Morgan's Makeover: A Work in Progress

The firm reported record profits and plans to spin off its Discover card biz, but CEO John Mack says the turnaround isn't done

On Dec. 19, Morgan Stanley (MS) Chief Executive John Mack reported record profits for his first full year back on the job at the No. 2 securities firm, but he said the company's turnaround is far from over.

When Mack, 62, returned in June, 2005, the company was in the midst of a civil war, which ultimately led to CEO Philip Purcell's ouster. Purcell had presided over a financial supermarket that included everything from investment banking to the Discover credit-card business. Mack has left the supermarket business to rivals such as Citibank (C), which have more scale.

The new model, with a focus on investment banking, trading, private equity, hedge funds, and high-end wealth management, is closer to that of Goldman Sachs (GS). Last week, Goldman announced a $9.5 billion profit for the year, the largest in the history of the securities business (see, 12/13/06, "All That Glitters Is Goldman").

Record Quarter

Mack says Morgan Stanley has come a long way, but that a lot of work remains to be done, especially in areas such as asset management. "When I came here, the firm was really in turmoil," Mack said Dec. 19 during a conference call with investors. "There's still room for improvement, but I couldn't be more pleased with the progress we made," he said. Last week, the board gave Mack a record $40 million bonus for his efforts, which included the firing of 1,000 brokers who the company says didn't meet its standards.

On Dec. 19, Morgan Stanley reported a record fourth-quarter profit from continuing operations of $2.21 billion, up 26% from the $1.78 billion reported in the fourth quarter of 2005. Net revenues rose 24%, to $8.6 billion. On a per-share basis, profits were $2.08, up from $1.64 during the fourth quarter of last year. Analysts had expected a profit of about $1.78 a share. The company's shares rose 48 cents, to $80.85. They're up 43% for the year.

For the fiscal year ended Nov. 30, profit from continuing operations was a record $7.497 billion, up 44% from $5.192 billion in the previous year. Revenues climbed 26%, to $33.9 billion. The company also announced that it was spinning off the Discover credit-card unit. Mack, who declined to endorse a spin-off of the business in 2005, said the timing was right this time because sales and profits at Discover are strong and that the rest of the Morgan Stanley is in better shape, too. It doesn't need Discover the way it did 18 months ago.

Hedge-Fund Offensive

Financial-services experts said the company's performance was strong, notwithstanding a decline in private equity revenue. Equity sales and trading revenue rose 32% and investment-banking revenue rose 34%. "Morgan Stanley is a bulge-bracket firm that capitalized well on strong market conditions," said Eric Weber, managing director and chief operating officer of Freeman & Co., an investment bank that specializes in financial services. Asset-management revenues for the year fell from $2.9 billion to $2.77 billion. But Weber said that the unit, which includes hedge funds and private equity, actually grew by $50 million excluding private equity. The private-equity business can be volatile for a publicly held corporate parent, because revenue rises and falls with the sale of portfolio companies.

Weber said Morgan has been buying its way into alternative investments, while Goldman has been building its own hedge-fund and private-equity units. Morgan Stanley has acquired or invested in five hedge funds since Mack arrived. During the fourth quarter alone, it acquired Frontpoint Partners and made minority investments in Avenue Capital and Lansdowne Partners. Chief Financial Officer David Sidwell said margins in asset management would fall next year because Morgan Stanley will continue to make investments in those areas.

Morgan boosted its return on equity to 24%, from 19% in the prior year. But it still lags the performance of rival Goldman, which had a return of 33%. "Our goal is to get margins consistent with industry leaders. That's going to take a couple of years to achieve," Mack said.

Strong Wind

The private equity business is the place to be right now. Returns have been in the 40% to 50% range at top tier funds. That won't continue, but strong results will still draw lots of capital from pension funds and other big investors (see, 11/7/06, "The Money Behind the Private Equity Boom").

Hedge-fund returns have been strong, too. While average returns are said to be in the 9% range, individual funds can be much more lucrative. Sidwell said Morgan would continue to develop its hedge-fund business, and that the company was comfortable with its risk-management overall. Hedge funds can be risky, although blowups have been rare so far (see, 9/20/06, "Are There More Amaranths Lurking?").

Morgan Stanley had the benefit of a strong wind in its sails. The stock market has rallied into record territory since the summer, boosting trading profits and giving CEOs more confidence to do deals. It's possible that those conditions will change next year, but most experts believe the risk is relatively low. So with plenty of investment banking business in the pipeline, 2007 will likely be another strong year.

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