Morgan Stanley Final -...

23
Strategic Report Jason T. Hathaway Matthew Lubman Brendan Springstubb April 20, 2005

Transcript of Morgan Stanley Final -...

Page 1: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Strategic Report

Jason T. Hathaway Matthew Lubman Brendan Springstubb April 20, 2005

Page 2: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 2

Table of Contents

Company History 3 Competitive Analysis 6 Internal Rivalry 6 Entry 8 Substitutes and Complements 8 Supplier Power 9 Buyer Power 10 Financial Analysis 11 Company Analysis 12 Competitive Environment 14 Discounted Cash Flow Analysis 17 Key Issues and Solutions 18 Conclusion 22 References 23

Page 3: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 3

Company History

Morgan Stanley is one of the largest financial service firms in the

world, offering financial products and services to investors and corporations

worldwide. In 2003, Morgan Stanley ranked first in Global Equity Trading

among the major financial service firms, second in announced Global Mergers

and Acquisitions, third in Global Equity Underwriting, and fourth in Global

Debt Underwriting. Morgan Stanley’s current standing as a leader in the

Diversified Financial Services Industry (the “Industry”) stems from the 1997

merger between Morgan Stanley Group, Inc. and Dean Witter, Discover & Co.

The history of Morgan Stanley can be traced back to the opening of the

first Dean Witter brokerage office in San Francisco, California, in 1924.

During the late 1920s and early 1930s, Dean Witter steadily grew its

brokerage business, becoming one of the nation’s leading financial service

firms. In 1938, Dean Witter became one of the first financial services firms

to establish a National Research Department. Only seven years later, in

1945, the Company became the first financial services firm to formally train

account executives. Throughout the 1950s and early 1960s, Dean Witter

continued to grow by acquiring a number of smaller brokerage firms. Also,

the Company’s growth during the 1950s and 1960s can be traced to Dean

Witter’s integration of new computer technology with its growing brokerage

business. In 1961, Dean Witter became the first securities firm to use

electronic data processing.

Dean Witter first went public in 1972. Six years later, in 1978, the

Company merged with Reynolds & Co. in the largest securities merger to

date. And in 1979, Dean Witter became the first brokerage firm to hold

offices in all 50 states and the District of Columbia. In 1981, however, the

Company was acquired by Sears, Roebuck, & Co. Five years after being

purchased, Dean Witter expanded its business to include credit services with

the launching of its Discover Card unit in 1986. In 1993, Sears, Roebuck, &

Co. opted to spin off Dean Witter Discover to public shareholders. Then, in

1996, just one year before its merger with Morgan Stanley, Dean Witter

Page 4: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 4

created an electronic system that enabled clients to make banking and

securities transactions via the Internet.

In 1935, Morgan Stanley opened its first office in New York. Following

the Glass Steagall Banking Act in 1933, which forced firms to choose

between their commercial banking and investment banking businesses,

Henry S. Morgan, Harold Stanley, and a select group of other finance

professionals left J.P. Morgan & Co. and Drexel & Co. to form the investment

banking firm of Morgan Stanley & Co., Inc. One year after its inception,

Morgan Stanley had achieved 24% market share among public offerings. In

1941, the Company joined the New York Stock Exchange (NYSE) and

reorganized itself as a partnership. Morgan Stanley continued to grow its

business throughout the 1950s, with its most notable transaction being the

Company’s co-management of the World Bank bond offering in 1952.

Throughout the 1960s, Morgan Stanley entered a period of growth and

expansion that continued through the 1997 merger with Dean Witter. In

1967, the Company opened Morgan Stanley & CIE. International in Paris and

London in an effort to pursue the growing international securities market.

Also, in 1969, Morgan Stanley expanded its business model to include real

estate financing and advisory services. In 1971, Morgan Stanley entered the

sales and trading business and established its Mergers and Acquisitions

Group. By 1975, the Company had expanded its business through its

addition of institutional investors, making Morgan Stanley a full service

financial firm. Only two years later, in 1977, the Company formed Morgan

Stanley Realty, Inc. and Morgan Stanley Private Wealth Management.

Throughout the 1980s and 1990s, Morgan Stanley continued to expand, with

the two most notable transactions being its establishment of the Novus credit

card network and the Company’s acquisition of Van Kampen American Capital

Mutual Fund Family.

In 1997, Morgan Stanley Group, Inc. and Dean Witter, Discover & Co.

merged to form the modern Morgan Stanley, a global market leader in

securities, asset management, and credit services. Only a year later, Morgan

Stanley raised $4.4 billion for Dupont’s spin off of Conoco, which was the

Page 5: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 5

largest initial public offering in the United States to date. In the following

five years, Morgan Stanley continued to grow through a series of

acquisitions. In 1999, the Company acquired AB Asesores, Spain’s largest

financial service firm. In the same year, Morgan Stanley purchased the

private wealth management firm, Graystone Partners, LP, and also joined

with Sanwa Bank in an attempt to provide investment products to Japan. In

2000, the Company purchased Ansett Worldwide Aviation Services to become

one of the largest financial owners of aircraft. In the following years, the

Company serviced some of the largest financial transactions to date in the

United States. Most notably, in 2001, Morgan Stanley served as the

underwriter for the $4.1 billion public offering of Agere Systems, the largest

initial public offering to date in the United States.

Page 6: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 6

Competitive Analysis

Any analysis of the Diversified Financial Services Industry requires an

initial definition of the product and geographic markets in which firms

compete. The products offered by firms in the Industry include institutional

securities, private wealth management, asset management, and for some

firms, credit services. For most firms in the Industry, however, credit

services comprise only a small fraction of total revenues, implying that the

main product markets in the Industry are simply institutional securities,

private wealth management, and asset management. Hence, Morgan

Stanley’s main competitors are Bear Sterns, Citigroup, Credit Suisse First

Boston, Goldman Sachs, JP Morgan Chase, Lehman Brothers, Merrill Lynch,

and UBS. Since all of the major firms in the Industry offer financial services

throughout the world, geographic considerations are of relatively little

importance to defining the market. That is, all firms in the Industry complete

in the global marketplace. While there are a number of other firms, such as

Charles Schwab, American Express, and Bank of America, that compete in

specific product markets, our five forces analysis focuses primarily on the

major financial services firms identified above.

Internal Rivalry

The Diversified Financial Services Industry is extremely competitive.

At the core of competition in the market is the vast number of firms offering

wide varieties of financial services to consumers. The intense competition

within the Industry is easily justified by the fact that there are at least nine

major firms competing within the Industry’s main product markets. In

addition to the primary competitors identified above, firms in the Industry

must also compete with smaller, more regionally focused firms such as

Wachovia, Wells Fargo, and American Express, all of which offer financial

services to individuals and corporate clients.

Competition in the Industry is also heightened by the fact that

financial products are relatively undifferentiated. For example, if a consumer

firm is considering launching an IPO, any number of the nine main firms in

Page 7: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 7

the Industry, plus other banking firms outside of the well-defined Industry,

may be in direct competition to be hired to underwrite the transaction. With

all of investment banks in the Industry offering nearly identical products,

competition to provide investment banking services is extremely intense.

Internal rivalry is further augmented by low switching costs incurred by

buyers. Using the example above, it is easy to see that the consumer firm

contemplating an IPO incurs minimal costs in choosing Morgan Stanley over

say, Goldman Sachs. The lack of product differentiation and low switching

costs that increase internal rivalry extend beyond investment banking. On

the asset management side, products are essentially undifferentiated;

individual investors and private wealth managers can choose to allocate

funds to any number of asset management firms. Switching costs for these

buyers are also low, as they have the freedom to transfer/remove funds

essentially without penalty. Of the three main products offered by firms in

the Industry, private wealth management is perhaps the most differentiated

and has the highest switching costs to buyers. Buyers may develop loyalties

to private wealth managers over time, increasing the implicit cost of hiring a

new financial advisor. Barring individual loyalties among investors, buyers

can costlessly hire and fire financial advisors.

Finally, internal rivalry in the Industry results from the relative size of

particular transactions. In investment banking, one or two large transactions

can launch firms to the top of the Industry rankings. For example, Proctor &

Gamble’s $57 billion purchase of Gillette substantially altered the rankings for

top merger advisors to date in 2005, landing Goldman Sachs, Merrill Lynch,

and UBS in the top three in the Industry. Prior to the merger, UBS had

never been included among the top three in merger advisory services. Thus,

we see that large transactions, such as the Proctor & Gamble/Gillette merger,

increase internal rivalry as firms attempt to capitalize on rare, high-revenue

transactions. Once again, the same trend is observed in the asset

management and private wealth management product markets. Firms in the

Industry compete aggressively for large individual and institutional accounts

that bolster fees and commissions.

Page 8: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 8

Entry

There is a relatively low threat of entry to the Diversified Financial

Services Industry. Due to the size of the firms in the Industry and the

maturity of the market, it would be, for all practical purposes, impossible for

any start-up financial services firm to ever enter the market or compete

effectively with Morgan Stanley or any other firm in the Industry. Thus, the

most significant threat of entry is the possibility that a middle-market firm,

such as Lazard or CIBC World Markets, could grow its business fast enough

to enter the market and steal market share from existing firms. Such

prominent middle-market firms are already viewed as peripherally

competitive to the established firms in the Industry with respect to specific

product groups, such as investment banking. However, there is still

relatively little threat that any middle-market firm would be able to enter the

market and steal significant market share from existing firms. Reputation is

an extremely important firm quality in the Industry, and hence, it is unlikely

that any new firm would have the ability to steal substantial market share

from existing, highly reputable firms. Furthermore, the experience curve in

the Industry also limits entry. Implicitly, firms such as Goldman Sachs, who

have a great deal of transaction experience in every product market are

more likely to be hired to conduct similar transactions in the future. Entry is

also deterred by certain economies of scale possessed by larger firms; such

economies include research costs, Industry experience, administrative costs,

technical efficiency, etc.

Substitutes and Complements

The primary substitute to Diversified Financial Services is for buyers to

diversify their financial purchases independently. For example, individual

investors can choose not to hire private wealth managers, but instead to

handle their investments personally through an independent account. They

may choose to individually buy stocks and/or mutual funds, based on their

own research or gained knowledge. Investors can choose to substitute away

Page 9: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 9

from securities in general by investing in real estate, hedge funds, or

alternative investments.

Buyers also have a wide range of asset management services from

which to choose beyond those offered by firms in the Diversified Financial

Services Industry. For example, buyers can substitute away from services

offered by Merrill Lynch or Morgan Stanley by once again investing their

funds independently in mutual funds or other asset management firms.

Examples include Fidelity, Van Kampen, and Janus.

With respect to investment banking, buyers have the ability to

substitute away from the Diversified Financial Services Industry by hiring an

investment bank not explicitly included in the Industry; for example, buyers

may choose a boutique investment bank, such as Barrington Associates, for

mergers and acquisitions advisory, or a hedge fund or private equity firm as

a source of capital-raising.

For those firms in the Industry that offer credit services, buyers have

the option of opening an account with a credit services firm not already in

the Industry, such as American Express. Ultimately, however, the threat of

buyers substituting away from firms in the Industry is relatively small due to

the number of buyers in the market.

Supplier Power

Firms in the Industry face very little supplier power. Diversified

Financial Services firms have two groups of suppliers: (1) capital providers,

including mutual funds, hedge funds, and institutional buyers of equity and

debt financing, and (2) employees. In the case of capital providers, firms in

the Industry are not subject to either direct or indirect supplier power. That

is, suppliers of capital have very little pricing power over firms in the

Industry due to the large number of suppliers; in other words, the supply

market for firms in the Industry is not very concentrated. Employees have

low to medium supplier power in commanding a higher wage. In each

division of Diversified Financial Services firms, there are usually a few top

finance professionals at the executive level, called “rainmakers.” These

Page 10: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 10

rainmakers generate large amounts of business for their respective firms.

For example, in private wealth management, a rainmaker may be a financial

advisor who has an extremely large amount of assets under management.

Seemingly, these rainmakers have at least some supplier power over their

respective firms because they have the ability to take their talents to a

competing firm. The same is true for top investment bankers and asset

managers.

Buyer Power

Buyers include individuals and institutions that purchase financial

services from firms in the Industry. With respect to investment banking,

buyers include corporations seeking to finance projects and/or undertake

mergers or acquisitions. Other buyers include wealthy individual investors

purchasing the services of a private wealth manager, and a money manager

purchasing asset management services. Buyers in the Industry are

essentially price-takers. That is, they have little power to alter purchase

prices from sellers due to low concentrations of buyers in the market. As a

result of the large number of buyers in the market, no single buyer can

significantly alter the price it pays for financial services. A summary of our

five forces analysis is shown in the following table:

Five Forces Analysis

Internal

Rivalry Entry

Substitutes and

Complements Supplier Power

Buyer

Power

High Low Low to Medium Low to Medium Low

Page 11: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 11

Financial Analysis

As a diversified financial services firm, Morgan Stanley operates in four

primary lines of business: (1) Institutional Securities, which includes

investment banking, sales, trading, financing, and market-making activities,

(2) the Individual Investor Group, which manages assets for wealthy private

individuals, (3) Investment Management, whose services include asset

management and private equity activities, and (4) Credit Services, led by the

Company’s Discover Financial Services unit. In 2004, Morgan Stanley

reported total revenues of $39,549 million and net income of $4,486 million.

Of the $39,549 million, Institutional Securities earned $9,378 million in 2004,

or 23.7% of total revenues. The Individual Investor Group accounted for

8.25% of the Company’s total revenues, posting revenues of $3,264 million.

The Company’s Investment Management unit earned $4,412 million

(11.16%), while Credit Services accounted for $1,318 million (3.33%). The

Company’s largest source of revenue, however, came in the form of dividend

and interest income, stemming from aggregate financing and investing

activities. Dividend and interest income accounted for 47% of the

Company’s revenues, or $18,590 million. The composition of Morgan

Stanley’s 2004 revenues is shown in Figure 1 below:

Figure 1

24%

8%

11%

3%

47%

7%

InvestmentBankingIndividualInvestor GroupInvestmentManagementCredit Services

Interest andDivident IncomeOther Income

Page 12: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 12

Company Analysis

Morgan Stanley’s current share price is $56.95, which implies a market

capitalization of $61.41 billion. Since the collapse of the Internet bubble in

2000 and the events of September 11th in 2001, Morgan Stanley has

successfully increased its market capitalization by and average of 8.3%

between 2002 and 2004. During the 3-year period, the Company’s market

capitalization grew from just over $48 billion in 2002 to $61.41 billion at the

end of 2004. The Company’s revenues grew 10% in 2004, well above its 5-

year average of 2.3%, but moderately lower than its 10-year average

revenue growth rate of 14.3%. Furthermore, net income increased by 18%

in 2004, above both the Company’s 5-year average of 2.2% and its 10-year

average of 17%. Morgan Stanley’s return on equity was 15.9% in 2004, up

from 15.23% in 2003 and 13.65% in 2002. The observed growth in the

Company’s return on equity can be directly traced to its increased

profitability, as its net profit margin improved steadily in each of the past

three years. In 2004, Morgan Stanley reported a profit margin of 11.34%, a

moderate increase from the 10.84% and 9.21% reported in 2003 and 2002,

respectively. The 3-year increase in return on equity is also linked to the

significant increase in the amount of assets held by the Company. In 2004,

the Company reported an increase of $234 million in long-term investments,

resulting from recovering financial markets and improved economic

conditions. As a result, Morgan Stanley was able to increase its asset-base

from roughly $530 billion in 2002 to over $774 billion at the end of 2004.

Also, the significant increase in the asset value boosted the Company’s

financial leverage. In 2002, Morgan Stanley had an asset-to-equity ratio of

24.19; however, by the end of 2004, the Company had increased its financial

leverage to 27.49. Using DuPont Analysis, Figure 2 illustrates the increase in

the Company’s return on equity due to increases in both profitability and

financial leverage between 2002 and 2004:

Page 13: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 13

Figure 2

Year Profit Margin Asset Turnover

Financial

Leverage

Return on

Equity

2004 11.34% 5.10% 27.49 15.90%

2003 10.84% 5.80% 24.24 15.23%

2002 9.21% 6.13% 24.19 13.65%

Morgan Stanley’s ability to increase both profitability and the value of

its assets over the past three years has been fully reflected in its share price.

At the end of 2002, shares were trading on the New York Stock Exchange at

$39.92. By the end of 2004, however, shares were trading at $56.95, up an

average of 12.57% per year. Of course, the increase in share price in the

period between 2002 and 2004 reflects the Company’s recovery from the

collapse of the technology bubble and the events of September 11th, both of

which had devastating effects on Morgan Stanley due to the Company’s

sensitivity to overall market conditions. Figure 3 illustrates the Company’s

share price over the last five years compared to the performance of the S&P

500:

Figure 3

Page 14: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 14

As evidenced by Figure 3, both Morgan Stanley and the S&P 500

suffered substantial losses in share price as a result of the collapse of the

Internet boom and the subsequent attacks of September 11th. It is clear,

however, that Morgan Stanley’s share price suffered significantly larger

declines in value than the S&P 500. Such phenomenon may not only be

explained qualitatively by Morgan Stanley’s dependence on financial markets,

but is also justified quantitatively by the Company’s high beta value. Morgan

Stanley has a beta of 1.956, which is high for any industry, including

Diversified Financial Services. In short, the large risk premium required by

equity holders due to Morgan Stanley’s exposure to changes in the overall

economy makes the Company’s share price more volatile with respect to

changing market conditions.

Competitive Environment

While there are many financial services firms, Morgan Stanley’s

primary competitors in the Diversified Financial Services Industry are

Citigroup, Merrill Lynch, and Goldman Sachs. It is difficult at times to

accurately assess the competitive environment in the Diversified Financial

Services Industry as a result of the size of Citigroup’s assets and its overall

dominance in the Credit Services Market. For example, at the end of 2004,

Citigroup’s asset-base was over 1.264 trillion, more than 60% larger than the

next firm in the Industry. In 2004, Citigroup’s market capitalization was over

$248 billion, more than four-times that of the second largest firm. Figure 4

illustrates the size of each firm relative to its competitors:

Page 15: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 15

Figure 4

Company

Morgan

Stanley Citigroup

Goldman

Sachs

Merrill

Lynch Industry

Market Value (billions) 61.41 248.49 52.97 55.65 104.63

Assets (millions) 775,410 1,264,032 531,379 494,518 766,335

Revenues (millions) 39,549 108,276 29,839 27,745 51,352

Net Income (millions) 4,486 17,046 4,553 3,988 7,518

As evidenced by Figure 4, Citigroup is the largest firm in the Industry.

Citigroup’s market capitalization, asset-base, revenues, and net income are

so large that, from a monetary perspective, it appears to be in a league of its

own. It is also evident from Figure 4, however, that Morgan Stanley appears

to be well positioned in the Industry in terms of market value, assets,

revenues and net income, as the Company is second only to Citigroup in

three of the four categories. To better assess Morgan Stanley’s competitive

position in the Industry, it is necessary to analyze the profitability of each

company and the Industry as a whole. Figure 5 illustrates, through the use

of DuPont Analysis, the profitability of each company in the Industry

compared to the Industry average:

Figure 5

Company

Morgan

Stanley Citigroup

Goldman

Sachs Merrill Lynch Industry

Net Profit Margin 11.34% 15.74% 15.26% 14.37% 14.18%

Asset Turnover 5.10% 8.57% 5.62% 5.61% 6.22%

Financial Leverage 27.49 12.90 21.19 17.88 19.86

Return on Equity 15.90% 17.39% 18.15% 14.42% 16.47%

Return on Assets 0.58% 1.35% 0.86% 0.81% 0.90%

As demonstrated by the financial leverage ratio of each company,

Morgan Stanley is the most levered, with an assets-to-equity ratio of 27.49.

Morgan Stanley’s high leverage ratio is consistent with its high beta value.

In general, the more levered a firm is, the more risky it will be viewed by

investors, and hence, the higher the required rate of return used to discount

Page 16: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 16

future cash flows. Thus, while Morgan Stanley’s profit margin is well below

the industry average of 14.18%, the Company’s return on equity is still

relatively competitive as a result of its leverage. Finally, Morgan Stanley’s

return on assets of .58% is well below the Industry average of .90%.

From an equity pricing perspective, it is vital for an investor to be

aware of average prices, multiples, and levels of risk within the Industry.

Figure 6 illustrates the share price, price-to-earnings multiple, and beta value

for each company in the Diversified Financials Industry, along with the

Industry average:

Figure 6

Company

Morgan

Stanley Citigroup

Goldman

Sachs Merrill Lynch Industry

P/E 13.96 15.19 12.34 14.19 13.92

Share Price ($) 56.95 47.88 110.02 59.93 68.70

Beta 1.96 1.33 1.63 1.61 1.63

The most important statistic given in Figure 6 appears to be the beta

values for each of the four firms. Morgan Stanley has the largest beta in the

Industry, which implies that the Company is more risky than any of the other

three firms. As would be expected from the size of its assets, Citigroup has

the smallest beta, which implies that it is less risky than the other firms in

the Industry. Both Goldman Sachs and Merrill Lynch have beta values nearly

equal to the Industry average. Figure 7 graphically illustrates share price

performance for each firm in the Industry, along with the S&P 500:

Page 17: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 17

Figure 7

Discounted Cash Flow Analysis

Assuming a risk-free rate of return on a ten-year Treasury note of

4.36% (the current yield), a constant beta value of 1.956, and an expected

market return of 7% in the future, Morgan Stanley would have to maintain

5.5% growth for the next ten years and 3% thereafter in order to justify its

current share price of $56.95. Given these assumptions, it is difficult to

determine whether Morgan Stanley is currently undervalued. There appears

to be insufficient evidence to support a “BUY”, “STRONG BUY”, or “SELL”

rating at this time. Ultimately, discounted cash flow analysis yields a “HOLD”

rating on Morgan Stanley’s common stock, the same rating currently given

by Standard and Poor’s.

Page 18: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 18

Evaluation of Key Issues

Issue 1: Discover Financial Services: Sell or Spin Off?

On April 4, 2005, Morgan Stanley announced that the Company’s

board had approved for management to pursue a spin off of its Discover

Financial Services unit. The announcement appears to stem from recent

attacks by eight former executives on the job performance of current

Chairman and Chief Executive Officer, Phillip J. Purcell. The group of former

executives currently own 11 million shares, or approximately one percent of

shares outstanding. Morgan Stanley must currently decide whether a sale of

the unit to another credit card company will increase shareholder value (in

both the short-run and the long-run) more than spinning off Discover into its

own separate entity through the issuance of Discover stock to current

Morgan shareholders. Nearly all Industry analysts value the Discover unit at

somewhere between $9-15 billion, with most agreeing that a spin off would

be valued at approximately $11 billion. Possible buyers that may be

interested in acquiring Discover include JP Morgan Chase, Bank of America,

American Express, MBNA & Co., and Capital One Financial Corp., among

others.

Solution: Sell Discover

We recommend that Morgan Stanley capitalize on the current market

for its Discover Financial Services unit. Even if the Company is able to fetch

a spin off price at the upper end of analysts’ estimates (say, $11 billion, or

even more optimistically, $12 billion), very little, if any, shareholder value

will be created directly from the spin off. Furthermore, it is possible that the

spin off could dilute shareholder value if the spin off does not fetch a market

price equal to that which is currently embedded in the value of Morgan

Stanley. That is, it is possible that the unit may be viewed by investors as

less valuable on its own than it is under the umbrella of Morgan Stanley.

Even if such a result is unlikely, it is still a risk borne by existing shareholders

since equity offerings do not always live up to the expectations of Wall Street

analysts. True, the spin off could prove to be successful in the long run

Page 19: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 19

under new management; however, Discover is peripheral to Morgan’s core

securities business. In order to do what’s best for shareholders in both the

short- and long-run, Morgan should refocus its strategy on growing its core

securities business.

If Morgan Stanley chooses to sell Discover to an existing credit card

company, it will almost assuredly be able to fetch a price that is substantially

higher than its spin off value. One possible reason for this is that existing

credit card companies will value Discover more highly as a result of possible

synergies, existing management effectiveness, etc. If Discover simply

becomes an independent entity, there is no guarantee that, even under new

and/or better management, it will be more profitable in the future than

expected, a result needed in order to increase shareholder value. Thus,

Morgan Stanley should allow shareholders to “cash out” of Discover because

the price it receives for the unit can be used to grow Morgan Stanley’s core

securities business, a strategy that is less risky and has a higher probability

of increasing shareholder value. The price obtained by Morgan Stanley for its

Discover unit will enable the Company to allocate funds to help grow its

Institutional Securities, Asset Management, and Individual Investor Groups.

Moreover, the immediate increase in shareholder wealth resulting from the

acquisition announcement (assuming the tender price is above the market

value) may serve to mitigate the current pressure of Phillip Purcell to resign.

If nothing else, an immediate increase in shareholder wealth will buy Mr.

Purcell some time to prove that he can operate Morgan Stanley’s core

securities business profitably.

Issue 2: Underperformance of Asset Management

The asset management division of Morgan Stanley has grown its

revenues by an average of 4% over the past three years; however, the unit’s

five-year average annual growth rate is slightly less than zero. These

returns, while subject to conditions in the market, reflect an under

performance based on the expectations of Wall Street analysts.

Furthermore, Morgan Stanley is subject to the growing trend of talented

Page 20: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 20

asset managers fleeing large investment banks to join hedge funds or other

asset management firms, which may possess greater compensation

schedules.

Solutions: Acquisitions and Lateral Hires

With the sale of its Discover unit, Morgan Stanley will have the cash

needed to re-vitalize its asset management unit, which has recently under

performed and subsequently hurt shareholder value. Improvement within

the asset management division of the Company can be done in a number of

ways. First, and most likely, Morgan Stanley could seek to acquire an

existing asset management firm as a means of adding value to its existing

asset management division. That is, we feel that Morgan Stanley should use

the money from its sale of Discover to grow its core securities business by

locating and acquiring an existing asset management firm(s). While Morgan

has come under scrutiny over past acquisitions, shareholders would likely

approve the acquisition of an existing asset management firm since it

represents an investment in the Company’s core securities business. Thus,

we feel that Morgan may find it beneficial to explore possible acquisitions in

the asset management market.

Secondly, we recommend that Morgan Stanley take additional

measures to improve the quality of finance professionals in its asset

management division. For example, Morgan could seek to laterally hire

successful asset managers who are currently employed at other firms.

Morgan Stanley’s corporate culture and reputation make it an attractive work

environment for finance professionals. Morgan could play this card as a

means of attracting new, talented asset managers, particularly those working

at smaller, lesser-known firms. It is also possible that incentive packages

could be created to laterally hire asset managers from Morgan’s direct

competitors (i.e., Merrill Lynch, Citigroup, etc.), though such a strategy may

prove problematic if it causes “wage wars” between competing firms. One

possibility to avoid such a problem would be to set contracts for a specific

length of time, thus ensuring that a “rainmaker” does not simply leave

Page 21: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 21

Morgan after receiving an incentive package. Fixed-length contracts would

most likely increase profitability, especially if the Company can laterally hire

a few of the top finance professionals in the Industry. But Morgan’s culture

could prove to be the most powerful tool in recruiting lateral hires,

particularly those who have shown persistent success at smaller asset

management firms and/or hedge funds. A similar process could also be used

to attract successful financial advisors from other firms to Morgan’s

Individual Investor Group.

Page 22: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 22

Conclusion

In summary, our analysis suggests that Morgan Stanley adopt a “back

to basics” approach to its corporate strategy. In particular, the company

should sell its Discover unit and pump the proceeds back into its three core

lines of business: Institutional Securities, Individual Investor Group, and

Asset Management. Given current market conditions, we are confident that

Discover will sell to another credit card company at a price much higher than

it would as a spin off. Furthermore, the sell off will not only increase

shareholder value, but will also likely relieve, at least to some degree, the

current pressure being put on Mr. Purcell by former Morgan executives.

Finally, the sell off will provide the capital needed to restore Morgan’s core

business units to prosperity, particularly its asset management division.

Page 23: Morgan Stanley Final - Pomonaeconomics-files.pomona.edu/.../sagegroup2005/Reports/Morganstanley.pdf1996, just one year before its merger with Morgan Stanley, Dean Witter . Morgan Stanley

Morgan Stanley

SageGroup, LLC. 23

References

The Wall Street Journal

Yahoo! Finance

Morgan Stanley Corporate Website

Hoovers Online

Standard and Poor’s

Morgan Stanley 10-K