Wells-Merlin Deal Raises Concern

Credit rating agency Moody’s Investors Service, a division of Moody’s Corp. ( MCO - Analyst Report ) has raised concerns about Wells Fargo & Company ( WFC - Analyst Report ) following its recent announcement to buy San Francisco and New York-based Merlin Securities LLC, according to a report in the New York Times. As per the rating agency, the deal is considered as a credit negative for Wells Fargo.

Merlin is a provider of prime brokerage services and technology in the asset management industry. On the other hand, Wells Fargo has expertise in consumer and commercial lending and mortgage business. The company has performed comparatively better due to lesser exposure to the capital market businesses, which are susceptible to market volatility.

However, its foray into prime brokerage signals the company’s intention to expand its capital market business and investment-banking activities in particular. This would in turn add to its risk profile.

Notably, prime brokerage refers to a range of services offered by investment banks and securities firms to hedge funds and other professional investors. Services provided under prime brokering are securities lending, leveraged trade executions and cash management, among other things.

The Deal

In the last week of April, Wells Fargo Securities, the investment banking and capital markets wing ofWells Fargo, announced an agreement to buy Merlin Securities LLC to expand its capital market business. The financial terms of the deal were not disclosed. The transaction, pending regulatory approvals and certain customary closing conditions, is expected to be over by the third quarter of 2012.

Following the deal closure, Wells Fargo will not only gain experienced employees, but also the established status of a strong prime brokerage. Additionally, the completion of the acquisition will provide new cross-selling opportunities to the customers of both companies. This deal provides opportunity for Wells Fargo to diversify its revenue stream and aid in boosting its top line.

In fact, the Merlin’s deal represents Wells Fargo's second acquisition in the prime brokerage field. Earlier, in September 2011, Wells Fargo announced its plan to acquire LaCrosse Global Fund Services from Cargill Inc. LaCrosse is an independent hedge-fund administration and middle-office service provider company of Cargill. The deal is subject to certain regulatory approvals in several jurisdictions.

The acquisition of Merlin will result in Wells Fargo stepping into the shoes of The Goldman Sachs Group Inc. ( GS - Analyst Report ) , JPMorgan Chase & Co. ( JPM - Analyst Report ) and Morgan Stanley ( MS - Analyst Report ) , which are already major prime brokerage units.

Our Take

Though this Merlin deal reflects Wells Fargo’s focus on developing its capital market business subject to market volatility, we believe that the company’s measured approach, risk monitoring efforts and a better management would help in growing the business and add to its expertise.

As a matter of fact, strategic acquisitions have been part of Wells Fargo’s endeavor to strengthen its business model, expand capabilities and diversify. With cross-selling as its key strength, Wells Fargo has a diverse geographic and business mix that enables it to sustain consistent earnings growth.

Opportunistic acquisition and the demise of some smaller players helped the company garner a larger market share. Yet, top-line headwinds and regulatory issues remain the causes of concern.

Wells Fargo currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Moreover, considering the fundamentals, we maintain a long-term Neutral recommendation on the stock.