Fitch Ratings has upgraded the rating outlook on Lehman Brothers Holdings Inc. to Positive from Stable.

The rating agency says that it believes the rating outlook revision is warranted based on the firm’s growing market share in equity sales and trading, investment banking and asset management; earnings retention, which has improved equity levels relative to risk appetite; and continuing stability and diversification in its funding base.

Fitch previously upgraded Lehman’s senior unsecured ratings in 2001 following reductions in its reliance on short-term debt, greater balance in its business segments and reduced retention of credit intensive assets.

“Since then the size and breadth of the fixed-income market has increased significantly improving stability of earnings, and driving higher margins,” it notes. “Lehman continues to possess a leading fixed-income franchise and has benefited from this growth. In addition, the vertical integration of mortgage origination and servicing operations into its securitization business (along with other operations) has positively affected profit margins leading to very strong performance.”

The equity market has also grown at a significant but slower pace, Fitch notes, and Lehman has taken market share. Fitch expects the growth of market share in equity sales and trading to continue over the next several years and ultimately result in greater diversification of revenues. “Lehman has expanded market share in equities through technological improvements, growth in equity distribution capabilities, and maintenance of well respected research and unique relationships with institutional investors. Its growth in advisory business has also positively affected equity underwriting revenues,” it adds.

It adds that Lehman’s prime brokerage business is expanding, but its scale is below that of several competitors. Fitch believes that its proprietary risk appetite is also below the company’s peers. “While these serve to reduce its overall risk appetite, it also may hinder Lehman’s ability to increase market share sufficiently to improve earnings diversification,” it notes.

“Lehman’s investment banking franchise has grown in scale, enhancing firm-wide performance from underwriting activity in both debt and equity. Growth in advisory, equity and debt underwriting fees of 32% year over year exceeded peers. Its ranking in global debt and equity underwriting league tables improved from #5 to #2 from 2004 to 2005 and they continue to gain market share. While league table rankings are misleading, Fitch believes Lehman can further expand, and has created financing capacity through syndicated and club deals offsetting some of its funding disadvantage due to its relative capital size,” it says.

It also notes that Lehman successfully integrated Neuberger Berman, exceeding efficiency projections and substantially growing assets under management largely organically. Fitch says it believes the business has additional growth capacity and operating leverage. “Challenges remain in achieving sufficient scale as the industry appears to be moving towards larger and larger competitors who could potentially pressure fees and limit Lehman’s ability to compete,” it adds.

“Lehman has been able to achieve market expansion and improve its efficiency and profit margins. It has entertained a number of acquisitions but has maintained discipline around cultural fit and price,” Fitch observes.

“An upgrade of Lehman’s long-term ratings may occur if it can continue to show positive earnings momentum, improve earnings diversification through scale, maintain profit margins and maintain its current stable funding base,” it explains. “Fitch will continue to monitor the growth in each business segment, Lehman’s risk appetite and the stability of its earnings, capital and funding. Market and credit risk are conservatively managed. Based on internal Fitch calculations, Lehman’s market risk appetite is in the low to mid-range of its peers. Long-term funding is stable and structured to avoid near term rollover risks.”