Morgan Stanley: Too Pliant a Board

S&P thinks the main worry for investors is weakening board independence in the wake of a power struggle at the financial-services giant

The executive makeup of Morgan Stanley (MWD ; recent price: $52) has changed dramatically in the past month at the hand of Chairman and CEO Philip Purcell -- and the impact on the company's board of directors should give shareholders pause, S&P analyst Robert Hansen believes.

"In essence, Purcell has effectively stacked the deck in his favor," says Hansen, who has a hold recommendation on Morgan Stanley shares. "We think that shareholder dissent, executive departures, and management-control issues will continue to hurt employee morale and client relationships, issues that we do not see being resolved quickly."

BOARD-CEO TIES. Eight former executives called for Purcell's ouster in early March, apparently prompted by concerns about the company's leadership, plus what they viewed as a languishing stock price. Later that month, Purcell replaced President Stephan Newhouse with two co-presidents, Zoe Cruz and Stephen Crawford. Both were also added to the board.

Many top-level executives have since left, including Vikram Pandit, who oversaw sales and trading, and John Havens, head of equities. Morgan Stanley announced the departures of Vice-Chairman Joseph Perella and head of investment banking, Terry Meguid, on Apr. 13.

Despite the shakeup, the board confirmed its full confidence in Purcell and the management's strategies on Apr. 12. "We think the board's unwavering support for Purcell stems from its historical ties to this executive," Hansen says. Four of the company's directors served on the Dean Witter, Discover & Co.'s board when Purcell headed that firm, which merged with Morgan Stanley in 1997. Meanwhile, none of the current members served on the Morgan Stanley board prior to the merger.

MANAGEMENT ABOUT-FACE. Aside from helping the company draw a lot of media coverage, what is the impact of these events, and why should investors be concerned? The biggest worry, says Hansen, is the deterioration of board independence. He cites the increase in the number of board members and their close ties to the chief. Hansen also believes Morgan Stanley should split Purcell's dual role as CEO and chairman.

Another issue, in Hansen's view, is what Morgan Stanley will do with its Discover Financial Services unit. The company said it would consider spinning off Discover. S&P expects management to recommend this course of action to the board.

Hansen believes a tax-free spin-off of Discover would maximize shareholder value but views such a move as "an about-face by management, largely intended to appease and derail dissident shareholders." He expects the spin-off by late in its fiscal year 2005 (ending November).

APPROPRIATE DISCOUNT. Hansen is also concerned about Morgan's compensation policies, an issue pervasive among its competitors. He notes that Purcell was awarded $22 million in total compensation in 2004, up 37% from about $16 million a year earlier, despite the stock significantly underperforming its peers.

Morgan Stanley shares recently traded at nearly 12 times Hansen's earnings-per-share estimate for fiscal 2005, which is a discount to peers, the overall market, and the stock's 10-year historical average of nearly 15 times. However, Hansen views the discount as appropriate, given his concerns about regulatory issues, generous executive compensation, and corporate-governance concerns relating to the independence of the board of directors. His 12-month target price is $58, which is equal to about 13 times his fiscal 2005 EPS estimate.

Burba is a reporter for S&P Global Editorial Operations

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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