When John Mack returned to Morgan Stanley as chief executive in 2005 after a heated boardroom split, the move was widely seen as a victory for the firm’s investment bankers and traders. Those masters of the universe had chafed under the leadership of Philip Purcell, who had hailed from the company’s lower-brow retail brokerage and credit card subsidiary, Dean Witter, Discover & Co. Mack, who started his career as a Morgan Stanley bond trader, seemed just the man to restore Morgan’s core investment banking franchise to its former glory.
It’s no small irony, then, that as Mack prepares to step down as CEO at the end of this year, the firm’s strongest point is arguably its retail brokerage arm, not the investment bank. The latter business has racked up tens of billions of dollars in losses on subprime mortgages and other bad assets over the past two years and has so far missed out on the revival of Wall Street trading profits this year. The brokerage arm, however, has risen to the top of the industry thanks to a $2.7 billion merger with Citigroup’s Smith Barney unit. And it’s a sign of the times that the brokerage’s boss, James Gorman, is succeeding Mack as CEO.
Morgan Stanley Smith Barney, the new venture owned 51 percent by Morgan and 49 percent by Citi, is the world’s largest brokerage firm, with $1.42 trillion in client assets and 18,444 financial advisers — ahead of longtime industry leader Merrill Lynch & Co., now an arm of Bank of America Corp., which has $1.3 trillion in assets and 15,008 advisers. Morgan still trails in terms of profitability, but Gorman has already made strides and vows to prevail on that measure as well.
“We are No. 1,” the 51-year-old tells Institutional Investor in an interview. “We are creating a distribution giant with a lot of muscle.”
Indeed. Morgan Stanley Smith Barney now claims 29 of the top 100 advisers as ranked by revenue, according to Barron’s, compared with 22 for Merrill Lynch. In the fast-growing field of separate managed accounts, the new venture boasts assets of $320.6 billion, surpassing Merrill’s $259.8 billion.
Citigroup analyst Keith Horowitz estimates that the venture will increase retail brokerage’s contribution to total earnings at Morgan Stanley to some 30 to 35 percent, assuming the firm exercises its option to take 100 percent ownership of the unit in the next five years, compared with 20 to 25 percent recently. Morgan Stanley’s net brokerage revenue rose 46 percent from the first to the second quarter of this year, to $1.9 billion; the period included just one month’s contribution from Smith Barney.
Challenges abound, though. Morgan Stanley and Smith Barney suffered combined outflows of brokerage client assets of $32 billion in each of the first and second quarters of this year; Smith Barney also saw 1,106 advisers walk out the door in the first quarter. Gorman and his top executives face a tough task in integrating the two businesses and keeping top talent and clients happy at a time when financial turmoil has prompted many retail investors to pull back from the markets.
“Morgan Stanley is making a very logical bet on retail,” says Brad Hintz, an analyst at Sanford C. Bernstein & Co. “It will be a powerful franchise, but it just might not be as powerful as pure mathematics would argue.”
Some analysts worry that because Morgan paid a full price for Smith Barney, it will struggle to earn solid returns. “Make no mistake, this is not a steal like Bear Stearns or Lehman,” says one fund manager who holds shares in both Morgan Stanley and Citigroup and who spoke on condition of anonymity. “It will generate an okay — not bad, but also not great — return on capital.”
Moreover, Morgan isn’t the only firm placing its chips on retail. As big as the new venture is, it faces potent rivals. The financial crisis and the resulting shakedown on Wall Street have redrawn the competitive map of the brokerage industry, leaving three very dominant full-service players head and shoulders above the rest of the pack: Morgan Stanley Smith Barney, Bank of America–Merrill Lynch and Wells Fargo Wachovia.
Investors hope the deal with Smith Barney will make Morgan Stanley a more balanced company, with stable earnings from the joint venture to offset the volatility of its investment banking business. They believe that the brokerage will be a commanding vehicle for gathering deposits and improving the company’s funding profile. Morgan Stanley’s share of the combined brokerage’s retail deposits rose by $3 billion in the second quarter, to $50 billion.
Morgan Stanley’s brokerage business was lagging rivals badly when Mack arrived. In the first quarter of 2006, the firm’s average adviser was generating $554,000 a year in revenue and handling $70 million in client assets, far behind industry leader Merrill Lynch, which boasted assets of $98 million per adviser. Gorman had been running Merrill’s thundering herd of brokers and nearly doubled pretax profit margins from 2001 to 2005 — from 12.2 percent to 20 percent — by weeding out underperforming brokers and using compensation incentives to get his team to focus on wealthier clients.
To jump-start his business, Mack did the logical thing and poached Gorman from Merrill in 2006. The lanky Australian quickly went about applying his tried-and-true methods to Morgan. He eliminated an entire layer of management, slashed the number of regional offices from eight to four and made himself head of national sales. He then dismissed 500 low-end financial advisers and rejiggered compensation formulas to get the remaining staff to target high-margin clients. He eliminated broker compensation for accounts of less than $50,000 and reduced it for those of $50,000 to $75,000. Higher-producing advisers were rewarded with such benefits as a deferred-compensation program and access to the company’s alternative-investments program.
Gorman also made a point of reaching out to top advisers to retain their loyalty throughout the changes. Gregory Vaughan, a Morgan Stanley adviser based in Menlo Park, California, recalls receiving an unexpected call from Gorman the first day the executive joined Morgan Stanley. “It had not happened before, and I really appreciated that,” says Vaughan, who oversees $11.8 billion in assets for ultrahigh-net-worth clients and is ranked by Barron’s as the U.S.’s No. 1 adviser.
The results of Gorman’s efforts were impressive. Average revenue and client assets per adviser rose to $853,000 and $90 million, respectively, in the fourth quarter of 2007 before falling in the bear market, to $630,000 and $64 million in the first quarter of this year.
Smith Barney offered the potential for an instant upgrade. The firm’s brokers boasted average revenue of $849,000 apiece and $96 million in client assets last year. So with parent Citigroup looking to shrink and raise capital, Gorman jumped at the opportunity to do a deal.
With Gorman moving up to the CEO suite, the job of running Morgan Stanley Smith Barney falls to Charles Johnston, the former head of Citi’s global wealth management business who is president of the new joint venture. He is being helped by Andy Saperstein, Gorman’s former lieutenant at Merrill Lynch, who is responsible for all the brokerage branches, and James Rosenthal, who is overseeing the integration of the two businesses.
Johnston is a merger veteran, having started his career at Lehman Brothers and seen that business altered or enlarged over the years by deals with Shearson, American Express Co., Smith Barney, Salomon Brothers and Citicorp. “We have a culture that’s a blend of all those firms,” he explains. “We feel like we know this business pretty well. We expect to deliver.”
Johnston doesn’t have time to waste. Gorman has promised investors that the venture will produce $1.1 billion in cost reductions and $275 million in revenue synergies and achieve a minimum 20 percent pretax profit margin by 2011.
To hit those targets, Johnston and Rosenthal are consolidating management, the technology platforms and the back offices of the two groups. They cut 13 divisional and regional heads on June 1, when the merger became effective. Executives who survived the cull got a message of tough love, says Johnston: “Congratulations, you’ve got the job. But here’s part of your job, which is to take the cost out.”
The firm also adopted a so-called complex structure, something utilized by Merrill and UBS, under which some of its managers run more than one branch. As a result, the venture now has a total of 847 branch managers and 958 branches.
The venture’s brokers can now sell funds and investment products offered by both Morgan Stanley and Citigroup, and are starting to offer clients securities underwritten by each of the parents. That enhanced distribution should give a helpful push to Morgan’s underwriting businesses. “Now that we have the largest distribution, issuers will see us as more attractive to do new issues with,” says Rosenthal.
Some analysts regard that distribution power as one of the key long-term benefits of the deal. “With the largest distribution platform, Morgan Stanley can potentially drive more products through it,” says Howard Chen, an analyst at Credit Suisse. “But we are at an early stage of that story.”
Every merger produces its casualties, however, and Morgan Stanley Smith Barney is no exception. Although the pace of defections by Smith Barney advisers has slowed dramatically since the first quarter, one East Coast adviser said he decided to leave in May because a rival firm offered a 200 percent signing bonus, compared with the 75 percent bonus he would have received to stay at Morgan Stanley Smith Barney.
Gorman and Johnston, though, have worked hard to woo Smith Barney brokers since the merger was announced at the start of the year. “The most important thing is to let people get to know you, get to know what you think and what you want to accomplish,” notes Johnston.
Gorman sees the current wave of consolidation signaling the end game in the U.S. wealth management industry, and he is already casting his eye overseas. He says he has looked at some European private banking businesses with a view toward expanding internationally but has ruled out possible deals in the near term. For now the priority is to ensure the smooth integration of his new domestic brokerage juggernaut.
“We are in for marathons here,” says Gorman. The hope is that victory waits at the finish line.
