Believe it or not... Paine Webber Is Alive and Kicking Yes, Paine Webber. Wall Street has predicted for years that it would be merged out of existence. Instead, it's preparing for battle on the Internet.
By Bethany McLean

(FORTUNE Magazine) – To watch the television ads for online brokerages like E*Trade and Ameritrade, you would think human brokers were overpriced, arrogant, and dumb. "My broker said, 'You're gonna hate online trading,'" says one man in an ad for e-brokers. "You can add that to the long list of things he was wrong about." "We're betting on ourselves," says a confident woman in another ad. It's obvious: Traditional brokers are middlemen on the verge of extinction.

If so, the company atop the endangered-species list is Paine Webber, the nation's fourth-largest brokerage. This is a firm whose lifeblood is the commissions it earns for trading stocks and bonds on behalf of individual investors. Its CEO, 64-year-old Donald Marron, has ruled since 1980--when the Dow was below 1000 and calculators were considered high tech. Many on Wall Street think that Marron, a serious art collector, is more interested in his Lichtensteins and Jasper Johnses than in financial planning or online trading--and that Paine Webber long ago lost its way. "Its reason for existence was to make others look good," says Bob Upton, senior director at Fitch IBCA.

Right now it's Paine Webber that's looking good. The company's first-quarter earnings beat Wall Street estimates by almost 40%. Revenues, earnings, commissions, and assets under management grew at higher rates than Merrill Lynch's. Over the past five years the stock of stodgy Paine Webber has not only kept pace with Merrill's but also trounced both the S&P 500 and the shares of glamorous J.P. Morgan.

To many Wall Streeters, the firm's survival represents the dumb luck of the bull market and the triumph of mediocrity. Paine Webber is neither No. 1 nor No. 2 in any of its major businesses, and it blundered through the 1980s as it repeatedly tried and failed to turn itself into an investment bank. But crediting only the bull market ignores several choices Paine Webber made in the early 1990s that mostly defied conventional wisdom, yet turned out to be right--at least so far. During an era when global financial behemoths began offering everything from investment banking to insurance, Paine Webber stayed small (its 1998 net revenues of $4.4 billion are only 25% larger than Morgan Stanley Dean Witter's profits of $3.3 billion), domestic (96% of net revenues are from the U.S.), and embarrassingly retail (75% of net revenues come from individual investors). And while Paine Webber didn't exactly embrace the Internet early on, it is not turning a cold shoulder to it either.

For all the commotion about online trading, it's way too early to identify Internet winners and losers in the brokerage business. In the first quarter of 1999, Charles Schwab gained 42% more assets than full-service Merrill Lynch. And E*Trade's recent agreement to buy Telebanc Financial means that, unlike either Schwab or the full-service firms, it can offer customers both banking and brokerage products online. But the full-service firms aren't playing ostrich anymore. In early June, Merrill Lynch announced that by December it would offer customers online trades for $29.95 (the same price Schwab charges), plus fee-based accounts that include advice and electronic trades. Paine Webber intends to introduce its own Internet plan later this summer. "For the first time we're hearing, 'Oh, wow! These guys get it!'" says Paine Webber President Joseph Grano. "That never happened before."

One reason it's happening is Grano himself. At the end of the 1980s, Paine Webber was bleeding. In 1988 its brokers ranked last in productivity (the amount of revenue each broker generates), and the firm owed hundreds of thousands of dollars in fines to the SEC for sales and trading abuses. That's when Marron hired Grano, formerly the head of Merrill Lynch's retail-brokerage unit, a step one portfolio manager calls "the smartest move Marron ever made."

It wasn't obvious at the time. Grano, 51, left Merrill when he was passed over for the top job (he says he quit for other reasons), and he has been criticized for a series of bad financial deals in the 1980s. But critics have found little to complain about in recent years. A Vietnam veteran who served as a Green Beret, Grano pushed Paine Webber in the direction it's headed now. He felt strongly that the company should focus on affluent customers (households with $500,000 or more); that it should get those assets into fee-based accounts that generate recurring revenue--the holy grail of the brokerage industry; and that it must persuade customers to turn to Paine Webber for a lifetime relationship rather than a one-trade encounter.

Paine Webber's research department also deserves credit for the firm's improving fortunes. According to the Wall Street Journal, which does a quarterly study of the performance of stocks recommended by 15 major brokerages, Paine Webber has the best five-year record, with a return nearly double that of Merrill Lynch and Morgan Stanley. Moreover, the brokers who sell those stocks include 1,000 of the best in the business, collected at a fire-sale price when Paine Webber bought Kidder Peabody from General Electric in 1994. Grano recalls that "Kidder brokers thought they were going from the NFL to the AFL." But the fact is that Kidder was in chaos at the time, badly damaged by allegations that bond trader Joseph Jett had created false profits. Paine Webber bought Kidder for a net cost of just $90 million. By comparison, First Union recently agreed to pay about $1 billion to buy Everen Capital, a regional firm with 1,840 brokers.

Today Paine Webber controls $372 billion in client assets, up 50% since the end of 1996. Three years ago, its brokers brought in an average of $30 million a day of client assets. Last month, the firm's best ever, brokers brought in $180 million. According to Hal Schroeder, an analyst at Keefe Bruyette & Woods, the average Paine Webber broker collects about 90% of what the average Merrill broker does, vs. just 65% in 1997.

The brokers have also managed to get customers to pay recurring fees for products like wrap accounts, in addition to commissions. Over the past two years, fee-based revenues have grown 29% annually, double the growth rate of commissions. "If you took our name off [the firm] and you got to the facts, it would be a pretty good picture," says Mark Sutton, president of Paine Webber's private-client group.

Ironically, Paine Webber is even looking relatively stronger in a business that has been a disaster for it: proprietary mutual funds. For years Paine Webber's funds performed so badly that brokers simply stopped selling them. Only 20% of the mutual funds sold by Paine Webber are proprietary, vs. 45% at Merrill Lynch and 75% at Morgan Stanley. But in-house funds are falling out of favor with investors tired of having poor-performing products pushed on them. The upshot is that Paine Webber has considerably less to lose than its peers.

The company is taking a much more activist approach toward another big issue: the Internet. Paine Webber executives recognize that like it or not, the Internet will irrevocably change the brokerage business. At the same time, to say that flesh-and-blood brokers will be forced out of business by the likes of Ameritrade and E*Trade assumes that the Internet can do everything for every investor. It can't.

What the Net does do is make crystal clear what's a commodity (trading, access to information) and what's not (products, advice, the human touch). The amount of investing information flooding the Internet may actually accelerate the need for advice. Says Marron: "Advice may end up being the one significant distinguishing characteristic for all of us." Wealthy clients, in particular, aren't likely to spend time surfing the Net for advice; many don't even know how. Moreover, they want to put their money in the care of someone they know. They want eyes to look into, a hand to shake. "Clients want to be close to their money," says Marron. "And the more money they have, the closer they want to be to it."

Even clients with less money may be willing to pay for advice if they can trade cheaply online. Analysts approve of Paine Webber's Internet strategy because, as Sutton puts it, "Our objective is to give people a choice in how they pay for financial services." Like Merrill, Paine Webber will offer online trading as part of a fee-based account. But it will not let clients just trade at a discounted price, as Merrill will. Instead, it will have an a la carte menu. Clients will be assessed a flat fee each year--say, $1,200--to make a certain number of online trades and to have several consultations with a financial adviser. Or they can pay to talk to an adviser, then pay a separate low price, say $15, to trade online. "The client can do what the client wants," says Marten Hoekstra, who heads marketing for the private-client business.

Marron believes his firm's single-minded focus on the U.S. retail-brokerage business is a definite advantage. He points out that the U.S. has a market capitalization of $15 trillion, vs. just $10 trillion for the next 20 countries combined. Says Richard Skaggs, an analyst at Loomis Sayles and a Paine Webber stock owner: "I don't think we can point to any time when Paine Webber's lack of an international presence has hurt it."

Marron wasn't always so content with his firm's mission. He said several times during the 1980s that he wanted to make his company "one of the top five investment banking firms by 1989." Although he spent hundreds of millions trying to do just that, all he has to show for the expense is Paine Webber's strength in niche businesses like municipal underwriting (which it acquired with Kidder). The firm has almost no presence in the sexy areas of equity underwriting or mergers and acquisitions. Ultimately, that may limit what it can offer individual investors, because there are some synergies between retail brokerage and investment banking that Paine Webber lacks. For example, it can't flip hot IPOs to important clients.

Marron is frequently disparaged for his failures, but make no mistake: This guy is a survivor. "I think he's grossly underestimated," says Michael Flanagan, an analyst at Financial Service Analytics. In 1958 the 24-year-old Marron, a college dropout with an IQ of 190, founded his own investment bank (Grano didn't graduate from college either). At 30 he sold it to a firm called Mitchell Hutchins, which he built into a top research firm and sold to Paine Webber in 1977. In his spare time he co-founded the economic forecasting firm DRI, which he sold to McGraw Hill in 1979. "He's always been like a minnow swallowing a whale, but somehow he always ends up on top," says Gary Goldstein, president of the Whitney Group.

Even Paine Webber's extensive art collection may be working in Marron's favor. He is hardly a dilettante spending shareholders' money to spruce up the walls. Marron was president of the board of trustees of the Museum of Modern Art from 1986 to 1991 and is now vice chairman. Paine Webber's collection of contemporary art is one of the country's best. How has it been as an investment? Marron merely says, "Not like an Internet stock." But his smile contains the implication that it has done quite well. And as public relations, it can't be beaten. When the firm sent its show "Artworks: The Paine Webber Collection of Contemporary Masters" on a two-year national tour that ended in 1997, Paine Webber brokers across the country were able to invite top clients to a real event. Marron also likes to say the art is good for morale: "You have to have an office, so why not look at a Jasper Johns rather than a reproduction?"

Here's another question: When will Marron sell Paine Webber? It has been the subject of takeover rumors for years, linked to every suitor imaginable. While Wall Streeters say both Morgan Stanley and Goldman Sachs consider Paine Webber too small to buy, it has not lacked for opportunities to cash out. Marron, say people familiar with the firm, has turned down a number of "very, very good offers." "Paine Webber is renowned for not wanting to sell," says Charles M. White, the president of money-management firm Avatar Associates.

It is Marron's decision to make. Paine Webber's largest shareholders--General Electric, which owns 21.7%, and Yasuda, a Japanese insurance company that owns 7.7%--are both required to vote with management, and Paine Webber's board has been mostly handpicked by Marron. Although Marron owns 1.5% of the company and stands to make out well should it be sold, there is talk on Wall Street that he wants to buy, not sell. A regional brokerage or a small asset-management firm are possible targets. In a recent analyst report, Hal Schroeder wrote, "Investors will ultimately maximize value in Paine Webber when a larger global franchise, or at least one with aspirations along those lines, buys the company." Then he adds, "Bottom line: This company will be sold only if and when Mr. Marron is ready."

It will be several years--and many e-trades later--before it's clear whether a firm like Paine Webber can continue to stand alone. Don Marron has a proven track record of selling at the right time. The question Marron can't answer is whether Paine Webber's best time is yet to come, or whether it has come and gone, making him and his investors wish that he had accepted one of those "very, very good offers" in the days before the Internet changed everything.