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Morgan Stanley & Dean Witter To Merge


 On February 5, Morgan Stanley and Dean Witter, Discover & Co. announced their intention to merge. The new company, to be called Morgan Stanley, Dean Witter, Discover & Co., will be the largest U.S. securities firm measured in terms of market value.


Different Strategies
These two firms have traditionally followed different strategies. Morgan Stanley is an investment bank catering to top global corporations. It has roughly 4,000 employees outside the U.S., spread among 26 offices in 25 countries.

Dean Witter, on the other hand, is a "retail" firm specializing in stock brokerage, asset management and credit cards. Its international presence is spread between London and a couple of small offices in Switzerland with no presence in Asia. It has concentrated on selling U.S. stocks, futures products, and some fixed-income securities, mostly to small and midsize institutions.

Strategic Issues
Although these issues are not strictly finance-related, I thought they might be of interest as the issues are extremely important from a business point of view.

There are at least two strategic issues that might be of interest. First, the move signifies a change in the focus of Morgan Stanley from institutional investors to one that also includes retail. This can be seen as direct competition with Merrill Lynch. However, one difference between these two potential competitors is that Merrill accomplished this through internal growth.

Second is the issue of "buy vs. make." Morgan Stanley obviously had an option to accomplish the change in its focus through internal expansion, i.e., "make" as opposed to "buy" an existing product or service. The "buy" option is typically followed when there is a narrow time-window of opportunity for the company to get into that line of business. An aggressive expansion by Morgan Stanley into the retail business might increase competition in that segment of the industry, thus driving profit margins down. Another motive is that some countries don’t allow multinational companies to have 100% ownership of local companies, forcing them to form either alliances or mergers with local firms.


Change in Industry


The securities industry has been undergoing a change that might even be considered a move back to the 1950’s and 1960’s.

Indeed, the middle class and baby boomers have fallen in love with U.S. stocks. More than 63 million people own shares in mutual funds, up from 38 million four years ago. In 1996, Americans poured $235 billion into mutual funds, making them by far the most popular individual investing vehicle. What is also very interesting is the fact that most of the money went to funds that invest in the stocks rather than bonds or money market instruments. By contrast, in 1990 only $22 billion went into mutual funds.

 The prominence of the individual investor on Wall Street is hardly new. In the 1950s and 1960s, individual investors as a group were very important to the sale of securities. However, this started changing in the late 1960s, and over the next couple of decades large institutional investors (pension funds, money management firms, insurance companies) came to dominate trading. With such a shift in the composition of trading activity came the emergence of investment banking firms catering to these large investors.

Floyd Norris of the New York Times attributes the recent changes to two factors. First, the unabated bull market that began in 1982 has brought individual investors back in force, both directly and through mutual funds. A large proportion of that money is funneled into mutual funds through retail brokers. Thus, the growth in the retail business.

Second, there is a shift underway in corporate America away from traditional defined-benefit pension plans, in which the company put in the money and guaranteed a monthly check at retirement, and toward defined-contribution plans, such as 401(k) plans, in which the investment decisions are made by the individual. Since 1984, the amount of money held in 401(k) accounts has soared from about $55 billion to more than $750 billion while the total in all forms of defined-contribution plans has grown to about $1.5 trillion.

Serving the 401(k) is much closer to traditional retail brokerage activity than to the requirements of institutional sales. That is what Dean Witter, Discover & Co. is best known for.

Investment banks have not completely ignored this market. For instance, Morgan Stanley in 1996 acquired Van Kampen/American Capital, an Oakbrook Terrace, Ill., asset-management company with nearly $40 billion in mutual funds that are sold by brokers. This has forced Morgan to look for ways to sell the mutual funds. In a comparable move, Salomon Inc. has recently linked up with Fidelity Investments' brokerage unit to sell stocks to Fidelity's brokerage clients.


New Approach to Commission
The retail industry itself is changing too. Brokers typically get a higher commission from selling mutual funds put together by their employer. Merrill Lynch, for instance, has recently introduced a program that permits relatively small investors to pay brokers a flat percentage of assets under management, rather than by trade. The idea is that the broker's profits grow only if the customers do well.

The pilot program, which was offered in a limited number of branches, has raised $100 million in customer assets in three months. These fee-based programs now account for about $30 billion out of the $830 billion that Merrill's customers have at the firm, and the firm's executives expect the proportion to grow rapidly.


Dean Witter History

     Business: Retail broker, credit card issuer

                Headquarters: New York
                Employees: 30,800
                1996 revenue: $9.03 billion
                1996 profit: $951 million

Dean Witter, Discover, traces its origins back to a brokerage firm founded by Dean Witter in San Francisco in 1924. It was bought by Sears in 1981 for $661 million in cash and stock. But Sears eventually decided to exit the financial services business, selling a stake to the public in 1993 and then distributing its remaining 80% interest to Sears shareholders the same year.

 Dean Witter has 9,100 retail brokers, a highly profitable credit card business (which brought in $500 million in pretax profit last year) and its own mutual fund management.


Morgan History


                         Business: Investment banking
                         Headquarters: New York
                         Employees: 9,700
                         1996 revenue: $13.14 billion
                         1996 profit: $1.03 billion

Morgan Stanley has catered to Wall Street's biggest blue-chips. It was the investment-banking arm of J.P. Morgan & Co., before the two giant institutions were split apart in 1935. After the stock-market crash of 1929, the Glass-Steagall Act mandated the separation of commercial banks and securities firms.


Synergy & Value Creation

When Would Mergers Make Economic Sense?
The objective of a manager is to maximize the wealth of shareholders by undertaking projects that create value. Thus, a merger becomes viable only if it creates additional value for shareholders.

 In a merger, value is created only if: the market value of the combined companies is greater than the sum of the pre-merger market values of the two companies. In this case, the after merger market value of Morgan Stanley, Dean Witter, Discovery, Inc. should be greater than pre-merger combined market values of Dean Witter and Morgan Stanley.


Let’s start with a simple example. Suppose companies A and B each have only one product which are identical. Company A has 500 clients and company B has 1,000. If you combine these two companies, you will get one company that has 1,500 clients being served identical products.

 This combination by itself does not necessarily create additional value. To create value there has to be something new that is a consequence of the merger. This might include: (1) additional clients, beyond the pre-merger 1,500; (2) the ability of the combined company to perform the same operation at lower costs; or (3) charging a higher price.

Morgan Stanley is the creator of certain products targeted to the retail investor. Since it does not have the necessary expertise in that particular area, it might make sense for it to team up with someone such as Dean Witter.

Morgan Stanley, as an investment bank, counsels corporate clients, which often leads to underwriting their stocks and bonds. Moreover, as noted above, it has also recently gotten into the money management business, partly through mutual funds. So it is creating "product," which it needs someone to sell. Dean Witter, on the other hand, has a well established retail sales infrastructure. However, one needs to be very careful when looking at the sales data on mutual funds. Many of these funds’ performance have been less than average while attracting assets mainly because -- until last year -- brokers got paid more to sell them than funds managed by outsiders. (See also Merrill Lynch’s approach above)

Morgan Stanley’s international experience can sell to U.S. through Dean Witter a wide array of foreign stocks, bonds and other products. Such a move is timely as Americans have over the past few years become the world's biggest international investors.

Morgan Stanley is expected to cross-market its products to Discover's 39 million card holders in the U.S. Moreover, a possible new source of business is expanding Dean Witter's Discover credit card overseas, where Morgan Stanley has been strong. Some analysts have expressed skepticism about such synergies, noting that Discover's customer base is largely lower- and middle-income who might not be receptive to the products and services offered by Morgan Stanley.

For Dean Witter, the merger would provide access to a vast array of investment-banking products, including initial public offerings and bond deals to sell to small investors.

Culture and Doubt to Benefits
A nagging question to the above sources of value creation is the issue of a cultural clash. The culture that inspires Dean Witter's 9,100 brokers to sell stocks, bonds and mutual funds to individuals, families, and small businesses is not the same one that makes Morgan Stanley investment bankers tick.

The only other investment bank that has been able to cater to these two distinct markets has been Merrill Lynch, with a major difference being that it has been achieved through internal expansion.


Morgan Stanley's shareholders will receive 1.65 Dean Witter shares for each Morgan Stanley share they hold. Thus, based on the price the day before the deal was announced, $57.375 a share, Morgan Stanley's shareholders would receive Dean Witter stock worth $63.73, an 11 percent premium over market value. This puts the deal at nearly $10 billion. But any future increases in the price of Dean Witter stock would increase the value of the deals, too.

 The seemingly high exchange factor has been attributed to the fact that when the two companies first agreed to merge in early January, the 1.65 exchange ratio would have resulted in no premium to either side, but in the subsequent days Dean Witter's stock has jumped and Morgan Stanley's has fallen.


Market Reaction
On the day of the announcement, shares of both companies soared, with Morgan Stanley climbing to $65.25 a share, up $7.875, or 14%, while Dean Witter climbed to $40.625, up $2, or 5.2%, both in New York Stock Exchange composite trading.


History of Wall Street Mergers: What Worked and What Didn’t

Deals That Worked

        Merrill Lynch/White Weld, 1978

                         * Retail broker Merrill bought investment bank White Weld.
                         Although several bankers fled, enough stayed to provide the seeds
                         for today's powerhouse.

       Phibro/Salomon Brothers, 1981

                         * The commodities traders at Phibro thought they would make
                         more money buying the securities trading firm of Salomon. But
                         markets changed, Salomon turned the tables, and ran the
                         combined firm.

       Primerica (now Travelers)/Smith Barney, 1993

                         * Travelers Chairman Sandy Weill is credited as being an
                         extraordinary manager. He bought low, controlled costs and set
                         financial goals.

Deals That Didn't

         Lehman Brothers/Shearson Loeb Rhoades, 1981

                 * The quintessential culture clash between investment bankers at
                         Lehman and the retail brokers at Shearson.

         American Express/Shearson Lehman Brothers, 1984 

          * Another culture clash, exacerbated by senior management fights
                         and business missteps.

         Sears, Roebuck/Dean Witter Reynolds, 1981

                         * The promised synergies between the giant retailer and the retail
                         stock-broker never materialized, even after Sears required Dean
                         Witter brokers to set up shop in Sears stores.

Deals With Doubts

         Credit Suisse/First Boston, 1988

                         * Credit Suisse's deep pockets saved First Boston, endangered by
                         risky mergers. The Swiss bank's controls cause friction, but the
                         combined firm does have a global reach.

         Equitable/Donaldson, Lufkin & Jenrette, 1985

                         * Equitable kept its hands off day-to-day management and its
                         capital has helped DLJ, which repaid the effort by generating cash
                         for the insurer during tough times.

         Prudential/Prudential-Bache Securities, 1981

                         * Some synergies were achieved, but lawsuits alleging the sale of
                         inappropriate securities and insurance products hamper the firms.

                 SOURCES: Staff reports, International Directory of Company
                         Histories, Hoover's Handbook of American Business, Moody's
          Bank and Finance Manual complied by Washington Post (February 7,  1997)

Web sites:

Dean Witter
Morgan Stanley


Washington Post (February 7, 1997), NY Times (February 6 and 7, 1997), and WSJ (February 5 and 6, 1997)


By Alex Tajirian

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