NEW YORK (CNNfn) - Embracing an online business it has traditionally shunned, Merrill Lynch agreed Tuesday to pay about $900 million in stock for Herzog Heine Geduld, the third largest U.S. firm linking buyers and sellers on the Nasdaq.|
The deal propels Merrill Lynch into second place behind the nation's leading market maker, the Jersey City, N.J.-based Knight/Trimark Group. The privately owned Herzog, also of Jersey City, said it makes markets in about 5,000 Nasdaq stocks, including every IPO and secondary offering.
The acquisition significantly bolsters the brokerage firm's ability to conduct high-volume trading in over-the-counter stocks on the technology-rich Nasdaq. Herzog has an 8 percent market share in the OTC markets, analysts said. Market makers offer to buy and sell stock for investors and make money on the spread between a stock's asking price and offer price.
"Merrill used to be the largest market maker years ago and got out when the spreads narrowed," said analyst Robert Napoli of investment bank ABN AMRO. "They viewed that as a mistake and are trying to get back in. It's a very profitable business."
Merrill had considered building its own OTC market maker but decided instead to go with Herzog, analysts said. Herzog says it handles 6-to-8 percent of Nasdaq's total trading volumes
"Instead of building a market maker, they bought it," said Napoli.
Access to Herzog's broker-dealers
New York-based Merrill (MER: Research, Estimates) said it will exchange 8.5 million shares for all of Herzog's outstanding stock, valuing the market maker at $914 million based on Merrill's closing price of 107-1/2 Monday. Herzog is owned entirely by its employees.
The deal gives Merrill, the No.1 U.S. investment bank ranked by total revenue, instant access to Herzog's more than 475 external broker-dealers, who generate a majority of their business through online trading. Combined, the company will now execute an estimated 170 million shares of over-the-counter daily trading volume.
"In 32 years I've never been more excited about the business than I am today," said Buzzy Geduld, Herzog's longtime president and chief executive, told CNNfn.com. "Their internal [trading] flow, their ability to open institutional flow for us throughout the states and their business in Europe and Asia made this a marriage made in heaven for us."
Merrill expects the deal, which it hopes to close during the third quarter, to immediately add to its earnings.
The New York-based investment bank has been routinely criticized for dragging its feet when it came to embracing the Internet. The company has customarily shunned online services, insisting its customers preferred the human advisory skills its brokers provided. It has moved some of its investment services online only after fleet-footed competitors, such as Charles Schwab (SCH: Research, Estimates) and E*Trade (EGRP: Research, Estimates), started nipping at its heels.
Merrill Lynch's Thomas Joyce, currently head of Merrill's equity market structures said the company approached Herzog after realizing most of its current order flow was suddenly in stocks in which it did not make a market. (378KB AIFF) (378KB WAV)
Geduld intends to remain with the company as the chairman and CEO of Herzog, which will become a wholly owned subsidiary of Merrill. Geduld and Joyce will be jointly responsible for expanding the company's platform globally, beginning in Europe.
In early afternoon trading, Merrill shares were down 3/4 at 106-3/4.
Market makers versus ECNs
Founded in 1926, Herzog is a member of the New York Stock Exchange as well as one of the oldest Nasdaq trading firms. The firm's London unit, Herzog Heine Geduld International, also offers market-making services on EASDAQ, the pan-European stock market based in Brussels, and on the London Stock Exchange.
Herzog competes against other top market makers, including Knight/Trimark Group Inc. (NITE: Research, Estimates) and Schwab.
Analyst Napoli said the deal for Herzog signals that Merrill is backing market makers as opposed to electronic communications networks (ECN) such as Island. ECNs, he said, are hoping to supplant market makers by offering cheap and quick online trading.
"In practice that theory doesn't work as well," Napoli said. "Market makers provide capital the ECNs can't provide. This deal is a vote against the ECNs."
Analyst Clare Nickson, of UBS Warburg, said market makers and ECNs will both have a role to play. "This deal is just Merrill saying that the market making approach is still alive and kicking," she said. "But Merrill will still continue to use ECNs for some flow."