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http://online.barron...5504694820.html

The Opportunity in Bear Stearns' Adversity
By ANDREW BARY

THE RECENT TROUBLES AT BEAR STEARNS, including the collapse of two mortgage hedge funds and the forced resignation of one of its top executives, is heightening speculation on Wall Street that the maverick firm may be sold in the next year.

Nothing is apt to happen soon as Bear (ticker: BSC) seeks to ride out the recent storms in financial markets that have hurt two of its key businesses: mortgage trading and lending for leveraged buyouts. Bear's chief executive, the 73-year-old Jimmy Cayne, is a championship bridge player who'd undoubtedly want a stronger hand than Bear now holds before entertaining any thought of selling the 84-year-old company. If Bear Stearns does face any unexpected liquidity problems, it wouldn't be surprising to see Cayne's bridge-playing pal, Warren Buffett, ride to the rescue with an investment from Berkshire Hathaway. China, too, might invest in Bear.

Barron's has closely followed Bear Stearns in recent years. We wrote a bullish cover story on the firm three years ago, ("How Sweet It Is," Aug. 2, 2004), when the stock traded around 82. .

Our take, after speaking with some investors knowledgeable about Bear Stearns, is that the recent turmoil surrounding the firm, including the brief collapse in its share price after Standard & Poor's made a surprise -- and arguably rash -- decision on Aug. 3 to consider a downgrade of the firm's credit rating, may make Cayne and his main constituency, Bear's employees, more willing to consider a deal with a larger company. Employees own almost a third of the company's 149 million shares.
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Bear Stearns CEO Jimmy Cayne may be pondering a question raised by an investor in his firm: How many near-death experiences do its leaders want to go through?

As one sizable Bear Stearns investor says: "If you're a 50-year-old senior managing director at Bear with $30 million of stock, how many more near-death experiences do you want to go through, even if they're based more on perception than reality?" The problem is that perception can become reality for a securities firm like Bear Stearns, which supports a $400 billion balance sheet with $13 billion of equity capital and a lot of debt.

The company has a valuable franchise that could be attractive to JPMorgan Chase (JPM) or one of several European banks, including Deutsche Bank (DB) or UBS (UBS). With a stock-market value of $16 billion, Bear Stearns is the most digestible of the top Wall Street firms. It has a well-deserved reputation as a nimble, trading-oriented firm with strong risk management that has delivered mightily for shareholders since going public in 1986. An insular place with a distinctive culture, Bear relishes its scrappy underdog image. Top management invariably comes from within, and employees often spend a career at the firm.

Bond and equity trading continue to generate the bulk of Bear's earnings, contributing two-thirds of profits in the first six months of its fiscal year. The firm also has a lucrative prime brokerage business, which involves providing hedge funds with an array of services, including custody, securities lending and clearing. Bear Stearns is the No. 3 U.S. prime broker, behind Morgan Stanley (MS) and Goldman Sachs (GS), in a business with significant barriers to entry. Among its other assets are its headquarters, a 43-story midtown Manhattan tower, completed in 2001, that could be worth $2 billion, way above its carrying value under $500 million.

Bulls argue that Bear Stearns shares, which finished Friday around 110, look attractive trading at 1.2 times their book value of $92.50. That's the lowest price/book ratio among the major Street firms. Bear's price/book ratio is also at the low end of its historical range. Lehman Brothers (LEH), whose trading-oriented business mix most resembles Bear's, trades at 59 -- 1.6 times book value -- while Goldman, now the Street's preeminent firm, trades for 180, or 2.2 times book. Bear's stock is the worst performer among its peers this year, off 32%, versus about 10% for Goldman and Morgan Stanley shares.
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Bear Stearns stock lately has been among the brokerage sector's most volatile. In mid-July, it hit a high of 142; last Monday, it fell to an intraday low of 99, on the news that Warren Spector, the co-president and head of the firm's powerful fixed-income unit, had been forced to resign. Spector had been the odds-on favorite to succeed Cayne, Bear's boss of the past 14 years. By Wednesday morning, the shares topped 125. Then, they fell back.

ALAN SCHWARTZ, A CO-PRESIDENT of Bear Stearns and head of its investment-banking division, became sole president following Spector's departure. That made him the frontrunner to succeed Cayne, who shows no interest in retiring. Schwartz says that his message to the firm's 15,000 employees was that there is opportunity in the market's dislocations. "This is a time that is tailor-made for Bear Stearns. We tend to outperform in difficult markets." Schwartz said the firm, backed by ample liquidity, will get back on the "offensive" by executing its long-standing strategy of taking prudent trading risks and building book value per share.

Bear declined to discuss any potential takeover. But bulls maintain that if the firm can maintain most of its recent earnings power, it could ultimately fetch $200 in a takeover next year -- about two times forward book value.
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An investment in Bear Stearns is riskier than one in Merrill Lynch or Morgan Stanley, which boast more diversified businesses. The current quarter, which for Bear Stearns ends on Aug. 31, is proving to be difficult for brokerage companies because of credit-market setbacks.

Last week, Credit Suisse analyst Susan Roth Katzke slashed her third-quarter estimate for Bear Stearns to $2.20 a share from $3.20 and cut her estimate for the current fiscal year, which ends in November, to $12.40 a share from $14.65. Bear earned $14.27 in 2006. Katzke retained her Outperform rating on Bear Stearns, but cut her price target to 145 from 190 a share.

If Bear does earn $2.20 a share in the quarter, it probably would be a huge triumph because the Street appears to be banking on the possibility of an outright loss, despite the firm's assertion that it was profitable in June and July.
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One of the biggest concerns about the company involves its loan commitments to private-equity firms for leveraged buyouts. Bear Stearns has an estimated $9 billion of such commitments. Because of the fallout in the credit markets, it could be staring at a loss of $500 million or more on those commitments, analysts write. Bear says it has been hedging its commitments, which would mitigate any losses.

Bear Stearns gets an estimated 30% of its fixed-income revenue from mortgage trading, a business hard-hit by the subprime-mortgage mess. The firm also is a leading participant in the risk-arbitrage market. That has been hurt by investors' doubts about whether private-equity firms will be able to complete such giant buyouts as those involving First Data (FDC), Archstone-Smith (ASN) and Clear Channel Communications (CCU).

Bear's brass hasn't endeared itself to investors lately. When Sam Molinaro, its CFO, sought to reassure investors about Bear's liquidity position via an Aug. 3 conference call, he apparently inflamed the situation by observing that Bear faces the worst fixed-income market in 22 years. Cayne read a statement at the start of the call, then disappeared. Some investors weren't happy about that.

By forcing out Spector, Cayne probably bought more time for himself in the top job because Schwartz may need to establish himself as legitimate CEO material. Schwartz, 57, is a very capable investment banker, but that business is only a modest profit contributor at Bear Stearns. Will Bear's board entrust the firm to an investment banker with no experience in the complex and capital-intensive trading businesses? It has long been speculated that Cayne sees himself as the last CEO of an independent Bear Stearns. It's possible that, in the event of a merger, Spector could return to the firm as its leader.
The firm's stock is cheap and it could be ready for a takeover, says Andrew Bary.

WHY MIGHT BEAR SELL? Its equity capital base, now $13 billion, has doubled in the past five years, but it trails those of Lehman, Goldman and others at a time when the securities business is getting riskier and more capital-intensive. Lehman has $20 billion of equity capital; Goldman, $35 billion; Morgan Stanley, $40 billion. Bear also gets less revenue from fee-based businesses like asset management. The upshot: a lower return on equity than its rivals. Bear also lacks scale internationally, unlike its main competitors. Some investors think Bear should sell its asset-management arm because it lacks size. Bear says it's committed to the business.

The Bottom Line
Bear Stearns is battered, but if it emerges intact from its latest crisis, it eventually could be sold at a price close to double its current price.

Bear's prime-brokerage business is a jewel, but has lost some ground to the larger Goldman and Morgan Stanley. Recent credit jitters don't help Bear's prime-brokerage operation because clients don't want to worry about their custodian's financial health. Goldman and Morgan Stanley assuredly are trying to capitalize on the situation. A merger with Bear Stearns would give JPMorgan CEO Jamie Dimon the formidable prime-brokerage platform that his bank has been unable to build on its own.

Bear has long defied doubters who say it lacks the firepower to compete against Morgan Stanley, Goldman, Merrill and the major banks. Assuming that it emerges healthy from the current financial tumult, it will have the luxury to decide whether to remain independent. A sale looks like a better bet than it did a few months ago. But either way, shareholders could win.