In late September Morgan Stanley (NYSE: MS) will file its report for the quarter ending August 31, 2007. This period coincides perfectly with the dog days of summer in the investment banking business.
The company's 3rd quarter report should display all the volatility in the financial markets during that period. What will it say about the company's performance under such pressure? And what effect will investor reactions have on Morgan Stanley's stock price? For a discussion of the theory behind this analysis see my book Competing for Customers and Capital.
This is 7th in my series of posts on the competition for customers and capital among four leading investment banks. In this post I speculate, using the tools enterprise marketing, on how Morgan Stanley management might profit from the dog days and its attendant market volatility. The other players in this analysis are Goldman Sachs (NYSE: GS), Lehman Brothers (NYSE: LEH) and Merrill Lynch (NYSE: MER).
HIGHLY SEASONAL REVENUES
The last ten quarters reveal a marked seasonality in the pattern of combined net revenues for these four investment banks. This chart shows the quarterly peaks and valleys over the period from February, 2005 through May, 2007 (white triangles).
The historical dog days of summer are the valleys: $22 billion in August, 2005 and $25 billion in August 2006. The chart also includes a forecast (in blue) of the group's net revenue in August, 2007 if the 5.7% historical pattern of year-on quarterly CAGR holds true. In about six weeks we will know.
WHEN LESS IS MORE
Across a broad range of industries and companies, enterprise marketing expenses and revenues move in lock step. For example, in a study I did on the relationship between expenses and revenues of 497 companies in 30 industries in 2003 the correlation coefficent averaged 0.96, with a standard deviation of 0.07.
A similar relationship between enterprise marketing and net revenues appears for three of the four investment banks in this analysis. The correlation coefficients for GS, LEH and MER in the last ten quarters are 0.84, 1.00, and 0.64 respectively. But, MS was a different story: its correlation coefficient was -0.32. That's not a typo. The correlation was negative! Less was more for Morgan Stanley.
How did they do that? Management slashed the company's cost per dollar of net revenues from $1.23 in May, 2005 to $0.64 in May, 2007. In short, the company went from being very inefficient and losing $0.23 on every dollar of net revenue, to being highly efficient and earning $0.36 on every dollar.
For details on the enterprise marketing expenses of investment banks and their cost per dollar of revenue see my post "Citigroup Enterprise Marketing Expenses: The Middle Line."
THEORY MEETS REALITY
Market share attraction theory says that an efficient company will attract revenues in direct proportion to its share of enterprise marketing expenses, other things being equal. This chart shows Morgan Stanley's market share attraction from February, 2005 through May 2007. The vertical (green) axis is the company's share of net revenues in each of the ten quarters. The horizontal (red) axis is its share of enterprise marketing expenses in the same ten quarters.
If Morgan Stanley had attracted customers in direct proportion to its share of enterprise marketing expenses, the relationship between share of revenue and share of expenses would be described by the dotted diagonal line in this chart. In May, 2005 the company spent 43% of enterprise marketing resources to generate just 32% of revenues. After a long but steady march toward high enterprise marketing efficiency, in May, 2007 management spent 31% of the resources and generated 31% of the revenues. Clearly, management was not blindly setting expenses as a percent of revenues. Rather, it took a bee-line to that level of expenses the theory would predict. In May, 2007 its theoretical marketing efficiency ratio was exactly one, corresponding with that $0.64 per dollar of revenue.
A DOG DAY SCENARIO
Will the dog days be amplified by the down market? If so, how will the other players respond? What will Morgan Stanley management do while experiencing the down market during the 3rd quarter? How will they expect the competition to react under the same circumstances? Here's one of many possible scenarios that might play out:
1. Group revenues fall 12% from the dog day low.
2. Competitors cut enterprise marketing 15%.
3. Morgan Stanley hits 33.7% maximum earnings share.
4. Management drives cost per dollar down to $0.59.
CAPITALIZING ON THE DOG DAYS
This table compares Morgan Stanley's actual results in August, 2006 with forecast results in August, 2007, based on my scenario. I don't expect the forecast numbers to appear in their income statement when it's filed in late September. The purpose is not to crystal ball gaze. Rather it is to hypothesize on reasonable objectives that management might have set for the quarter, based on history and the principles of enterprise marketing.
These are challenging objectives. By achieving maximum earnings market share at 33.7%, net revenues would hold constant at $8.0 billion -- even in this double-down market. Further decreases in Morgan Stanley's cost per dollar of net revenue would hammer enterprise marketing expenses down from $7.4 billion in August, 2006 to $4.7 billion in August, 2007. The combination of these actions would drive operating income before depreciation up from $0.6 billion in the previous year to $3.3 billion in August, 2007. This pumps the ratio of earnings to net revenues up from 7% to 41%.
MORGAN STANLEY'S STOCK PRICE?
This is a pop quiz! If management actually delivered this performance in its 3rd quarter report, what would be its stock price on September 28? Here's a benchmark to consider: MS closed at $62.23 on Friday August 17, down from $85.82 on May 31, 2007. What do you think?
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