Tuesday, April 26, 2005

Morgan Stanley: Worth its Weight in People.

Morgan Stanley is losing talent – and losing its competitive edge as a result. Two high profile investment bankers, Joseph Perella and Tarek Abdel-Meguid, have left Morgan Stanley because they are upset with CEO Philip Purcell and his moves to shake-up management and direct the company’s future.

It is these moves, defectors claim, that have damaged the company’s competitive advantage. Former Morgan Stanley president Robert Scott recently said in a company presentation that Purcell's mismanagement of the retail brokerage and asset management divisions had cost Morgan Stanley $30 billion in lost market capitalization.

These numbers don’t lie. Morgan Stanley has underperformed the banking industry since its merger with Dean Witter. According to Morningstar, Morgan Stanley shares have trailed the industry by 4.5% percentage points annually, on average, over the past five years. In 2004, shares trailed the industry and the S&P 500 by 12.9% and 13.1%, respectively. The company also appears to be less profitable: According to Yahoo! Finance, Morgan Stanley’s operating margins trail competitor Goldman Sachs’ by about 4.5 percentage points, and the industry by about 1.20 points. Key executives have left at a time when Morgan Stanley is vying for market share in a market rejuvenated by a sharp increase in initial public offerings (IPO’s increased 195% in 2004 compared to 2003, according to Hoover’s).

The problem for Morgan Stanley is two-fold; First, investment banking clients tend to stick with their bankers, no matter what firm they’re working with. These clients comprise the billion-dollar meat of the company; without them, the company is hollow. The departure of key bankers like Perella and Abdel-Meguid puts Morgan Stanley’s revenues and profits at risk. Second, and more importantly, investment bankers tend to stick together. Perella’s and Abdel-Meguid’s departures triggered the resignation of high-level employees including Guru Ramakrishnan and Stephan Newhouse. This puts Morgan Stanley, and Purcell, in a tight spot when it comes to making everyone happy: if one person leaves, others will follow.

CEO Purcell’s recent actions appear to qualify these posits: According to TheDeal.com, Purcell tried to make high level executives, including former president of institutional securities Vikram Pandit, “swear to uphold [Purcell’s] reign,” before Purcell would promote them to higher positions. Purcell needs to retain top talent to keep Morgan Stanley’s business strong, but his fears of internal revolt prompted him to resort to drastic measures to keep people like Pandit with the firm.

If revenues and profits depend on people like Perella and his peers, does this mean that Morgan Stanley’s competitive advantage has more to do with its human capital than its brand equity? We believe so. The brand-equity of an investment bank is a byproduct of the people that work there and a mirror image of its talent pool. This creates a network effect, whereby a bank attracts talent, which bolsters the reputation of the bank, which attracts more talent, and so forth.

Industry observers cite how damaging it is when top talent leaves: “What Purcell has done to stay in power has weakened the firm,” said Richard X. Bove, an analyst at Punk Ziegel. And the dissidents, other than ripping up the company, they have provided no plan and no cash. As a result the franchise starts to erode, and Purcell loses the freedom to do what is best for the company.”

We believe that the Morgan Stanley brand (or any investment bank’s brand) is not sustainable without talented people. Excerpts from a recent letter written by eight influential former executives and shareholders to Morgan Stanley’s board of directors confirm this: “unless immediate action is taken to reverse the loss of talent, the firm's ability to restore its reputation and its competitive edge will be put at risk.” Additionally, Standard and Poor's lowered its credit outlook for Morgan Stanley this week "based on uncertainty about the management structure going forward."


We concede that The Morgan Stanley name has some strength of its own. After all, its sheer size in terms of assets under management (nearly $500 billion) provide it with a competitive edge over smaller firms – smaller firms simply don’t have the client base to subscribe to new IPOs that Morgan Stanley does. Additionally, the company’s track record of bringing firms public make it a go-to source for financing. Over time, however, we believe that it is top talent like Joseph Perella who provide firms like Morgan Stanley with its competitive edge. Without them, it’s just another name.

Deborah Battat, Edward Connolly, T.K. MacKay

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