The Management Turmoil Muddying Morgan Stanley's Waters


By Margaret Popper Judging by their stock charts, Goldman Sachs' (GS) and Morgan Stanley Dean Witter's (MWD) boats are pushed by the same tides. They both hit the top of their 52-week trading ranges in September and fell sharply in December. Since then, both stocks have climbed back, with Goldman at $117, a little closer to its 52-week high of $134 than Morgan Stanley -- trading at around $84 -- is to its 52-week high of $110.

The lows reflect investors' fears about the effective shutdown of the IPO markets in the second half of 2000, an important source of investment-banking revenue, as well as trading losses incurred, often on behalf of clients. The rebound reflects investor confidence that the Federal Reserve will continue cutting interest rates, thereby reducing the cost of funds and increasing corporate clients' appetite for raising money in the capital markets.

DIFFERENT STRATEGIES. Though their stocks have been moving in tandem, these companies are hardly twins. Morgan Stanley Dean Witter is pursuing a full-service strategy, including brokerage for individuals, a credit-card business, and a large asset-management practice, all of which Goldman for the most part has shunned.

Succeeding in the full-service business requires keeping a tight rein on costs, which so far Morgan Stanley has managed admirably. But a steady stream of key management defections over the past four to five months -- culminating late in January with those of President and Chief Operating Officer John Mack and Richard DeMartini, chairman and CEO of the firm's international private-client group -- could make it harder to maintain this discipline going into 2001.

The management changes could affect the momentum of the firm's biggest growth area for 2001: Europe. Economists predict Europe's economy will grow twice as fast as that of the U.S. this year. Increased deregulation, privatization, and participation of individual investors in stocks should also contribute to hot growth in Europe. So until the management dustup settles, investors might be wise to stay on the sidelines.

MISSED EARNINGS. A comparative newbie in full service, Morgan Stanley has shown veteran Merrill Lynch (MER) a thing or two about managing costs. Morgan Stanley ended 2000 with a return on equity (ROE) of 30.9%, well above Merrill's 24.2% and even above that of pure-play investment bank Goldman, which had an ROE of 27%. That's in a year that Morgan Stanley missed its third-quarter earnings as a result of stock and commodity-trading losses, and then missed fourth-quarter earnings for its fiscal year ending Nov. 30 due to junk-bond-trading losses.

Responsibility for the company's cost structure is generally handled by Chairman Phil Purcell, former head of Dean Witter Reynolds. The firm's recent announcement of a name change from the polysyllabic Morgan Stanley Dean Witter to just Morgan Stanley suggests that Purcell has little Dean Witter nostalgia. Purcell built the Discover card to be a cash cow, with its own merchant network and a system that doesn't split processing fees with a bank the way Visa and MasterCard do.

Purcell also expanded Dean Witter in the early '90s by hiring young, cheap brokers and training them from scratch. That strategy hasn't changed in the U.S., which could help Morgan Stanley's network of 16,000 retail brokers survive the current choppy markets, particularly if they can continue to cross-sell asset-management services to retail and institutional clients.

PROVIDING STABILITY. Of course, analysts generally are pleased with the way Morgan Stanley has implemented its 1997 merger with retail-broker and credit-card giant Dean Witter Reynolds. "With Morgan Stanley Dean Witter or Merrill Lynch, retail brokerage and their ancillary businesses don't necessarily provide higher returns on equity, but they provide stability of earnings," says David Burns, an analyst at money manager Federated Investors.

Investment-banking revenues are more volatile, particularly since institutional clients generally expect their bankers to make markets in securities that are hard to unload. That can mean the investment bank ends up taking losses in a down market. For example, Morgan Stanley Dean Witter had paper losses of $70 million in its private-equity portfolio as a result of market making in 2000.

Morgan Stanley may see costs rise as it pursues it European strategy. It has had to go into individual countries and buy up small, well-respected local brokerages. This is a more expensive way to build a sales force, but it may be the only way to recreate in Europe what Morgan Stanley is in the U.S.: an investment-banking and brokerage giant. Its first such acquisition was of AB Asesores in Madrid in 1999. Last year, it bought Quilter Holdings in London.

LONG-TERM PROSPECTS. Once Morgan Stanley has brokerage offices across Europe, it should be able to use them to significantly increase its European asset-management business as well. "Going forward, we believe that much of the margin improvement in the company's asset-management business is done," wrote James Mitchell of Putnam Lovell in his Jan. 9 report on the company. "We expect earnings growth to track more in line with asset and revenue growth, which we expect to be 10% to 15% over the long term."

Along the same lines, the firm is beginning a campaign to push the Discover card overseas, another product that could be marketed to its retail client base. But creating brand awareness abroad could be costly, since Discover is now a U.S. card. Nonetheless, Europe offers a much greater field for credit-card growth than the U.S., where the business is fairly mature. With its economy expected to grow twice as fast as that of the U.S. this year, "Europe will be the bulk of the firm's growth," says Marc Halperin, a senior portfolio manager at Federated.

Although Morgan Stanley seems to be managing its defections seamlessly, the talent drain hasn't abated. It began with the head of the institutional investment-banking business last August, spread to the head of fixed income, and finally reached the top levels with Mack's departure. The exit of DeMartini, architect of the European retail strategy, who joined Bank of America, is a sore disappointment. At the very least, his departure raises potential for some disruption on an important growth front. The company declined comment on the resignations.

MAKES YOU WONDER. Analysts aren't sure what the impact of the executive shuffle will be. "The management defections won't hurt the fundamental earnings story, but it does make you wonder," says Diana Yates, analyst at AG Edwards. Still, Morgan Stanley has its staunch defenders, among them Guy Moszkowski, Salomon Smith Barney's financial-institutions guru.

He says Morgan Stanley has a deep enough bench to weather the recent defections. "Mack is an extremely talented guy, and you never like to see someone like that leave a firm, but Phil Purcell is still chairman. He's a visionary," Moszkowski says. He credits Purcell with recognizing the importance of online brokerage early on with his acquisition of Lombard but also having enough sense to retrench so Morgan Stanley wouldn't compete with the online services catering to day traders.

With a $100-a-share 12-month target price on the stock, Moszkowski isn't even the most bullish of Morgan Stanley's followers. The target prices of the 16 analysts who follow the stock range from $90 to $115, according to First Call data. Consensus earnings per share for the first quarter of fiscal 2001 is $1.06 -- flat in comparison to the fourth quarter of 2000. Analysts' consensus for full-year earnings is $4.92 per share, up only 4% from 2000. Revenues will grow 23%, from $26.4 billion in fiscal 2000 to $32.6 billion in 2001, according to analysts' consensus.

If those target prices seem out of line with such scrawny earnings growth, that's because analysts usually predict low earnings growth for investment banks as a result of their volatility. Over the long run, most analysts believe Morgan Stanley will be a top performer among its peers. "We see it as a long-term hold," says Federated's Halperin. "We'll buy it on the dips." With its stock trading at a fairly robust 16.9 times 2001 earnings per share, that's probably a wise strategy until the management picture clears a bit. Popper covers the markets for BW Online in our daily Street Wise column


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