When There's J.P. Morgan Takeover Talk, People Listen

On a day dominated by the announcement that Credit Suisse First Boston will buy Donaldson Lufkin & Jenrette(DLJ), it may be profitable, as the financial services consolidation wave rolls on, to look for the next likely merger target: J.P. Morgan & Co.(JPM). Today Morgan rose $2.06 to close at $151.06, yet another record high. It may even be a good spec at this lofty level.

It's a sad story of how J.P. Morgan came to be takeover bait. Once upon a time -- about 10 years ago -- J.P. Morgan still had a chance to stay in the first rank of financial intermediaries. The bank's AAA credit rating was nearly incomparable. Its reputation was outstanding both as a corporate banker and as a money manager for wealthy individuals. And it had a unique international presence around the globe.

That combination could have fueled enormous future growth and profitability. Remember the financial landscape back then. Many competing banks were politely going under from bad real estate loans. Businesses big and small were perforce going global. More and more people with savings and new riches -- especially baby boomers -- were about jump into the stock market. And foreigners were poised to shovel unprecedented amounts of pounds, yen and francs into U.S. securities market.

But J.P. Morgan blew it. Instead of leveraging its natural strengths as a distinguished bank/trust company in a changing world, it tried to reinvent itself as an investment bank. That meant charging into such volatile and intensely competitive businesses as derivatives trading and securities underwriting where it had no natural edge. In addition, it turned down numerous offers to acquire or merge with competitors, deciding instead to proudly go it alone.

The strategy was, in retrospect, a slow-motion fiasco. Morgan never blew up like a Bankers Trust, but it slowly slipped from the top tier. It became a slow-growing commercial bank with a second-rate investment banking and capital markets arm. As the chief investment officer for one of the biggest family fortunes in America says, "They are meaningless in the world today. You can go through your entire financial life without ever doing business with them."

Contrast J.P. Morgan with Morgan Stanley Dean Witter(MWD), which in the early '90s was just one of a dozen good U.S. investment banks. It caught the wave big time to become today one of the two premier Wall Street firms. (Goldman Sachs & Co. (GS) is the other.) It made a killing in investment banking, made timely acquisitions like Dean Witter to get more distribution and moved into the consumer finance business via Discover.

A Tale of Two Stocks J.P. Morgan and Morgan Stanley have taken different paths.

The numbers paint the picture. Morgan Stanley boasts a 34% return on equity, while J.P. Morgan's is 16% and has not exceeded 19% in the past five years. Stanley's five-year revenue growth rate is 17% vs. J.P.'s 7%. Looking ahead, analysts expect Stanley to boost profits by about 15% per year while J.P. is down for 10%.

Of course, J.P. probably won't have much of a future as an independent firm. It's just bait waiting to be swallowed up by bigger fish. That's why the stock's at an all-time high. In contrast, Morgan Stanley is trading at its all-time high because investors think, rightly or wrongly, that it has a bright future ahead.

Here's a bit of relevant news about J.P. and Stanley. Turns out that three years ago a senior representative from Morgan Stanley and Sandy Warner of J.P. Morgan met informally in private to discuss the possibility of merging their firms, according to two sources familiar with the meeting. The notion was, according to the sources, that a recombination of the two, which were one before banking laws outlawed such combinations, might make sense in a world where global reach and cross-market selling are essential for the majors. Both firms declined to comment on the report.

The talk to put Humpty Dumpty back together again went nowhere, obviously. It foundered largely because Morgan Stanley did not need J.P. Morgan's investment banking departments, say the sources. There was no agreement on who would be the hunter and who the prey. And evidently, Morgan Stanley was not interested in paying a premium for Warner's commercial banking relationships. In an era when money center banks like J.P. Morgan are steadily being disintermediated -- a fancy way of saying replaced as sources of capital by the financial markets -- why would Morgan Stanley want J.P. Morgan?

That said, J.P might be a decent speculation today. Merrill Lynch bank analyst Judah Kraushaar says so in a report released Wednesday. It's his "favorite investment ... either as a going concern or as a takeover speculation." He notes the real value in the business is in asset management and international banking. (Those, of course, are the two great businesses the bank always had.) Kraushaar sees a "franchise value" for J.P. of $180 to 240 per share.

Here's another take. Morgan management has badly misallocated capital for a good ten years now. The market is saying: "Let someone else run the business. Your strategy has been flawed. You don't make sense as a stand-alone institution."

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