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5 Short Sighted Stock Spinoffs

Stocks in this article: MCD CMG MHS MRK BKS GME MS DFS KMX

2. Morgan Stanley's 2007 Discover Financial Drama

With a boardroom drama for his ouster escalating, Morgan Stanley (MS) Chief Executive Philip Purcell began to pull for a 2005 spin of the investment bank's credit card unit Discover Financial Services (DFS), which he built at Dean Witter prior to the two firms' 1997 merger.

Purcell called for the spin instead of a previously rumored sale to help reestablish Morgan Stanley's investment banking pedigree after top tier rivals Goldman Sachs (GS) and Merrill Lynch, along with scrappier competitors Bear Stearns and Lehman Brothers gained market share. While Purcell said a spin would maximize Discover's value, it would also help Morgan Stanley, " Further intensify our focus on the high return growth opportunities within our integrated securities businesses."

Heading the vaunted investment bank was an unusual coup for Purcell. After working as a consultant at McKinsey & Co., Purcell entered banking by way of Sears Roebuck when the retailer bought brokerage Dean Witter Reynolds in 1981. Hired to head Dean Witter, Purcell then founded the Discover Card in 1986, which grew to be one of the largest U.S. credit card issuers. At the same time, Purcell freed Dean Witter and its Discover business through a 1993 IPO. Four years later, the firm merged with Morgan Stanley.

After the merger, Purcell took Morgan Stanley's reins and forced out the company's President John Mack, who went on to head Credit Suisse First Boston (CS). With growing dissatisfaction of the post-merger culture, a faction of Morgan's board pulled for Purcell's ouster, leading to his 2005 resignation. Mack returned triumphantly to Morgan Stanley to complete the Discover spinoff, which was first floated by Purcell as he faced pressure to resign.

In June 2007, over two years after the spin proposal was made by Purcell, Morgan Stanley's board agreed to complete the spinoff. Echoing Purcell's words, CEO Mack said the move would maximize Discover's growth, while allowing Morgan Stanley to focus on its institutional securities unit that had earned $21.1 billion in revenue, driving a record $7.5 billion 2006 profit.

After the spin, the shares values and growth prospects of the two businesses diverged tremendously. Only months later, blips of an oncoming credit crunch emerged and a little over a year later, Morgan Stanley faced demise. Since its June 2007 IPO, Discover's shares have shed nearly 4%, while Morgan Stanley's shares have plummeted nearly 75%.

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With the onset of the financial crisis and a souring of mortgage securities, Morgan Stanley, like its Wall Street peers took billions in writedowns, losing a record $3.5 billion in the fourth quarter of 2007. As quarterly losses continued in 2008, the firm managed to survive the crisis that felled three of its peers by selling a 20% stake to Mitsubishi UFJ for $9 billion in October 2008. A year later, John Mack stepped down as CEO, leading to the nomination James Gorman, an executive with a brokerage background, who pulled the bank back from risky trading businesses.

In retrospect, the spin may have been a strategic misstep ahead of the crisis. Discover Financials' earnings and balance sheet proved to be a source of stability. Just over a year after the spin, Morgan Stanley had to convert to a bank holding company to access the Federal Reserve's discount window as interbank lending dried in the days after the bankruptcy of Lehman Brothers. At that time, Discover Bank - an arm of Discover Financial - had over $28 billion in deposits, giving the unit a stable funding source and $10.2 billion in cash to weather the crisis. During the crisis, Discover Financial also saw minimal losses.

Meanwhile, Discover Financial has grown revenue and profit at a faster rate, stabilizing shares. Revenue has grown 42% and profits have doubled to $2.2 billion at Discover Financial since 2006, as of the year ended in December. In contrast, Morgan Stanley's revenue has grown just over 8% and profits, fueled by accounting gains on the value of the firm's debt, are still well below pre-crisis levels.

To move away from trading businesses that are now confined by new regulations, Morgan Stanley cut a brokerage the venture with Citigroup (C) in 2009 , buying a 51% stake in a JV called Morgan Stanley Smith Barney. In 2012, the firm will be able to begin accumulating shares, putting it on a path for full ownership by 2014.

For more on Morgan Stanley and Citigroup shares, see 19 S&P laggards that could be leaders in 2012 and 10 New York banks with the most upside for investors.

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