SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 27, 1997 ------------- COMMISSION FILE NUMBER 1-7182 -------------- MERRILL LYNCH & CO., INC. - ----------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) DELAWARE 13-2740599 - ----------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) WORLD FINANCIAL CENTER, NORTH TOWER, NEW YORK, NEW YORK 10281-1332 - ----------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (212) 449-1000 - ----------------------------------------------------------------------------- Registrant's telephone number, including area code - ----------------------------------------------------------------------------- Former name, former address and former fiscal year, if changed since last report. - ----------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO --- --- APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 331,375,776 shares of Common Stock (as of the close of business on August 1, 1997) PART I. FINANCIAL INFORMATION ----------------------------- ITEM 1. Financial Statements -------------------- MERRILL LYNCH & CO., INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED EARNINGS (UNAUDITED)
FOR THE THREE MONTHS ENDED ----------------------------- JUNE 27, JUNE 28, PERCENT(1) (Dollars in Millions, Except Per Share Amounts) 1997 1996 INCREASE ---------- ---------- ---------- REVENUES Commissions................................... $ 1,078 $ 970 11.2% Interest and dividends........................ 4,330 3,040 42.4 Principal transactions........................ 1,151 908 26.7 Investment banking............................ 625 580 7.8 Asset management and portfolio service fees................................. 670 553 21.2 Other........................................ 157 139 12.8 ------- ------ ------- Total Revenues................................ 8,011 6,190 29.4 Interest Expense............................ 4,044 2,810 43.9 ------- ------ ------- Net Revenues.................................. 3,967 3,380 17.3 ------- ------ ------- NON-INTEREST EXPENSES Compensation and benefits..................... 2,004 1,741 15.1 Communications and equipment rental........... 170 137 24.2 Occupancy..................................... 124 113 9.8 Depreciation and amortization................. 108 98 9.7 Professional fees............................. 197 140 40.6 Advertising and market development............ 156 124 25.3 Brokerage, clearing, and exchange fees........ 112 101 10.7 Other......................................... 312 228 36.9 ------- ------ -------- Total Non-Interest Expenses................... 3,183 2,682 18.6 ------- ------ -------- EARNINGS BEFORE INCOME TAXES AND DIVIDENDS ON PREFERRED SECURITIES ISSUED BY SUBSIDIARIES............................... 784 698 12.4 Income Tax Expense............................ 290 265 9.7 Dividends on Preferred Securities Issued by Subsidiaries....................... 13 - N/M ------- ------ -------- NET EARNINGS.................................. $ 481 $ 433 11.1% ======= ====== ======== NET EARNINGS APPLICABLE TO COMMON STOCKHOLDERS................................. $ 472 $ 422 11.9% ======= ====== ======== EARNINGS PER COMMON SHARE (2): Primary..................................... $ 1.24 $ 1.09 ======= ====== Fully diluted............................... $ 1.23 $ 1.09 ======= ====== DIVIDEND PAID PER COMMON SHARE................ $ .20 $ .15 ======= ====== AVERAGE SHARES USED IN COMPUTING EARNINGS PER COMMON SHARE (2): Primary..................................... 379.4 385.9 ======= ====== Fully diluted............................... 384.4 385.9 ======= ======
(1) Percentages are based on actual numbers before rounding. (2) All share and per share amounts have been restated for the two-for-one common stock split, effected in the form of a 100% stock dividend, paid on May 30, 1997. See Notes to Consolidated Financial Statements 2 MERRILL LYNCH & CO., INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED EARNINGS (UNAUDITED)
FOR THE SIX MONTHS ENDED ---------------------------- JUNE 27, JUNE 28, PERCENT(1) (Dollars in Millions, Except Per Share Amounts) 1997 1996 INCREASE ---------- ------------ ---------- REVENUES Commissions................................... $ 2,193 $ 1,959 11.9% Interest and dividends........................ 8,178 6,050 35.2 Principal transactions........................ 2,215 1,891 17.1 Investment banking............................ 1,233 958 28.8 Asset management and portfolio service fees................................. 1,316 1,090 20.7 Other......................................... 327 261 25.5 ------- ------- ----- Total Revenues................................ 15,462 12,209 26.6 Interest Expense............................ 7,654 5,568 37.5 ------- ------- ----- Net Revenues.................................. 7,808 6,641 17.6 ------- ------- ----- NON-INTEREST EXPENSES Compensation and benefits..................... 3,991 3,432 16.3 Communications and equipment rental........... 328 268 22.5 Occupancy..................................... 244 229 6.7 Depreciation and amortization................. 213 196 8.5 Professional fees............................. 395 270 45.9 Advertising and market development............ 300 239 25.7 Brokerage, clearing, and exchange fees........ 230 207 10.8 Other......................................... 556 431 28.8 ------- ------- ----- Total Non-Interest Expenses................... 6,257 5,272 18.7 ------- ------- ----- EARNINGS BEFORE INCOME TAXES AND DIVIDENDS ON PREFERRED SECURITIES ISSUED BY SUBSIDIARIES...................... 1,551 1,369 13.3 Income Tax Expense............................ 581 526 10.5 Dividends on Preferred Securities Issued by Subsidiaries...................... 23 - N/M ------- ------- ----- NET EARNINGS.................................. $ 947 $ 843 12.3% ======= ======= ===== NET EARNINGS APPLICABLE TO COMMON STOCKHOLDERS................................. $ 927 $ 820 13.1% ======= ======= ===== EARNINGS PER COMMON SHARE (2): Primary..................................... $ 2.41 $ 2.11 ======= ======= Fully diluted............................... $ 2.40 $ 2.11 ======= ======= DIVIDENDS PAID PER COMMON SHARE............... $ .35 $ .28 ======= ======= AVERAGE SHARES USED IN COMPUTING EARNINGS PER COMMON SHARE (2): Primary..................................... 384.2 388.7 ======= ======= Fully diluted............................... 386.8 389.2 ======= =======
(1) Percentages are based on actual numbers before rounding. (2) All share and per share amounts have been restated for the two-for-one common stock split, effected in the form of a 100% stock dividend, paid on May 30, 1997. See Notes to Consolidated Financial Statements 3 MERRILL LYNCH & CO., INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(Dollars in Millions, Except Per Share Amounts) JUNE 27, DEC. 27, ASSETS 1997 1996 ----------------------------------------------------------------- --------- --------- CASH AND CASH EQUIVALENTS........................................ $ 4,528 $ 3,375 -------- -------- CASH AND SECURITIES SEGREGATED FOR REGULATORY PURPOSES OR DEPOSITED WITH CLEARING ORGANIZATIONS........................ 9,707 5,628 -------- -------- MARKETABLE INVESTMENT SECURITIES................................. 2,659 2,180 -------- -------- TRADING ASSETS, AT FAIR VALUE Corporate debt and preferred stock............................... 32,950 24,270 Contractual agreements........................................... 16,219 13,465 Equities and convertible debentures.............................. 22,288 13,153 U.S. Government and agencies..................................... 9,595 9,304 Non-U.S. governments and agencies................................ 13,236 7,758 Mortgages, mortgage-backed, and asset-backed..................... 7,018 5,189 Money markets.................................................... 1,609 1,209 Municipals....................................................... 1,419 1,176 -------- -------- Total............................................................ 104,334 75,524 -------- -------- RESALE AGREEMENTS................................................ 60,447 58,402 -------- -------- SECURITIES BORROWED.............................................. 36,287 24,692 -------- -------- RECEIVABLES Customers (net of allowance for doubtful accounts of $45 in 1997 and $39 in 1996).................................... 22,810 18,309 Brokers and dealers.............................................. 6,683 6,205 Interest and other............................................... 6,541 5,280 -------- -------- Total............................................................ 36,034 29,794 -------- -------- INVESTMENTS OF INSURANCE SUBSIDIARIES............................ 5,034 5,107 LOANS, NOTES, AND MORTGAGES (net of allowance for loan losses of $122 in 1997 and $117 in 1996)................... 3,866 3,334 OTHER INVESTMENTS................................................ 1,203 1,125 PROPERTY, LEASEHOLD IMPROVEMENTS, AND EQUIPMENT (net of accumulated depreciation and amortization of $2,709 in 1997 and $2,523 in 1996)........................... 1,857 1,670 OTHER ASSETS..................................................... 2,080 2,185 -------- -------- TOTAL ASSETS..................................................... $268,036 $213,016 ======== ========
See Notes to Consolidated Financial Statements 4 MERRILL LYNCH & CO., INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(Dollars in Millions, Except Per Share Amounts) LIABILITIES, PREFERRED SECURITIES ISSUED BY SUBSIDIARIES, JUNE 27, DEC. 27, AND STOCKHOLDERS' EQUITY 1997 1996 --------------------------------------------------------------- --------- -------- LIABILITIES REPURCHASE AGREEMENTS.......................................... $ 68,058 $ 62,669 -------- -------- COMMERCIAL PAPER AND OTHER SHORT-TERM BORROWINGS............... 57,431 39,333 -------- -------- TRADING LIABILITIES, AT FAIR VALUE U.S. Government and agencies................................... 16,436 13,965 Contractual agreements......................................... 12,810 11,221 Equities and convertible debentures............................ 16,234 8,332 Non-U.S. governments and agencies.............................. 9,012 7,135 Corporate debt and preferred stock............................. 4,799 2,762 Municipals..................................................... 122 130 -------- -------- Total ......................................................... 59,413 43,545 -------- -------- CUSTOMERS...................................................... 13,677 11,758 INSURANCE...................................................... 4,859 5,010 BROKERS AND DEALERS............................................ 7,097 3,407 OTHER LIABILITIES AND ACCRUED INTEREST......................... 15,643 13,973 LONG-TERM BORROWINGS........................................... 33,963 26,102 -------- -------- TOTAL LIABILITIES.............................................. 260,141 205,797 -------- -------- PREFERRED SECURITIES ISSUED BY SUBSIDIARIES 627 327 -------- -------- STOCKHOLDERS' EQUITY PREFERRED STOCKHOLDERS' EQUITY................................. 425 619 -------- -------- COMMON STOCKHOLDERS' EQUITY (1) Common stock, par value $1.33 1/3 per share; authorized: 500,000,000 shares; issued: 1997 and 1996 - 472,660,324 shares................... 630 630 Paid-in capital................................................ 1,065 989 Foreign currency translation adjustment........................ 5 10 Net unrealized gains on investment securities available-for-sale (net of applicable income tax expense of $17 in 1997 and $5 in 1996)....................... 31 9 Retained earnings.............................................. 8,678 7,868 -------- -------- Subtotal................................................... 10,409 9,506 Less: Treasury stock, at cost: 1997 - 143,611,883 shares; 1996 - 141,411,196 shares..... 3,099 2,895 Unallocated ESOP reversion shares, at cost: 1996 - 3,077,556 shares.................................. - 24 Employee stock transactions................................. 467 314 -------- -------- TOTAL COMMON STOCKHOLDERS' EQUITY.............................. 6,843 6,273 -------- -------- TOTAL STOCKHOLDERS' EQUITY..................................... 7,268 6,892 -------- -------- TOTAL LIABILITIES, PREFERRED SECURITIES ISSUED BY SUBSIDIARIES, AND STOCKHOLDERS' EQUITY........................ $268,036 $213,016 ======== ======== BOOK VALUE PER COMMON SHARE.................................... $ 20.86 $ 19.19 ======== ========
(1) All share and per share amounts have been restated for the two-for-one common stock split, effected in the form of a 100% stock dividend, paid on May 30, 1997. See Notes to Consolidated Financial Statements 5 MERRILL LYNCH & CO., INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS (UNAUDITED)
FOR THE SIX MONTHS ENDED ---------------------------- (Dollars in Millions) JUNE 27, JUNE 28, 1997 1996 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings..................................................... $ 947 $ 843 Noncash items included in earnings: Depreciation and amortization.................................. 213 196 Policyholder reserves.......................................... 122 138 Other.......................................................... 590 307 (Increase) decrease in operating assets: Trading assets................................................. (28,710) (8,999) Cash and securities segregated for regulatory purposes or deposited with clearing organizations...................... (4,079) 401 Securities borrowed............................................ (11,595) (3,340) Customers...................................................... (4,506) (2,638) Sales of trading investment securities......................... 501 - Purchases of trading investment securities..................... (431) - Other.......................................................... (2,504) (6,460) Increase (decrease) in operating liabilities: Trading liabilities............................................ 15,868 5,604 Customers...................................................... 1,919 (1,280) Insurance...................................................... (251) (330) Other.......................................................... 5,197 9,326 ------- ------- CASH USED FOR OPERATING ACTIVITIES............................... (26,719) (6,232) ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from (payments for): Maturities of available-for-sale securities.................... 1,551 1,570 Sales of available-for-sale securities......................... 1,063 784 Purchases of available-for-sale securities..................... (3,283) (2,160) Maturities of held-to-maturity securities...................... 556 385 Purchases of held-to-maturity securities....................... (320) (244) Other investments and other assets............................. (247) (340) Property, leasehold improvements, and equipment................ (400) (173) ------- ------- CASH USED FOR INVESTING ACTIVITIES............................... (1,080) (178) ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from (payments for): Repurchase agreements, net of resale agreements................ 3,343 (2,017) Commercial paper and other short-term borrowings............... 18,098 3,156 Issuance and resale of long-term borrowings.................... 11,874 9,371 Settlement and repurchase of long-term borrowings.............. (3,868) (3,842) Issuance of subsidiaries' preferred securities................. 300 - Redemption of remarketed preferred stock....................... (194) - Common stock transactions...................................... (465) (479) Dividends...................................................... (136) (119) ------- ------- CASH PROVIDED BY FINANCING ACTIVITIES............................ 28,952 6,070 ------- ------- INCREASE(DECREASE) IN CASH AND CASH EQUIVALENTS.................. 1,153 (340) Cash and cash equivalents, beginning of year..................... 3,375 3,091 ------- ------- CASH AND CASH EQUIVALENTS, END OF PERIOD......................... $ 4,528 $ 2,751 ======= =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for: Income taxes totaled $413 in 1997 and $633 in 1996. Interest totaled $7,294 in 1997 and $5,359 in 1996. See Notes to Consolidated Financial Statements 6 MERRILL LYNCH & CO., INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 27, 1997 (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) BASIS OF PRESENTATION The consolidated financial statements include the accounts of Merrill Lynch & Co., Inc. (the "Company") and subsidiaries (collectively, "Merrill Lynch"). All material intercompany balances have been eliminated. The December 27, 1996 consolidated balance sheet was derived from the audited financial statements. The interim consolidated financial statements for the three- and six-month periods are unaudited; however, in the opinion of the management of Merrill Lynch, all adjustments, consisting only of normal recurring accruals, necessary for a fair statement of the results of operations have been included. These unaudited financial statements should be read in conjunction with the audited financial statements included in Merrill Lynch's Annual Report on Form 10-K for the year ended December 27, 1996. The nature of Merrill Lynch's business is such that the results of any interim period are not necessarily indicative of results for a full year. Prior period financial statements have been reclassified, where appropriate, to conform to the 1997 presentation. ACCOUNTING CHANGE In June 1996, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". SFAS No. 125 provides guidance for determining whether a transfer of financial assets is treated as a sale or a financing. Additionally, if a transfer qualifies as a financing transaction, the statement contains provisions that may require the recognition of collateral received or provided, in addition to the financing balance. In December 1996, the FASB issued SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125", which defers for one year the effective date of the collateral provisions for all transactions and the sale provisions for repurchase agreements, securities lending, and similar transactions. These provisions will be applied prospectively to transactions entered into after December 31, 1997; accordingly, the expected impact of adopting such provisions on Merrill Lynch's results of operations cannot be determined. Merrill Lynch adopted the provisions of SFAS No. 125 not deferred by SFAS No. 127 for all transactions entered into subsequent to December 31, 1996. This resulted in a net increase in trading assets and repurchase agreements of approximately $3 billion at the end of the 1997 second quarter. 7 NEW ACCOUNTING PRONOUNCEMENT In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share", which is effective for fiscal years ending after December 15, 1997. SFAS No. 128 simplifies the guidance for computing earnings per share ("EPS") and replaces the presentation of primary and fully diluted EPS with basic and diluted EPS. Basic EPS excludes dilution related to incremental shares (common share equivalents) and is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS includes incremental shares. Presented below is basic and diluted EPS under SFAS No. 128 compared with primary and fully diluted EPS:
Three Months Ended Six Months Ended ----------------------- ---------------------- June 27, June 28, June 27, June 28, 1997 1996 1997 1996 ---------- --------- ---------- -------- Pro Forma SFAS No. 128: Basic $ 1.43 $ 1.24 $ 2.80 $ 2.39 Diluted 1.25 1.10 2.41 2.13 As Currently Reported: Primary 1.24 1.09 2.41 2.11 Fully diluted 1.23 1.09 2.40 2.11
COMMERCIAL PAPER AND OTHER SHORT-TERM BORROWINGS Commercial paper and other short-term borrowings at June 27, 1997 and December 27, 1996 are presented below:
June 27, Dec. 27, 1997 1996 ------- ------- Commercial paper $32,486 $23,558 Demand and time deposits 9,524 9,311 Securities loaned 7,014 2,751 Bank loans and other 8,407 3,713 ------- ------- Total $57,431 $39,333 ======= =======
PREFERRED SECURITIES ISSUED BY SUBSIDIARIES On February 6, 1997, Merrill Lynch Preferred Capital Trust II (the "Trust"), a subsidiary of the Company, issued $300 of 8% Trust Originated Preferred Securities (Service Mark). The Trust holds preferred securities of a partnership, which is also a subsidiary of Merrill Lynch. The assets of the partnership consist primarily of debt securities of the Company and one of its subsidiaries. The Company has guaranteed, on a subordinated basis, certain payments by the Trust and the partnership. 8 REMARKETED PREFERRED (SERVICE MARK) STOCK, SERIES C ("RP STOCK") Merrill Lynch redeemed all outstanding shares of RP Stock in the first quarter of 1997. COMMON EQUITY On April 15, 1997, Merrill Lynch's Board of Directors declared a two-for-one common stock split, effected in the form of a 100% stock dividend. The new shares were distributed on May 30, 1997 to stockholders of record on May 2, 1997. The par value of these shares remained at $1.33 1/3 per share. Accordingly, an adjustment totaling $315 from paid-in capital to common stock was required to preserve the par value of the post-split shares. All share and per share data presented in these financial statements have been restated for the effect of the split. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK Merrill Lynch enters into various derivative contracts to meet clients' needs and to manage its own market risks. Derivative contracts often involve future commitments to exchange interest payment streams or currencies (such as interest rate and currency swaps or foreign exchange forwards) or to purchase or sell other financial instruments at specified terms on a specified date. Options, for example, can be purchased or written on a wide range of financial instruments such as securities, currencies, futures, and various market indices. The notional or contractual amounts of derivatives provide only a measure of involvement in these types of transactions and represent neither the amounts subject to the various types of market risk nor the future cash requirements under these instruments. The notional or contractual amounts of derivatives used for trading purposes by type of risk follow: 9
(in billions) Interest Equity Commodity Rate Currency Price Price Risk (1)(2) Risk (3) Risk Risk ----------- -------- ------- --------- June 27, 1997 ------------- Swap agreements $1,362 $ 161 $ 17 $ 3 Forward contracts 39 198 1 19 Futures contracts 151 2 13 2 Options purchased 114 77 32 2 Options written 126 77 46 4 December 27, 1996 ----------------- Swap agreements $1,212 $ 140 $ 13 $ 3 Forward contracts 24 147 1 17 Futures contracts 126 2 7 5 Options purchased 85 76 21 3 Options written 118 72 31 3
(1) Certain derivatives subject to interest rate risk are also exposed to the credit spread risk of the underlying financial instrument, such as total return swaps and similar instruments. (2) Forward contracts subject to interest rate risk principally represent "To Be Announced" mortgage pools that bear interest rate as well as principal prepayment risk. (3) Included in the currency risk category are certain contracts that are also subject to interest rate risk. The notional or contractual amounts of derivatives used to hedge exposure related to borrowings or other non-trading activities follow: (in billions) June 27, Dec. 27, 1997 1996 -------- ------------ Interest rate derivatives(1) $49 $36 Currency derivatives(1) 7 7 Equity derivatives 2 2 (1) Includes swap contracts totaling $1 billion notional that contain embedded options hedging callable debt at both dates. Most of these derivatives are entered into with Merrill Lynch's derivative dealer subsidiaries, which intermediate interest rate, currency, and equity risks with third parties in the normal course of their trading activities. In the normal course of business, Merrill Lynch enters into underwriting commitments, when-issued transactions, and commitments to extend credit. Settlement of these commitments as of June 27, 1997 would not have a material effect on the consolidated financial condition of Merrill Lynch. REGULATORY REQUIREMENTS Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S"), a registered broker-dealer and a subsidiary of the Company, is subject to net capital requirements of Rule 15c3-1 of the Securities Exchange Act of 1934. Under the alternative method permitted by this rule, the minimum required net capital, as defined, shall not be less than 2% of aggregate debit items arising from customer transactions. At June 27, 1997, MLPF&S's regulatory net capital of $1,638 was 9% of aggregate debit items, and its 10 regulatory net capital in excess of the minimum required was $1,264. Merrill Lynch Government Securities Inc. ("MLGSI"), a primary dealer in U.S. Government securities and a subsidiary of the Company, is subject to the capital adequacy requirements of the Government Securities Act of 1986. This rule requires dealers to maintain liquid capital in excess of market and credit risk, as defined, by 20% (a 1.2-to-1 capital-to-risk standard). At June 27, 1997, MLGSI's liquid capital of $978 was 246% of its total market and credit risk, and liquid capital in excess of the minimum required was $501. Merrill Lynch International ("MLI"), a registered U.K. broker-dealer and a subsidiary of Merrill Lynch, is subject to capital requirements of the Securities and Futures Authority ("SFA"). Financial resources, as defined, must exceed the total financial resources requirement of the SFA. At June 27, 1997, MLI's financial resources were $3,647, and exceeded the minimum requirement by $938. Merrill Lynch Capital Markets PLC ("MLCM"), a U.K. subsidiary of Merrill Lynch and a dealer in over-the-counter equity derivatives, became subject to the capital requirements of the SFA on January 1, 1997. At June 27, 1997, MLCM's financial resources were $1,545, and exceeded the minimum requirement by $562. In 1997, MLI became Merrill Lynch's primary dealer for new global equity derivatives business. INTEREST EXPENSE Interest expense includes payments in lieu of dividends of $6.2 and $1.4 for the second quarters of 1997 and 1996, respectively. For the six-month periods ended June 27, 1997 and June 28, 1996, payments in lieu of dividends were $8.3 and $3.0, respectively. LITIGATION MATTER An action is pending in the United States District Court for the Central District of California by Orange County, California (the "County") which filed a bankruptcy petition in the United States Bankruptcy Court for the Central District of California on December 6, 1994, against the Company and certain of its subsidiaries in connection with Merrill Lynch's business activities with the Orange County Treasurer-Tax Collector. In addition, other actions are pending against the Company and/or certain of its officers, directors, and employees and certain of its subsidiaries in federal and state courts in California and New York. These include class actions and stockholder derivative actions brought by persons alleging harm to themselves or to Merrill Lynch arising out of Merrill Lynch's dealings with the Orange County Treasurer-Tax Collector, or from the purchase of debt instruments issued by the County that were underwritten by the Company's subsidiary, MLPF&S. See "Commitments and Contingencies" in the notes to Merrill Lynch's audited consolidated financial statements contained in the 1996 10-K as well as "Legal Proceedings" in the 1996 10-K and this Quarterly Report on Form 10-Q. 11 INDEPENDENT ACCOUNTANTS' REPORT To the Board of Directors and Stockholders of Merrill Lynch & Co., Inc.: We have reviewed the accompanying condensed consolidated balance sheet of Merrill Lynch & Co., Inc. and subsidiaries ("Merrill Lynch") as of June 27, 1997, and the related condensed statements of consolidated earnings for the three- and six-month periods ended June 27, 1997 and June 28, 1996 and consolidated cash flows for the six-month periods ended June 27, 1997 and June 28, 1996. These financial statements are the responsibility of the management of Merrill Lynch & Co., Inc. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to such condensed consolidated financial statements for them to be in conformity with generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of Merrill Lynch as of December 27, 1996, and the related statements of consolidated earnings, changes in consolidated stockholders' equity and consolidated cash flows for the year then ended (not presented herein); and in our report dated February 24, 1997, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 27, 1996 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ Deloitte & Touche LLP New York, New York August 8, 1997 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ----------------------------------------------------------- AND RESULTS OF OPERATIONS ------------------------- Merrill Lynch & Co., Inc. ("the Company" and, together with its subsidiaries and affiliates, "Merrill Lynch") is a holding company that, through its subsidiaries and affiliates, provides investment, financing, insurance, and related services worldwide. Merrill Lynch conducts its businesses in global financial markets that are influenced by numerous unpredictable factors. These factors include economic conditions and monetary policy, the liquidity of global markets, international and regional political events, regulatory developments, the competitive environment, and investor sentiment. These conditions or events can significantly impact the volatility of financial markets. While greater volatility increases risk, it may also increase order flow, which in turn may benefit Merrill Lynch businesses, such as trading and brokerage. Revenues and net earnings may vary significantly from period to period due to these unpredictable factors and the resulting market volatility. Global financial markets continued to flourish for much of 1997, after generally robust performances in 1995 and 1996. This trend has been led by a stable U.S. economy, heightened investor and issuer activity, low inflation, and relatively low interest rates. U.S. equity markets, except for a mild downturn that began in March and continued into April, were bullish in the second quarter of 1997, perpetuating the trend started more than two years ago. The Dow Jones Industrial Average ("DJIA"), despite the April retraction, posted its largest second-quarter percentage gain since 1938 and reached record levels for the tenth consecutive quarter. U.S. bond prices increased in the second quarter of 1997 as long-term interest rates decreased. Although interest rates were slightly lower at quarter-end compared to the same point a year ago, interest rates for much of the 1997 second quarter were higher relative to the 1996 second quarter. Overall, global equity prices, as measured by the Dow Jones World Index, increased during the 1997 second quarter. For the first half of 1997, equity prices in many countries were up more than U.S. equity prices when measured in local currency terms; however, in U.S. dollar terms, most of these increases did not exceed the U.S. increase due to the overall strengthening of the U.S. dollar versus many local currencies during the period. Global underwriting volume in the 1997 first half was up moderately compared with the same period a year ago. The second quarter increase was fueled by debt issuances, but concerns about sustainability of U.S. equity market price levels dampened underwriting volume in equities. U.S. initial public offerings, in particular, fell nearly 42%, to $11.1 billion, from $18.9 billion in the second quarter of 1996, according to Securities Data Co. ("SDC"). Strategic services activities remained strong during the 1997 second quarter, reflecting a continuation of the high level of mergers and acquisitions activity experienced throughout 1996 and the 1997 first quarter. Driven by globalization and other competitive and economic factors, companies continued to seek strategic alliances to increase earnings growth and expand into new markets and businesses. 13 Due to the cyclicality of the financial services industry, Merrill Lynch continually evaluates its businesses across market cycles for profitability and alignment with long-term strategic objectives. Merrill Lynch seeks to mitigate the effect of market downturns by expanding its global presence, developing and maintaining long-term client relationships, closely monitoring costs and risks, and continuing to diversify revenue sources.
RESULTS OF OPERATIONS (in millions, except For the Three Months Ended per share amounts) ----------------------------------- Increase June 27, March 28, June 28, 2Q97 Versus ------------ 1997 1997 1996 1Q97 2Q96 -------- ---------- ---------- ---- ---- Total revenues $8,011 $7,451 $6,190 7.5% 29.4% Net revenues 3,967 3,841 3,380 3.3 17.3 Net earnings 481 465 433 3.5 11.1 Net earnings applicable to common stockholders 472 455 422 3.8 11.9 Earnings per common share (1): Primary 1.24 1.17 1.09 6.0 13.8 Fully diluted 1.23 1.17 1.09 5.1 12.8 Return on average common stockholders' equity 28.5% 28.3% 29.2%
(1) "All per share amounts have been restated for the two-for-one common stock split, effected in the form of a 100% stock dividend, paid on May 30, 1997." The discussion that follows emphasizes the comparison between the second quarters of 1997 and 1996 and presents additional information on the comparison between the six-month periods, where appropriate. Merrill Lynch's net earnings were a record $481 million in second quarter 1997, up 3% from the previous record of $465 million in first quarter 1997 and 11% above the $433 million earned in the 1996 second quarter. Record revenues were achieved in principal transactions, investment banking, and asset management and portfolio service fees. Increases in revenues were partially offset by increased costs, particularly performance-based compensation, technology-related expenses, and provisions for various business activities. For the 1997 first half, net earnings were a record $947 million, up 12% from the previous record of $843 million in the first half of 1996. Year-to-date earnings per common share were $2.41 primary and $2.40 fully diluted, compared with $2.11 primary and fully diluted for the 1996 period, as restated for the common stock split. Annualized return on average common equity was 28.3% for the 1997 first half versus 28.7% in the prior year period. 14 Commissions revenues are summarized as follows:
Three Months Ended Six Months Ended ------------------------------- -------------------------------- (in millions) June 27, June 28, % June 27, June 28, % 1997 1996 Inc. 1997 1996 Inc. -------- -------- ---- -------- -------- ---- Listed and over-the-counter $ 605 $517 17% $1,230 $1,064 16% Mutual funds 321 309 4 665 608 9 Other 152 144 5 298 287 4 ------ ---- ------ ------ Total $1,078 $970 11 $2,193 $1,959 12 ====== ==== ====== ======
Commissions revenues from listed securities increased 24% from second quarter 1996 as a result of higher trading volumes on many global exchanges. Mutual fund commissions revenues rose due to higher distribution fees, primarily related to prior period sales. Significant components of interest and dividend revenues and interest expense follow:
Three Months Ended Six Months Ended ---------------------- --------------------- (in millions) June 27, June 28, June 27, June 28, 1997 1996 1997 1996 -------- -------- -------- -------- Interest and dividend revenues: Trading assets $1,329 $ 986 $2,555 $1,945 Resale agreements 1,155 714 2,086 1,404 Securities borrowed 931 644 1,763 1,319 Margin lending 507 369 958 742 Other 408 327 816 640 ------ ------ ------ ------ Total 4,330 3,040 8,178 6,050 ------ ------ ------ ------ Interest expense: Borrowings 1,699 1,131 3,213 2,248 Repurchase agreements 1,302 854 2,366 1,702 Trading liabilities 738 580 1,490 1,132 Other 305 245 585 486 ------ ------ ------ ------ Total 4,044 2,810 7,654 5,568 ------ ------ ------ ------ Net interest and dividend profit $ 286 $ 230 $ 524 $ 482 ====== ====== ====== ======
Net interest and dividend profit increased 24% from the 1996 second quarter. Interest and dividend revenues and expenses are a function of the level and mix of interest-earning assets and interest-bearing liabilities and the prevailing level, term structure, and volatility of interest rates. Merrill Lynch hedges certain of its long- and short-term payment obligations with interest rate and currency swaps. The effect of these hedges, which is included in "Borrowings" above, increased (decreased) interest expense by approximately $7 and $(23) million for the 1997 and 1996 second quarters, respectively. 15 Principal transactions revenues were up 27% from the 1996 second quarter to $1.2 billion due to higher trading revenues from equities and equity derivatives, fixed-income products, interest rate and currency swaps, and foreign exchange instruments. The table that follows provides information on aggregate trading revenues, including related net interest. Interest revenue and expense amounts are based on financial reporting categories and management's assessment of the cost to finance trading positions, after consideration of the underlying liquidity of these positions.
Principal Net Interest Net (in millions) Transactions Revenue Trading Revenues (Expense) Revenue --------------- --------------- --------------- 1997 1996 1997 1996 1997 1996 ---- ---- ---- ---- ---- ---- Second Quarter - -------------- Equities and equity derivatives $ 391 $ 290 $ 4 $ (27) $ 395 $ 263 Taxable fixed-income 342 243 76 66 418 309 Interest rate and currency swaps 287 249 (50) (24) 237 225 Municipals 84 94 3 2 87 96 Foreign exchange and commodities 47 32 1 (5) 48 27 ------ ------ ------ ------ ------ ------ Total $1,151 $ 908 $ 34 $ 12 $1,185 $ 920 ====== ====== ====== ====== ====== ======
First Half - ---------- Equities and equity derivatives $ 707 $ 637 $ (28) $ (55) $ 679 $ 582 Taxable fixed-income 667 509 153 125 820 634 Interest rate and currency swaps 597 505 (75) (35) 522 470 Municipals 167 168 8 3 175 171 Foreign exchange and commodities 77 72 2 (8) 79 64 ------ ------ ------ ------ ------ ------ Total $2,215 $1,891 $ 60 $ 30 $2,275 $1,921 ====== ====== ====== ====== ====== ======
Trading and related hedging and financing activities affect the recognition of both principal transactions revenues and net interest and dividend profit. In assessing the profitability of its trading activities, Merrill Lynch aggregates net interest and principal transactions revenues. For financial reporting purposes, however, realized and unrealized gains and losses on trading positions, including hedges, are recorded in principal transactions revenues. The net interest carry (i.e., the spread representing interest earned less financing costs) for trading positions, including hedges, is recorded either as principal transactions revenues or net interest profit, depending on the nature of the specific instruments. Changes in the composition of trading inventories and hedge positions can cause the recognition of revenues within these categories to fluctuate. 16 Equities and equity derivatives trading revenues were $391 million, up 35% from the 1996 second quarter due to higher revenues from global equity derivatives and U.S. equities and convertibles, partially offset by a decline in non-U.S. equities trading revenues. Increased profitability on equity derivative transactions and price appreciation in the U.S. equity market resulted in higher revenues. The decline in non-U.S. equities was primarily driven by lower values for Japanese positions. Taxable fixed-income trading revenues were $342 million, up 40% from the 1996 second quarter. Trading revenues from taxable fixed-income products, except for U.S. Government and agency securities, benefited from the declining interest rate environment as investors sought higher yielding instruments. Interest rate and currency swap trading revenues increased 15% to $287 million primarily due to improved performance in the U.S. dollar-denominated derivatives market, as well as higher revenues from currency-related products. Municipal securities trading revenues were down 11% from last year's second quarter to $84 million primarily due to lower margins on sales of shorter term instruments. Foreign exchange and commodities trading revenues were up 49% to $47 million, attributable mainly to fluctuations in the U.S. dollar versus European currencies and the Japanese yen. A summary of Merrill Lynch's investment banking revenues follows:
Three Months Ended Six Months Ended ---------------------------------- -------------------------------- (in millions) June 27, June 28, % June 27, June 28, % 1997 1996 Inc.(Dec.) 1997 1996 Inc. -------- -------- ---------- -------- -------- ---- Underwriting $452 $469 (4)% $ 903 $762 18% Strategic services 173 111 56 330 196 69 ---- ---- ------ ---- Total $625 $580 8 $1,233 $958 29 ==== ==== ====== ====
Underwriting revenues, while strong, declined from the 1996 second quarter due to lower equity underwriting volume as compared to the record level of the 1996 second quarter. This decline was partially offset by higher debt issuances. Merrill Lynch's underwriting market share information follows:
Three Months Ended Three Months Ended June 27, 1997 June 28, 1996 ------------------- -------------------- Market Market Share Rank Share Rank ------ ---- ------ ---- U.S. Debt 16.3% 1 16.2% 1 Equity 13.6 2 13.4 3 Debt and Equity 16.6 1 15.8 1 GLOBAL Debt 12.8 1 12.5 1 Equity 12.3 3 12.4 3 Debt and Equity 13.2 1 12.7 1
"Source: SDC statistics based on full credit to book manager." 17 Strategic services revenues advanced to a record $173 million, attributable to an increase in mergers and acquisitions activity industrywide. Merrill Lynch's mergers and acquisitions market share information based on transaction value follows:
Three Months Ended Three Months Ended June 27, 1997 June 28, 1996 --------------------- ----------------------- Market Market Share Rank Share Rank ------ ---- ------ ---- COMPLETED TRANSACTIONS U.S. 26.3% 2 34.8% 2 Global 20.9 2 21.5 2 ANNOUNCED TRANSACTIONS U.S. 15.8 3 38.4 1 Global 10.0 4 26.1 1
"Source: SDC statistics based on full credit to both target and acquiring companies' advisors." Merrill Lynch's asset management and portfolio service fees are summarized below:
Three Months Ended Six Months Ended ---------------------------- ------------------------------- (in millions) June 27, June 28, % June 27, June 28, % 1997 1996 Inc. 1997 1996 Inc. -------- -------- ---- -------- -------- ---- Asset management fees $291 $245 19% $ 575 $ 483 19% Portfolio service fees 190 147 28 367 288 28 Account fees 107 100 8 212 196 8 Other fees 82 61 35 162 123 32 ---- ---- ------ ------ Total $670 $553 21 $1,316 $1,090 21 ==== ==== ====== ======
Asset management fees, which include primarily fees earned on mutual funds sponsored by Merrill Lynch, increased due to strong inflows of client assets and net asset appreciation. Total assets in worldwide client accounts reached a record $940 billion at quarter-end, compared with $756 billion at the end of the 1996 second quarter. Assets under management were $257 billion at quarter-end, compared with $207 billion a year ago. New money investments accounted for approximately 39% of the increase from a year ago in client assets and approximately 34% of the increase in assets under management. In addition to new money investments, the 1996 fourth quarter acquisition of Hotchkis and Wiley, a Los Angeles-based asset management company, added approximately $10 billion of assets, principally in private portfolio funds. Portfolio service fees also benefited from inflows of client assets. Increases in the number of accounts and asset levels led to higher revenues from asset-based fee products, primarily Merrill Lynch Consults (Registered Trademark), Asset Power (Registered Trademark), and Mutual Fund Advisor (Service Mark). Account fees rose due to an increase in the number of customer and custodial accounts. Other fee-based revenues were up due primarily to increased revenues from mortgage servicing and transfer agency activities. 18 Other revenues were $157 million, up 13% from $139 million in the 1996 second quarter. The increase was principally due to realized merchant banking investment gains. Merrill Lynch's non-interest expenses are summarized below:
Three Months Ended Six Months Ended ---------------------- ---------------------- June 27, June 28, June 27, June 28, (in millions) 1997 1996 1997 1996 -------- -------- -------- -------- Compensation and benefits $2,004 $1,741 $3,991 $3,432 ------ ------ ------- ------- Non-interest expenses, excluding compensation and benefits: Communications and equipment rental 170 137 328 268 Occupancy 124 113 244 229 Depreciation and amortization 108 98 213 196 Professional fees 197 140 395 270 Advertising and market development 156 124 300 239 Brokerage, clearing, and exchange fees 112 101 230 207 Other 312 228 556 431 ------ ------ ------ ------ Total non-interest expenses, excluding compensation and benefits 1,179 941 2,266 1,840 ------ ------ ------ ------ Total non-interest expenses $3,183 $2,682 $6,257 $5,272 ====== ====== ====== ====== Compensation and benefits as a percentage of net revenues 50.5% 51.5% 51.1% 51.7% Compensation and benefits as a percentage of pretax earnings before compensation and benefits 71.9% 71.4% 72.0% 71.5%
Non-interest expenses were up 19% from the 1996 second quarter. The largest expense category, compensation and benefits expense, rose 15% from the 1996 second quarter due to higher incentive compensation and increased headcount. Incentive compensation was up primarily due to higher profitability. The increase in salary costs was primarily due to the addition of approximately 5,400 employees since the end of the 1996 second quarter, resulting in approximately 52,400 employees at the end of the 1997 second quarter. Hirings of technical and other support personnel, together with headcount added by business acquisitions, were responsible for approximately 77% of the increase. The ratio of support employees and sales assistants to producers increased from 1.47 in second quarter 1996 to 1.55 in second quarter 1997. Facilities-related costs, which include communications and equipment rental, occupancy, and depreciation and amortization, rose 15% in the aggregate to $402 million as increased business volumes, continued emphasis on technology initiatives, and expansion of facilities worldwide led to higher costs. 19 Professional fees increased 41%, partly due to higher management and systems consulting costs related to various strategic market development and technology projects. Advertising and market development expense rose 25% due in part to increased international travel. Brokerage, clearing, and exchange fees were up 11% due to higher global securities trading volume. Other expenses rose 37%. This increase was attributable to provisions for various business activities, including $30 million for a settlement with the Orange County District Attorney's office and $45 million for the costs of certain client claims arising in Asia which were quantifiable at quarter-end. [See Part II, Item 1, Legal Proceedings for further information on the Orange County settlement.] Income tax expense was $290 million in the 1997 second quarter. The effective tax rate in the 1997 second quarter was 37.0%, compared with 37.9% in the year-ago period. LIQUIDITY AND LIABILITY MANAGEMENT The primary objective of Merrill Lynch's funding policies is to assure liquidity at all times. Merrill Lynch's liquidity management strategy has three key components: (i) to maintain alternative funding sources such that all debt obligations maturing within one year can be funded when due without issuing new unsecured debt or liquidating any business assets; (ii) to concentrate unsecured, general purpose borrowings at the Company level; and (iii) to expand and diversify Merrill Lynch's funding programs. Merrill Lynch's primary alternative funding sources to unsecured borrowings are repurchase agreements and secured bank loans, which require pledging unhypothecated marketable securities. Other funding sources include liquidating cash equivalents; securitizing loan assets; and drawing on committed, unsecured credit facilities ("Credit Facilities") provided by banks, which at June 27, 1997 totaled $6.6 billion and were not drawn upon. Merrill Lynch regularly reviews the level and mix of its assets and liabilities to assess its ability to conduct core business activities without issuing new unsecured debt or drawing upon the Credit Facilities. The mix of assets and liabilities provides flexibility in managing liquidity since a significant portion of assets turn over frequently and are typically match-funded with liabilities having similar maturities and cash flow characteristics. At June 27, 1997, substantially all of Merrill Lynch's assets were considered readily marketable by management. Merrill Lynch concentrates its unsecured, general purpose borrowings at the Company level, except where tax regulations, time zone differences, or other business considerations make this impractical. The benefits of this strategy are reduced financing costs; simplicity, control, and wider name recognition by creditors of Merrill Lynch; and enhanced flexibility to meet fluctuating funding requirements across subsidiaries. Finally, Merrill Lynch strives to expand and diversify its funding programs and investor and creditor base. Merrill Lynch benefits by distributing its debt through its own sales force to a large, diversified customer base. Additionally, Merrill Lynch maintains strict concentration standards for short-term borrowings, including limits for any single investor. Commercial paper is the major source of short-term general purpose funding. Commercial paper outstanding totaled $32.5 billion at June 27, 1997 and $23.6 20 billion at December 27, 1996, which was equal to 12% and 11% of total assets at second quarter-end 1997 and year-end 1996, respectively. Outstanding long-term debt at June 27, 1997 increased to $34.0 billion, from $26.1 billion at year-end 1996. At June 27, 1997, the Company's senior long-term debt and preferred stock were rated by recognized credit rating agencies, as follows: Senior Preferred Debt Stock Rating Agency Rating Rating ------------- ------ --------- Duff & Phelps Credit Rating Co. AA AA- Fitch Investors Service, L.P. AA AA- IBCA Inc. AA- Not Rated Japan Bond Research Institute AA Not Rated Moody's Investors Service, Inc. Aa3 aa3 Standard & Poor's AA- A Thomson BankWatch, Inc. AA+ Not Rated During the first six months of 1997, the Company issued $11.1 billion in long-term debt. During the same period, maturities and repurchases were $3.3 billion. In addition, approximately $789 million of the Company's long-term debt securities held by subsidiaries were sold and $595 million were purchased. At June 27, 1997, $25.0 billion of term debt had maturity dates beyond one year. Approximately $68.5 billion of the Company's indebtedness at June 27, 1997 is considered senior indebtedness as defined in its subordinated indenture. As part of Merrill Lynch's overall liquidity management strategy, its insurance subsidiaries regularly review the funding requirements of their contractual obligations for in-force, fixed-rate life insurance and annuity contracts and expected future acquisition and maintenance expenses for all contracts. Insurance subsidiaries market primarily variable life insurance and variable annuity products. These products are not subject to the interest rate, asset/liability matching, and credit risks attributable to fixed-rate products, thereby reducing the risk profile and liquidity demands on the insurance subsidiaries. At June 27, 1997, approximately 87% of invested assets of insurance subsidiaries were considered liquid by management. CAPITAL RESOURCES AND CAPITAL ADEQUACY Merrill Lynch is one of the most highly capitalized U.S. institutions primarily involved in the global securities business, with $6.9 billion in common equity and $425 million in preferred stock at June 27, 1997. During the first quarter of 1997, the Company redeemed all of its $194 million Remarketed Preferred (Service Mark) Stock, Series C shares, and a subsidiary of the Company issued $300 million of perpetual Trust Originated Preferred Securities (Service Mark). These subsidiary-issued preferred securities, in addition to $327 million of preferred securities outstanding of other subsidiaries, further strengthened Merrill Lynch's equity capital base. 21 Merrill Lynch's leverage ratios were as follows: Adjusted Leverage Leverage Ratio(1) Ratio(2) -------- -------- Period-end June 27, 1997 33.9x 21.7x December 27, 1996 29.5x 18.0x Average (3) Six months ended June 27, 1997 34.7x 20.7x Year ended December 27, 1996 33.5x 19.9x (1) Total assets to total stockholders' equity and preferred securities issued by subsidiaries. (2) Total assets less resale agreements and securities borrowed to total stockholders' equity and preferred securities issued by subsidiaries. (3) Based on month-end balances. Overall capital needs are continually reviewed to ensure that Merrill Lynch's capital base can support the estimated risks of its businesses as well as the regulatory and legal capital requirements of its subsidiaries. Statistically- based product risk models are used to estimate potential losses arising from market and credit risks. These dynamic models incorporate changes in business risk into Merrill Lynch's equity requirements. Based upon these analyses and other criteria, management believes that Merrill Lynch's equity base is adequate. Merrill Lynch operates in many regulated businesses that require various minimum levels of capital (see "Regulatory Requirements" section in Notes to the Consolidated Financial Statements - Unaudited). Merrill Lynch's broker-dealer, banking, insurance, and futures commission merchant activities are subject to regulatory requirements that may restrict the free flow of funds to affiliates. Regulatory approval is generally required for paying dividends in excess of certain established levels, making affiliated investments, and entering into management and service agreements with affiliated companies. CAPITAL PROJECTS AND EXPENDITURES Merrill Lynch continually prepares for the future by expanding its operations and investing in new technology to improve service to our clients. To support business expansion, for example, Merrill Lynch plans to build a new European headquarters in London for approximately $650 million. Completion of this facility is expected to occur in 2001. Significant technology initiatives include Trusted Global Advisor (Service Mark) and Year 2000 systems compliance. Trusted Global Advisor (Service Mark), a new technology platform for Financial Consultants, is expected to be completed in fourth quarter 1998, with estimated remaining costs of approximately $400 million. The Year 2000 systems modifications are expected to be completed in early 1999. The remaining costs are estimated at $200 million and will cover hardware and software upgrades, systems consulting, and computer maintenance. AVERAGE ASSETS AND LIABILITIES Merrill Lynch monitors changes in its balance sheet using average daily balances that are determined on a settlement date basis and reported for management information purposes. Financial statement balances are recorded on a trade date basis as required under generally accepted accounting principles. The following discussion compares changes in settlement date average daily balances. For the first six months of 1997, average daily assets were $264 billion, up 11% versus $237 billion for the 1996 fourth quarter. Average daily liabilities rose 11% to $256 billion from $230 billion for the 1996 fourth 22 quarter. The major components in the growth of average daily assets and liabilities for the first half of 1997 are summarized as follows: (in millions) Increase in Percent Average Assets Increase -------------- -------- Trading assets $13,393 16% Resale agreements and securities borrowed 8,911 9 Increase in Percent Average Liabilities Increase ------------------- -------- Trading liabilities $ 9,008 19% Repurchase agreements and securities loaned 6,573 7 Long-term borrowings 5,129 20 Commercial paper and other short-term borrowings 3,883 10 Due to the adoption of SFAS No. 125, average balances of trading assets and repurchase agreements increased by approximately $2 billion (for more information on SFAS No. 125, see "Accounting Change" section in Notes to Consolidated Financial Statements - Unaudited). In addition, during the first half of 1997, trading assets and liabilities (which include on-balance-sheet hedges used to manage trading risks) rose as volume increased, benefiting from higher customer demand. Repurchase agreements and securities loaned transactions and resale agreements and securities borrowed transactions rose to fund the increase in trading activity. In addition, these transactions increased as a result of expanded matched-book activity, primarily involving governments and agencies securities. Assets are funded through diversified sources which include repurchase agreements, commercial paper and other unsecured short-term borrowings, long-term borrowings, and equity. In addition to the increase in repurchase agreements and securities loaned transactions, the growth in average assets was funded by higher short- and long-term borrowings, particularly commercial paper and medium-term notes. NON-INVESTMENT GRADE HOLDINGS AND HIGHLY LEVERAGED TRANSACTIONS Non-investment grade holdings and highly leveraged transactions involve risks related to the creditworthiness of the issuers or counterparties and the liquidity of the market for such investments. Merrill Lynch recognizes these risks and, whenever possible, employs strategies to mitigate exposures. The specific components and overall level of non-investment grade and highly leveraged positions may vary significantly from period to period as a result of inventory turnover, investment sales, and asset redeployment. NON-INVESTMENT GRADE HOLDINGS In the normal course of business, Merrill Lynch underwrites, trades, and holds non-investment grade cash instruments in connection with its investment banking, market-making, and derivative structuring activities. Non-investment grade trading inventories have continued to increase to satisfy growing client demand for higher-yielding investments, including emerging market and other 23 non-U.S. securities. Non-investment grade securities have been defined as debt and preferred equity securities rated BB+ or lower, or equivalent ratings by recognized credit rating agencies, certain sovereign debt in emerging markets, amounts due under various derivative contracts from non-investment grade counterparties, and other instruments that, in the opinion of management, are non-investment grade. Non-investment grade trading inventories are carried at fair value. Merrill Lynch's insurance subsidiaries also hold non-investment grade securities that are classified as available-for-sale and are carried at fair value. A summary of positions with non-investment grade issuers (for cash instruments) or counterparties (for derivatives in a gain position) follows: (in millions) June 27, Dec. 27, 1997 1996 -------- -------- Trading assets: Cash instruments $9,149 $7,585 Derivatives(1) 2,463 2,470 Trading liabilities - cash instruments 2,387 905 Insurance subsidiaries' investments 227 206 (1) Collateral of $728 and $848 was held at June 27, 1997 and December 27, 1996, respectively, to reduce risk related to these derivative balances. Included in the preceding table are debt and equity securities and bank loans of companies in various stages of bankruptcy proceedings or in default. At June 27, 1997, the carrying value of such debt and equity securities totaled $106 million, of which 54% resulted from Merrill Lynch's market-making activities in such securities. This compared with $133 million at December 27, 1996, of which 58% related to market-making activities. In addition, Merrill Lynch held distressed bank loans totaling $481 million and $351 million at June 27, 1997 and year-end 1996, respectively. Derivatives may also expose Merrill Lynch to credit risk related to the underlying security where a derivative contract can either synthesize ownership of the underlying security (e.g., long total return swap) or potentially force ownership of the underlying security (e.g., short put option). In addition, derivatives may subject Merrill Lynch to credit spread risk, since changes in credit quality of the underlying securities may affect the derivatives' fair values. 24 A summary of exposures related to derivatives with non-investment grade underlying securities follows: (in millions) June 27, Dec. 27, 1997 1996 -------- -------- Derivative fair values: Trading assets(1) $ 269 $ 63 Trading liabilities 245 64 Derivative notionals (off-balance-sheet)(2) 2,501 2,895 (1) Included in these amounts are $12 and $9 at June 27, 1997 and year-end 1996, respectively, that are also exposed to credit risk related to a non-investment grade counterparty, which are included in the preceding table. (2) Calculated as notional subject to strike or reference price. Merrill Lynch engages in hedging strategies to reduce its exposure associated with non-investment grade positions by purchasing an option to sell the related security or by entering into other offsetting derivative contracts. Merrill Lynch also uses non-investment grade trading inventories, principally non-U.S. governments and agencies securities, to hedge the exposure arising from structured derivative transactions. A summary of cash instruments and derivatives used to hedge the credit risk of non-investment grade positions follows: (in millions) June 27, Dec. 27, 1997 1996 -------- -------- Trading assets - cash instruments $ 759 $ 905 Derivative notionals (off-balance-sheet)(1) 2,164 1,311 (1) Calculated as notional subject to strike or reference price. At June 27, 1997, the largest non-investment grade concentration consisted of various sovereign and corporate issues of a South American country totaling $1.3 billion, some of which represented hedges of other financial instruments. HIGHLY LEVERAGED TRANSACTIONS Merrill Lynch provides financing and advisory services to, and invests in, companies entering into leveraged transactions, which may include leveraged buyouts, recapitalizations, and mergers and acquisitions. Merrill Lynch provides extensions of credit to leveraged companies in the form of senior and subordinated debt, as well as bridge financing on a select basis. In addition, Merrill Lynch syndicates loans for non-investment grade companies or in connection with highly leveraged transactions and may retain a residual portion of these loans. 25 Merrill Lynch holds direct equity investments in leveraged companies and interests in partnerships that invest in leveraged transactions. Merrill Lynch has also committed to participate in limited partnerships that invest in leveraged transactions. Future commitments to participate in limited partnerships and other direct equity investments will be determined on a select basis. A summary of loans, investments, and commitments related to highly leveraged transactions follows: (in millions) June 27, Dec. 27, 1997 1996 -------- -------- Loans (net of allowance for loan losses)(1) $258 $340 Equity investments(2) 137 113 Partnership interests 100 104 Bridge loan - 31 Additional commitments to invest in partnerships 77 82 Unutilized revolving lines of credit and other lending commitments(3) 146 301 (1) Represented outstanding loans to 33 and 36 companies at June 27, 1997 and year-end 1996, respectively. (2) Invested in 51 and 48 enterprises at June 27, 1997 and year-end 1996, respectively. (3) Subsequent to quarter-end, Merrill Lynch committed to extend a $450 million senior secured credit facility and a $215 million senior subordinated bridge loan to a counterparty in connection with its proposed acquisition transaction. Merrill Lynch plans to syndicate the loan but may retain a residual portion. At June 27, 1997, no one industry sector accounted for more than 23% of total non-investment grade positions and highly leveraged transactions. 26 STATISTICAL DATA Selected statistical data for the last five quarters are presented below for informational purposes:
2ND QTR. 3RD QTR. 4TH QTR. 1ST QTR. 2ND QTR. 1996 1996 1996 1997 1997 -------- -------- -------- -------- -------- CLIENT ACCOUNTS (IN BILLIONS): Assets in U.S. Client Accounts $ 714 $ 735 $ 792 $ 818 $ 886 Assets in Non-U.S. Client Accounts 42 44 47 50 54 -------- -------- -------- -------- -------- Total Assets in Client Accounts $ 756 $ 779 $ 839 $ 868 $ 940 ======== ======== ======== ======== ======== Assets Under Management: Money Market $ 84 $ 86 $ 90 $ 99 98 Equity 53 54 59 62 68 Fixed-Income 41 42 43 43 45 Private Portfolio 25 27 38 40 43 Insurance 4 4 4 3 3 -------- -------- -------- -------- -------- Total Assets Under Management $ 207 $ 213 $ 234 $ 247 $ 257 ======== ======== ======== ======== ======== ML Consults(Registered Trademark) $ 19 $ 20 $ 21 $ 21 $ 24 Mutual Fund Advisor(Service Mark) and Asset Power(Registered Trademark) $ 7 $ 8 $ 9 $ 10 $ 13 401(k) Assets $ 40 $ 41 $ 45 $ 47 $ 51 UNDERWRITING (DOLLARS IN BILLIONS)(A): Global Debt and Equity: Volume $ 47 $ 45 $ 50 $ 56 $ 59 Market Share 12.7% 14.0% 13.2% 13.2% 13.2% U.S. Debt and Equity: Volume $ 39 $ 36 $ 42 $ 45 $ 48 Market Share 15.8% 16.9% 16.7% 16.1% 16.6% - ----------------------------------------------------------------------------------------------------- FULL-TIME EMPLOYEES: U.S. 39,900 41,400 42,200 42,900 43,600 Non-U.S. 7,100 7,400 7,600 8,400 8,800 -------- -------- -------- -------- -------- TOTAL 47,000 48,800 49,800 51,300 52,400 ======== ======== ======== ======== ======== Financial Consultants and Account Executives Worldwide 14,000 14,300 14,400 14,600 14,800 Support Personnel to Producer ratio (B) 1.47 1.48 1.51 1.53 1.55 INCOME STATEMENT: Net Earnings (in millions) $ 433 $ 331 $ 445 $ 465 $ 481 Annualized Return on Average Common Stockholders' Equity 29.2% 21.5% 28.5% 28.3% 28.5% Earnings per Common Share(C): Primary $ 1.09 $ .84 $ 1.14 $ 1.17 $ 1.24 Fully Diluted $ 1.09 $ .84 $ 1.14 $ 1.17 $ 1.23 BALANCE SHEET (IN MILLIONS): Total Assets $205,175 $207,911 $213,016 $247,603 $268,036 Total Stockholders' Equity $ 6,514 $ 6,618 $ 6,892 $ 6,925 $ 7,268 SHARE INFORMATION (IN THOUSANDS)(C): Weighted Average Shares Outstanding: Primary 385,866 378,420 378,889 389,067 379,429 Fully Diluted 385,866 381,268 381,405 389,067 384,450 Common Shares Outstanding (D) 337,849 331,258 328,172 330,921 329,048 Shares Repurchased 12,120 9,104 6,848 7,538 5,632 - -------------------------------------------------------------------------------------------------------
(A) Full credit to book manager. Market share data derived from Securities Data Co. (B) Support personnel includes sales assistants. (C) Earnings per common share amounts and other share information have been adjusted for the two-for-one common stock split, paid May 30, 1997. (D) Does not include 5,059, 4,187, 3,077 and 936 unallocated reversion shares held in the Employee Stock Ownership Plan at period end June 28, 1996, September 27, 1996, December 27, 1996, and March 28, 1997, respectively, which are not considered outstanding for accounting purposes. At June 27, 1997, these shares had been fully allocated. 27 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Since the filing of the Company's 1996 Form 10-K and of the Company's Quarterly Report on Form 10-Q for the quarter ended March 28, 1997 (the "First Quarter 1997 10-Q"), the following events have taken place with respect to several of the actions reported therein. Capitalized terms used herein without definition have the meanings set forth in the 1996 10-K. ORANGE COUNTY LITIGATION. On April 17, 1997, the court in the Atascadero Federal Court Action granted defendants' motion to abstain from deciding the Action pending final resolution of the Atascadero State Court Action. On May 20, 1997, plaintiffs filed a notice of appeal. On May 6, 1997, plaintiffs in the Atascadero State Court Action filed a notice of appeal. On June 17, 1997, a subsidiary of the Company, MLPF&S, entered into an Agreement of Settlement and Release with the District Attorney of Orange County (the "District Attorney") that resolved the District Attorney's factual inquiry into MLPF&S' role in underwriting three debt offerings of Orange County and one debt offering of Orange County Flood Control District in 1994 (the "Settlement"). MLPF&S expressly denied and did not admit any wrongdoing or liability in connection with the Settlement. In connection with the Settlement, MLPF&S agreed to pay $30 million to the General Fund of Orange County. The Settlement provides, among other things, for MLPF&S to implement certain internal procedures when it acts pursuant to negotiated underwritings as the managing or sole underwriter of securities issued by the State of California and/or any county, municipality, district, special governmental agency or other entity or authority located in California. NASDAQ ANTITRUST LITIGATION. On May 20, 1997, the plaintiffs in the NASDAQ Antitrust Litigation class action, who have intervened in the civil antitrust action filed by the Antitrust Division of the United States Department of Justice in order to object to the 28 settlement of that action, filed an appeal of the district court's approval of the settlement. On May 21, 1997, the district court granted a stay, pending completion of the appeal, of the portion of the district court's order approving the settlement that provided for the tape recording of telephone conversations by defendants' over-the-counter desk traders. On June 30, 1997, the plaintiffs in the class action filed in connection with the NASDAQ Antitrust Litigation filed a motion seeking court approval of settlements entered into by the plaintiffs and certain of the defendants in that action. The settling defendants do not include MLPF&S, a defendant in the action. GSLIC LITIGATION. On July 28, 1997, the plaintiffs in the derivative action filed a notice of appeal. For more detailed information regarding litigation matters involving the Company, see "Item 3. -- Legal Proceeding" in the 1996 10-K ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On April 15, 1997, the Company held its Annual Meeting of Stockholders. Further details concerning matters submitted for vote of security holders can be found in the Company's Quarterly Report on Form 10-Q for the quarter ended March 28, 1997. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (4) Instruments defining the rights of security holders, including indentures: Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, the Company hereby undertakes to furnish to the Securities and Exchange Commission (the "Commission"), upon request, copies of the instruments defining the rights of holders of long-term debt securities of the Company that authorize an amount of securities constituting 10% or less of the total assets of the Company and its subsidiaries on a consolidated basis. (10)(i) Merrill Lynch & Co., Inc. 1997 KECALP Deferred Compensation Plan for a Select Group of Eligible Employees (11) Statement re: computation of per common share earnings. (12) Statement re: computation of ratios. (15) Letter re: unaudited interim financial information. (27) Financial Data Schedule. 29 (b) Reports on Form 8-K The following Current Reports on Form 8-K were filed by the Company with the Commission during the quarterly period covered by this Report: (i) Current Report dated April 15, 1997 for the purpose of filing the Preliminary Unaudited Earnings Summary of the Company for the three-month period ended March 28, 1997. (ii) Current Report dated May 2, 1997 for the purpose of filing the Preliminary Unaudited Consolidated Balance Sheet of the Company as of March 28, 1997. (iii) Current Report dated May 30, 1997 for the purpose of filing restated common share data to give effect to the Company's two-for-one common stock split. (iv) Current Report dated June 3, 1997 for the purpose of filing the form of Registrant's Nikkei 225 Market Index Target-Term Securities due June 14, 2002. 30 INDEX TO EXHIBITS Exhibits 10(i) Merrill Lynch & Co., Inc. 1997 KECALP Deferred Compensation Plan for a Select Group of Eligible Employees 11 Statement re: computation of per share earnings 12 Statement re: computation of ratios 15 Letter re: unaudited interim financial information 27 Financial Data Schedule