CSFB faces need for brutal cost-cutting

If your revenues are up 13.7% in the most difficult year in a decade in investment banking, and you still make a loss of $961m (€1.1bn), you clearly have a cost problem. Analysis of last week's results casts an unusually detailed light on how and why CSFB fell from being the star of the technology boom, how it was uniquely ill-prepared and too profligate to cope with last year's downturn, and how it lost $1bn.

It reveals a firm at which nearly 60% of all bonuses are guaranteed, which paid nearly $500m in retention payments, which has fired more than one in three investment bankers in the past 18 months, and which made a loss of $652m in the second half, even before $845m of exceptional items.

The analysis shows a firm as reliant on an unlikely continued boom in fixed income as it used to be on the technology and telecoms sector, and which has 2,500 fewer front-office staff in investment banking and equities than after it had paid $11.4bn for Donaldson, Lufkin & Jenrette (DLJ) in 2000. CSFB also paid $1.25bn (net of tax) in acquisition interest, amortisation of goodwill, intangible assets and retention payments in 2001 for the DLJ deal.

Worst of all, the analysis suggests that to meet Mack's draconian cost-cutting targets, CSFB will have to fire anything from 1,250 to 3,900 more staff.

Looking ahead, it is also clear that Mack was only half right. With CSFB's huge dependence on fixed income, and with M&A and equity capital markets facing a tougher year this year than in 2001, CSFB also has a revenue problem - like the rest of Wall Street.

The writing had been on the wall for several quarters before things really went pear-shaped. In the fourth quarter of 2000, the firm made a net profit of $416m. This almost halved in the first quarter of 2001, then more than halved again. Profits plunged to a net loss of $289m in the third quarter. In the final three months of the year, the firm made a net loss of $363m, even before $845m in exceptionals, including $100m to settle its IPO investigation and $583m to pay off redundant staff.

CSFB's problems can be traced back several years to when Allen Wheat, the then chief executive, launched a dramatic push to catch up in investment banking. Wheat paid over the odds to lure top dealmakers, traders and analysts to CSFB, who almost all received three-year guarantees. Teams such as Frank Quattrone's technology team cut their own profit-share deals in a practice that became endemic across the firm. When such teams threatened to leave, as Jack DiMaio's fixed income team did last year, their guarantees were upped and extended.

The bank set out to dominate the technology sector. The gamble seemed to be paying off: in 2000, CSFB had the top market share in technology and telecoms M&A globally, with a staggering 34% and 24% share respectively, in the two largest sectors for deals. In equity new issues, it controlled 35% of the technology market and 23% of telecoms. One third of telecoms high-yield deals went through CSFB. Profits soared. So did costs, with compensation rising to 59% of revenues.

DLJ should have given CSFB critical mass in private equity, high yield, equities and M&A. CSFB scythed through the 12,000 staff at DLJ. For those staff it retained, CSFB has paid around $120m every quarter for the past 18 months in retention payments and more than $300m a quarter in amortisation of goodwill and acquired intangibles. Private equity last year made a loss on $138m, revenues in the equities business fell 23%, high yield hit a brick wall and investment banking revenues plunged by a quarter.

Mack has moved quickly to stamp out the profligacy of Wheat's CSFB. Since the DLJ merger, CSFB has fired a net 5,383 staff, or 17.6% of its workforce (see table). More than 2,500 were fired in the fourth quarter alone.

In unusual detail, the presentation broke down the headcount massacre by division and function. In front-office investment banking, staffing has fallen by 1,588 since the merger with DLJ, representing an astonishing 34.9% of the total bankers. The headcount in equities tumbled 24.6%. The net headcount reduction in the front office of 2,072 staff since the merger represents one in every six bankers. In the back office, 1,547 staff were cut, or 13.3% of all support staff. In fixed income, staffing has risen 23% since the merger and revenues have nearly doubled.

It is not over yet. Mack was characteristically blunt when he said that he expected revenues in 2002 to be lower than in 2001, and 'there will be more headcount reductions in investment banking this year'.

At the heart of CSFB's problem is its compensation ratio - the cost of salary and bonuses as a proportion of net revenues. For every $1m in revenues at CSFB in 2001, $575,000 went straight out the door in salaries and bonuses, before other costs and expenses, compared to an industry average of just 50.7%. Goldman Sachs scraped by with a figure of 48.7% last year, while Merrill Lynch, Lehman Brothers and Bear Stearns managed on around 51%.

Getting this ratio down has become Mack's Holy Grail. 'The goal is to get compensation ratio down to the industry average. We've made a lot of progress but there's a way to go. There are a number of significant obstacles to achieving this, such as outstanding guaranteed contracts,' he said. His swingeing cuts to save $1bn in costs launched in September slashed the ratio to just under 45%, but Mack accepts this is unrealistic in the short term. 'The figure of 45% achieved in the fourth quarter is totally unrealistic, given the outstanding contracts. 55% would be a good target,' he said.

This is not good news for those left at CSFB. Based on 2001 income and costs, this would require a further $350m saving in staff costs, which implies a further 5% cull and 1,250 redundancies this year. To reach the industry average, the required staff cuts could rise to as many as 3,390. If this happens, CSFB will have the same number of staff in the business areas where it operated pre-DLJ as it did before the merger.

The news is worse for senior bankers, one of whom said last week that cost cuts were specifically targeted at them. According to a presentation last year by Philip Ryan, chief financial officer of Credit Suisse, one less front-office banker saves $678,000, compared to just $151,000 in savings from firing a back-office member of staff.

Mack also revealed the extent of the guaranteed bonus problem: while bonus per capita fell 49% at CSFB last year, 'between 55% and 60% of bonuses paid last year were guaranteed'. He is hoping to reduce that figure to more like 25%. Couple this admission with an unusual slide in the presentation which broke down staff costs across Credit Suisse group into bonuses, salaries and retention payments, and you arrive at the startling conclusion that as much as 80% of its staff costs were fixed.

According to this slide, Credit Suisse Group paid out $4.7bn in bonuses in 2001 and a further $481m in retention payments. Ryan said that the vast majority of these went to CSFB. Assume conservatively that 75% of this total $5.2bn was accounted for by CSFB, and that up to 60% of bonuses were guaranteed, and you have 81% of CSFB's $8.04bn remuneration bill going in salaries, retention payments and guaranteed bonuses.

Mack is not just attacking bonuses and headcount. He has renegotiated many of the most excessive guaranteed contracts in exchange for equity, to create a 'one firm culture'. One analyst at Morgan Stanley described his efforts last year as 'inspirational'. Mack said: 'We're travelling differently, working differently - doing everything differently.' He recalled in his first visit to CSFB in London last year, a senior banker invited him to the British Open, where the bank was entertaining 30 clients for a week. 'I called the planning department and asked how much that was costing. I can tell you that we will never sponsor the British Open again,' he said. 'It's all about refocusing how we do our business.'

CSFB also revealed for the first time last week how and where it made its money (see pie chart), underlining how dependent CSFB is on the future health of key sectors. Investment banking, which employs 29% of CSFB's front-office staff, generated just 19.9% of the firm's revenues last year. Equities, with 27% of the staff, holds its own with 27.9% of revenues. Fixed income, which has nearly doubled its headcount since the merger and which now has 30.4% of all front-office staff, is relied upon to provide a whopping 40.7% of revenues.

A closer analysis of these broad divisions suggests CSFB is even more exposed. CSFB splits ECM revenues 50/50 between equities and investment banking. But a calculation of total ECM revenues as a proportion of all equity-related revenues shows that primary equities account for 35% of all equity revenues - at a time when new issues this year are running 47% below last year in Europe and 21% down in the US. Globally, new issues were down 49% in 2001 on the year before, when CSFB last made a profit. Of the non-primary equities business at CSFB, 40%, or $1.3bn, comes from equity derivatives and convertibles trading, representing 9.5% of the firm's total revenues.

Derivatives love volatility, and unfortunately equity market volatility is down 32% globally on this time last year and 23% on the last quarter, according to CSFB's own research. Customer equities business should remain steady with trading volumes down just 0.9% globally this year.

M&A, which generated 10.7% of CSFB's revenues (and 54% of its investment banking revenues), faces similar problems, with announced deals this year down 61% in the US and 63% in Europe.

So it all comes down to fixed income - as it does for much of Wall Street this year. However, investment-grade and high-yield issuance are down 11% and 13% this year in the US, which will not be offset by the 9% rise in European issuance.

With rates cut 11 times last year, they are going in just one direction from now on. Ominously, one reason cited by CSFB for its worse-than-announced fourth quarter results, was a slowdown in fixed income.

Mack is confident that the staff cuts have made 'no impact on our ability to attract and process new business'. Indeed, the firm increased its market share and ranking in equities and M&A in the past year, albeit with a marginal increase in its share of a much smaller market than the year before.

Patently, CSFB does not need and cannot afford as many staff as it still has, given market conditions. Mack has made a heroic effort so far to tackle the problem. If business does not pick up, the recent speculation about selling a drastically pruned CSFB to a bigger rival could become reality.