Tuesday, April 26, 2005

Mr. Purcell …wake up and get with the program!

GSB alum, Philip Purcell (class of ’67), is not very popular outside the Morgan Stanley boardroom. The board still supports him as Chairman and CEO and has avoided thus far to take the advice of the ‘Group of eight’ (erstwhile Directors of the firm who hold just over 1% of Morgan Stanley’s equity) to replace Purcell. The firm however continues to suffer on many levels – the loss of valuable human assets, the continuing decline in stock price, and the fading reputation of integrity and excellence. The basis for the case built up by the ‘group of eight’ for the ouster of Purcell is primarily the lackluster performance of the firm’s stock relative to its peer group (Goldman Sachs, Merrill Lynch and Bear Stearns). The consequence has been an unpleasant public exchange of letters and statements (reported as headlines in major business dailies), a management shake-up (resignation of several key employees, including 5 key Institutional Securities heads within a span of a few weeks) and the announcement to spin off the highly profitable “Discover” business unit.

While this public drama at Morgan Stanley ensues, we strongly feel that the critical issue of recent trends in the profitability of Investment Banking industry is being overlooked. We contend that this could be the root of the current debate and changes at Morgan Stanley. Assuming that Purcell remains in control, what does Morgan Stanley have to do to undo the damage and regain the respect and trust of the shareholders, employees, and clients? The management needs to bring immediate focus on the organizational structure of the firm. Morgan Stanley is behind in adapting in this extremely fast changing and highly competitive industry. An analysis of the recent performance of Equities division within the Institutional Securities business, across major Investment Banks, shows the following trends: falling margins; merging of Equities and Fixed Income divisions; higher profitability of the Fixed Income divisions over Equities (especially in the last 12 months); and an increase in proprietary trading.

In the 2004 annual report, Purcell highlighted the fact that Morgan Stanley’s competitive advantage is its global leadership position in Equities. Unfortunately their Equities expertise did not help them in an economy that favored Debt securities. Purcell believes the economy is shifting in their favor, but in a world of uncertainty they cannot afford to take this gamble. Morgan Stanley needs to balance its Institutional Securities Unit by strengthening its Fixed Income area. As it is structured now, its fortunes are somewhat linked to the performance of the Equity capital markets in general, which partly explains its poor stock performance.

Media reaction to these series of events has been mixed. While reaction to the management shake-up has been a little ambiguous, the spin-off of Discover (which ‘had the best profit growth of any of our reporting businesses’[1]) has been a complete volte-face on the business strategy described in the 2004 Annual Report to shareholders. Some analysts feel that the latter is the result of a “knee-jerk” reaction to pacify complaining shareholders, others highlight that it may be the result of a trade-off by Purcell to facilitate the current changes in the management committee and add two new appointments to the Board. Others still believe that it’s a Dean Witter – Morgan Stanley (merged in 1996) leadership control battle. Nevertheless, there is media consensus on the implications of this spate of events on the current businesses of Morgan Stanley. Employee morale may further suffer if the current ‘defamation’ case against Purcell is sustained by the ‘group of eight’. Client relationships will be the next to be adversely affected and the competitive advantage of the firm may be seriously jeopardized resulting in an even poor stock performance going forward.

In this entire unsettling episode some critical questions remain unanswered. How can Morgan Stanley remain competitive in the current environment? Should it re-balance its business mix by shifting more resources towards Fixed Income than Equities (primary source of its competitive advantage)? Given the falling margins in the Equities business, will another bull run really benefit Morgan Stanley as much as it has done so in the past? What about the spin-off of Discover … Was it a forced and poor business decision? After all Discover had been pivotal in diversifying Morgan Stanley’s business portfolio risk all this while. What about the impact of the current debate and series of events, …… will it result in the much feared brain drain? But perhaps an even more disturbing underlying concern - Is there an ulterior motive in the actions of the ‘group of eight’? Are they instigating all this publicity to manipulate a sell-off in the stock to facilitate a takeover by a larger financial institution?

Its time Mr. Philip Purcell wake up and get with the program!

Jenny Hannus, Shilpa Kumar, Ritesh Singhania


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