To hear Smith Barney chief executive officer James Dimon talk, the proposed merger between Morgan Stanley and Dean Witter Discover is one of the best things that could have happened to his firm. “It has legitimized everything we’ve ever done,” beams Dimon, at 40 the youngest CEO on Wall Street. “In some small, peculiar way, it helps. It’s hard to say Morgan Stanley Dean Witter makes a lot of sense without saying Smith Barney makes a lot of sense.”
In the past, Smith Barney’s retail investor focus has been disparaged by blue-chip investment bank competitors. Thus the decision of that most elite of such banks, Morgan Stanley, to join forces with down-scale retail brokerage Dean Witter, is no doubt a source of reflected glory at Smith Barney.
But there’s little for Dimon to gloat over. Smith Barney has been the institution viewed until now, perhaps as Merrill Lynch’s closest competitor in the lucrative retail business and a close rival in asset management through parent Travelers Group’s mutual funds. Now the creation of a new colossus in the industry is causing domestically-orientated Smith Barney to rethink its strategy for building investment banking and research and expanding internationally.
To that end, says Dimon, “we have an open mind to think through who we would partner up with” a comment that sounds like an advertisement for a foreign suitor. Smith Barney recently reached an agreement to share research internally with BZW in London, though both institutions say the deal is too small to be a prelude to a merger. At the same time, says Dimon, “we’d be happy if it led to additional things. It is good for both of us.”
Other Wall Street firms are pondering their positions from a similar point of view. So too are European universal banks, which until now have decided to build in, rather than buy into, the big American market. Other actors in the unfolding drama are US commercial banks, which this month are unleashed to buy brokerages as a result of Federal Reserve Board interpretative changes to the Glass-Steagall law that separates investment and commercial banking.
“We’ve been waiting for these things to happen,” notes Dimon. “You knew you were going to pick up the newspaper and read about it someday.” It’s not clear yet which institutions have the most to gain or lose in the suddenly transformed environment after the Morgan Stanley/Dean Witter merger. Few expected these two to get together, though in retrospect the combination seems logical, given each institution’s strategic weaknesses.
Immediately after the merger, the fourth-largest US retail brokerage, PaineWebber, emerged as the next possible takeover target, followed by speculation about AG Edwards, a highly regarded regional brokerage. Asset managers, which for some time have been selling at high prices, are expected to become even hotter properties. Among the big ones remaining that are publicly held are Franklin/Templeton (which is itself a merged company), T Rowe Price, Alliance Capital, John Nuveen and Pimco Advisors. Another frequently mentioned merger candidate is regional brokerage Legg Mason, 50% of whose earnings derive from asset management.
Morgan Stanley Dean Witter, as the new, combined company is to be known, is being created by a stock swap. Its market capitalization of $21 billion and its $270 billion in assets under management mean that by these measurements Morgan has effectively jumped from bottom to top of the top-tier bulge-bracket companies. So, its two fiercest competititors, Merrill Lynch and Goldman Sachs, are unlikely to stand still.
Merrill, now knocked off its perch as the largest firm, can no longer claim to be the only investment bank to offer retail and institutional services and asset management, note competitors with glee. But it is Goldman Sachs, which so far has shunned retail, that many bankers think has been most outflanked by the move. “It will be interesting to see if Goldman thinks it can survive without that lower-grade business,” says a former Morgan salesman. Investment banks, he explains, historically have disliked the retail business because it is “time-consuming”. Others suggest that Goldman may seek to join with a bank for greater capital strength.
The only major US investment bank to remain a private partnership, Goldman has been rumoured as a merger partner for such unlikely candidates as Citicorp and discount brokerage Charles Schwab. Indeed, Goldman has begun a mini-acquisition spree, albeit solely of asset-management firms: last year it bought US-based Liberty Investment Management and British pension fund manager CIN Management. At the very least, Goldman will be buying more asset managers, according to people familiar with the firm. “The world has changed a lot,” says one such individual. “Goldman is looking at competitors all the time and if it thought it had to make changes to be competitive, the firm would change in a minute.”
The future of less profitable, second-tier bulge-bracket firms such as Lehman Brothers and Salomon Brothers is even more uncertain. Lehman has been looked at by many potential suitors over the years yet has insisted that it wants to remain independent. Salomon this year announced a deal with the biggest US fund manager, $430 billion-asset Fidelity, whereby the latter will receive Salomon’s equity research and be guaranteed 10% of its stock offerings.
Upping the ante
Bankers say the deal may help Salomon. Given its focus on proprietary trading, Salomon has long lacked distribution. Moreover, while US securities regulations forbid brokers to place new issues in their own mutual funds, such is not the case if those are sold to outsiders in this case, Fidelity.
Nonetheless, many observers are sceptical of such strategic alliances. “We’ve seen a lot of these attempts to market services through someone else’s distribution channel,” says one Wall Street executive, “but if there is no proprietary interest in one another, no common ownership, more often than not these things collapse.” And now that Morgan and Dean Witter have upped the ante by their merger, such deals are viewed as even less exciting. On the other hand, the executive suggests, “if this is a marriage looming, then it is something worthwhile watching”.
What comes next, however, may be just as big a surprise as the Morgan/Dean deal. “Nobody got this one,” says Raphael Soifer, a financial industry analyst at Brown Brothers Harriman. To a great extent, that was because of the vastly different cultures of the two institutions. Morgan Stanley for some time has been the white shoe firm among the elite of Wall Street while Dean Witter cannot shake the blue-collar image that its merger with retailer Sears Roebuck gave it during the 1980s. Culture clashes are widely considered to be the biggest impediment to successful mergers.
With hindsight, however, many observers consider the combination a brilliant move. As there is so little overlap between the two institutions, many think the cultural differences can be largely avoided. “It’s a perfect marriage,” says Gary Goldstein, who heads executive search firm Whitney Group.
The culture gap, too, may not be as wide as some think. Morgan Stanley still markets its prestigious name but former Morgan bankers say that the firm’s culture has been changing since the former partnership went public a decade ago then grew into a huge global institution. The shift intensified under CEO John Mack, a former bond trader and salesman far removed from the patrician investment-banking clique that previously dominated the firm.
Significantly, in recent years a huge number of leading bankers have left Morgan for such institutions as Deutsche Morgan Grenfell, Credit Suisse First Boston, BZW, NatWest Markets and Smith Barney. “The momentum that’s going to carry this [merger] forward is the old Morgan Stanley cachet,” notes one senior Wall Street executive, “but the reality may be totally different, and with Dean Witter imposed on it, it’s got to be diluted.”
The two men who will lead the new combine have contrasting personalities though both are considered shrewd and capable managers. Low-key Philip Purcell, the former Dean Witter Discover chairman known for his “aw, shucks” mannerisms, will be chairman and CEO. The more aggressive Mack will be president and chief operating officer. He will have responsibility for the securities and investment-banking business along with Morgan’s asset management business. This means that the former retail securities business of Dean Witter will report directly to him. “Intimidating” is the adjective most often applied to Mack by former colleagues and business associates; “Mack the Knife” is his nickname.
Purcell and Mack had been considering a merger of their firms for two years. The announcement on February 5 immediately raised the tension in Dean Witter’s research department. Research, a Morgan strong point, is one area of overlap. “I thought: ‘Oh my God, do I have a job?'” recalls one Dean Witter research analyst. “There were a lot of locked doors; people calling headhunters.” Since then, he says, the mood has calmed down, management telling analysts that they will be given generous severance pay if forced to leave. Some areas of Dean Witter’s retail focus have already been assured of future employment. Its real estate and health care banking and research groups have accepted invitations to remain.
Purcell will oversee Dean Witter’s credit card and asset-management businesses. But given Mack’s history at Morgan Stanley, where he unseated Robert Greenhill as president then pushed chairman Richard Fisher into the background, most investment bankers believe Mack will not settle for the number two positon for long.
Both companies declined to comment to Euromoney on the merger yet what they are trying to achieve does say much about the direction of the industry: the two firms have been enjoying good runs but faced significant obstacles while going it alone. As Mack proclaimed when the deal was announced: “This bold move will accelerate the ability of both companies to achieve our respective long-term strategic goals.”
Moody’s Investors Service quickly put the ratings of the new firm on review, for a possible upgrade. “The possibility is that the combination is in some way more than the sum of the parts,” explains Haig Nargesian, the Moody’s analyst for the deal. Senior debt for Dean Witter is now rated A2 and Morgan is A1.
Morgan Stanley’s returns have lagged behind those of competitors, though they were boosted in 1996 by strong mergers-and-acquisitions and initial-public-offering markets to 30% measured as a pre-tax return on equity. In recent years, the pre-tax returns were often much lower 18% in 1995 and 13% in 1994, for example. This has been due in part to the firm’s huge investments in international expansion and technology. “Richard Fisher and Mack have said consistently over the last several years that they are deliberately penalizing the return in order to invest in the future,” says Soifer.
Though Morgan’s emerging-markets bet appeared to be paying off as those markets turned bullish, the company’s volatile earnings history last year still brought it a low stock-price multiple relative to the earnings nine to the market’s 19. Competitors believe that this did not sit well with senior executives whose personal wealth was tied up in the firm’s ownership. About 40% of Morgan stock was held by employees before the merger.
Mack was already retrenching in some areas of investment, particularly fixed-income technology. One particular foreign exchange project, known as Icor, was a “tremendous disaster supposedly it was the keymark investment banking project coming out of technology and it was abandoned”, says a former Morgan executive.
Morgan is not alone in its attempts to cushion earnings by building a more stable base of asset-management fees. “The current craze of investment banking is to get fee-based income to offset the volatility of other businesses,” says a senior executive at a European investment bank. US mutual funds seem like a perfect route that many argue is non-cyclical.
“There is a structural change under way in how Americans save,” says George Salem, banking analyst for Gerard Klauer & Marrison and who describes the merger as a “watershed” in the consolidation of the industry. Over four years, mutual funds have more than doubled their assets (now at $3.4 trillion in the US), while assets under management grew by about 25% last year. Bank deposits have inched up by only 10%.
A simple means of distribution
Morgan’s attempts to develop asset management fell at the first hurdle. A proposed merger with SG Warburg in 1994 was aborted. Morgan wanted Warburg solely for its high-performing Mercury Assset Management. Then early last year, Morgan achieved its first asset-management acquisition, institutional fund manager Miller Anderson & Sherrerd. The move was widely applauded. However, last summer’s expensive ($1.2 billion) purchase of retail fund manager Van Kampen American Capital has proved problematic. Van Kampen’s performance has been sluggish, garnering low ratings from Morningstar, the premier US fund-rating organization. Indeed, some of the Van Kampen funds have faced withdrawals even during the current equity boom. As Morgan lacked its own distribution mechanism for the product, it has been forced to sell through other retail brokers. Many bankers believe that this has proved a difficult task.
Morgan appointed former chief financial officer Philip Duff to head Van Kampen only two weeks before the announcement of the acquisition (he has since been named CFO of the new, merged company). Many bankers and analysts have subsequently speculated that Morgan looked at the Dean Witter retail sales force as a simple means of distribution for mutual funds. That makes the Van Kampen deal look like a bad trade. “What is it that they bought with Van Kampen if Dean Witter has to carry the distribution load?” asks Soifer.
Immediately after the Morgan/Dean merger announcement, Morgan Stanley executives talked about the desire to use Dean Witter’s sales force to sell Morgan’s underwritings. This is unsurprising, given that in the industry in general, there has been a gradual shift of thinking over the past decade as the need to garner retail ownership of new issues has become very important. In the past, say Wall Street executives, institutional firms “sold against retail”, arguing that institutions would be more stable shareholders. Retail investors, so the theory went, would sell at the first sign of a panic. But when the little guys did not desert the market in the 1987 global stock-market crash, presumptions were turned on their head. It is now the institutional owners who are viewed as more willing to sell out quickly and move on, depressing the price of the shares.
On the other hand, individual investors probably hold on to an equity issue for four or five years, according to independent securities industry analyst Perrin Long. They leave their money in mutual funds for six years, he suggests. Merrill has played this trend, moving up in the investment banking league tables by marketing its strength in retail distribution.
But most investment bankers say that lining up retail distribution for new issues is not difficult, especially in today’s market. Certainly it has not kept such investment banks as Goldman Sachs from appearing in the top ranks of the bulge-bracket firms. Investment bankers simply hire retail firms as co-managers the role that Dean Witter has played until now. “Retail people are always screaming they don’t get enough stock,” says Long. Dean Witter, he says, will be the main beneficiary of this aspect of the link-up with Morgan, given the latter’s “higher class of research and better trading expertise”.
Bulging brackets
Competitor investment bankers argue that their clients are best served by picking and choosing retail co-managers, often focusing geographically on smaller firms with superior local reputations rather than on the major brokerages. The main benefit for Morgan Stanley, says Long, is that it will not have to split the management and syndicate fees with a co-manager: “It is logical that in a deal book-managed by Morgan Stanley, instead of taking down 25% to 40%, they could take down 60% for their own account.”
Nonetheless, investment bankers express puzzlement over the rationale of such a strategy. “If their bet is that the US customer base is terribly valuable over the next decade, that’s a hell of a bet on the stock market at these levels,” says one senior banker. He argues that investment bankers make their money “by being relatively light on their feet”. The retail base, he says, “brings a large amount of complications to manage. It’s very different from what we do and it slows you down. You’re committed through thick and thin. The market slows down, and you’ve got to keep them on the rolls. You can’t close your Toledo office just because your customers have gone quiet.”
Another pertinent issue for Morgan Stanley was its relatively small equity capital base of $6.5 billion (common and preferred stock) and the low stock price and declining position in the bulge-bracket underwriting rankings. Not only did these impede Mack’s desire to be number one, as one former Morgan banker put it, but they made Morgan potentially a takeover target. That issue would have become more acute once the Glass-Steagall walls came down this month and US commercial and foreign banks with much bigger capital bases became able to buy brokerages. “Why be in a defensive position? Why not take a leadership position?” asks Whitney Group’s Goldstein.
Morgan Stanley Dean Witter will have close to $11 billion in equity capital. “Everybody’s talking about the end-game for the millennium and the five global universal banking powers that will bestride the universe,” says Craig Foster, senior fixed-income executive at Credit Suisse First Boston in New York. “This is a way to get more capital for that.”
Other institutions with huge equity capital bases include Deutsche Bank, with $15 billion, Merrill with $6.1 billion at the end of 1995 and Goldman with $5.25 billion in 1996. Credit Suisse finally completed its full-scale merger with CS First Boston, allowing the investment bank to raise its capital to an estimated $9 billion from $2 billion. If Morgan Stanley Dean Witter succeeds in achieving a higher credit rating, future debt capital and financing costs will be lowered.
“Capital is what is going to drive the bigger transactions,” says Goldstein. “If Morgan were left behind, there is only so much they can do in terms of underwriting.” Dean Witter, significantly, had already caught the eye of some analysts for what they termed its “excess capital”. No doubt Morgan Stanley noticed this too. At the end of 1995, the amount of capital that Dean Witter’s holding company had not allocated to any particular line of business amounted to $800 million 7% of the Morgan/Dean combine’s current equity. More recent numbers are not available but although the total declined in 1996 from $800 million, “it’s still a large chunk of money”, says Moody’s Nargesian.
Dean Witter too had strategic reasons for seeking a merger. (Warburg was one that it talked to in 1993 and 1994, at which time the two firms had a research-sharing relationship.) While Dean Witter boasted a steady 31% to 32% pre-tax return on equity over the past three years, the future was not looking quite so rosy. Purcell, a former partner at management consultancy McKinsey & Co, had convinced Sears to buy Dean Witter in the 1980s. When the marriage was a flop, he engineered the spin-off and began to turn the brokerage around.
Purcell focused on building Dean Witter’s credit-card business, which last year provided about 50% of earnings through its Discover card. Morgan Stanley insiders have pointed to this credit-card business as one of the gems of the deal but some analysts say the business has peaked and the once-lofty margins are being eroded by higher loan losses.
According to Nargesian, Dean Witter’s current ratings, which are lower than Morgan’s, reflect concerns about the card business. In recent years, he says, Dean Witter’s card-fraud-linked losses and charge-offs have been higher than than those of many of its competitors. Moreover, Dean Witter’s customer base is a lower-income group than that of many bank competitors, potentially making it (and now Morgan Stanley) more vulnerable to recession. Another disadvantage is that the credit card is sold solely in the US, where the business faces the most competition. “The credit-card business does add an element of earnings stability but there are some serious issues here,” says Nargesian.
Wall Street psychology
One big advantage of the Discover card compared with others is that it is not sold through banks, thus cutting out middleman fees. But, if successful, a lawsuit under way against Visa and MasterCard that seeks to allow banks the right to sell other cards, such as Discover, would end that advantage. (It would also make it easier for a big US commercial bank to buy Dean Witter.) Analyst Joan Solotar of Donaldson Lufkin & Jenrette thinks that eventually Morgan Stanley Dean Witter may sell the credit-card business.
A bull market has helped Dean Witter’s retail securities brokerage, the third-largest sales force behind Merrill and Smith Barney, to make up for the credit-card business’s shortcomings, according to analysts. Dean Witter has expanded the business aggressively, hiring hundreds of new brokers in the last two years. At the same time, it has been a laggard in facing the new competitive and technological trends in the industry. Fee-based sales practices, selling non-proprietary products and embracing new technologies such as the Internet for marketing and trading are examples of activities in which Dean Witter has fallen behind its two major competitors. Earnings were also less exciting. With just 20% more brokers, Smith Barney earned double what Dean Witter posted last year.
The strategy previously employed by Dean Witter came under fire and has been revamped recently, a move that could hurt profitability. Historically, it sold more proprietary products (the various Dean Witter funds from its asset-management business) to customers than did its competitors. But that practice, among others, has drawn criticism from an industry group chaired by Securities and Exchange Commission chairman Arthur Levitt.
A sign that Dean Witter was conscious of problems came with its decision in November to buy Lombard Securities, an Internet trading company. “It was a small acquisition but says a lot strategically,” says Nargesian. “They were saying essentially that they recognize in the future securities aren’t distributed exclusively through brokers, and they’re going to want a piece of that technological link.”
The combined Morgan/Dean may eventually diminish the singular problems faced by each. There are few people willing to argue otherwise. “I don’t think you’re going to make a lot of money betting against John Mack,” says Foster.
One achievement is already clear: Wall Street psychology is open to violent swings and with just one move, Morgan Stanley and Dean Witter have changed conventional wisdom. For years, this said that huge combinations don’t work, American Express’s failed merger with Lehman Brothers, Shearson and EF Hutton being the leading example of such a disaster. Now, however, big is again beautiful. The much-heralded and oft-unfulfilled promise of synergy is being touted anew, even by those such as banking analyst Salem, despite his observation that “never before have two such disparate securities firms joined forces successfully”.
Salem suggests that the Morgan/Dean message to other financial institutions, from brokerages to banks, is simple: buy soon and buy big. That’s certainly the way that bankers appear to be thinking. This latest merger “opens the mind to bigger and more glorious combinations”, says Smith Barney’s Dimon, noting that the new competition “accelerates the timeline” for institutions thinking of buying or merging.
Dimon is also president of Travelers, a financial empire of insurance, asset management, consumer finance and securities brokerage that was created by mergers orchestrated by his mentor, chairman and chief executive officer Sanford Weill.
Weill has a history of building dynasties, starting with the creation of Shearson from several smaller firms. He then sold Shearson to American Express. Travelers later repurchased the retail business of Shearson Lehman from Amex, merging it into Smith Barney. Will they join the race?
“You don’t shut a door before you’ve had a chance to talk,” says Dimon. “If someone called today and said we’d been thinking it over and believe it would make sense well, maybe it would.”
