Morgan Punts Discover

Profit is down at the investment firm, which plans to spin off its card group.
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Updated from 9:43 a.m.

Morgan Stanley

(MS) - Get Report

reported an 11% decline in fourth-quarter profit, and in a surprising move it announced it will spin off its Discover credit card business.

The Discover spin-off is a stunning turnound for Morgan Stanley CEO and Chairman John Mack, who last year rejected such an idea. In the past, Discover has been a drag on the investment firm's earnings, but recently it has begun generating nice returns.

Net income at Morgan Stanley fell from the year-ago period, which included an after-tax gain of $700 million stemming from the sale of its former aircraft-leasing business.

In the quarter, Morgan Stanley earned $2.2 billion, or $2.08 a share, compared with $2.47 billion, or $2.32 a share, in the year-ago period. Net revenue rose 24% to $8.6 billion.

Analysts surveyed by Thomson Financial were looking for earnings of $1.77 cents a share on revenue of $8.3 billion. The current quarter included a tax beneift of $280 million, or 27 cents a share, which most analysts did not factor into their estimate.

On an operating basis, which exluded the tax benefit and other one-time events, Morgan Stanley earned $2.08 a share, compared with $1.64 a share a year ago. On that basis, earnings exceeded analyst expectations.

Shares were up $1.11 to $80.37 in early morning trading, largely on the Discover spin-off news.

After former CEO Phil Purcell was ousted in a push led by Morgan Stanley's investment bankers and replaced by Mack, many on Wall Street had been predicting a Discover spin-off. In spinning off Discover, Mack is taking another step toward undoing the acrimonious marriage of Morgan Stanley and the retail brokerage Dean Witter, to which Discover belonged.

Purcell had actually suggested the possibility of spinning off Discover in a last-ditch bit to retain his job.

Morgan Stanley says its board decided to spin off the Discover business in order "to increase shareholder value.'' Many on Wall Street are applauding Mack's about-face and say he is taking the right steps to streamline the investment firm's operations.

"Discover didn't fit the profile," says David Hendler, an analyst at CreditSights. "There was never really a good effort to integrate Discover across the franchise."

"They want to be more like

Goldman Sachs

," he says. "They want to do a lot of private-equity and proprietary trading and hedge fund activity ... and not be distracted by the credit card cycle, which may be deteriorating. Why get weighed down by credit cards' cyclical trends when it's not really part of your core business?

A week ago,

Goldman Sachs

(GS) - Get Report

reported a 93% gain in fourth-quarter earnings, closing out the most profitable year in the firm's history.

In the current quarter, the Discover business generated revenue of $963 million, a 39% gain from the year-ago period. But on a sequential basis, revenue at the credit card firm fell 8% from the third quarter of this year. For the full year, the credit card unit's income rose 86%, to $1.07 billion.

Average "managed" credit card loans at the end of the fourth quarter rose just 6% from a year earlier, to $49.1 billion at Discover. Total accounts of $45.3 million were virtually flat at the end of the quarter.

While spinning off Discover may make sense for Morgan Stanley shareholders in the short term, it's unclear how well the credit card business will fare over the long haul. In recent years, the number of independent credit card firms has declined, as card companies have hooked up with banks to give more heft to their balance sheets and gain borrowing power.

In the credit card universe, Discover is a big player, but it lacks the prestige of an American Express or cards issued by big banks such as

Citigroup

(C) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

or

Bank of America

(BAC) - Get Report

. Discover also doesn't have the market breadth of a

MasterCard

(MA) - Get Report

or Visa.

Some analysts say that Discover's limited availability and lack of stature compared with those of other credit cards was a hindrance to its brand.

"I am very pleased that they're getting rid of Discover," says Brad Hintz, an analyst at Sanford Bernstein. "If I am out on a date and the waiter brings me my bill and I want to impress the girl, do I pull out a Discover card or American Express card? It's a wonderful observation of the weakness of the credit card."

However, "Discover did not have the same ratings as Morgan Stanley at the time of the merger in 1997, so how much capital do they have to put into Discover in order to keep the ratings the same?" Hintz asks.

Hintz, a former Morgan Stanley employee, owns a small amount of stock related to an employee stock options plan.

Fitch Ratings, according to

Reuters

, responded to the Discover news by cutting Morgan Stanley's credit rating to negative. The bond rating agency says the card business generates substantial cash for the firm.

Meanwhile, the quarter was a solid one for Morgan Stanley. Revenue from Morgan Stanley's investment-banking operations surged 32% from a year earlier, to $1.5 billion. Principal trading was up 44%, however down 20%, to $2.26 billion, Morgan Stanley said. Asset-management revenue fell 19% from a year earlier, to $718 million.

Morgan Stanley's noninterest expenses rose 19%, to $5.7 billion. Compensation and benefits as a percentage of net revenue was 39% in the quarter, up 1 percentage point from a year earlier.