The Purcell Discount

When Morgan Stanley and Dean Witter got married back in 1997, the idea was to create a Wall Street powerhouse: a white shoe investment bank (Morgan Stanley) with a nationwide, albeit work-a-day, distribution network (Dean Witter). That, at least, was the vision of Philip Purcell, who headed Dean Witter and engineered the deal.

Ten years after the consummation, the two camps are hotly arguing over whether the vision has been realized. On the one side sits Purcell and the Morgan board of directors; on the other is the G8 — a group of eight former Morgan Stanley employees who own 1 percent of the company's stock and are calling for Purcell's head. The G8's grievances boil down to this: Morgan's stock is off nearly 30 percent from 2000 highs (including dividends) and badly trailing the shares of its peers. At the same time, Morgan's revenues are down by 9 percent, and net income has dropped 18 percent, according to Richard Bové of Punk Ziegel. (For comparisons, see table on page 74.) All of this points to a management that is failing. Yet Purcell received a 40 percent pay hike in 2004.

But to investors, more important than those grievances is this question: Hovering at a recent $51.73 — down from its all-time highs of $110 a share — are Morgan Stanley common shares a buy?

It's a difficult question. Clearly, Morgan is on the ropes a bit. Investment banking talent has been walking recently, its Discover Card is in a slow-growth mode, the firm's funds are, on average, lackluster and a practice which has helped the firm thrive — manufacturing proprietary product and selling it via higher commission through its retail distribution arm — has been ruled illegal. (See “Trouble In The House That Purcell Built?” Registered Rep., April 2004).

Still, for a speculative-minded investor, Morgan shares are probably a decent buying opportunity. Even with Purcell at the helm, the firm's forecasted growth is competitive. And if the G8 dissidents get their way, the stock could get a nice bump. Shares would also likely rise if the company were acquired, in whole or in part.

But summing up Morgan is a little more complicated than that. Since the 1997 merger, the stock has returned 248 percent (including dividends), beating most of its peers. Also, Morgan in the late 1990s had become a top New Economy investment bank. Consequently, Morgan's shares were awarded higher valuations — sometimes double that of its peers. This meant the stock had further to fall in reaching reasonable trading levels.

Discover This

What the G8 wants to do is to break up Morgan Stanley into its investment bank (investment banking “pure plays” Bear Stearns, Goldman Sachs and Lehman have performed well over the last five years) and sell off the retail brokerage and credit-card businesses. On this last point, Purcell threw the dissidents a bone. The board's approval of a Discover spinoff in April, just a few weeks after the G8 group had called for Purcell's ouster, came at a curious time to say the least.

Bear Stearns' analyst Daniel Goldberg suggests the announcement was meant to mollify dissident shareholders. Other analysts, speaking off the record, weren't so kind; they likened the Discover spinoff to a “shell game” with the sole purpose of protecting Purcell. The angry eight point out that a Discover transaction is curious, because this would signal an about face from its pledge to be a one-stop financial supermarket. Indeed, the company declared that to be essential to its future success. The fact that the board is now promoting a spinoff as a means to enhance value has left the Street a bit, shall we say, confused.

More to the point for investors is the fact that few believe the deal would help the firm's stock price much. The stand-alone Discover division would likely trade at a 15 percent to 20 percent premium to its receivables. Running the numbers, this equates to about $11 billion in value for stockholders. When coupled with the value of the remaining units, which would be worth about $45 a share, according to Punk Ziegel analyst Bové, the combined value would be only slightly above the current market value. (The wild card is that the Discover shareholders could see upside if a suitor quickly emerges to buy it outright.)

Then there's a bigger question of whether Morgan itself is takeover bait. There is probably nothing on the table right now, but all kinds of names have been mentioned, from Bank of America to J.P. Morgan Chase. Perhaps the most interesting potential buyer can be found across the pond. Britain's Independent reported that HSBC was considering a $75 billion bid, which would represent a roughly 25 percent premium to the then-current share price. Such a bid makes sense because the bank has made a push to expand its consumer finance footprint. In 2003, it purchased Household International. But again, to be successful, Purcell and the board would have to OK the sale. Few think they would do that. (Morgan Stanley and HSBC both declined to comment.)

Taking Care of the 11,000

In terms of Morgan's advisory business, Fox-Pitt, Kelton analyst David Trone says that the firm needs to boost productivity and focus its roughly 11,000 advisors on higher-net-worth clients. (Morgan brokers rank third in production behind Merrill and Smith Barney.) Morgan also needs to move away from its dependence on lone-wolf big producers and focus on team selling to be successful at pedaling its full product line, Bové says. But that approach to marketing involves building out interdepartmental communications and is expensive. And, it remains to be seen if Purcell is willing to invest time and money in an effort to undo the lone producer mentality he helped create and copy the models of other top retail firms, including Merrill.

Another rift is growing in its investment banking business. In terms of both dollar volume and market share the firm was among the top rainmakers in the first quarter. But two legendary dealmakers, Joseph Perella and Tarek Abdel Meguid, have joined the defectors.

Given all this, what is the upside to Morgan Stanley as a stand-alone, assuming Purcell stays at the helm? It depends.

Yes, the shares, despite their drop since 2000, still trade over two times book value, which is a roughly 10 percent to 15 percent premium to its peers, including Merrill and Lehman (see table). Morgan also trades at more than 12 times its trailing 12-month earnings, which is roughly at an 8 percent to 10 percent premium to its peers. And although it is essentially in-line with other firms when it comes to consensus forecasted earnings growth over the next year and next five years, recent employee defections and an unclear plan to grow it its retail business are qualitative factors which can't be overlooked.

In short, Morgan Stanley stock is just a bit too pricey — unless you're willing to bet on a special event. The best-case scenario is buying on the hopes of getting shares in a Discover spinoff, and then having that company acquired. Or, in the alternative, believing that Morgan, in spite of Purcell's firm grip, could be a takeover target. But this might be wishful thinking.

In short, unless you are willing to roll the dice, the stock should remain a pass.

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