Thursday, June 02, 2005

Morgan Stanley: Hunted or Hunter

During the past month, the roles of the game seem to have been reversed for the Wall Street powerhouse Morgan Stanley. Well regarded as a dealmaker, the focus is on Morgan Stanley again, but this time the storied firm is in the uncomfortable and unimaginable position of acquisition target. The apparent cause of this change in fortune lies in internal disagreements, related to the company’s management performance, between its Chief Executive Officer Philip Purcell and old-line Morgan Stanley investment bankers. The firm’s turmoil has encouraged outsiders to bet on the likelihood of spin-offs or even a complete sale of the firm, in which players such as Bank of America and HSBC Holdings top the buyer’s list. If the rumors turn into reality, this will have been the first attempt of merger with another investment bank since Credit Suisse First Boston’s disastrous $13 billion deal with Donaldson, Lufkin & Jenrette Inc. in 2000.

Cultural clash or merely a conspiracy? The eight former executives waging the campaign against Mr. Purcell are veteran bankers from the firm before its merge with the retail brokerage house Dean Witter. They are claiming weak performances by businesses in the latter division drag down the performance of the whole company. They are also accusing Mr. Purcell – a former McKinsey & Co. consultant credited with making Dean Witter into a consumer powerhouse – of favoring executives from his old firm. Indeed, the recent nomination of two co-presidents (Stephen Crawford and Zoe Cruz) triggered the departure of several bankers (including the “rainmaker” Joseph Perella) feeding a growing culture clash between the white-shoe Wall Street firm and the retail division, including its Discover card unit.

HSBC: The White Knight? Lately, London-based HSBC Holdings plc. has been making a push in the global merger and acquisition advisory business, but it is still far away from the top position in the famous (or infamous) league tables, especially in the US market. Measured by market value, HSBC is the largest banking company in the UK and second largest in the world. In addition to commercial banking services, the firm provides asset management, leasing services and, primarily through HSBC Investment Bank, investment banking services.

During the last few weeks, rumors intensified that HSBC was weighing a possible $75 billion bid for Morgan Stanley. However, sources say the British bank would not make such an aggressive move, and would consider an offer only with the full agreement and support of the US bank’s board.

Morgan Stanley under fire. Amid efforts to quell the firm’s turmoil, the US investment bank announced its intention to spin off its Discover credit card unit (a business built by Purcell). As the seventh largest issuer of general-purpose credit cards in the United States, Discover would be an attractive target in the credit card industry. In addition, its spin off would pre-empt calls by shareholders to break up the company, while making the remainder of the firm less appealing as a takeover target. However, the strategy seems more of an attempt of the firm’s CEO to remain in power than addition to shareholder value. Indeed, one could argue that the investment bank will decrease market value for the following reasons:

Through divestiture of its Dean Witter retail brokerage or Discover credit card businesses, Morgan Stanley would lose the benefit of having diversified businesses that keep its revenue stable through downturns;

Divestitures would likely unleash ratings downgrades from important rating agencies such as S&P and Moody’s. In this regard, Standard & Poor’s analyst Tom Foley said, “We would consider downgrading Morgan Stanley if they were to spin off one of their divisions”.

The firm could be too small to be able to compete against its rivals who are all expanding instead of shrinking. Examples are Lehman Brother’s acquisition of asset management Neuberger Berman, Merrill Lynch’s decision to keep its own asset management division, and Bank of America and JP Morgan’s huge mergers.

On the other hand, one could argue that by divesting, Morgan Stanley could return to its roots: a pure investment bank focusing all its efforts in revenue growth and profitability margins.

Is Morgan Stanley worthy? Absolutely. Under all conditions, the US investment bank would foster HSBC’s ambitions in the US market. With a market value of $177.8 billion, HSBC could easily swallow Morgan Stanley whole, and finally consolidate a top position in investment banking. Despite prior history of investment banking acquisitions resulting in a massive departure of talent, firms like Morgan Stanley could absorb such large-scale departures by rapidly replacing old talent with new stars.

Considering solely the Discover credit card unit spin-off, which the market prices at around $14 billion, HSBC could be considered a strong buyer, due to its expansion strategy in US market. This strategy is evident in the firm’s $14.2 billion acquisition of Household International, a major provider of consumer finance and a top 10 issuer of credit cards in the United States.

Finally, Morgan Stanley’s current situation could not be better from an acquirer’s perspective: it is the worst performing stock among the five largest independent securities companies (shares were down 27% in the past four years, plunging 50% since its peak in September 2000) and the series of internal conflicts make the venerable investment bank not only a vulnerable prey but also attractive at a discounted price.

Marcelo Hanan
Gabrielle Lambert
Valentin Pitarque

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