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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MAY 31, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 1-11758
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
----------------
DELAWARE 36-3145972
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
1585 BROADWAY 10036
NEW YORK, NY (ZIP CODE)
(ADDRESS OF PRINCIPAL
EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 761-4000
----------------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
As of June 27, 1997 there were 586,983,199 shares of Registrant's Common
Stock, par value $.01 per share, outstanding.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
INDEX TO QUARTERLY REPORT ON FORM 10-Q
MAY 31, 1997
PAGE
----
PART I--FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Financial Condition--May 31, 1997
(unaudited) and Fiscal Year End 1996................................. 1
Condensed Consolidated Statements of Income--Three and Six Months
Ended May 31, 1997 and 1996 (unaudited).............................. 2
Condensed Consolidated Statements of Cash Flows--Six Months Ended May
31, 1997 and 1996 (unaudited)........................................ 3
Notes to Condensed Consolidated Financial Statements (unaudited)...... 4
Independent Accountants' Report....................................... 11
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................. 14
PART II--OTHER INFORMATION
Item 1. Legal Proceedings............................................... 30
Item 4. Submission of Matters to a Vote of Security Holders............. 30
Item 6. Exhibits and Reports on Form 8-K................................ 31
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
AT FISCAL
MAY 31, YEAR END
1997 1996
----------- ---------
(UNAUDITED)
ASSETS
Cash and cash equivalents............................... $ 4,331 $ 6,544
Cash and securities deposited with clearing organiza-
tions or segregated under federal and other regulations
(including securities at fair value of $4,515 at May
31, 1997 and $3,759 at fiscal year end 1996 ).......... 6,178 5,209
Financial instruments owned:
U.S. government and agency securities.................. 13,032 12,032
Other sovereign government obligations................. 21,606 19,473
Corporate and other debt............................... 19,923 16,899
Corporate equities..................................... 16,595 12,662
Derivative contracts................................... 11,137 11,220
Physical commodities................................... 215 375
Securities purchased under agreements to resell......... 67,819 64,021
Securities borrowed..................................... 58,193 43,546
Receivables:
Consumer loans (net of allowances of $821 at May 31,
1997 and $802 at fiscal year end 1996)................ 20,322 21,262
Customers, net......................................... 14,537 8,600
Brokers, dealers and clearing organizations............ 3,021 5,421
Fees, interest and other............................... 4,711 3,981
Office facilities, at cost (less accumulated deprecia-
tion and amortization of $1,177 at May 31, 1997 and
$1,060 at fiscal year end 1996)........................ 1,655 1,681
Other assets............................................ 6,709 5,934
-------- --------
Total assets............................................ $269,984 $238,860
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Commercial paper and other short-term borrowings........ $ 23,999 $ 26,326
Deposits................................................ 7,575 7,213
Financial instruments sold, not yet purchased:
U.S. government and agency securities.................. 13,100 11,395
Other sovereign government obligations................. 14,304 6,513
Corporate and other debt............................... 1,530 1,176
Corporate equities..................................... 14,253 8,900
Derivative contracts................................... 9,487 9,982
Physical commodities................................... 74 476
Securities sold under agreements to repurchase.......... 89,503 86,863
Securities loaned....................................... 16,033 12,907
Payables:
Customers.............................................. 24,399 22,062
Brokers, dealers and clearing organizations............ 6,399 1,820
Interest and dividends................................. 3,103 1,678
Other liabilities and accrued expenses.................. 7,172 6,340
Long-term borrowings.................................... 25,898 22,642
-------- --------
256,829 226,293
-------- --------
Capital Units........................................... 999 865
-------- --------
Commitments and contingencies
Shareholders' equity:
Preferred stock........................................ 877 1,223
Common stock(1) ($0.01 par value, 1,750,000,000 shares
authorized, 602,834,714 and 611,314,509 shares
issued, 586,342,798 and 572,682,876 shares
outstanding at May 31, 1997 and at fiscal year end
1996)................................................. 6 6
Paid-in capital(1)..................................... 3,760 4,007
Retained earnings...................................... 8,039 7,477
Cumulative translation adjustments..................... (9) (11)
-------- --------
Subtotal............................................. 12,673 12,702
Note receivable related to sale of preferred stock to
ESOP.................................................. (77) (78)
Common stock held in treasury, at cost(1) ($0.01 par
value, 16,491,916 and 38,631,633 shares at May 31,
1997 and at fiscal year end 1996)..................... (432) (1,005)
Stock compensation related adjustments................. (8) 83
-------- --------
Total shareholders' equity........................... 12,156 11,702
-------- --------
Total liabilities and shareholders' equity.............. $269,984 $238,860
======== ========
- --------
(1) Historical amounts have been restated to reflect the Company's two-for-one
stock split.
See Notes to the Condensed Consolidated Financial Statements.
1
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA)
THREE MONTHS SIX MONTHS
ENDED MAY 31, ENDED MAY 31,
----------------------- -----------------------
1997 1996 1997 1996
----------- ----------- ----------- -----------
(UNAUDITED) (UNAUDITED)
Investment banking............. $ 581 $ 604 $ 1,103 $ 1,062
Principal transactions
Trading...................... 722 680 1,591 1,503
Investments.................. 136 38 192 31
Commissions.................... 484 463 974 911
Fees
Asset management,
distribution and
administration.............. 610 430 1,197 820
Merchant and cardmember...... 424 354 860 684
Servicing.................... 186 182 386 378
Interest and dividends......... 3,197 2,830 6,566 5,644
Other.......................... 36 37 67 66
----------- ----------- ----------- -----------
Total revenues................ 6,376 5,618 12,936 11,099
Interest expense............... 2,478 2,251 5,187 4,515
Provision for consumer loan
losses........................ 378 238 755 485
----------- ----------- ----------- -----------
Net revenues................. 3,520 3,129 6,994 6,099
----------- ----------- ----------- -----------
Compensation and benefits...... 1,505 1,314 2,995 2,572
Occupancy and equipment........ 127 119 255 239
Brokerage, clearing and
exchange fees................. 113 78 208 155
Information processing and
communications................ 267 241 537 469
Marketing and business
development................... 274 247 562 483
Professional services.......... 99 73 192 142
Other.......................... 178 167 360 349
Merger related costs........... 74 -- 74 --
----------- ----------- ----------- -----------
Total non-interest expenses.. 2,637 2,239 5,183 4,409
----------- ----------- ----------- -----------
Income before income taxes..... 883 890 1,811 1,690
Income tax expense............. 356 322 713 629
----------- ----------- ----------- -----------
Net income..................... $ 527 $ 568 $ 1,098 $ 1,061
=========== =========== =========== ===========
Preferred stock dividend
requirements.................. $ 18 $ 17 $ 37 $ 33
=========== =========== =========== ===========
Earnings applicable to common
shares(1)..................... $ 509 $ 551 $ 1,061 $ 1,028
=========== =========== =========== ===========
Earnings per common share(2)
Primary...................... $ 0.85 $ 0.92 $ 1.78 $ 1.71
=========== =========== =========== ===========
Fully diluted................ $ 0.83 $ 0.90 $ 1.74 $ 1.68
=========== =========== =========== ===========
Average common shares
outstanding(2)
Primary...................... 598,282,535 597,949,948 595,600,065 600,468,484
=========== =========== =========== ===========
Fully diluted................ 611,724,590 610,894,787 609,524,101 614,316,613
=========== =========== =========== ===========
- --------
(1) Amounts shown are used to calculate primary earnings per common share.
(2) Historical share and per share amounts have been restated to reflect the
Company's two-for-one stock split.
See Notes to the Condensed Consolidated Financial Statements.
2
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
SIX MONTHS
ENDED MAY 31,
------------------
1997 1996
-------- --------
(UNAUDITED)
Cash flows from operating activities
Net income............................................... $ 1,098 $ 1,061
Adjustments to reconcile net income to net cash used for
operating activities:
Non-cash charges included in net income................ 782 576
Changes in assets and liabilities:
Cash and securities deposited with clearing
organizations or segregated under federal and other
regulations......................................... (978) (1,116)
Financial instruments owned, net of financial
instruments sold, not yet purchased................. 5,659 7,319
Securities borrowed, net of securities loaned........ (11,596) (10,815)
Receivables and other assets......................... (4,822) (2,903)
Payables and other liabilities....................... 9,524 3,168
-------- --------
Net cash used for operating activities..................... (333) (2,710)
-------- --------
Cash flows from investing activities
Net payments for:
Property, equipment and leasehold improvements......... (52) (76)
Purchase of Miller Anderson & Sherrerd, LLP, net of
cash acquired......................................... -- (200)
Net principal disbursed on consumer loans.............. (1,773) (4,163)
Purchases of consumer loans............................ -- (5)
Sales of consumer loans................................ -- 3,951
Other investing activities............................. (29) (42)
-------- --------
Net cash used for investing activities..................... (1,854) (535)
-------- --------
Cash flows from financing activities
Net proceeds related to short-term borrowings............ 780 2,434
Securities sold under agreements to repurchase, net of
securities purchased under agreements to resell......... (2,547) (710)
Proceeds from
Issuance of common stock............................... 62 99
Issuance of long-term borrowings....................... 5,612 5,871
Issuance of Capital Units.............................. 134 --
Payments for
Repurchases of common stock............................ (124) (824)
Repayments of long-term borrowings..................... (2,261) (2,310)
Redemption of cumulative preferred stock............... (345) --
Cash dividends......................................... (179) (148)
-------- --------
Net cash provided by financing activities.................. 1,132 4,412
-------- --------
Elimination of Dean Witter, Discover & Co.'s net cash
activity for the month of December 1996 and 1995.......... (1,158) (542)
-------- --------
Net (decrease) increase in cash and cash equivalents....... (2,213) 625
Cash and cash equivalents, at beginning of period.......... 6,544 3,936
-------- --------
Cash and cash equivalents, at end of period................ $ 4,331 $ 4,561
======== ========
See Notes to the Condensed Consolidated Financial Statements.
3
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. INTRODUCTION AND BASIS OF PRESENTATION
The Merger
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged
with and into Dean Witter, Discover & Co. ("Dean Witter Discover") (the
"Merger"). At that time Dean Witter Discover changed its corporate name to
Morgan Stanley, Dean Witter, Discover & Co. (the "Company"). In conjunction
with the Merger, the Company issued 260,861,078 shares of its common stock, as
each share of Morgan Stanley common stock then outstanding was converted into
1.65 shares of the Company's common stock (the "Exchange Ratio"). In addition,
each share of Morgan Stanley preferred stock was converted into one share of a
corresponding series of preferred stock of the Company. The Merger was treated
as a tax free exchange.
The Company
The condensed consolidated financial statements include the accounts of
Morgan Stanley, Dean Witter, Discover & Co. and its U.S. and international
subsidiaries, including Morgan Stanley & Co. Incorporated ("MS&Co."), Morgan
Stanley & Co. International Limited ("MSIL"), Morgan Stanley Japan Limited
("MSJL"), Dean Witter Reynolds Inc. ("DWR"), Dean Witter InterCapital Inc.,
and NOVUS Credit Services Inc.
The Company, through its subsidiaries, provides a wide range of financial
securities services on a global basis and provides credit and transaction
services nationally. Its securities and asset management businesses include
securities underwriting, distribution and trading; merger, acquisition,
restructuring, real estate, project finance and other corporate finance
advisory activities; asset management; merchant banking and other principal
investment activities; brokerage and research services; the trading of foreign
exchange and commodities as well as derivatives on a broad range of asset
categories, rates and indices; and global custody, securities clearance
services and securities lending. The Company's credit and transaction services
businesses include the operation of the NOVUS(R) Network, a proprietary
network of merchant and cash access locations, and the issuance of proprietary
general purpose credit cards. The Company's services are provided to a large
and diversified group of clients and customers, including corporations,
governments, financial institutions and individuals.
Basis of Financial Information and Change in Fiscal Year End
The condensed consolidated financial statements give retroactive effect to
the Merger which was accounted for as a pooling of interests. The pooling of
interests method of accounting requires the restatement of all periods
presented as if Dean Witter Discover and Morgan Stanley had always been
combined. The fiscal year end 1996 shareholders' equity data reflects the
accounts of the Company as if the preferred and additional common stock had
been issued during all periods presented.
Prior to the Merger, Dean Witter Discover's year ended on December 31 and
Morgan Stanley's fiscal year ended on November 30. Subsequent to the Merger,
the Company adopted a fiscal year end of November 30. All information included
herein for the three and six month periods ended May 31, 1997 and 1996 and as
of May 31, 1997 reflect the change in fiscal year-end. Fiscal year end 1996
data combines Dean Witter Discover's historical information as of December 31,
1996 and Morgan Stanley's historical information as of November 30, 1996.
The condensed consolidated financial statements are prepared in accordance
with generally accepted accounting principles, which require management to
make estimates and assumptions regarding certain trading inventory valuations,
consumer loan loss levels, the potential outcome of litigation and other
matters that affect the financial statements and related disclosures.
Management believes that the estimates utilized in the preparation of the
condensed consolidated financial statements are prudent and reasonable. Actual
results could differ from these estimates.
4
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Certain reclassifications have been made to prior year amounts to conform to
the current presentation. All material intercompany balances and transactions
have been eliminated.
The condensed consolidated financial statements should be read in
conjunction with the Company's supplemental consolidated financial statements
and notes thereto for the fiscal year ended 1996 included in the Company's
Current Report on Form 8-K dated May 31, 1997 and filed on June 2, 1997 (the
"Form 8-K"). The condensed consolidated financial statements reflect all
adjustments (consisting only of normal recurring adjustments) which are, in
the opinion of management, necessary for the fair statement of the results for
the interim period. The results of operations for interim periods are not
necessarily indicative of results for the entire year.
The combined and separate results of operations for Dean Witter Discover and
Morgan Stanley during the periods preceding the Merger were as follows (in
millions):
THREE MONTHS SIX MONTHS
ENDED MAY 31, ENDED MAY 31,
------------- -------------
1997 1996 1997 1996
------ ------ ------ ------
Net Revenues
Dean Witter Discover........................... $1,638 $1,601 $3,318 $3,122
Morgan Stanley................................. 1,882 1,528 3,676 2,977
------ ------ ------ ------
Combined..................................... $3,520 $3,129 $6,994 $6,099
====== ====== ====== ======
Net Income
Dean Witter Discover........................... $ 217 $ 267 $ 472 $ 487
Morgan Stanley................................. 310 301 626 574
------ ------ ------ ------
Combined..................................... $ 527 $ 568 $1,098 $1,061
====== ====== ====== ======
In connection with the Merger, the Company incurred pre-tax costs of $74
million ($63 million after-tax) in the second fiscal quarter of 1997. These
costs consisted primarily of proxy solicitation costs, severance costs,
financial advisory and accounting fees, legal and regulatory filing fees.
Financial instruments, including derivatives, used in the Company's trading
activities are recorded at fair value, and unrealized gains and losses are
reflected in trading revenues. Interest revenue and expense arising from
financial instruments used in trading activities are reflected in the
consolidated statements of income as interest revenue or expense. The fair
values of trading positions generally are based on listed market prices. If
listed market prices are not available or if liquidating the Company's
positions would reasonably be expected to impact market prices, fair value is
determined based on other relevant factors, including dealer price quotations
and price quotations for similar instruments traded in different markets,
including markets located in different geographic areas. Fair values for
certain derivative contracts are derived from pricing models which consider
current market and contractual prices for the underlying financial instruments
or commodities, as well as time value and yield curve or volatility factors
underlying the positions. Purchases and sales of financial instruments are
recorded in the accounts on trade date. Unrealized gains and losses arising
from the Company's dealings in over-the-counter ("OTC") financial instruments,
including derivative contracts related to financial instruments and
commodities, are presented in the accompanying condensed consolidated
statements of financial condition on a net-by-counterparty basis, when
appropriate. Reverse repurchase and repurchase agreements are presented net-
by-counterparty, when appropriate.
Equity securities purchased in connection with merchant banking and other
principal investment activities are initially carried in the consolidated
financial statements at their original costs. The carrying value of such
equity securities is adjusted when changes in the underlying fair values are
readily ascertainable, generally as evidenced by listed market prices or
transactions which directly affect the value of such equity securities.
Downward adjustments relating to such equity securities are made in the event
that the Company determines
5
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
that the eventual realizable value is less than the carrying value. The
carrying value of investments made in connection with principal real estate
activities which do not involve equity securities are adjusted periodically
based on independent appraisals, estimates prepared by the Company of
discounted future cash flows of the underlying real estate assets or other
indicators of fair value.
Loans made in connection with merchant banking and investment banking
activities are carried at cost plus accrued interest less reserves, if deemed
necessary, for estimated losses.
The Company has entered into various contracts as hedges against specific
assets, liabilities or anticipated transactions. These contracts include
interest rate swap, foreign exchange forward, foreign currency exchange, cost
of funds and interest rate cap agreements. The Company uses interest rate and
currency swaps to manage the interest rate and currency exposure arising from
certain borrowings and to match the refinancing characteristics of consumer
loans with the borrowings that fund these loans. For contracts that are
designated as hedges of the Company's assets and liabilities, gains and losses
are deferred and recognized as adjustments to interest revenue or expense over
the remaining life of the underlying assets or liabilities. For contracts that
are hedges of asset securitizations, gains and losses are recognized as
adjustments to servicing fees. Gains and losses resulting from the termination
of hedge contracts prior to their stated maturity are recognized ratably over
the remaining life of the instrument being hedged. The Company also uses
foreign exchange forward contracts to manage the currency exposure relating to
its net monetary investment in non-U.S. dollar functional currency operations.
The gain or loss from revaluing these contracts is deferred and reported
within cumulative translation adjustments in shareholders' equity, net of tax
effects, with the related unrealized amounts due from or to counterparties
included in receivables from or payables to brokers, dealers and clearing
organizations.
Earnings Per Share
The calculations of earnings per common share are based on the weighted
average number of common shares and share equivalents outstanding and gives
effect to preferred stock dividend requirements. Per share and share amounts
have been restated to reflect the Company's two-for-one stock split effective
January 14, 1997, as well as the additional shares issued to Morgan Stanley
shareholders pursuant to the Exchange Ratio.
Accounting Pronouncements
As of January 1, 1997, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," which is effective for
transfers of financial assets made after December 31, 1996, except for certain
financial assets for which the effective date has been delayed for one year.
SFAS No. 125 provides financial reporting standards for the derecognition and
recognition of financial assets, including the distinction between transfers
of financial assets which should be recorded as sales and those which should
be recorded as secured borrowings. The adoption of the enacted provisions of
SFAS No. 125 had no material effect on the Company's financial position or
results of operations. The Company is currently evaluating the impact of the
deferred provisions of SFAS No. 125.
The Financial Accounting Standards Board has issued SFAS No. 128, "Earnings
per Share" ("EPS"), effective for periods ending after December 15, 1997, with
restatement required for all prior periods. SFAS No. 128 replaces the current
EPS categories of primary and fully diluted with "basic", which reflects no
dilution from common stock equivalents, and "diluted", which reflects dilution
from common stock equivalents and other dilutive securities based on the
average price per share of the Company's common stock during the period. The
adoption of SFAS No. 128 would not have had, and is not expected to have, a
material effect on the Company's EPS calculation.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." These statements, which are
effective for fiscal years beginning after December 15, 1997, establish
standards for the reporting and display of comprehensive income and disclosure
requirements related to segments.
6
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
2. CONSUMER LOANS
Activity in the allowance for consumer loan losses was as follows (in
millions).
THREE MONTHS SIX MONTHS
ENDED MAY 31, ENDED MAY 31,
-------------- --------------
1997 1996 1997 1996
------ ------ ------ ------
Balance, beginning of period.................... $ 809 $ 643 $ 781 $ 685
Provision for loan losses....................... 378 238 755 485
Less deductions
Charge-offs................................... 415 264 817 511
Recoveries.................................... (42) (39) (82) (69)
------ ------ ------ ------
Net charge-offs............................. 373 225 735 442
------ ------ ------ ------
Other(1)........................................ 7 (13) 20 (85)
------ ------ ------ ------
Balance, end of period.......................... $ 821 $ 643 $ 821 $ 643
====== ====== ====== ======
- --------
(1) Primarily reflects net transfers related to asset securitizations.
Interest accrued on loans subsequently charged off, recorded as a reduction
of interest revenue, was $85 million and $160 million in the second fiscal
quarter of 1997 and six months ended May 31, 1997 and $39 million and $78
million in the second fiscal quarter of 1996 and six months ended May 31,
1996.
The Company received proceeds from asset securitizations of $1,047 million
and $3,667 million in the second fiscal quarter and six months ended May 31,
1996. The uncollected balances of consumer loans sold through securitizations
were $13,024 million and $13,197 million at May 31, 1997 and fiscal year end
1996. The allowance for loan losses related to securitized loans, included in
other liabilities and accrued expenses, was $440 million and $445 million at
May 31, 1997 and fiscal year end 1996.
3. LONG-TERM BORROWINGS
Long-term borrowings at May 31, 1997 scheduled to mature within one year
aggregated $5,392 million.
During the six month period ended May 31, 1997, the Company issued senior
notes aggregating $5,771 million, including non-U.S. dollar currency notes
aggregating $1,079 million, primarily pursuant to its public debt shelf
registration statements. The weighted average coupon interest rate of these
notes was 6.1% at May 31, 1997; the Company has entered into certain
transactions to obtain floating interest rates based on either short-term
LIBOR or repurchase agreement rates for Treasury securities. Maturities in the
aggregate of these notes for fiscal years ending are as follows: 1997, $12
million; 1998, $779 million; 1999, $946 million; 2000, $732 million; 2001, $74
million; and thereafter, $3,228 million. In the six month period ended May 31,
1997, $2,261 million of senior long-term notes matured.
On June 2, 1997, the Company's shelf registration statement for $7 billion
of additional debt securities, warrants, preferred stock or purchase contracts
or any combination thereof in the form of units, became effective.
7
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
4. PREFERRED STOCK AND CAPITAL UNITS
Preferred stock is composed of the following issues:
SHARES OUTSTANDING
AT BALANCE AT
------------------- -------------------
FISCAL
MAY 31, YEAR END MAY 31, FISCAL YEAR
1997 1996 1997 END 1996
--------- --------- ------- -----------
(DOLLARS IN
MILLIONS)
ESOP Convertible Preferred Stock, liq-
uidation preference $35.88............ 3,675,445 3,699,302 $132 $ 133
Series A Fixed/Adjustable Rate Cumula-
tive Preferred Stock,
stated value $200..................... 1,725,000 1,725,000 345 345
7 -3/4% Cumulative Preferred Stock,
stated value $200..................... 1,000,000 1,000,000 200 200
7 -3/8% Cumulative Preferred Stock,
stated value $200..................... 1,000,000 1,000,000 200 200
8.88% Cumulative Preferred Stock,
stated value $200..................... -- 975,000 -- 195
8 -3/4% Cumulative Preferred Stock,
stated value $200..................... -- 750,000 -- 150
---- ------
Total.................................. $877 $1,223
==== ======
Each issue of outstanding preferred stock ranks in parity with all other
outstanding preferred stock of the Company.
During the first fiscal quarter of 1997, the Company redeemed all 975,000
shares of its 8.88% Cumulative Preferred Stock at a redemption price of
$201.632 per share, which reflects the stated value of $200 per share together
with an amount equal to all dividends accrued and unpaid to, but excluding,
the redemption date.
During the second fiscal quarter of 1997, the Company redeemed all 750,000
shares of its 8- 3/4% Cumulative Preferred Stock at a redemption price of $200
per share.
The Company has Capital Units outstanding which were issued by the Company
and Morgan Stanley Finance plc ("MS plc"), a U.K. subsidiary. A Capital Unit
consists of (a) a Subordinated Debenture of MS plc guaranteed by the Company
and having maturities from 2013 to 2017 and (b) a related Purchase Contract
issued by the Company, which may be accelerated by the Company beginning
approximately one year after the issuance of each Capital Unit, requiring the
holder to purchase one Depositary Share representing shares (or fractional
shares) of the Company's Cumulative Preferred Stock.
5. COMMON STOCK AND SHAREHOLDERS' EQUITY
In conjunction with the Merger, the Company increased the number of
authorized common shares to 1,750 million and changed the number of authorized
preferred shares to 30 million.
Prior to the consummation of the Merger, both Morgan Stanley and Dean Witter
Discover rescinded their respective outstanding share repurchase
authorizations. At the time of the Merger, 5,902,751 shares of Morgan Stanley
common stock which had been held in treasury was retired.
MS&Co. and DWR are registered broker-dealers and registered futures
commission merchants subject to the minimum net capital requirements of the
Securities and Exchange Commission, the New York Stock Exchange and the
Commodities Futures Trading Commission. MS&Co. and DWR have consistently
operated in excess of these net capital requirements. MS&Co.'s net capital
totaled $1,971 million at May 31, 1997 which exceeded the amount required by
$1,631 million. DWR's net capital totaled $627 million at May 31, 1997 which
exceeded the amount required by $516 million. MSIL, a London-based broker
dealer subsidiary, is subject to the capital requirements of the Securities
and Futures Authority, and MSJL, a Tokyo-based broker-dealer, is subject to
the capital requirements of the Japanese Ministry of Finance. MSIL and MSJL
have consistently operated in excess of their respective regulatory capital
requirements.
8
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Under regulatory net capital requirements adopted by the Federal Deposit
Insurance Corporation ("FDIC") and other regulatory capital guidelines, FDIC
insured financial institutions must maintain (a) 3% to 5% of Tier 1 capital,
as defined, to total assets ("leverage ratio") and (b) 8% combined Tier 1 and
Tier 2 capital, as defined, to risk weighted assets ("risk-weighted capital
ratio"). At May 31, 1997, the leverage ratio and risk-weighed capital ratio of
each of the Company's FDIC insured financial institutions exceeded these and
all other regulatory minimums.
Certain other U.S. and non-U.S. subsidiaries are subject to various
securities, commodities and banking regulations, and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. These subsidiaries have consistently operated
in excess of their local capital adequacy requirements.
6. ACQUISITION AND DISPOSITION
On April 3, 1997, the Company acquired the institutional global custody
business of Barclays PLC ("Barclays"). The amount of consideration for this
business is to be fixed over a period of time based on account retention. The
transaction involved approximately $254 billion of assets administered by
Barclays. Barclays has agreed to provide global subcustodial services to the
Company for a period of time after completion of the acquisition.
In May 1997, the Company announced plans for the sale of the DWR
institutional futures business to Banque Indosuez. The Company does not expect
this sale to have a material effect on results of operations or financial
position.
7. CONTINGENT LIABILITIES
In the normal course of business, the Company has been named as a defendant
in various lawsuits and has been involved in certain investigations and
proceedings. Some of these matters involve claims for substantial amounts.
Although the ultimate outcome of these matters cannot be ascertained at this
time, it is the opinion of management, after consultation with outside
counsel, that the resolution of such matters will not have a material adverse
effect on the consolidated financial condition of the Company, but may be
material to the Company's operating results for any particular period,
depending upon the level of the Company's income for such period.
8. DERIVATIVE CONTRACTS AND OTHER COMMITMENTS AND CONTINGENCIES
In the normal course of business, the Company enters into a variety of
derivative contracts related to financial instruments and commodities. The
Company uses swap agreements in its trading activities and in managing its
interest rate exposure. The Company also uses forward and option contracts,
futures and swaps in its trading activities; these financial instruments also
are used to hedge the U.S. dollar cost of certain foreign currency exposures.
In addition, financial futures and forward contracts are actively traded by
the Company and are used to hedge proprietary inventory. The Company also
enters into delayed delivery, when-issued, and warrant and option contracts
involving securities. These instruments generally represent future commitments
to swap interest payment streams, exchange currencies or purchase or sell
other financial instruments on specific terms at specified future dates. Many
of these products have maturities that do not extend beyond one year; swaps
and options and warrants on equities typically have longer maturities. For
further discussion of these matters, refer to "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Derivative
Financial Investments", and Note 8 to the supplemental consolidated financial
statements for the fiscal year ended 1996, included in the Form 8-K.
These derivative instruments involve varying degrees of off-balance sheet
market risk. Future changes in interest rates, foreign currency exchange rates
or the fair values of the financial instruments, commodities or indices
underlying these contracts ultimately may result in cash settlements exceeding
fair value amounts recognized in the condensed consolidated statements of
financial condition, which, as described in Note 1, are recorded at fair
value, representing the cost of replacing those instruments.
9
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The Company's exposure to credit risk with respect to these derivative
instruments at any point in time is represented by the fair value of the
contracts reported as assets. These amounts are presented on a net-by-
counterparty basis (when appropriate), but are not reported net of collateral,
which the Company obtains with respect to certain of these transactions to
reduce its exposure to credit losses.
The credit quality of the Company's trading-related derivatives at May 31,
1997 and fiscal year end 1996 is summarized in the tables below, showing the
fair value of the related assets by counterparty credit rating. The credit
ratings are determined by external rating agencies or by equivalent ratings
used by the Company's Credit Department:
COLLATERALIZED OTHER NON-
NON-INVESTMENT INVESTMENT
AAA AA A BBB GRADE GRADE TOTAL
------ ------ ------ ------ -------------- ---------- -------
MAY 31, 1997 (DOLLARS IN MILLIONS)
Interest rate and
currency swaps and
options (including
caps, floors and swap
options) and other
fixed income securities
contracts.............. $ 575 $1,707 $1,878 $ 465 $ 17 $278 $ 4,920
Foreign exchange forward
contracts and options.. 547 1,322 537 93 -- 129 2,628
Mortgage-backed
securities forward
contracts, swaps and
options................ 88 48 50 5 -- 3 194
Equity securities
contracts (including
equity swaps, warrants
and options)........... 906 685 381 153 291 14 2,430
Commodity forwards,
options and swaps...... 90 300 205 224 3 143 965
------ ------ ------ ------ ---- ---- -------
Total................. $2,206 $4,062 $3,051 $ 940 $311 $567 $11,137
====== ====== ====== ====== ==== ==== =======
Percent of total........ 20% 37% 27% 8% 3% 5% 100%
====== ====== ====== ====== ==== ==== =======
AT FISCAL YEAR END 1996
Interest rate and cur-
rency swaps and options
(including caps, floors
and swap options) and
other fixed income se-
curities contracts..... $ 792 $1,445 $2,018 $ 696 $ 31 $183 $ 5,165
Foreign exchange forward
contracts and options.. 727 824 539 28 -- 50 2,168
Mortgage-backed securi-
ties forward contracts,
swaps and options...... 66 65 64 19 -- 5 219
Equity securities
contracts (including
equity swaps, warrants
and options)........... 1,074 274 408 60 426 43 2,285
Commodity forwards, op-
tions and swaps........ 95 318 318 280 72 300 1,383
------ ------ ------ ------ ---- ---- -------
Total.................. $2,754 $2,926 $3,347 $1,083 $529 $581 $11,220
====== ====== ====== ====== ==== ==== =======
Percent of total........ 24% 26% 30% 10% 5% 5% 100%
====== ====== ====== ====== ==== ==== =======
A substantial portion of the Company's securities and commodities
transactions are collateralized and are executed with and on behalf of
commercial banks and other institutional investors, including other brokers and
dealers. Positions taken and commitments made by the Company, including
positions taken and underwriting and financing commitments made in connection
with its merchant banking and other principal investment activities, often
involve substantial amounts and significant exposure to individual issuers and
businesses, including non-investment grade issuers. The Company seeks to limit
concentration risk created in its businesses through a variety of separate but
complementary financial, position and credit exposure reporting systems,
including the use of trading limits based in part upon the Company's review of
the financial condition and credit ratings of its counterparties.
See also the "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Risk Management" in the Form 8-K for discussions of the
Company's risk management policies and procedures for its securities
businesses.
The Company had approximately $5.0 billion and $3.4 billion of letters of
credit outstanding at May 31, 1997 and at fiscal year end 1996 to satisfy
various collateral requirements.
10
INDEPENDENT ACCOUNTANTS' REPORT
To the Directors and Shareholders of
Morgan Stanley, Dean Witter, Discover & Co.
We have reviewed the accompanying condensed consolidated statement of
financial condition of Morgan Stanley, Dean Witter, Discover & Co. and
subsidiaries as of May 31, 1997, and the related condensed consolidated
statements of income for the three and six month periods ended May 31, 1997
and 1996, and cash flows for the six month periods ended May 31, 1997 and
1996. These condensed consolidated financial statements are the responsibility
of the management of Morgan Stanley, Dean Witter, Discover & Co. We were
furnished with the report of other accountants on their review of the interim
financial information of Morgan Stanley Group Inc. and subsidiaries for the
quarter ended February 28, 1997, which statements reflect total revenues of
$4,076 million and $3,308 million for the three month periods ended February
28, 1997 and February 29, 1996, respectively. We were also furnished with the
report of other accountants on their review of the interim financial
information of Morgan Stanley Group Inc. and subsidiaries for the quarter
ended May 31, 1996, which statements reflect total revenues of $3,393 million
and $6,701 million for the three and six month periods ended May 31, 1996,
respectively.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review and the reports of other accountants, we are not aware
of any material modifications that should be made to such condensed
consolidated financial statements for them to be in conformity with generally
accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the supplemental consolidated statement of financial condition of
Morgan Stanley, Dean Witter, Discover & Co. and subsidiaries as of fiscal year
1996, and the related supplemental consolidated statements of income, cash
flows and changes in shareholders' equity for the year then ended (not
presented herein), included in Morgan Stanley, Dean Witter, Discover & Co.'s
Current Report on Form 8-K dated May 31, 1997 and filed on June 2, 1997; and
in our report dated May 31, 1997, we expressed an unqualified opinion on those
supplemental consolidated financial statements based on our audit and the
report of other auditors.
/s/ DELOITTE & TOUCHE LLP
New York, New York
July 15, 1997
11
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
The Board of Directors
Morgan Stanley Group Inc.
We have reviewed the condensed consolidated statement of financial condition
of Morgan Stanley Group Inc. and subsidiaries as of February 28, 1997 and the
related condensed consolidated statements of income for the three-month
periods ended February 28, 1997 and February 29, 1996, and the condensed
consolidated statements of cash flows for the three-month periods ended
February 28, 1997 and February 29, 1996. These financial statements are the
responsibility of the Company's management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data, and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, which will
be performed for the full year with the objective of expressing an opinion
regarding the financial statements taken as a whole. Accordingly, we do not
express such an opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to the accompanying condensed consolidated financial statements
referred to above for them to be in conformity with generally accepted
accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated statement of financial condition of Morgan Stanley
Group Inc. as of November 30, 1996, and the related consolidated statements of
income, shareholders' equity, and cash flows for the fiscal year then ended
(not presented herein) and in our report dated January 7, 1997, we expressed
an unqualified opinion on those consolidated financial statements. In our
opinion, the information set forth in the accompanying condensed consolidated
statement of financial condition as of November 30, 1996, is fairly stated, in
all material respects, in relation to the consolidated statement of financial
condition from which it has been derived.
/s/ Ernst & Young LLP
New York, New York
March 27, 1997
12
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
The Board of Directors
Morgan Stanley Group Inc.
We have reviewed the condensed consolidated statement of financial condition
of Morgan Stanley Group Inc. and subsidiaries as of May 31, 1996 and the
related condensed consolidated statements of income for the three-month and
six-month periods ended May 31, 1996 and 1995, and the condensed consolidated
statements of cash flows for the six-month periods ended May 31, 1996 and
1995. These financial statements are the responsibility of the Company's
management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data, and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, which will
be performed for the full year with the objective of expressing an opinion
regarding the financial statements taken as a whole. Accordingly, we do not
express such an opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to the accompanying condensed consolidated financial statements
referred to above for them to be in conformity with generally accepted
accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated statement of financial condition of Morgan Stanley
Group Inc. as of November 30, 1995, and the related consolidated statements of
income, shareholders' equity, and cash flows for the ten month period then
ended (not presented herein) and in our report dated January 4, 1996, we
expressed an unqualified opinion on those consolidated financial statements.
In our opinion, the information set forth in the accompanying condensed
consolidated statement of financial condition as of November 30, 1995, is
fairly stated, in all material respects, in relation to the consolidated
statement of financial condition from which it has been derived.
/s/ Ernst & Young LLP
New York, New York
July 2, 1996
13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
INTRODUCTION
The Merger
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged
with and into Dean Witter, Discover & Co. ("Dean Witter Discover") (the
"Merger"). At that time, Dean Witter Discover changed its corporate name to
Morgan Stanley, Dean Witter, Discover & Co. (the "Company"). In conjunction
with the Merger, each share of Morgan Stanley common stock then outstanding
was converted into 1.65 shares of the Company's common stock (the "Exchange
Ratio"), and each share of Morgan Stanley preferred stock was converted into
one share of a corresponding series of preferred stock of the Company. The
Merger was treated as a tax free exchange.
Basis of Financial Information and Change in Fiscal Year End
The condensed consolidated financial statements give retroactive effect to
the Merger which was accounted for as a pooling of interests. The pooling of
interests method of accounting requires the restatement of all periods
presented as if Dean Witter Discover and Morgan Stanley had always been
combined. The fiscal year end 1996 shareholders' equity data reflects the
accounts of the Company as if the preferred and additional common stock had
been issued during all periods presented.
Prior to the Merger, Dean Witter Discover's year ended on December 31 and
Morgan Stanley's fiscal year ended on November 30. Subsequent to the Merger,
the Company adopted a fiscal year end of November 30. All information included
herein for the three and six month periods ended May 31, 1997 and 1996 and as
of May 31, 1997 reflect the change in fiscal year-end. Fiscal year end 1996
data combines Dean Witter Discover's historical information as of December 31,
1996 and Morgan Stanley's historical information as of November 30, 1996.
RESULTS OF OPERATIONS
The Company's results of operations may be materially affected by market
fluctuations and by economic factors. The Company's securities business,
particularly its involvement in primary and secondary markets for all types of
financial products, including derivatives, is subject to substantial positive
and negative fluctuations due to a variety of factors that cannot be predicted
with great certainty, including variations in the fair value of securities and
other financial products and the volatility and liquidity of trading markets.
Fluctuations also occur due to the level of market activity, which, among
other things, affects the flow of investment dollars into mutual funds, and
the size, number and timing of transactions or assignments (including
realization of returns from the Company's principal and merchant banking
investments). In the Company's credit and transaction services business,
changes in economic variables may substantially affect consumer loan growth
and credit quality. In addition, results of operations in the past have been
and in the future may continue to be materially affected by many factors of a
national and international nature, including economic and market conditions;
the availability of capital; the level and volatility of interest rates;
currency values and other market indices; the availability of credit;
inflation; and legislative and regulatory developments. Such factors may also
have an impact on the Company's ability to achieve its strategic objectives,
including (without limitation) profitable global expansion.
The Company's results of operations also may be materially affected by
competitive factors. In addition to competition from firms traditionally
engaged in the securities business, there has been increased competition in
the securities business from other sources, such as commercial banks,
insurance companies, mutual fund groups and other companies offering financial
services. As a result of recent or pending legislative and regulatory
initiatives in the U.S. to remove or relieve certain restrictions on
commercial banks, competition in some markets which have traditionally been
dominated by investment banks and retail securities firms has increased and
may
14
continue to increase in the near future. Such competition, among other things,
affects the Company's ability to attract and retain highly skilled
individuals. Competitive factors also affect the Company's success in
attracting and retaining clients and assets by its ability to meet investors'
saving and investment needs through consistency of investment performance and
access to financial products and advice. In the credit and transaction
services industry, competition centers on merchant acceptance of credit cards,
credit card account acquisition and customer utilization of credit cards.
Merchant acceptance is based on both competitive transaction pricing and the
volume of credit cards in circulation. Credit card account acquisition and
customer utilization are driven by the offering of credit cards with
competitive and appealing features such as no annual fees, low introductory
interest rates and other customized features targeting specific consumer
groups.
As a result of the above economic and competitive factors, net income and
revenues in any particular period may not be representative of full year
results and may vary significantly from year to year and from quarter to
quarter. The Company intends to manage its business for the long term and help
mitigate the potential effects of market downturns by strengthening its
competitive position in the global financial services industry through
diversification of its revenue sources and enhancement of its global
franchise. Maintaining high levels of profitable business activities,
emphasizing fee-based assets that are designed to generate a continuing stream
of revenues, managing risks, evaluating credit product pricing and monitoring
costs will continue to affect the overall financial results of the Company. In
addition, the two complementary trends in the financial services industry of
consolidation and globalization present, among other things, technological,
risk management and other infrastructure challenges that will require
effective resource allocation in order for the Company to remain competitive.
The favorable market and economic conditions that characterized fiscal 1996
have continued into the first half of fiscal 1997, although the financial
markets experienced a slowdown in the beginning of the second fiscal quarter,
partly driven by investor concerns regarding a potentially higher level of
inflation due to rising wages, a low unemployment rate, and strong industrial
production. In response to concerns of inflation and a fast growing U.S.
economy, the Federal Reserve Board raised the overnight lending rate by .25%
in March 1997. In spite of this development, the financial markets
demonstrated resilience as heavy cash inflows into mutual funds, better than
expected corporate earnings, moderate economic growth and indications of lower
inflationary pressures continued.
The Company's net income of $527 million and $1,098 million in the second
fiscal quarter and six month period ended May 31, 1997 represented a decrease
of 7% from the second fiscal quarter of 1996 and an increase of 4% from the
six month period ended May 31, 1996. Fully diluted earnings per common share
were $0.83 and $1.74 in the second fiscal quarter and six month period ended
May 31, 1997 compared to $0.90 and $1.68 in the comparable periods of fiscal
1996. The second fiscal quarter of 1997 net income included $63 million of
merger related costs. These costs consisted primarily of proxy solicitation
costs, severance costs, financial advisory and accounting fees, legal and
regulatory filing fees. Excluding these merger related costs, net income would
have increased 4% and 9% in the second fiscal quarter and six month period
ended May 31, 1997 from the comparable periods of fiscal 1996, and fully
diluted earnings per common share would have been $0.94 and $1.85.
The increase in net income in the second fiscal quarter and six month period
ended May 31, 1997, excluding the merger related costs, from the comparable
periods of 1996 was due to higher revenues from securities activities, assets
under management and credit card fees partially offset by higher credit card
net charge-offs and non-interest expenses. Securities and asset management
revenues were favorably impacted in the six month period ended May 31, 1997 by
the economic and market conditions described above. Additionally, both periods
of fiscal 1997 include the earnings of VK/AC Holding Inc., the parent of Van
Kampen American Capital, Inc. ("VKAC"), which was acquired in the fourth
quarter of fiscal 1996. Credit and Transaction Services net revenues were
impacted by rising credit losses which were offset by higher average levels of
consumer loans and pricing actions taken by the Company in fiscal 1996.
15
SECURITIES AND ASSET MANAGEMENT
STATEMENTS OF INCOME (DOLLARS IN MILLIONS)
THREE MONTHS SIX MONTHS
ENDED MAY 31, ENDED MAY 31,
------------- --------------
1997 1996 1997 1996
------ ------ ------- ------
Investment banking................................ $ 581 $ 604 $ 1,103 $1,062
Principal transactions:
Trading.......................................... 722 680 1,591 1,503
Investments...................................... 136 38 192 31
Commissions....................................... 476 463 965 911
Asset management, distribution and administration
fees............................................. 610 430 1,197 820
Interest and dividends............................ 2,416 2,167 5,018 4,322
Other............................................. 33 36 62 65
------ ------ ------- ------
Total revenues.................................. 4,974 4,418 10,128 8,714
Interest expense.................................. 2,191 2,004 4,617 3,996
------ ------ ------- ------
Net revenues.................................... 2,783 2,414 5,511 4,718
------ ------ ------- ------
Compensation and benefits......................... 1,369 1,195 2,724 2,332
Occupancy and equipment........................... 112 105 225 211
Brokerage, clearing and exchange fees............. 109 78 204 155
Information processing and communications......... 149 126 291 245
Marketing and business development................ 100 74 196 139
Professional services............................. 83 65 158 120
Other............................................. 114 84 240 194
------ ------ ------- ------
Total non-interest expenses..................... 2,036 1,727 4,038 3,396
------ ------ ------- ------
Income before income taxes ....................... 747 687 1,473 1,322
Income tax expense................................ 286 248 567 491
------ ------ ------- ------
Net income........................................ $ 461 $ 439 $ 906 $ 831
====== ====== ======= ======
Securities net revenues of $2,783 million and $5,511 million in the second
fiscal quarter and six month period ended May 31, 1997 represented an increase
of 15% and 17% from the comparable periods of fiscal 1996. Securities net
income of $461 million and $906 million in the second fiscal quarter and six
month period ended May 31, 1997 represented an increase of 5% and 9% from the
comparable periods of fiscal 1996. The increases in both periods reflected
higher levels of asset management, distribution and administration fees and
increased principal transaction trading and investment revenues, partially
offset by higher incentive-based compensation and non-interest expenses. In
the following discussion, amounts for the three and six month periods ended
May 31, 1996 are given in parentheses.
Investment Banking
Investment banking revenues are derived from the underwriting of securities
offerings and fees from advisory services. Investment banking revenues in the
second fiscal quarter declined to $581 million ($604 million), primarily
reflecting lower levels of equity underwriting revenues due to the decreased
levels of market activity, partially offset by continued strength in merger
and acquisition transactions. Fixed income underwriting revenues were
comparable to the prior year quarter. Revenues from issuances of investment
grade debt increased, benefiting from market liquidity and investor demand for
long duration securities. This was offset by a decline in revenues from global
high yield debt issuances, primarily resulting from lower transaction volume.
Equity financing revenues decreased, primarily due to a lower volume of equity
offerings as compared to the very strong levels of the prior year quarter,
which included some of the most significant transactions of fiscal 1996.
Revenues from merger, acquisition and restructuring activities increased,
primarily due to the extremely robust global market for these transactions.
Merger and acquisition activity was diversified across many industries, with
the financial services, food and beverage, health care and public utility
sectors contributing the greatest level of activity. Revenues from real estate
transactions also increased as compared to the second quarter of fiscal 1996.
16
In the six month period ended May 31, 1997, investment banking revenues
continued to benefit from strong volumes in the primary markets as well as a
significant level of global merger, acquisition and restructuring
transactions. Investment banking revenues increased to $1,103 million ($1,062
million), primarily reflecting higher levels of debt underwriting revenues,
partially offset by lower revenues from equity underwritings and merger,
acquisition and restructuring transactions.
Principal Transactions
Principal transaction trading revenues, which include revenues from customer
purchases and sales of securities in which the Company acts as principal, and
gains and losses on securities held for resale, including derivatives,
increased in the second fiscal quarter to $722 million ($680 million).
Fixed income trading revenues decreased in the second fiscal quarter from
the comparable prior year period, resulting from lower revenues from
government and corporate bond trading. The quarter's results were impacted by
economic indicators which continued to highlight the strength of the U.S.
economy. This data heightened investors' inflationary concerns, created
uncertainty regarding the Federal Reserve Board's interest rate policy, and
contributed to lower levels of trading volume and interest rate volatility. In
addition, the elections in France and other developments in Europe raised
uncertainty with respect to the approaching European Monetary Union ("EMU").
Equity trading revenues in the second fiscal quarter were comparable to the
strong level of revenues recorded in the second fiscal quarter of 1996.
Revenues from equity derivatives trading decreased due to lower levels of
market volatility. These results were offset by higher revenues from European
cash trading, driven by a strong primary calendar and higher levels of
customer activity as the major European exchanges achieved new records during
the quarter.
Trading revenues from commodity products in the second fiscal quarter were
also comparable to prior year levels. Revenues from energy products and
natural gas increased due to fluctuating prices and continued volatility in
these markets, resulting from higher than normal crude oil inventory levels
and unseasonably cold weather in the Northeast during the quarter. These
increases were offset by lower revenues from trading in commodity derivatives
and precious metals.
Foreign exchange trading revenues in the second fiscal quarter increased
significantly from the comparable period of fiscal 1996, attaining a second
consecutive record level of quarterly revenues. The increase was primarily
attributable to a greater volume of client transactions and increased
volatilities in the foreign exchange markets as the U.S. dollar strengthened
during the beginning of the quarter due to a positive outlook for U.S.
economic growth. The U.S. dollar also benefited from a disappointing outlook
on European growth, uncertainty regarding the timing of the EMU and the
strength of the "Euro" (the proposed replacement for the European Currency
Unit), and pessimism surrounding Japan's economic and political condition.
Principal transaction investment gains aggregating $136 million were
recognized in the second fiscal quarter ($38 million), primarily in connection
with increases in the carrying value of certain merchant banking investments.
The majority of this increase was related to an increase in the carrying value
of the Company's holdings of Fort Howard Corp., which announced that it will
merge with James River Corp.
Principal transaction trading revenues in the six month period ended May 31,
1997 were $1,591 million ($1,503 million). Equity trading revenues were
comparable to prior year levels, as higher revenues from equity cash products
were offset by lower revenues from equity derivatives trading. Equity cash
products continued to benefit from high trading volumes, strong customer
demand, and significant infusions of cash into equity mutual funds. Fixed
income trading revenues were also comparable to prior year levels, benefiting
from strong customer transaction volumes and volatility in the fixed income
markets, particularly during the first fiscal quarter of 1997. Commodities
trading revenues remained strong, as revenues from energy products and natural
gas benefited from market volatility and weather conditions. Revenues from
foreign exchange trading increased significantly, primarily driven by the
strengthening of the U.S. dollar and high levels of market volatility.
17
Principal transaction investment revenues aggregating $192 million ($31
million) were recognized during the six month period ended May 31, 1997,
primarily reflecting revenues related to the increase in the carrying value of
the Company's holdings of Fort Howard Corp., as well as real estate investment
gains.
Commissions
Commission revenues primarily arise from agency transactions in listed and
over-the-counter equity securities, and sales of mutual funds, futures,
insurance products and options. Commission revenues increased to $476 million
($463 million) in the second fiscal quarter. In U.S. markets, the Company
benefited from continued strong market share coupled with high volumes of
securities transactions. Trading volume also increased in Europe, as the major
European exchanges achieved new records during the quarter. Revenues were also
impacted by continued cash flows into the equity markets and from the
rebalancing of customer portfolios as investors sought to capitalize on robust
equity markets.
Commission revenues in the six month period ended May 31, 1997 increased to
$965 million ($911 million), principally reflecting increased customer
activity in the global markets for equity securities, as well as continued
inflows of funds into the equity markets from investors.
Asset Management, Distribution and Administration Fees
Asset management and administration revenues include fees for asset
management services, including fund management fees which are received for
investment management and for promoting and distributing mutual funds ("12b-1
fees"), other administrative fees and non-interest revenues earned from
correspondent clearing and custody services. Fund management fees arise from
investment management services the Company provides to registered investment
companies (the "funds") pursuant to various contractual arrangements. The
Company receives management fees based upon each fund's average daily net
assets. The Company receives 12b-1 fees for services it provides in promoting
and distributing certain open-ended funds. These fees are based on the lesser
of average daily fund asset balances or average daily aggregate net fund sales
and are affected by changes in the overall level and mix of assets under
management and administration. The Company also receives fees from investment
management services provided to segregated customer accounts pursuant to
various contractual arrangements.
Asset management and administration revenues increased significantly in the
second fiscal quarter to $610 million ($430 million), reflecting the Company's
continued emphasis on these businesses. The majority of the increase is
attributable to revenues from VKAC, which was acquired by the Company on
October 31, 1996. Higher fund management and 12b-1 fees as well as increased
revenues from international equity, emerging market and U.S. domestic equity
and fixed income products resulting from inflows of client assets and market
appreciation, also had a favorable impact on these revenues.
In the six month period ended May 31, 1997, asset management and
administration revenues increased significantly to $1,197 million ($820
million), primarily attributable to revenues associated with VKAC, higher 12b-
1 fees, increased revenues from international equity and emerging markets
products and continued growth in customer assets under management and
administration.
Customer assets under management or supervision increased to $303 billion
($204 billion), including $61 billion associated with the acquisition of VKAC
as well as continued inflows of new assets and appreciation in the value of
existing customer portfolios.
Customer assets under administration increased to $410 billion ($130
billion). Approximately $254 billion of this increase is attributable to the
Company's acquisition of the institutional global custody business of Barclays
PLC ("Barclays") on April 3, 1997, for consideration to be fixed over a period
of time. Appreciation in the value of customer portfolios and additional
assets placed under custody with the Company, including new customer accounts
as well as additional assets from existing customers, also contributed to the
growth in assets under administration.
18
Net Interest
Net interest and dividend revenues increased to $225 million ($163 million)
in the second fiscal quarter. Interest and dividend revenues rose to $2,416
million ($2,167 million), and interest expense increased to $2,191 million
($2,004 million), principally reflecting growth in interest-bearing assets and
liabilities. Interest and dividend revenues and expense are a function of the
level and mix of total assets, including financial instruments owned and
resale and repurchase agreements, and the prevailing level, term structure and
volatility of interest rates. Interest and dividend revenues and expense
should be viewed in the broader context of principal trading and investment
banking results. Decisions relating to principal transactions in securities
are based on an overall review of aggregate revenues and costs associated with
each transaction or series of transactions. This review includes an assessment
of the potential gain or loss associated with a trade, the interest income or
expense associated with financing or hedging the Company's positions, and
potential underwriting, commission or other revenues associated with related
primary or secondary market sales.
Net interest and dividend revenues were $401 million ($326 million) in the
six month period ended May 31, 1997. Interest and dividend revenues rose to
$5,018 million ($4,322 million) and interest expense increased to $4,617
million ($3,996 million). As noted in the quarter to quarter comparison of net
interest above, interest and dividend revenues and expense reflect principal
trading strategies and should be viewed in the broader context of principal
trading and investment banking results.
Non-Interest Expenses
Total non-interest expenses increased to $2,036 million ($1,727 million) in
the second fiscal quarter. Within that total, compensation and benefits
expense increased $174 million to $1,369 million ($1,195 million), principally
reflecting increased incentive compensation based on higher revenues and
earnings. Non-compensation expenses, excluding brokerage, clearing and
exchange fees, increased $104 million to $558 million. Approximately $40
million of this increase was attributable to expenses associated with VKAC.
Brokerage, clearing and exchange fees increased $31 million, primarily related
to the acquisitions of VKAC and the institutional global custody business of
Barclays. Occupancy and equipment expenses increased $7 million, primarily
related to the occupancy costs of VKAC and increased office space in New York.
Marketing and business development expenses increased $26 million, reflecting
increased travel and entertainment costs as the Company continues to develop
new business, as well as advertising costs associated with VKAC's retail
mutual funds. Professional services expenses increased $18 million, primarily
reflecting higher consulting costs associated with information technology
initiatives and the Company's increased global business activities, coupled
with expenses associated with VKAC. Information processing and communications
expenses increased $23 million, primarily due to the impact of increased rates
for certain data services, additional employees hired during fiscal 1996, and
the incremental expenses of VKAC. Other expenses increased $30 million, which
includes $10 million of goodwill amortization related to the acquisition of
VKAC. The increase also reflects the Company's higher level of business
activity and incremental expenses of VKAC.
In the six month period ended May 31, 1997, total non-interest expenses
increased to $4,038 million ($3,396 million). Within that total, employee
compensation and benefits expense increased to $2,724 million ($2,332
million), principally reflecting increased incentive compensation based on
higher revenues and earnings. Non-compensation expenses, excluding brokerage,
clearing and exchange fees, increased to $1,110 million ($909 million).
Approximately $79 million of this increase was attributable to the expenses of
VKAC. Brokerage, clearing and exchange fees increased $49 million, primarily
reflecting the acquisition of VKAC and the institutional global custody
business of Barclays, as well as increased securities trading volumes.
Occupancy and equipment expense increased $14 million, primarily reflecting
the occupancy costs of VKAC. Marketing and business development expenses
increased $57 million, reflecting higher travel and entertainment costs as
well as advertising costs associated with VKAC's retail mutual funds.
Professional services expenses increased $38 million, reflecting higher
consulting costs as a result of information technology initiatives and the
increased level of overall business activity. Information processing and
communications expense increased $46 million, reflecting higher data services
costs, incremental costs related to VKAC and increased headcount. Other
expenses increased by $46 million primarily as a result of goodwill
amortization associated with the acquisition of VKAC, as well as the impact of
a higher level of business activity on various operating expenses.
19
CREDIT AND TRANSACTION SERVICES
STATEMENTS OF INCOME (DOLLARS IN MILLIONS)
THREE MONTHS SIX MONTHS
ENDED MAY 31, ENDED MAY 31,
------------- -------------
1997 1996 1997 1996
------ ------ ------ ------
Fees
Merchant and cardmember.......................... $ 424 $ 354 $ 860 $ 684
Servicing........................................ 186 182 386 378
Commissions........................................ 8 -- 9 --
Other.............................................. 3 1 5 1
------ ------ ------ ------
Total non-interest revenues...................... 621 537 1,260 1,063
------ ------ ------ ------
Interest revenue................................... 781 663 1,548 1,322
Interest expense................................... 287 247 570 519
------ ------ ------ ------
Net interest income.............................. 494 416 978 803
Provision for consumer loan losses................. 378 238 755 485
------ ------ ------ ------
Net credit income................................ 116 178 223 318
------ ------ ------ ------
Net revenues..................................... 737 715 1,483 1,381
------ ------ ------ ------
Compensation and benefits.......................... 136 119 271 240
Occupancy and equipment............................ 15 14 30 28
Brokerage, clearing and exchange fees.............. 4 -- 4 --
Information processing and communications.......... 118 115 246 224
Marketing and business development................. 174 173 366 344
Professional services.............................. 16 8 34 22
Other.............................................. 64 83 120 155
------ ------ ------ ------
Total non-interest expenses...................... 527 512 1,071 1,013
------ ------ ------ ------
Income before income taxes......................... 210 203 412 368
Income tax expense................................. 81 74 157 138
------ ------ ------ ------
Net income......................................... $ 129 $ 129 $ 255 $ 230
====== ====== ====== ======
Credit and Transaction Services net income remained level in the second
fiscal quarter compared to the second fiscal quarter of 1996 and increased 11%
in the six month period ended May 31, 1997 compared to the six month period
ended May 31, 1996. In the second fiscal quarter, increases in non-interest
revenues and net interest income due to credit card fee and interest revenue
enhancements introduced in fiscal 1996 and higher average levels of consumer
loans were offset by increased credit losses. The increase in net income in
the six month period ended May 31, 1997 was due to the effects of credit card
fee and interest revenue enhancements and higher average levels of consumer
loans, partially offset by increased credit losses and higher non-interest
expenses.
Non-Interest Revenues. Total non-interest revenues increased 16% and 19% in
the second fiscal quarter and six month period ended May 31, 1997 from the
comparable periods of fiscal 1996.
Merchant and cardmember fees include revenues from fees charged to merchants
on credit card sales, late payment fees, overlimit fees, insurance fees, cash
advance fees, the administration of credit card programs and transaction
processing services. Merchant and cardmember fees increased 20% and 26% in the
second fiscal quarter and six month period ended May 31, 1997 from the
comparable periods of fiscal 1996. The increase was due to higher overlimit,
late payment and merchant fee revenues. Overlimit fees were implemented in
March 1996 and the amount of the fee was increased in the fourth fiscal
quarter of 1996. The increase in late payment fee revenues was due to an
increase in the incidence of late payments and a tightening, in the fourth
fiscal quarter
20
of 1996, of late payment fee terms. The increased incidence of late payments
was attributable to a higher level of delinquent accounts. The increase in
merchant fee revenue was due to growth in credit card transaction volume.
Servicing fees are revenues derived from consumer loans that have been sold
to investors through asset securitizations. Cash flows from the interest yield
and cardmember fees generated by securitized loans are used to pay investors
in these loans a predetermined fixed or floating rate of return on their
investment, to reimburse investors for losses of principal through charged off
loans and to pay the Company a fee for servicing the loans. Any excess net
cash flows remaining are paid to the Company. The servicing fees and excess
net cash flows paid to the Company are reported as servicing fees in the
consolidated statements of income. The sale of consumer loans through asset
securitizations therefore has the effect of converting portions of net credit
income and fee income to servicing fees.
The table below presents the components of servicing fees (dollars in
millions).
THREE
MONTHS SIX MONTHS
ENDED ENDED
MAY 31, MAY 31,
------------ -------------
1997 1996 1997 1996
----- ----- ------ -----
Merchant and cardmember fees....................... $ 105 $ 63 $ 216 $ 107
Interest revenue................................... 518 487 1,036 955
Interest expense................................... (204) (197) (407) (374)
Provision for consumer loan losses................. (233) (171) (459) (310)
----- ----- ------ -----
Servicing fees..................................... $ 186 $ 182 $ 386 $ 378
===== ===== ====== =====
Servicing fees remained level in the second fiscal quarter and the six month
period ended May 31, 1997 from the comparable periods of fiscal 1996. In both
periods, higher cardmember fees, as discussed previously, and a higher average
level of securitized loans were offset by a higher rate of credit losses on
securitized loans.
Net Interest Income. Net interest income is equal to the difference between
interest revenue derived from Credit and Transaction Services consumer loan
and short-term investment assets and interest expense incurred to finance
those assets. Credit and Transaction Services assets, primarily consumer
loans, earn interest revenue at both fixed rates and market-indexed variable
rates. The Company incurs interest expense at fixed and floating rates.
Interest expense also includes the effects of interest rate contracts entered
into by the Company as part of its interest rate risk management program. This
program is designed to reduce the volatility of earnings resulting from
changes in interest rates and is accomplished primarily through matched
financing, which entails matching the repricing schedules of consumer loans
and the related financing. Net interest income increased 19% and 22% in the
second fiscal quarter and the six month period ended May 31, 1997 from the
comparable periods of fiscal 1996 due to higher average levels of consumer
loans and a decline in interest rates, including the effect of interest rate
contracts, on the Company's borrowings. A higher yield on consumer loans,
which resulted from a shift in the mix of consumer loans to higher yielding
fixed rate loans and the effect of interest revenue enhancements made in
fiscal 1996, was offset by higher charge-offs of interest revenue.
21
The following tables present analyses of Credit and Transaction Services
average balance sheets and interest rates for the second fiscal quarter and
six month period ended May 31, 1997 and the comparable periods of fiscal 1996
and changes in net interest income during those periods.
AVERAGE BALANCE SHEET ANALYSIS (DOLLARS IN MILLIONS)
THREE MONTHS ENDED MAY 31,
-------------------------------------------------
1997 1996
------------------------ ------------------------
AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST
------- ----- -------- ------- ----- --------
ASSETS
Interest earning
assets:
General purpose credit
card loans............ $19,098 14.20% $684 $16,083 14.37% $581
Other consumer loans... 1,839 15.57 72 1,800 13.73 62
Investment securities.. 188 5.39 2 260 5.15 4
Other.................. 1,488 6.08 23 1,120 5.72 16
------- ---- ------- ----
Total interest
earning assets...... 22,613 13.70 781 19,263 13.68 663
Allowance for loan
losses................ (909) (640)
Non-interest earning
assets................ 1,738 1,325
------- -------
Total assets......... $23,442 $19,948
======= =======
LIABILITIES & SHAREHOLDER'S
EQUITY
Interest bearing
liabilities:
Interest bearing
deposits
Savings............... $ 1,013 4.05% $ 10 $ 1,015 4.57% $ 12
Brokered.............. 4,035 6.69 68 3,202 7.04 57
Other time............ 2,207 6.15 34 1,866 6.03 28
------- ---- ------- ----
Total interest
bearing deposits.... 7,255 6.15 112 6,083 6.32 97
Other borrowings....... 11,451 6.05 175 9,803 6.10 150
------- ---- ------- ----
Total interest
bearing liabilities. 18,706 6.09 287 15,886 6.18 247
Shareholder's
equity/other
liabilities........... 4,736 4,062
------- -------
Total liabilities &
shareholder's
equity.............. $23,442 $19,948
======= =======
Net interest income.... $494 $416
==== ====
Net interest margin.... 8.66% 8.58%
Interest rate spread... 7.61% 7.50%
22
AVERAGE BALANCE SHEET ANALYSIS (DOLLARS IN MILLIONS)
SIX MONTHS ENDED MAY 31,
-------------------------------------------------
1997 1996
------------------------ ------------------------
AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST
------- ----- -------- ------- ----- --------
ASSETS
Interest earning
assets:
General purpose credit
card loans............ $19,227 14.16% $1,357 $16,673 13.91% $1,160
Other consumer loans... 1,904 15.33 146 1,830 13.68 125
Investment securities.. 186 5.65 5 286 5.34 8
Other.................. 1,363 5.93 40 1,007 5.82 29
------- ------ ------- ------
Total interest
earning assets...... 22,680 13.69 1,548 19,796 13.36 1,322
Allowance for loan
losses................ (880) (658)
Non-interest earning
assets................ 1,749 1,349
------- -------
Total assets......... $23,549 $20,487
======= =======
LIABILITIES & SHAREHOLDER'S
EQUITY
Interest bearing
liabilities:
Interest bearing
deposits
Savings............... $ 1,025 4.33% $ 22 $ 1,005 4.57% $ 23
Brokered.............. 3,890 6.71 130 3,193 7.09 113
Other time............ 2,187 6.10 67 1,837 6.12 56
------- ------ ------- ------
Total interest
bearing deposits.... 7,102 6.18 219 6,035 6.38 192
Other borrowings....... 11,749 6.00 351 10,458 6.24 327
------- ------ ------- ------
Total interest
bearing liabilities. 18,851 6.07 570 16,493 6.29 519
Shareholder's
equity/other
liabilities........... 4,698 3,994
------- -------
Total liabilities &
shareholder's
equity.............. $23,549 $20,487
======= =======
Net interest income.... $ 978 $ 803
====== ======
Net interest margin.... 8.65% 8.11%
Interest rate spread... 7.62% 7.07%
23
RATE/VOLUME ANALYSIS (IN MILLIONS)
THREE MONTHS ENDED SIX MONTHS ENDED
MAY 31, 1997 VS 1996 MAY 31, 1997 VS 1996
----------------------- -----------------------
INCREASE/(DECREASE) INCREASE/(DECREASE)
DUE TO CHANGES IN DUE TO CHANGES IN
----------------------- -----------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
------- ----- ------ ------- ------ ------
INTEREST REVENUE
General purpose credit card
loans........................ $ 111 $ (8) $ 103 $ 174 $ 23 $ 197
Other consumer loans.......... 1 9 10 5 16 21
Investment securities......... (2) -- (2) (3) -- (3)
Other......................... 5 2 7 10 1 11
------ ------
Total interest revenue...... 115 3 118 189 37 226
------ ------
INTEREST EXPENSE
Interest bearing deposits
Savings...................... -- (2) (2) -- (1) (1)
Brokered..................... 15 (4) 11 25 (8) 17
Other time................... 5 1 6 11 -- 11
------ ------
Total interest bearing
deposits................... 19 (4) 15 34 (7) 27
Other borrowings.............. 25 -- 25 39 (15) 24
------ ------
Total interest expense...... 44 (4) 40 72 (21) 51
------ ------
Net interest income........... $ 71 $ 7 $ 78 $ 117 $ 58 $ 175
====== ===== ====== ====== ====== ======
The supplemental table below provides average managed loan balance and rate
information which takes into account both owned and securitized loans.
SUPPLEMENTAL AVERAGE MANAGED LOAN BALANCE SHEET INFORMATION (DOLLARS IN
MILLIONS)
THREE MONTHS ENDED MAY 31,
-----------------------------------------------------
1997 1996
-------------------------- --------------------------
AVG. BAL. RATE % INTEREST AVG. BAL. RATE % INTEREST
--------- ------ -------- --------- ------ --------
Consumer loans............. $34,032 14.85% $1,274 $30,215 14.89% $1,131
General purpose credit card
loans..................... 31,524 14.72 1,169 27,746 14.88 1,038
Total interest earning
assets.................... 35,709 14.44 1,299 31,594 14.48 1,150
Total interest bearing
liabilities............... 31,802 6.13 491 28,218 6.26 444
Consumer loan interest rate
spread.................... 8.72 8.63
Interest rate spread....... 8.31 8.22
Net interest margin........ 8.98 8.89
SIX MONTHS ENDED MAY 31,
-----------------------------------------------------
1997 1996
-------------------------- --------------------------
AVG. BAL. RATE % INTEREST AVG. BAL. RATE % INTEREST
--------- ------ -------- --------- ------ --------
Consumer loans............. $34,277 14.85% $2,538 $30,042 14.92% $2,240
General purpose credit card
loans..................... 31,703 14.74 2,331 27,554 14.90 2,053
Total interest earning
assets.................... 35,826 14.47 2,584 31,334 14.54 2,277
Total interest bearing
liabilities............... 31,997 6.12 977 28,030 6.37 893
Consumer loan interest rate
spread.................... 8.73 8.55
Interest rate spread....... 8.35 8.17
Net interest margin........ 9.00 8.84
Provision for Consumer Loan Losses. The provision for consumer loan losses
is the amount necessary to establish the allowance for loan losses at a level
the Company believes is adequate to absorb estimated losses in
24
its consumer loan portfolio at the balance sheet date. The Company's allowance
for loan losses is regularly evaluated by management for adequacy on a
portfolio by portfolio basis and was $821 million and $643 million at May 31,
1997 and 1996. The provision for consumer loan losses, which is affected by
net charge-offs, loan volume and changes in the amount of consumer loans
estimated to be uncollectable, increased 59% and 56% in the second fiscal
quarter and six month period ended May 31, 1997 from the comparable periods of
fiscal 1996 due to an increase in net charge-off rates. Net charge-offs as a
percentage of average consumer loans outstanding increased to 7.07% and 6.97%
in the second fiscal quarter and six month period ended May 31, 1997 from
5.00% and 4.77% in the comparable periods of fiscal 1996. The increase in the
Company's net charge-off rate was consistent with the industry-wide trend of
increasing credit loss rates that the Company believes is related, in part, to
increased consumer debt levels and bankruptcy rates. The Company believes that
this trend may continue and the Company may experience a higher net charge-off
rate for fiscal 1997 as compared to fiscal 1996. In fiscal 1996, the Company
took steps to reduce the impact of this trend, including raising credit
quality standards for new accounts, selectively reducing credit limits and
increasing collection activity. The Company believes the improved credit
quality standards and collection activity, while having a lesser impact in
fiscal 1996, may have an increased effect in fiscal 1997. The Company's
expectations about future charge-off rates and credit quality improvements are
subject to uncertainties that could cause actual results to differ materially
from what has been projected above. Factors that influence the level and
direction of consumer loan delinquencies and charge-offs include changes in
consumer spending and payment behaviors, bankruptcy trends, the seasoning of
the Company's loan portfolio, interest rate movements and their impact on
consumer behavior, and the rate and magnitude of changes in the Company's
consumer loan portfolio, including the overall mix of accounts, products and
loan balances within the portfolio.
Consumer loans are considered delinquent when interest or principal payments
become 30 days past due. Consumer loans are charged off when they become 180
days past due, except in the case of bankruptcies and fraudulent transactions,
where loans are charged off earlier. Loan delinquencies and charge-offs are
primarily affected by changes in economic conditions and vary throughout the
year due to seasonal consumer spending and payment behaviors. The Company
believes the increase in consumer loan delinquency rates at May 31, 1997 from
May 31, 1996 was related to the industry-wide credit conditions discussed
previously. The following table presents delinquency and net charge-off rates
with supplemental managed loan information.
ASSET QUALITY (DOLLARS IN MILLIONS)
MAY 31,
---------------------------------- FISCAL YEAR END
1997 1996 1996
---------------- ---------------- ----------------
OWNED MANAGED OWNED MANAGED OWNED MANAGED
------- ------- ------- ------- ------- -------
Consumer loans.......... $21,143 $34,167 $18,146 $30,806 $22,064 $35,261
Consumer loans
contractually past due
as a percentage of
consumer loans
30 to 89 days......... 4.24% 4.20% 3.61% 3.64% 4.42% 4.41%
90 to 179 days........ 2.77% 2.70% 2.21% 2.15% 2.89% 2.82%
Net charge-offs as a
percentage of average
consumer loans
(year-to-date)......... 6.97% 6.98% 4.77% 5.00% 6.23% 6.47%
Non-Interest Expenses. Non-interest expenses remained level in the second
fiscal quarter and increased 6% in the six month period ended May 31, 1997
from the comparable periods of fiscal 1996.
Employee compensation and benefits expense increased 14% and 13% in the
second fiscal quarter and six month period ended May 31, 1997 from the
comparable periods of fiscal 1996 due to an increase in the number of
employees. Marketing and business development expense remained level in the
second fiscal quarter of fiscal 1997 and increased 6% in the six month period
ended May 31, 1997 from the comparable periods of fiscal 1996. In the second
fiscal quarter, lower promotional expenses were offset by an increase in
Cardmember rewards
25
expense. The increase in the six month period ended May 31, 1997 was due to
higher Cardmember rewards expense. Cardmember rewards expense, which includes
the Cashback Bonus(R) Award, increased due to continued growth in credit card
transaction volume and increased cardmember qualification for higher award
levels.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets increased from $238.9 billion at fiscal year end
1996 to $270.0 billion at May 31, 1997, primarily reflecting growth in
financial instruments owned, resale agreements, securities borrowed and
customer receivables. A substantial portion of the Company's total assets
consists of highly liquid marketable securities and short-term receivables
arising principally from securities transactions. The highly liquid nature of
these assets provides the Company with flexibility in financing and managing
its business.
The Company's senior management and Finance and Risk Committee, which
includes senior officers from each of the major capital commitment areas,
among other things, establishes the overall funding and capital policies of
the Company, reviews the Company's performance relative to these policies,
allocates capital among business activities of the Company, monitors the
availability of sources of financing, reviews the foreign exchange risk of the
Company, and oversees the liquidity and interest rate sensitivity of the
Company's asset and liability position. The primary goal of the Company's
funding and liquidity activities is to ensure the stability of the Company's
funding base and to provide adequate financing sources over a wide range of
potential credit ratings and market environments.
The Company views return on equity to be an important measure of its
performance, in the context of both the particular business environment in
which the Company is operating as well as its peer group's results. In this
regard, the Company actively manages its consolidated capital position based
upon, among other things, business opportunities, capital availability and
rates of return together with internal capital policies, regulatory
requirements and rating agency guidelines and therefore may, in the future,
expand or contract its capital base to address the changing needs of its
businesses. The Company has also returned internally generated equity capital
which is in excess of the needs of its businesses through common stock
repurchases and dividends.
The Company funds its balance sheet on a global basis. The Company's funding
for its Securities segment is raised through diverse sources. These include
the Company's capital, including equity and long-term debt; medium-term notes;
internally generated funds; repurchase agreements; U.S., Canadian, French and
Euro commercial paper; letters of credit; unsecured bond borrows; German
Schuldschein loans; securities lending; buy/sell agreements; municipal re-
investments; master notes; and committed and uncommitted lines of credit.
Repurchase transactions and a portion of the Company's bank borrowings are
made on a collateralized basis and therefore provide a more stable source of
funding than short-term unsecured borrowings.
The funding sources utilized for the Company's Credit and Transaction
Services segment include asset securitizations, commercial paper, medium-term
notes, long-term borrowings, deposits, asset-backed commercial paper, Fed
Funds and short-term bank notes. The Company sells consumer loans through
asset securitizations using several transaction structures. Riverwoods Funding
Corporation ("RFC"), an entity included in the consolidated financial
statements of the Company, issues asset-backed commercial paper.
The Company's bank subsidiaries solicit deposits from consumers, purchase
federal funds and issue short-term bank notes. Interest bearing deposits are
classified by type as savings, brokered and other time deposits. Savings
deposits consist primarily of money market deposits and certificate of deposit
accounts sold directly to cardmembers and savings deposits from DWR clients.
Brokered deposits consist primarily of certificates of deposit issued by the
Company's bank subsidiaries. Other time deposits include institutional
certificates of deposit. The Company, through Greenwood Trust Company, an
indirect subsidiary of the Company, sells notes under a short-term bank note
program.
26
The Company maintains borrowing relationships with a broad range of banks,
financial institutions, counterparties and others from which it draws funds in
a variety of currencies. The volume of the Company's borrowings generally
fluctuates in response to changes in the amount of resale transactions
outstanding, the level of the Company's securities inventories and overall
market conditions. Availability and cost of financing to the Company can vary
depending upon market conditions, the volume of certain trading activities, the
Company's credit ratings and the overall availability of credit.
The Company's reliance on external sources to finance a significant portion
of its day-to-day operations makes access to global sources of financing
important. The cost and availability of financing generally are dependent on
the Company's short-term and long-term debt ratings. In addition, the Company's
debt ratings have a significant impact on certain trading revenues,
particularly in those businesses where longer term counterparty performance is
critical, such as over-the-counter derivative transactions. The Merger has not
had, and the Company does not expect that the Merger will have, a material
impact on the cost and availability of its financing or its business
activities.
As of June 30, 1997, the Company's credit ratings were as follows:
COMMERCIAL SENIOR
PAPER DEBT
------------ ------
Moody's Investors Service......... P-1 A1
Standard & Poor's................. A-1 A+
IBCA.............................. A1+ AA-
Thomson BankWatch................. TBW-1 AA
Dominion Bond Rating Service(1)... R-1 (middle) n/a
Duff & Phelps(2).................. D-1 A+
Fitch(2).......................... F-1+ AA-
- --------
(1) Dominion Bond Rating Service rates the Company's Canadian commercial paper
program.
(2) These ratings were assigned to Dean Witter Discover before the merger.
As the Company continues its global expansion and as revenues are
increasingly derived from various currencies, foreign currency management is a
key element of the Company's financial policies. The Company benefits from
operating in a number of different currencies because weakness in any
particular currency is often offset by strength in another currency. The
Company closely monitors its exposure to fluctuations in currencies and, where
cost-justified, adopts strategies to reduce the impact of these fluctuations on
the Company's financial performance. These strategies include engaging in
various hedging activities to manage income and cash flows denominated in
foreign currencies and using foreign currency borrowings, when appropriate, to
finance investments outside the U.S.
During the six month period ended May 31, 1997, the Company issued senior
notes aggregating $5,771 million, including non-U.S. dollar currency notes
aggregating $1,079 million. These notes have maturities from 1997 to 2017 and a
weighted average coupon interest rate of 6.1%; the Company has entered into
certain transactions to obtain floating interest rates based on either short-
term LIBOR or repurchase agreement rates for Treasury securities. At May 31,
1997 the aggregate outstanding principal amount of the Company's Senior
Indebtedness (as defined in the Company's public debt shelf registration
statements) was approximately $42.6 billion.
On June 2, 1997, the Company's shelf registration statement for $7 billion of
additional debt securities, warrants, preferred stock or purchase contracts or
any combination thereof in the form of units, became effective.
The Company maintains a senior revolving credit agreement with a group of
banks to support general liquidity needs, including the issuance of commercial
paper (the "Morgan Stanley Facility"). Under the terms of the credit agreement,
the banks are committed to provide up to $2.5 billion. The Company has assumed
the Morgan Stanley Facility as part of the Merger.
27
The Company also maintains a second senior revolving credit agreement with a
group of banks to support general liquidity needs, including the issuance of
commercial paper (the "DWD Facility"). Under the terms of the credit agreement
the banks are committed to provide up to $4.0 billion. As of second fiscal
quarter end 1997, the Company has never borrowed from the DWD Facility. In
April 1997, DWD renewed this facility which expires in April 1998.
The Morgan Stanley Facility and the DWD Facility both contain covenants that
require the Company to maintain minimum net worth requirements and specified
financial ratios. The Company believes that the covenant restrictions will not
impair the Company's ability to pay its current level of dividends. Prior to
the closing of the Merger, the Morgan Stanley Facility and the DWD Facility
were amended to conform such facilities to insure that they remain effective
subsequent to the closing of the Merger and to accommodate the Company's post-
Merger business activities and financing needs. The Company expects that a new
credit facility of the Company will replace the Morgan Stanley Facility and
the DWD Facility.
The Company maintains a master collateral facility that enables Morgan
Stanley & Co. Incorporated ("MS&Co."), one of the Company's U.S. broker-dealer
subsidiaries, to pledge certain collateral to secure loan arrangements,
letters of credit and other financial accommodations (the "MS&Co. Facility").
As part of this facility, MS&Co. also maintains a secured committed credit
agreement with a group of banks that are parties to the master collateral
facility under which such banks are committed to provide up to $1.5 billion.
The Company also maintains a revolving committed financing facility that
enables Morgan Stanley & Co. International Limited, the Company's U.K. broker-
dealer subsidiary, to secure committed funding from a syndicate of banks by
providing a broad range of collateral under repurchase agreements (the "MSIL
Facility"). Such banks are committed to provide up to an aggregate of $1.55
billion available in 12 major currencies.
RFC also maintains a $2.1 billion senior bank credit facility to support the
issuance of asset-backed commercial paper (the "RFC Facility").
The Company anticipates that it will utilize the Morgan Stanley Facility,
the DWD Facility, the MS&Co. Facility or the MSIL Facility for short-term
funding from time to time. RFC anticipates that it will utilize its facility
for short-term funding from time to time.
At May 31, 1997, certain assets of the Company, such as real property,
equipment and leasehold improvements of $1.7 billion, and goodwill and other
intangible assets of $1.5 billion, are illiquid. In addition, certain equity
investments made in connection with the Company's merchant banking and other
principal investment activities, high-yield debt securities, emerging market
debt, and certain collateralized mortgage obligations and mortgage-related
loan products are not highly liquid. In connection with its merchant banking
and other principal investment activities, the Company has equity investments
(directly or indirectly through funds managed by the Company) in privately and
publicly held companies. At May 31, 1997, the aggregate carrying value of the
Company's equity investments in privately held companies (including direct
investments and partnership interests) was $110 million, and its aggregate
investment in publicly held companies was $414 million.
The Company acts as an underwriter of and as a market-maker in mortgage-
backed pass-through securities, collateralized mortgage obligations and
related instruments, and as a market-maker in commercial, residential and real
estate loan products. In this capacity, the Company takes positions in market
segments where liquidity can vary greatly from time to time. The carrying
value of the portion of the Company's mortgage-related portfolio at May 31,
1997 traded in markets that the Company believed were experiencing lower
levels of liquidity than traditional mortgage-backed pass-through securities
approximated $1,972 million.
In addition, at May 31, 1997, the aggregate value of high-yield debt
securities and emerging market loans and securitized instruments held in
inventory was $1,378 million (a substantial portion of which was
28
subordinated debt) with not more than 6%, 14% and 14% of all such securities,
loans and instruments attributable to any one issuer, industry or geographic
region, respectively. Non-investment grade securities generally involve
greater risk than investment grade securities due to the lower credit ratings
of the issuers which typically have relatively high levels of indebtedness and
are, therefore, more sensitive to adverse economic conditions. In addition,
the market for non-investment grade securities and emerging markets loans and
securitized instruments has been, and may in the future be, characterized by
periods of volatility and illiquidity. The Company has in place credit and
other risk policies and procedures to control total inventory positions and
risk concentrations for non-investment grade securities and emerging market
loans and securitized instruments.
The Company may, from time to time, also provide financing or financing
commitments to companies in connection with its investment banking and
merchant banking activities. The Company may provide extensions of credit to
leveraged companies in the form of senior or subordinated debt, as well as
bridge financing on a select basis (which may be in connection with the
Company's commitment to the Morgan Stanley Bridge Fund, LLC). At May 31, 1997,
the Company had three commitments to provide an aggregate of $292 million and
had four loans in the aggregate amount of $282 million outstanding in
connection with its securitized debt and high yield underwriting activities.
Subsequent to this date, the Company entered into one additional commitment to
provide $67 million of financing.
The Company also engages in senior lending activities, including
origination, syndication and trading of senior secured loans of non-investment
grade companies. Such companies are more sensitive to adverse economic
conditions than investment grade issuers, but the loans are generally made on
a secured basis and are senior to any non-investment grade securities of these
issuers that trade in the capital markets. At May 31, 1997, the aggregate
value of senior secured loans and positions held by the Company was $360
million, and aggregate senior secured loan commitments were $66 million.
At May 31, 1997, financial instruments owned by the Company included
derivative products (generally in the form of futures, forwards, swaps, caps,
collars, floors, swap options and similar instruments which derive their value
from underlying interest rates, foreign exchange rates or commodity or equity
instruments and indices) related to financial instruments and commodities with
an aggregate net replacement cost of $11.1 billion. The net replacement cost
of all derivative products in a gain position represents the Company's maximum
exposure to derivatives related credit risk. Derivative products may have both
on- and off-balance sheet risk implications, depending on the nature of the
contract. It should be noted, however, that in many cases derivatives serve to
reduce, rather than increase, the Company's exposure to losses from market,
credit and other risks. The risks associated with the Company's derivative
activities, including market and credit risks, are managed on an integrated
basis with associated cash instruments in a manner consistent with the
Company's overall risk management policies and procedures. The Company manages
its credit exposure to derivative products through various means, which
include reviewing counterparty financial soundness periodically; entering into
master netting agreements and collateral arrangements with counterparties in
appropriate circumstances; and limiting the duration of exposure.
29
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
The following developments have occurred with respect to certain matters
previously reported in (i) Morgan Stanley's Annual Report on Form 10-K for the
fiscal year ended November 30, 1996, (ii) Dean Witter Discover's Annual Report
on Form 10-K for the year ended December 31, 1996, (iii) Morgan Stanley's
Quarterly Report on Form 10-Q for the fiscal quarter ended February 28, 1997,
(iv) Dean Witter Discover's Quarterly Report on Form 10-Q for the quarter
ended March 31, 1997, and (v) the Joint Proxy Statement/Prospectus of Morgan
Stanley and Dean Witter Discover dated April 11, 1997 (the "Joint Proxy
Statement").
MGN Pension Trustees Ltd., et al. v. Morgan Stanley Trust Company. The
action has been settled.
Department of Justice NASDAQ Investigation. On May 21, 1997, certain
intervenors appealed a portion of the Order and Stipulation, and the District
Court entered an order staying certain portions of the Order and Stipulation
pending the appeal.
Term Trust Class Actions. In the Keeley Action, motions by the defendants
for judgment on the pleadings were denied by the court on June 23, 1997.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
(a) The annual meeting of stockholders of Dean Witter Discover and a special
meeting of stockholders of Morgan Stanley were each held on May 28, 1997.
(b) The Dean Witter Discover stockholders voted on proposals to (1) adopt
the Amended and Restated Agreement and Plan of Merger (the "Merger Agreement")
dated as of April 10, 1997, between Dean Witter Discover and Morgan Stanley,
(2) elect directors, (3) ratify the appointment of Deloitte & Touche LLP as
independent auditors and (4) approve the Dean Witter Discover Employees'
Equity Accumulation Plan (the "EEAP"). The vote of the Dean Witter Discover
stockholders resulted in the approval of the Merger Agreement, the
ratification of the appointment of the independent auditors and the approval
of the EEAP. In addition, all nominees for election to the board were elected
to the terms of office set forth in the Joint Proxy Statement. The Morgan
Stanley stockholders voted on a proposal to adopt the Merger Agreement which
was also approved. The number of votes cast for, against or withheld, and the
number of abstentions and broker non-votes with respect to each proposal, is
set forth below.
30
DEAN WITTER DISCOVER
ANNUAL MEETING OF STOCKHOLDERS
AGAINST/ BROKER
FOR WITHHELD ABSTAIN NON-VOTE
----------- ---------- --------- ----------
Approval of the Merger Agreement: 283,826,530 2,603,192 1,874,639 16,846,697
Election of Directors:
Nominee:
Philip J. Purcell................. 301,120,996 3,213,769 * *
Thomas C. Schneider............... 301,296,038 3,038,727 * *
Edward A. Brennan................. 298,193,864 6,140,901 * *
C. Robert Kidder.................. 301,296,279 3,038,486 * *
Miles L. Marsh.................... 301,231,285 3,103,480 * *
Michael A. Miles.................. 301,146,657 3,188,108 * *
Clarence B. Rogers, Jr. .......... 299,313,460 5,021,305 * *
Ratification of Independent
Auditors: 301,860,670 1,451,888 1,838,500 *
Approval of the Dean Witter
Discover Employees' Equity
Accumulation Plan................. 197,401,066 85,258,315 5,643,754 16,847,923
MORGAN STANLEY SPECIAL MEETING OF STOCKHOLDERS
Approval of the Merger Agreement: 139,273,895 439,499 126,818 *
- --------
* Not Applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) EXHIBITS
An exhibit index has been filed as part of this Report on Page E-1.
(b) REPORTS ON FORM 8-K
Form 8-K dated April 15, 1997 reporting Items 5 and 7.
Form 8-K dated April 17, 1997 reporting Items 5 and 7.
Form 8-K dated April 17, 1997 reporting Items 5 and 7.
Form 8-K dated April 30, 1997 reporting Items 5 and 7.
Form 8-K dated May 31, 1997 reporting Items 5 and 7.
Form 8-K dated May 31, 1997 reporting Items 5 and 7.
31
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
Morgan Stanley, Dean Witter,
Discover & Co.
(REGISTRANT)
/s/ Eileen K. Murray
By: _________________________________
Eileen K. Murray, Controller and
Principal Accounting Officer
Date: July 15, 1997
32
EXHIBIT INDEX
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
QUARTER ENDED MAY 31, 1997
DESCRIPTION
-----------
11 Computation of earnings per share.
12 Computation of ratio of earnings to fixed charges.
15.1 Letter of awareness from Deloitte & Touche LLP, dated July 15, 1997,
concerning unaudited interim financial information.
15.2 Letter of awareness from Ernst & Young LLP, dated July 15, 1997,
concerning unaudited interim financial information.
27 Financial Data Schedule.
E-1