brokers. Seated in his Wall Street office adorned with a giant emerald rug, he dashes off memos with a trademark green, felt-tip pen. Tully, who lives in a rambling, converted monastery on the Connecticut waterfront, loves nothing more than taking the dinghy out for fishing on weekends, accompanied by his sons and, on special occasions, a bottle of champagne.
HEADING UP a Merrill branch office, the equivalent of running a small business, helped forge Tully's approach to management. Significantly, he started in 1955 not as a salesman but a numbers man. An accounting major at St. John's University, Tully soon became the operations manager of the Stamford office, monitoring budgets and margin accounts. There he absorbed the importance of watching expenses. "Even in a branch, you couldn't grow your way out of a cost problem," he says. Eyeing the big money in sales, Tully switched to broker, then rose to office manager. Each month he prominently displayed the firm-wide ranking of brokers by revenues. He'd get rid of anyone who consistently finished in the bottom quartile.
"How would your kids feel if I sent their father home with a bad report card?" he chided his brokers.
Tully prodded brokers to cast themselves in his image: a combination of workhorse who arrived at his desk at 7 a.m. and a pillar of the community who served on everything from the Chamber of Commerce to hospital boards. "The key," he says, "was developing 12 Dan Tullys, then 48 Dan Tullys."
In Stamford, Tully learned the Paterno lesson: It's solid, consistent practices--in controlling costs and generating sales--that win. "More and more companies think good management is being mean-spirited," he says. "That's wrong. It's really being tough-minded. Good management is discipline, procedures, and controls."
Recognizing Tully's talents, CEO Donald Regan practically dynamited the 44-year-old out of Stamford in 1976 to head retail marketing. "I finally decided I had to compete, or end up reporting to people who should have reported to me," says Tully, who helped roll out Regan's wildly successful Cash Management Account. In 1985, CEO William Schreyer appointed Tully president. They formed a classic team: Schreyer was the visionary, Tully the operating man. But it took the wrenching year of 1987 to galvanize their partnership. First, a single Merrill trader lost $377 million by taking huge, high-risk positions in mortgage-backed securities. Schreyer calls the explosion "my Chernobyl."
Tully became the crisis manager, operating from a conference room near the trading floor. He found an appalling lack of controls. Each trading desk had its own homemade risk-management system. But what most nettled Tully was runaway arrogance. A group of traders, some of them from the department that suffered the loss, demanded that Tully assure them the disaster wouldn't affect their bonuses. Tully was livid. "I told them, 'This is not gambling. I'm setting up parameters here. If you go outside them, I'll break your legs.' "
To prevent another meltdown, Tully established a risk-management department that's become a model for Wall Street firms. The group reports not to the heads of the trading desks, but to the president. The unit sets standards and monitors risk in every security. If it deems a position poorly hedged, it can order the trading desk to unwind it. As a result, Merrill hasn't suffered a major trading loss in almost a decade. Says Schreyer: "If I had any doubts about Dan's ability to replace me, they were totally erased by the way he handled the crisis."
After a second earthquake, the trauma of October 1987, Schreyer and Tully adroitly sidestepped a disaster and helped to hobble a competitor, in one deft stroke. In late 1987, a stricken E.F. Hutton had to put itself up for sale. Shearson, then owned by American Express, desperately wanted Hutton in order to become almost as big as Merrill Lynch. Recalls Tully: "We were the old, stodgy battleship, and Shearson was the destroyer coming up the Hudson." But Tully worried that Hutton came with dicey accounting methods and looming legal liabilities. He and Schreyer quickly decided not to bid. Tully told Hutton nothing until hours before the deadline, leaving the clear impression that Merrill would make an offer. Shearson put in the solo bid for Hutton--a fat one billion. A year later Shearson took a $165 million charge because of Hutton, and it continued to take write-downs in 1990.
The crash--and the two-year chill that followed for Merrill--prodded Schreyer and Tully to put shareholders first. By 1990 ROE had dropped so low that "my kids could have done a better job running the company," Tully recalls. That's when they set the goal that stands to this day: an average return on equity of at least 15%.
In the process, Tully and Schreyer tackled one of the perennial problems at Wall Street firms: Investment bankers and traders make huge amounts whether shareholders win or lose. Tully helped design a formula that, like the risk-management system, is a path breaker on Wall Street. Today traders and investment bankers get their bonuses from a single pool tied to ROE and profit. Thus, bonuses for an investment banker with a salary of $200,000 could reach $800,000 or more, or fall to a sliver of that. "A lot of firms haven't done it, and they've paid the price," says Tully. "Shame on them."
No matter how tightly Tully controls costs, he knows that he'll never compete with a Schwab on price. Merrill Lynch supports not only an expensive branch network, but a $200 million budget for research as well. By contrast, the discounters are stripped-down outfits that sell mainly through 800 numbers and don't employ analysts. Hence, they can sell stocks and bonds for a lot less than Merrill. But Merrill is striving to create a one-stop shop that untangles a well-to-do client's scrambled financial profile from retirement savings to mortgages, then provides an array of mutual funds, insurance products, trust accounts, and loans to put the picture in order.
The advice and planning, Tully figures, will enable Merrill to keep charging rich prices for its products.
There's already a measure of competition offering similar services, and it's bound to multiply. But for its Cadillac service, Merrill Lynch isn't courting the masses. Instead, it's aiming at a narrow segment, the wealthy and near-wealthy. The target is "priority households" with $250,000 to $5 million in liquid assets: families headed by executives, doctors, lawyers, entrepreneurs, all too busy making money to manage it--or retirees who'd rather fish and travel than pick mutual funds.
It's no wonder Merrill covets the well-heeled. Its 534,000 priority households--20% of its total customers--generate 80% of its brokerage revenues. The big money is in the hands of people over 50. Fortunately for Merrill, 36 million baby-boomers lugging a trove of savings will cross that milestone by 2005.
So attractive is this market that competitors are invading the advisory business too--discounters as well as full-service firms. Because the do-it-yourself market is limited, Schwab and Fidelity are courting the same base Merrill is after--the harried well-to-do. Their vehicle is the independent financial planner who funnels customers to them. The discounters provide them with a computer linkup and a menu of mutual funds. The combination of bargain products and low overhead enables the planners to earn more than they could as brokers.
Backed by Schwab or Fidelity, these planners battle head to head with Merrill Lynch. They compete in a hot area generally referred to as wrap accounts, portfolios of mutual funds that are chosen to achieve broad diversification. Though Merrill charges a lot more on a simple stock transaction (see table), when it comes to these wrap accounts, Merrill's fees are roughly in line with those of financial planners.
So while Merrill Lynch will never win the commission war, it may not have to. Instead, it's out to revolutionize pricing. Merrill is developing fee-based accounts that, in addition to "free" trades, will include complimentary financial plans, as well as a broad range of mutual funds (including Merrill's own funds, sans the customary 5% load), and even favorable-rate mortgages with no points.
Tully predicts Merrill can hold its own with the independent planners--and their discount sponsors--by offering one-stop shopping and more products at prices only slightly higher. The centerpiece is a recent product called Financial Foundation. A staff of financial planners in Denver crunch the numbers, and the client gets a leather-bound 80-page financial plan replete with pie charts. The crucial feature is a list of perhaps a dozen recommendations.
Headed for big estate taxes? Transfer half the family assets to your spouse to double the $600,000-estate tax exemption.
Too many bonds? Here's a better mix of domestic and foreign stocks.
Worried about estate taxes? Get extra life insurance so your offspring won't have to sell the country house to pay the death duties.
Within six months, Merrill assures clients, it can tidy up the messiest financial house with a fresh estate plan, a new, higher-yielding retirement portfolio, and nursing home insurance.
Every four to six months, strategists recommend a shift in asset allocation for Financial Foundation accounts. For 1995, Merrill advised most clients to hold a heavy 70% in equities in retirement portfolios and move an extra 5% from cash to bonds. The call proved prescient.
Urged on by the Financial Foundation's recommendations, clients can browse at Merrill for services that used to require an insurance salesman, a banker, an attorney, and a CPA. The firm now employees 200 specialists for estates, mortgages, trusts, and insurance. The estate expert will map out a plan for free, though clients still need an outside lawyer to draft the documents. "It's nice to get it all in one location," says Ron Hertel, a Bechtel engineer. Merrill offers mortgages you can't get at the local bank. Merrill clients put up 20% of the loan value in stocks or bonds, then borrow 100% of the price of a home, and pay interest only at the sweetheart rate of 6.5%.
As Merrill hands its brokers more new resources, it remains heavy-handed in making sure those brokers stay loyal. It requires new recruits to sign a draconian agreement pledging that if they leave Merrill, they won't contact their clients for a year. When a broker leaves, says Merrill, the firm typically keeps 60% of his accounts. That's extraordinary; usually brokers who walk take their clients along. "It's a dirty little secret," says an attorney who represents ex-Merrill brokers, "but a brilliant strategy."
Tully is aiming as well to establish the firm at the top of the institutional business. By 2005, he wants trading and investment banking to generate $16 billion in revenue (in 1995 it was $3.8 billion).
BUT MERRILL has a weakness. It's still struggling in one of the most lucrative aspects of the business--advising corporations on mergers and acquisitions. Merrill is especially weak with the Fortune 200. Morgan Stanley and Goldman Sachs have spent decades establishing close relationships with the CEOs of companies like Ford and GM. "We don't have the school ties," grouses Tully. What's more, Merrill rarely raids other firms for star investment bankers.
Yet at raising money for corporations, Merrill is a titan. Because Merrill Lynch trades 13% of the shares in Wal-Mart, 11% in Chrysler, and 12% in Goodyear, it's a logical choice for someone seeking an underwriter. Its institutional sales force knows just who's buying and selling the stock, and why. Corporations rely on Merrill to place their shares with the big buyers, at the best prices. Another strength is its vast retail distribution. That appeals strongly to Callaway Golf, which Merrill took public in 1992. "If you want your stock substantially held by both the public and institutions, Merrill is tops," says CEO Ely Callaway. "They treated us like IBM." The computer giant likes Merrill too: "If there's a retail component to a deal," says its former CFO Jerome York, "you must use Merrill Lynch."
Tully--who may step down as CEO next year, then serve a year as chairman--is grooming a successor in his own image. Komansky is a bear-shaped former broker who grew up in a tenement in the Bronx. A photo of the building still hangs on his office wall. "I look at it every time I start believing my own bullshit," jokes Komansky. He has had a superbly well-rounded career, heading both the brokerage and the capital markets businesses. Most of all, his vision of Merrill Lynch perfectly matches Tully's. "It's like that apartment house in the Bronx," he muses. "It's always been a melting pot." Tully and Komansky--who's half Jewish--wear trademark pins. Tully's is a shamrock, Komansky's a half-shamrock.
For each, Merrill Lynch has fulfilled another dream of an Irishman--the search for a pot of gold.
REPORTER ASSOCIATE Bethany McLean