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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED AUGUST 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 September 30, 1997 there were 592,420,211 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
QUARTER ENDED AUGUST 31, 1997
PAGE
----
PART I--FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Financial Condition--August 31,
1997 (unaudited) and Fiscal Year End 1996............................. 1
Condensed Consolidated Statements of Income--Three and Nine Months
Ended August 31, 1997 and 1996 (unaudited)............................ 2
Condensed Consolidated Statements of Cash Flows--Nine Months Ended Au-
gust 31, 1997 and 1996 (unaudited).................................... 3
Notes to Condensed Consolidated Financial Statements (unaudited)....... 4
Independent Accountants' Reports....................................... 11
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations..................................................... 14
PART II--OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.................................. 31
i
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
AT FISCAL
AUGUST 31, YEAR END
1997 1996
----------- ---------
(UNAUDITED)
ASSETS
Cash and cash equivalents............................... $ 9,386 $ 6,544
Cash and securities deposited with clearing
organizations or segregated under federal and other
regulations (including securities at fair value of
$1,777 at August 31, 1997 and $3,759 at fiscal year end
1996).................................................. 3,482 5,209
Financial instruments owned:
U.S. government and agency securities.................. 13,721 12,032
Other sovereign government obligations................. 21,625 19,473
Corporate and other debt............................... 20,231 16,899
Corporate equities..................................... 14,386 12,662
Derivative contracts................................... 14,995 11,220
Physical commodities................................... 292 375
Securities purchased under agreements to resell......... 80,705 64,021
Securities borrowed..................................... 55,154 43,546
Receivables:
Consumer loans (net of allowances of $868 at August
31, 1997 and $802 at fiscal year end 1996)............ 20,625 21,262
Customers, net......................................... 13,904 8,600
Brokers, dealers and clearing organizations............ 1,216 5,421
Fees, interest and other............................... 4,219 3,981
Office facilities, at cost (less accumulated
depreciation and amortization of $1,228 at August 31,
1997 and $1,060 at fiscal year end 1996) .............. 1,680 1,681
Other assets............................................ 6,859 5,934
-------- --------
Total assets............................................ $282,480 $238,860
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Commercial paper and other short-term borrowings........ $ 22,704 $ 26,326
Deposits................................................ 8,511 7,213
Financial instruments sold, not yet purchased:
U.S. government and agency securities.................. 12,602 11,395
Other sovereign government obligations................. 14,494 6,513
Corporate and other debt............................... 1,381 1,176
Corporate equities..................................... 13,011 8,900
Derivative contracts................................... 12,926 9,982
Physical commodities................................... 92 476
Securities sold under agreements to repurchase.......... 104,590 86,863
Securities loaned....................................... 15,682 12,907
Payables:
Customers.............................................. 19,718 22,062
Brokers, dealers and clearing organizations............ 7,989 1,820
Interest and dividends................................. 1,200 1,678
Other liabilities and accrued expenses.................. 8,598 6,340
Long-term borrowings.................................... 25,196 22,642
-------- --------
268,694 226,293
-------- --------
Capital Units........................................... 999 865
-------- --------
Commitments and contingencies
Shareholders' equity:
Preferred stock........................................ 876 1,223
Common stock(1) ($0.01 par value, 1,750,000,000 shares
authorized, 602,829,994 and 611,314,509 shares
issued, 591,895,690 and 572,682,876 shares
outstanding at August 31, 1997 and at fiscal year end
1996)................................................. 6 6
Paid-in capital(1)..................................... 3,710 4,007
Retained earnings...................................... 8,618 7,477
Cumulative translation adjustments..................... (7) (11)
-------- --------
Subtotal............................................. 13,203 12,702
Note receivable related to sale of preferred stock to
ESOP.................................................. (76) (78)
Common stock held in treasury, at cost(1) ($0.01 par
value, 10,934,304 and 38,631,633 shares at August 31,
1997 and at fiscal year end 1996)..................... (332) (1,005)
Stock compensation related adjustments................. (8) 83
-------- --------
Total shareholders' equity........................... 12,787 11,702
-------- --------
Total liabilities and shareholders' equity.............. $282,480 $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 NINE MONTHS
ENDED AUGUST 31, ENDED AUGUST 31,
----------------------- -----------------------
1997 1996 1997 1996
----------- ----------- ----------- -----------
(UNAUDITED) (UNAUDITED)
Investment banking............. $ 818 $ 486 $ 1,921 $ 1,548
Principal transactions:
Trading...................... 778 534 2,369 2,037
Investments.................. 206 29 398 60
Commissions.................... 559 417 1,533 1,328
Fees:
Asset management,
distribution and
administration.............. 656 423 1,853 1,243
Merchant and cardmember...... 433 366 1,293 1,050
Servicing.................... 196 207 582 585
Interest and dividends......... 3,570 3,035 10,136 8,679
Other.......................... 41 29 108 94
----------- ----------- ----------- -----------
Total revenues............... 7,257 5,526 20,193 16,624
Interest expense............... 2,765 2,412 7,952 6,927
Provision for consumer loan
losses........................ 385 307 1,140 792
----------- ----------- ----------- -----------
Net revenues................. 4,107 2,807 11,101 8,905
----------- ----------- ----------- -----------
Compensation and benefits...... 1,849 1,170 4,844 3,742
Occupancy and equipment........ 134 122 389 361
Brokerage, clearing and
exchange fees................. 130 76 338 231
Information processing and
communications................ 249 247 786 716
Marketing and business
development................... 293 247 855 730
Professional services.......... 127 84 319 226
Other.......................... 219 165 579 513
Merger related costs........... -- -- 74 --
----------- ----------- ----------- -----------
Total non-interest expenses.. 3,001 2,111 8,184 6,519
----------- ----------- ----------- -----------
Income before income taxes..... 1,106 696 2,917 2,386
Income tax expense............. 428 246 1,141 875
----------- ----------- ----------- -----------
Net income..................... $ 678 $ 450 $ 1,776 $ 1,511
=========== =========== =========== ===========
Preferred stock dividend
requirements.................. $ 15 $ 15 $ 52 $ 48
=========== =========== =========== ===========
Earnings applicable to common
shares(1)..................... $ 663 $ 435 $ 1,724 $ 1,463
=========== =========== =========== ===========
Earnings per common share(2)
Primary...................... $ 1.11 $ 0.74 $ 2.91 $ 2.45
=========== =========== =========== ===========
Fully diluted................ $ 1.09 $ 0.72 $ 2.84 $ 2.41
=========== =========== =========== ===========
Average common shares
outstanding(2)
Primary...................... 597,921,853 589,024,786 593,418,453 596,045,322
=========== =========== =========== ===========
Fully diluted................ 610,187,894 601,310,453 607,875,297 608,420,103
=========== =========== =========== ===========
- --------
(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)
NINE MONTHS
ENDED AUGUST
31,
----------------
1997 1996
------- -------
(UNAUDITED)
Cash flows from operating activities
Net income................................................. $ 1,776 $ 1,511
Adjustments to reconcile net income to net cash provided by
(used for) operating activities:
Non-cash charges included in net income.................. 1,252 942
Changes in assets and liabilities:
Cash and securities deposited with clearing
organizations or segregated under federal and other
regulations........................................... 1,717 (1,463)
Financial instruments owned, net of financial
instruments sold, not yet purchased................... 4,676 7,381
Securities borrowed, net of securities loaned.......... (8,907) (9,392)
Receivables and other assets........................... (2,497) (2,686)
Payables and other liabilities......................... 6,002 2,011
------- -------
Net cash provided by (used for) operating activities......... 4,019 (1,696)
------- -------
Cash flows from investing activities
Net (payments for) proceeds from:
Office facilities........................................ (92) (114)
Purchase of Miller Anderson & Sherrerd, LLP, net of cash
acquired................................................ -- (200)
Net principal disbursed on consumer loans................ (3,248) (5,986)
Purchases of consumer loans.............................. -- (5)
Sales of consumer loans.................................. 787 4,812
Other investing activities............................... (96) (70)
------- -------
Net cash used for investing activities....................... (2,649) (1,563)
------- -------
Cash flows from financing activities
Net proceeds (payments) related to short-term borrowings... 399 (1,354)
Securities sold under agreements to repurchase, net of
securities purchased under agreements to resell........... (200) 863
Proceeds from:
Issuance of common stock................................. 108 131
Issuance of long-term borrowings......................... 6,375 8,201
Issuance of Capital Units................................ 134 --
Issuance of cumulative preferred stock................... -- 195
Payments for:
Repurchases of common stock.............................. (124) (1,008)
Repayments of long-term borrowings....................... (3,398) (2,433)
Redemption of cumulative preferred stock................. (345) (138)
Cash dividends........................................... (319) (226)
------- -------
Net cash provided by financing activities.................... 2,630 4,231
------- -------
Elimination of Dean Witter, Discover & Co.'s net cash
activity for the month of December 1996 and 1995............ (1,158) (542)
------- -------
Net increase in cash and cash equivalents.................... 2,842 430
Cash and cash equivalents, at beginning of period............ 6,544 3,936
------- -------
Cash and cash equivalents, at end of period.................. $ 9,386 $ 4,366
======= =======
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
and 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 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 nine month periods ended August 31, 1997 and 1996 and
as of August 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 separate results of operations for Dean Witter Discover and Morgan
Stanley during the periods preceding the Merger, that are included in the
Company's Condensed Consolidated Statements of Income were as follows (dollars
in millions):
THREE
MONTHS
ENDED NINE SIX
AUGUST 31, MONTHS MONTHS
1996 ENDED ENDED
---------- AUGUST 31, MAY 31,
1996 1997
----------- --------
Net Revenues
Dean Witter Discover....................... $1,520 $4,641 $3,318
Morgan Stanley............................. 1,287 4,264 3,676
------ ------ ------
Combined................................. $2,807 $8,905 $6,994
====== ====== ======
Net Income
Dean Witter Discover....................... $ 231 $ 718 $ 472
Morgan Stanley............................. 219 793 626
------ ------ ------
Combined................................. $ 450 $1,511 $1,098
====== ====== ======
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 costs 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
condensed 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
on a net-by-counterparty basis, when appropriate.
Equity securities purchased in connection with merchant banking and other
principal investment activities are initially carried in the condensed
consolidated financial statements at their original cost. The carrying value
5
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
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 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
6
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
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.
2. CONSUMER LOANS
Activity in the allowance for consumer loan losses was as follows (dollars
in millions).
THREE MONTHS NINE MONTHS
ENDED AUGUST 31, ENDED AUGUST 31,
------------------ ------------------
1997 1996 1997 1996
-------- -------- -------- --------
Balance, beginning of period............. $ 821 $ 643 $ 781 $ 685
Provision for loan losses................ 385 307 1,140 792
Less deductions
Charge-offs............................ 401 293 1,218 804
Recoveries............................. (44) (35) (126) (104)
-------- -------- -------- -------
Net charge-offs...................... 357 258 1,092 700
-------- -------- -------- -------
Other(1)................................. 19 (21) 39 (106)
-------- -------- -------- -------
Balance, end of period................... $ 868 $ 671 $ 868 $ 671
======== ======== ======== =======
- --------
(1) Primarily reflects net transfers related to asset securitizations.
Interest accrued on loans subsequently charged off, recorded as a reduction
of interest revenue, was $70 million and $230 million in the third fiscal
quarter of 1997 and the nine months ended August 31, 1997 and $45 million and
$123 million in the third fiscal quarter of 1996 and the nine months ended
August 31, 1996.
The Company received proceeds from asset securitizations of $787 million in
the third fiscal quarter and nine months ended August 31, 1997 and $861
million and $4,673 million in the third fiscal quarter and nine months ended
August 31, 1996. The uncollected balances of consumer loans sold through
securitizations were $13,375 million and $13,197 million at August 31, 1997
and fiscal year end 1996. The allowance for loan losses related to securitized
loans, included in other liabilities and accrued expenses, was $424 million
and $445 million at August 31, 1997 and fiscal year end 1996.
3. LONG-TERM BORROWINGS
Long-term borrowings at August 31, 1997 scheduled to mature within one year
aggregated $5,565 million.
During the nine month period ended August 31, 1997, the Company issued
senior notes aggregating $6,361 million, including non-U.S. dollar currency
notes aggregating $1,040 million, primarily pursuant to its public debt shelf
registration statements. The weighted average coupon interest rate of these
notes was 6.1% at August 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, $975 million; 1999, $939 million; 2000, $743 million; 2001, $73
million; and thereafter, $3,619 million. In the nine month period ended August
31, 1997, $3,398 million of senior notes were repaid.
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
AUGUST 31, YEAR END AUGUST 31, FISCAL YEAR
1997 1996 1997 END 1996
---------- --------- ---------- -----------
(DOLLARS IN MILLIONS)
ESOP Convertible Preferred Stock,
liquidation preference $35.88..... 3,657,181 3,699,302 $131 $ 133
Series A Fixed/Adjustable Rate Cu-
mulative 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.............................. $876 $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 were 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 $1,939 million at August 31, 1997 which exceeded the amount required
by $1,537 million. DWR's net capital totaled $655 million at August 31, 1997
which exceeded the amount required by $543 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 August 31, 1997, the leverage ratio and risk-weighted 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 Bank PLC ("Barclays"). The amount of consideration for
this business is to be fixed over a period of time based on account retention.
Barclays agreed to provide global subcustodial services to the Company for a
period of time after completion of the acquisition.
In July 1997, the Company sold the DWR institutional futures business to
Carr Futures, Inc., a subsidiary of Credit Agricole Indosuez. This sale did
not have a material effect on the Company's 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 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--(CONTINUED)
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 August
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
------ ------ ------ ------ -------------- ---------- -------
AT AUGUST 31, 1997 (DOLLARS IN MILLIONS)
Interest rate and cur-
rency swaps and options
(including caps, floors
and swap options) and
other fixed income se-
curities contracts..... $ 822 $2,332 $2,161 $ 528 $ 27 $365 $ 6,235
Foreign exchange forward
contracts and options.. 779 2,646 962 137 -- 202 4,726
Mortgage-backed
securities forward
contracts, swaps and
options................ 156 73 39 4 -- 13 285
Equity securities con-
tracts (including eq-
uity swaps, warrants
and options)........... 897 594 524 183 540 17 2,755
Commodity forwards, op-
tions and swaps ....... 55 309 234 247 9 140 994
------ ------ ------ ------ ---- ---- -------
Total.................. $2,709 $5,954 $3,920 $1,099 $576 $737 $14,995
====== ====== ====== ====== ==== ==== =======
Percent of total........ 18% 40% 26% 7% 4% 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
securities forward
contracts, swaps and
options................ 66 65 64 19 -- 5 219
Equity securities con-
tracts (including eq-
uity 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 "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 $4.1 billion and $3.4 billion of letters of
credit outstanding at August 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 August 31, 1997, and the related condensed consolidated
statements of income for the three and nine month periods ended August 31,
1997 and 1996, and cash flows for the nine month periods ended August 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 August 31, 1996, which statements reflect total revenues
of $3,316 million and $10,017 million for the three and nine month periods
ended August 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
October 14, 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 (not presented herein). 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 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 August 31, 1996 and the
related condensed consolidated statements of income for the three-month and
nine-month periods ended August 31, 1996 and 1995, and the condensed
consolidated statements of cash flows for the nine-month periods ended August
31, 1996 and 1995 (not presented herein). 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 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
October 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 nine month periods ended August 31, 1997 and 1996 and
as of August 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 both in the U.S. and globally. 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
14
firms has increased and may continue to increase in the near future. In
addition, recent convergence and consolidation in the financial services
industry will lead to increased competition from larger diversified financial
services organizations. 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
business, 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 the global
financial markets in fiscal 1996 have prevailed through much of the first nine
months of fiscal 1997. In the U.S., moderate economic growth and low levels of
unemployment persisted in the third fiscal quarter. In addition, the levels of
inflation and interest rates remained relatively low, and the Federal Reserve
Board did not alter the overnight lending rate since March 1997. Strong
corporate earnings and consumer confidence, as well as high levels of cash
inflows into mutual funds, have also had a positive affect on U.S. financial
markets. While the overall performance of the U.S. stock market has been
extremely positive, such performance has, at times, been volatile. A sharp
selloff in the equity markets during March and April was followed by one of
the strongest rallies ever through July, only to be dampened by a significant
reduction in late summer. Conditions in most European markets were impacted by
preparations for the approaching European Monetary Union ("EMU"), causing
higher volatility in certain interest rates and currencies. In the Far East,
Japanese economic growth continued to lag, while financial markets in
Southeast Asia were adversely impacted by currency devaluations which occurred
in certain emerging market nations.
The Company's net income of $678 million and $1,776 million in the third
fiscal quarter and nine month period ended August 31, 1997 represented an
increase of 51% from the third fiscal quarter of 1996 and an increase of 18%
from the nine month period ended August 31, 1996. Fully diluted earnings per
common share were $1.09 and $2.84 in the third fiscal quarter and nine month
period ended August 31, 1997 compared to $0.72 and $2.41 in the comparable
periods of fiscal 1996. The Company's annualized return on common equity was
20.6% for the nine month period ended August 31, 1997, as compared with 20.7%
for the comparable prior year period. Net income for the nine months ended
August 31, 1997 included $63 million of merger related costs. These costs
consisted primarily of proxy solicitation costs, severance costs, financial
advisory and accounting fees, legal costs and regulatory filing fees.
Excluding these merger related costs, net income would have increased 22% in
the nine month period ended August 31, 1997 from the comparable period of
fiscal 1996, and fully diluted earnings per common share would have been
$2.95.
The increase in net income in the third fiscal quarter and nine month period
ended August 31, 1997 from the comparable periods of 1996 was due to higher
revenues from securities activities, including investment banking and
principal transactions, as well as increased revenues from higher assets under
management and
15
higher managed loans, and credit card fees. These increases were partially
offset by higher credit card net charge-offs and non-interest expenses.
Securities and Asset Management revenues were favorably impacted in the nine
month period ended August 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 positively impacted by pricing
actions taken by the Company in fiscal 1996 and higher average levels of
consumer loans offset by rising credit losses.
SECURITIES AND ASSET MANAGEMENT
STATEMENTS OF INCOME (DOLLARS IN MILLIONS)
THREE MONTHS NINE MONTHS
ENDED AUGUST 31, ENDED AUGUST 31,
----------------- -----------------
1997 1996 1997 1996
-------- -------- -------- --------
Investment banking......................... $ 818 $ 486 $ 1,921 $ 1,548
Principal transactions:
Trading................................... 778 534 2,369 2,037
Investments............................... 206 29 398 60
Commissions................................ 550 417 1,515 1,328
Asset management, distribution and adminis-
tration fees.............................. 656 423 1,853 1,243
Interest and dividends..................... 2,758 2,359 7,776 6,681
Other...................................... 38 28 100 92
-------- -------- -------- --------
Total revenues........................... 5,804 4,276 15,932 12,989
Interest expense........................... 2,462 2,160 7,079 6,156
-------- -------- -------- --------
Net revenues............................. 3,342 2,116 8,853 6,833
-------- -------- -------- --------
Compensation and benefits.................. 1,713 1,051 4,437 3,383
Occupancy and equipment.................... 118 108 343 319
Brokerage, clearing and exchange fees...... 126 76 330 231
Information processing and communications.. 141 124 432 369
Marketing and business development......... 101 63 297 202
Professional services...................... 103 71 261 191
Other...................................... 146 93 386 286
-------- -------- -------- --------
Total non-interest expenses.............. 2,448 1,586 6,486 4,981
-------- -------- -------- --------
Income before income taxes................. 894 530 2,367 1,852
Income tax expense......................... 350 184 917 675
-------- -------- -------- --------
Net income................................. $ 544 $ 346 $ 1,450 $ 1,177
======== ======== ======== ========
Securities and Asset Management net revenues of $3,342 million and $8,853
million in the third fiscal quarter and nine month period ended August 31,
1997 represented an increase of 58% and 30% from the comparable periods of
fiscal 1996. Securities and Asset Management net income of $544 million and
$1,450 million in the third fiscal quarter and the nine month period ended
August 31, 1997 represented an increase of 57% and 23% from the comparable
periods of fiscal 1996. The increases in both periods reflected higher levels
of investment banking, asset management, distribution and administration fees
and 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 nine month periods ended
August 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
third fiscal quarter increased to $818 million ($486
16
million), primarily reflecting continued strength in merger and acquisition
transactions as well as higher revenues from both equity and debt
underwritings. Revenues from merger, acquisition and restructuring activities
increased to record levels, as the global market for these transactions
continued to be robust. Merger and acquisition activity was diversified across
many industries, with the technology, oil and gas, manufacturing and financial
services sectors contributing the greatest level of revenues. Fixed income
underwriting revenues increased significantly, primarily attributable to
higher revenues from global high yield debt issuances as the favorable market
and economic conditions that existed during the quarter enabled certain non-
investment grade issuers to obtain attractive financing rates. Revenues from
issuances of investment grade debt also increased, benefiting from relatively
narrow interest rate spreads as well as market liquidity and strong investor
demand for corporate securities. Equity financing revenues also increased,
primarily due to a higher volume of equity offerings as compared to the prior
year quarter and a stronger market share.
In the nine month period ended August 31, 1997, investment banking revenues
continued to benefit from a significant level of global merger, acquisition
and restructuring transactions as well as strong volumes in the primary
markets. Investment banking revenues increased to $1,921 million ($1,548
million), primarily reflecting higher levels of debt underwriting revenues and
increased revenues from 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 significantly in the third fiscal quarter to $778 million ($534
million).
Fixed income trading revenues increased significantly in the third fiscal
quarter from the comparable prior year period. Conditions in fixed income
markets were generally favorable as inflationary fears subsided early in the
third fiscal quarter, triggering bond rallies in the U.S. and Europe. Revenues
from trading in fixed income derivative securities increased due to higher
levels of customer activity and generally volatile market conditions. Revenues
from trading in high-yield debt securities also increased, as the high-yield
market benefited from narrowing interest rate spreads and positive earnings
announcements by issuers in certain industries. Improved economic conditions
in various emerging markets, including Eastern Europe and Latin America,
contributed to higher revenues from trading in emerging market debt
securities. These increases were partially offset by lower revenues from
government and corporate bond trading.
Equity trading revenues in the third fiscal quarter increased as compared to
the third fiscal quarter of 1996. Revenues from trading in equity cash
products increased, benefiting from increased customer volume and a higher
market share, as well as strong levels of mutual fund inflows. Favorable
market conditions and strong corporate earnings, particularly in the U.S., and
a strong volume of equity issuances in European markets, also contributed to
the increase. These results were partially offset by lower revenues from
equity derivatives trading, which were impacted by lower volatility in certain
industry segments.
Trading revenues from commodity products reached record levels in the third
fiscal quarter as volatility in the oil and gas markets over the summer months
prompted heavier customer demand for risk management and trading services.
Revenues from trading in refined energy products benefited from fluctuating
energy prices as concerns about oversupply influenced the market. Revenues
from trading in natural gas increased due to rising market volatility,
particularly during the last month of the quarter. Revenues from trading in
precious and base metals also increased, benefiting from rising prices, higher
market volatility and increased customer activity in certain products.
Foreign exchange trading revenues in the third fiscal quarter increased
significantly from the comparable period of fiscal 1996, attaining record
revenues for the third consecutive quarter. The increase was primarily
attributable to continued volatility in the foreign exchange markets,
particularly in the German deutsche mark, the Japanese yen, and certain Asian
currencies. The U.S. dollar strengthened against the deutsche mark throughout
much of the quarter, driven by uncertainty regarding the timing of the EMU and
the strength of the "Euro" (the proposed replacement for the European Currency
Unit), as well as the strong growth of the U.S.
17
economy. The U.S. dollar also strengthened against the yen as Japanese
economic growth remained sluggish. Asian currency markets were particularly
volatile during the third fiscal quarter, primarily resulting from the
devaluation of the Thailand baht. Higher trading volumes and an increasing
customer base also contributed to the quarter's favorable results.
Principal transaction investment gains aggregating $206 million were
recognized in the third fiscal quarter ($29 million), primarily in connection
with increases in the carrying values of certain merchant banking investments
and gains from certain venture capital investments. The majority of the
increase in the value of the merchant banking investments was related to an
increase in the carrying value of the Company's holdings of Fort James Corp.,
the entity created as the result of the merger of Fort Howard Corp. and James
River Corp.
Principal transaction trading revenues in the nine month period ended August
31, 1997 were $2,369 million ($2,037 million). Equity trading revenues
increased over the comparable prior year period, primarily the result of
favorable market conditions, high trading volumes, strong customer demand, and
significant infusions of cash into equity mutual funds. Fixed income trading
revenues also increased from prior year levels, benefiting from strong
customer transaction volumes and volatility in the fixed income markets.
Commodities trading revenues remained strong due to a higher level of customer
activity, as well as continued market volatility for energy products and
natural gas. Revenues from foreign exchange trading increased significantly,
primarily driven by higher trading volumes, the strengthening of the U.S.
dollar and high levels of market volatility.
Principal transaction investment revenues aggregating $398 million ($60
million) were recognized during the nine month period ended August 31, 1997,
primarily reflecting revenues related to the increase in the carrying value of
the Company's holdings of Fort James Corp., as well as certain 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 $550 million
($417 million) in the third fiscal quarter. In U.S. markets, the Company
benefited from high volumes of equity offerings and securities transactions,
as well as larger trade sizes. Revenues from markets in the Far East also
benefited from a significant number of block trades occurring during the
quarter. In Europe, trading volumes continued to be high due to strong
corporate earnings and a high volume of equity issuances.
Commission revenues in the nine month period ended August 31, 1997 increased
to $1,515 million ($1,328 million), principally reflecting increased customer
activity in the global markets for equity securities as well as a strong
market share. Revenues were also impacted by the high volume of equity
issuances and the rebalancing of customer portfolios as investors sought to
capitalize on robust equity markets.
Asset Management, Distribution and Administration Fees
Asset management, distribution 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.
18
Asset management, distribution and administration revenues increased
significantly in the third fiscal quarter to $656 million ($423 million),
reflecting the Company's continued emphasis on these businesses. The majority
of the increase was 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 products resulting from inflows of client assets and market
appreciation, also had a favorable impact on these revenues.
In the nine month period ended August 31, 1997, asset management,
distribution and administration revenues increased significantly to $1,853
million ($1,243 million), primarily attributable to revenues associated with
VKAC, higher fund management and 12b-1 fees, increased revenues from
international equity, emerging market and U.S. domestic equity and fixed
income products, and continued growth in customer assets under management and
administration.
Customer assets under management or supervision increased to $325 billion
($203 billion), including $65 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 management included
products offered primarily to individual investors of $186 billion ($101
billion) and products offered primarily to institutional investors of $139
billion ($102 billion).
Customer assets under administration in the global custody business
increased to $403 billion ($132 billion). Approximately $237 billion of this
increase is attributable to the Company's acquisition of the institutional
global custody business of Barclays Bank PLC ("Barclays") on April 3, 1997,
and approximately $200 billion of these assets remain subject to current
clients of Barclays agreeing to become clients of the Company. 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.
Net Interest
Net interest and dividend revenues increased to $296 million ($199 million)
in the third fiscal quarter. Interest and dividend revenues rose to $2,758
million ($2,359 million), and interest expense increased to $2,462 million
($2,160 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 $697 million ($525 million) in the
nine month period ended August 31, 1997. Interest and dividend revenues rose
to $7,776 million ($6,681 million) and interest expense increased to $7,079
million ($6,156 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 $2,448 million ($1,586 million) in
the third fiscal quarter. Within that total, compensation and benefits expense
increased $662 million to $1,713 million ($1,051 million), principally
reflecting increased incentive compensation based on higher revenues and
earnings. Non-
19
compensation expenses, excluding brokerage, clearing and exchange fees,
increased $150 million to $609 million. Approximately $41 million of this
increase was attributable to expenses associated with VKAC. Brokerage,
clearing and exchange fees increased $50 million, primarily related to the
acquisitions of VKAC and the institutional global custody business of
Barclays, as well as increased securities trading volumes. Occupancy and
equipment expenses increased $10 million, primarily due to the occupancy costs
of VKAC and increased office space in London and Hong Kong. Marketing and
business development expenses increased $38 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 $32 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 $17 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 $53 million, which
includes $10 million of goodwill amortization associated with the acquisition
of VKAC. The increase also reflects the Company's higher level of business
activity and incremental expenses of VKAC.
In the nine month period ended August 31, 1997, total non-interest expenses
increased to $6,486 million ($4,981 million). Within that total, employee
compensation and benefits expense increased to $4,437 million ($3,383
million), principally reflecting increased incentive compensation based on
higher revenues and earnings. Non-compensation expenses, excluding brokerage,
clearing and exchange fees, increased to $1,719 million ($1,367 million).
Approximately $121 million of this increase was attributable to the expenses
of VKAC. Brokerage, clearing and exchange fees increased $99 million,
primarily reflecting the acquisitions of VKAC and the institutional global
custody business of Barclays, as well as increased securities trading volumes.
Occupancy and equipment expense increased $24 million, primarily reflecting
the occupancy costs of VKAC and increased office space in London and Hong
Kong. Marketing and business development expenses increased $95 million,
reflecting higher travel and entertainment costs, as well as advertising costs
associated with VKAC's retail mutual funds. Professional services expenses
increased $70 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 $63
million, reflecting higher data services costs, incremental costs related to
VKAC and increased headcount. Other expenses increased by $100 million, which
includes goodwill amortization of $30 million associated with the acquisition
of VKAC, as well as the impact of a higher level of business activity on
various operating expenses.
20
CREDIT AND TRANSACTION SERVICES
STATEMENTS OF INCOME (DOLLARS IN MILLIONS)
NINE MONTHS
THREE MONTHS ENDED AUGUST
ENDED AUGUST 31, 31,
----------------- -------------
1997 1996 1997 1996
-------- -------- ------ ------
Fees:
Merchant and cardmember....................... $ 433 $ 366 $1,293 $1,050
Servicing..................................... 196 207 582 585
Commissions..................................... 9 -- 18 --
Other........................................... 3 1 8 2
-------- -------- ------ ------
Total non-interest revenues................... 641 574 1,901 1,637
-------- -------- ------ ------
Interest revenue................................ 812 676 2,360 1,998
Interest expense................................ 303 252 873 771
-------- -------- ------ ------
Net interest income........................... 509 424 1,487 1,227
Provision for consumer loan losses.............. 385 307 1,140 792
-------- -------- ------ ------
Net credit income............................. 124 117 347 435
-------- -------- ------ ------
Net revenues.................................. 765 691 2,248 2,072
-------- -------- ------ ------
Compensation and benefits....................... 136 119 407 359
Occupancy and equipment......................... 16 14 46 42
Brokerage, clearing and exchange fees........... 4 -- 8 --
Information processing and communications....... 108 123 354 347
Marketing and business development.............. 192 184 558 528
Professional services........................... 24 13 58 35
Other........................................... 73 72 193 227
-------- -------- ------ ------
Total non-interest expenses................... 553 525 1,624 1,538
-------- -------- ------ ------
Income before income taxes...................... 212 166 624 534
Income tax expense.............................. 78 62 235 200
-------- -------- ------ ------
Net income...................................... $ 134 $ 104 $ 389 $ 334
======== ======== ====== ======
Credit and Transaction Services net income increased 29% in the third fiscal
quarter of 1997 as compared to the third fiscal quarter of 1996 and increased
16% in the nine month period ended August 31, 1997 as compared to the nine
month period ended August 31, 1996. In both the third fiscal quarter and nine
month period ended August 31, 1997, net income was positively impacted by
credit card fee and interest revenue enhancements introduced in fiscal 1996
and higher average levels of consumer loans, partially offset by increased
credit losses and increases in non-interest expenses.
Non-Interest Revenues. Total non-interest revenues increased 12% and 16% in
the third fiscal quarter and nine month period ended August 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 18% and 23% in the
third fiscal quarter and nine month period ended August 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. Also contributing to the increase in overlimit fees in the
third fiscal quarter was an increase in overlimit occurrences compared to the
same period last year. The increase in late payment fee revenues was due to an
increase in the incidence of late payments resulting from a tightening in the
fourth fiscal quarter of 1996 of late payment fee terms and a higher level of
delinquent accounts. The increase in merchant fee revenue was due to growth in
credit card transaction volume.
21
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 NINE MONTHS
ENDED ENDED
AUGUST 31, AUGUST 31,
------------ --------------
1997 1996 1997 1996
----- ----- ------ ------
Merchant and cardmember fees...................... $ 108 $ 80 $ 325 $ 187
Interest revenue.................................. 512 511 1,547 1,466
Interest expense.................................. (204) (203) (611) (577)
Provision for consumer loan losses................ (220) (181) (679) (491)
----- ----- ------ ------
Servicing fees.................................... $ 196 $ 207 $ 582 $ 585
===== ===== ====== ======
Servicing fees decreased 5% in the third fiscal quarter of 1997 and
decreased 1% in the nine month period ended August 31, 1997 from the
comparable periods of fiscal 1996. The decrease in the third fiscal quarter
was due to a higher rate of credit losses on securitized loans, partially
offset by higher cardmember fees. In the nine month period ended August 31,
1997 servicing fees were impacted by a higher level of securitized loans
outstanding during the period, 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 loans
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 related financing. Net interest income increased 20% and 21% in the third
fiscal quarter and the nine month period ended August 31, 1997 from the
comparable periods of fiscal 1996 predominately due to higher average levels
of consumer loans. Net interest income was favorably impacted by a higher
yield on consumer loans, which resulted from a shift in the mix of consumer
loans to higher yielding loans and the effect of interest revenue enhancements
made in fiscal 1996, mostly offset by higher charge-offs of interest revenue.
22
The following tables present analyses of Credit and Transaction Services
average balance sheets and interest rates for the third fiscal quarter and
nine month period ended August 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 AUGUST 31,
-------------------------------------------------
1997 1996
------------------------ ------------------------
AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST
------- ----- -------- ------- ----- --------
ASSETS
Interest earning assets:
General purpose credit card
loans....................... $20,017 14.19% $716 $16,796 14.11% $596
Other consumer loans......... 1,667 15.90 66 1,652 14.85 62
Investment securities........ 158 5.49 2 234 5.56 3
Other........................ 1,698 6.54 28 1,035 5.76 15
------- ---- ------- ----
Total interest earning as-
sets...................... 23,540 13.67 812 19,717 13.64 676
Allowance for loan losses.... (831) (647)
Non-interest earning assets.. 1,709 1,358
------- -------
Total assets............... $24,418 $20,428
======= =======
LIABILITIES & SHAREHOLDER'S
EQUITY
Interest bearing liabilities:
Interest bearing deposits
Savings..................... $ 924 4.08% $ 10 $ 1,019 4.58% $ 12
Brokered.................... 4,963 6.64 83 3,435 6.90 60
Other time.................. 2,229 6.15 35 1,946 6.00 30
------- ---- ------- ----
Total interest bearing de-
posits.................... 8,116 6.22 128 6,400 6.26 102
Other borrowings............. 11,300 6.14 175 9,865 6.05 150
------- ---- ------- ----
Total interest bearing lia-
bilities.................. 19,416 6.19 303 16,265 6.17 252
Shareholder's equity/other
liabilities................. 5,002 4,163
------- -------
Total liabilities & share-
holder's equity........... $24,418 $20,428
======= =======
Net interest income.......... $509 $424
==== ====
Net interest margin.......... 8.57% 8.55%
Interest rate spread......... 7.48% 7.47%
23
AVERAGE BALANCE SHEET ANALYSIS (DOLLARS IN MILLIONS)
NINE MONTHS ENDED AUGUST 31,
------------------------------------------------------
1997 1996
----------------------------- ------------------------
AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST
------------------- -------- ------- ----- --------
ASSETS
Interest earning assets:
General purpose credit
card loans............. $ 19,494 14.17% $2,073 $16,714 13.98% $1,756
Other consumer loans.... 1,823 15.51 212 1,771 14.05 187
Investment securities... 182 5.46 7 269 5.40 11
Other................... 1,475 6.14 68 1,016 5.77 44
-------- ------ ------- ------
Total interest earning
assets............... 22,974 13.68 2,360 19,770 13.45 1,998
Allowance for loan loss-
es..................... (812) (655)
Non-interest earning as-
sets................... 1,696 1,353
-------- -------
Total assets.......... $ 23,858 $20,468
======== =======
LIABILITIES & SHAREHOLDER'S EQ-
UITY
Interest bearing liabil-
ities:
Interest bearing depos-
its
Savings................ $ 992 4.25% $ 32 $ 1,010 4.57% $ 35
Brokered............... 4,250 6.68 213 3,274 7.02 173
Other time............. 2,205 6.11 101 1,873 6.08 86
-------- ------ ------- ------
Total interest bearing
deposits............. 7,447 6.19 346 6,157 6.34 294
Other borrowings........ 11,604 6.05 527 10,260 6.19 477
-------- ------ ------- ------
Total interest bearing
liabilities.......... 19,051 6.11 873 16,417 6.25 771
Shareholder's
equity/other liabili-
ties................... 4,807 4,051
-------- -------
Total liabilities &
shareholder's equity. $ 23,858 $20,468
======== =======
Net interest income..... $1,487 $1,227
====== ======
Net interest margin..... 8.62% 8.26%
Interest rate spread.... 7.57% 7.20%
24
RATE/VOLUME ANALYSIS (DOLLARS IN MILLIONS)
THREE MONTHS ENDED
AUGUST 31, NINE MONTHS ENDED
1997 VS 1996 AUGUST 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.............. $ 116 $ 4 $ 120 $ 289 $ 28 $ 317
Other consumer loans..... -- 4 4 5 20 25
Investment securities.... (1) -- (1) (4) -- (4)
Other.................... 11 2 13 22 2 24
------ --------
Total interest revenue. 132 4 136 322 40 362
------ --------
INTEREST EXPENSE
Interest bearing deposits
Savings................. (1) (1) (2) (1) (2) (3)
Brokered................ 26 (3) 23 51 (11) 40
Other time.............. 4 1 5 15 -- 15
------ --------
Total interest bearing
deposits.............. 27 (1) 26 62 (10) 52
Other borrowings......... 23 2 25 63 (13) 50
------ --------
Total interest expense. 49 2 51 122 (20) 102
------ --------
Net interest income...... $ 83 $ 2 $ 85 $ 200 $ 60 $ 260
====== ===== ====== ======== ======= ========
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 AUGUST 31,
-------------------------------------------------
1997 1996
------------------------ ------------------------
AVG. AVG.
BAL. RATE % INTEREST BAL. RATE % INTEREST
------- ------ -------- ------- ------ --------
Consumer loans................. $34,620 14.83% $1,294 $31,401 14.81% $1,169
General purpose credit card
loans......................... 32,283 14.73 1,198 29,079 14.76 1,079
Total interest earning assets.. 36,476 14.38 1,322 32,670 14.45 1,187
Total interest bearing liabili-
ties.......................... 32,352 6.21 507 29,218 6.19 455
Consumer loan interest rate
spread........................ 8.62 8.61
Interest rate spread........... 8.17 8.26
Net interest margin............ 8.87 8.91
NINE MONTHS ENDED AUGUST 31,
-------------------------------------------------
1997 1996
------------------------ ------------------------
AVG. AVG.
BAL. RATE % INTEREST BAL. RATE % INTEREST
------- ------ -------- ------- ------ --------
Consumer loans................. $34,393 14.84% $3,831 $30,496 14.88% $3,409
General purpose credit card
loans......................... 31,899 14.74 3,529 28,064 14.85 3,132
Total interest earning assets.. 36,050 14.44 3,906 31,781 14.51 3,464
Total interest bearing liabili-
ties.......................... 32,126 6.15 1,484 28,428 6.31 1,348
Consumer loan interest rate
spread........................ 8.69 8.57
Interest rate spread........... 8.29 8.20
Net interest margin............ 8.95 8.86
25
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 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 $868 million and $671 million at August 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 25% and 44% in the third fiscal quarter and nine
month period ended August 31, 1997 from the comparable periods of fiscal 1996
due to an increase in net charge-offs. The increase in net charge-offs was due
to increases in the rate of charge-offs and, to a lesser extent, higher
average levels of consumer loans. Net charge-offs as a percentage of average
consumer loans outstanding increased to 6.53% and 6.82% in the third fiscal
quarter and nine month period ended August 31, 1997 from 5.56% and 5.04% 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 expects to experience a higher net charge-
off rate for full fiscal year 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. In fiscal 1997, the Company intensified
these efforts and continues to implement measures designed to improve the
credit quality of both new and existing credit card accounts. 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. The Company believes the increase in
consumer loan delinquency rates at August 31, 1997 from August 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)
AUGUST 31, FISCAL YEAR END
---------------------------------- ----------------
1997 1996 1996
---------------- ---------------- ----------------
OWNED MANAGED OWNED MANAGED OWNED MANAGED
------- ------- ------- ------- ------- -------
Consumer loans.......... $21,493 $34,868 $18,828 $32,159 $22,064 $35,261
Consumer loans
contractually past due
as a percentage of
consumer loans
30 to 89 days.......... 4.50% 4.51% 4.08% 4.11% 4.42% 4.41%
90 to 179 days......... 2.96% 2.97% 2.35% 2.30% 2.89% 2.82%
Net charge-offs as a
percentage of average
consumer loans
(year-to-date)......... 6.82% 6.86% 5.04% 5.19% 5.45% 5.59%
Non-Interest Expenses. Non-interest expenses increased 5% in the third
quarter of 1997 and increased 6% in the nine month period ended August 31,
1997 from the comparable periods of fiscal 1996.
Compensation and benefits expense increased 14% and 13% in the third fiscal
quarter and nine month period ended August 31, 1997 from the comparable
periods of fiscal 1996 due to an increase in the number of employees,
including collection personnel. Information processing and communications
expense decreased 12% in the third fiscal quarter and remained relatively
constant in the nine months ended August 31, 1997 from the
26
comparable periods of fiscal 1996. The decrease in the third fiscal quarter
was due to an adjustment resulting from the sale of the Company's indirect
interest in one of the Company's transaction processing vendors. Professional
services expense increased 85% and 66% in the third fiscal quarter and nine
month period ended August 31, 1997 from the comparable periods of fiscal 1996
due to increases in consumer credit counseling and collections services.
Marketing and business development expense increased 4% in the third fiscal
quarter of fiscal 1997 and increased 6% in the nine month period ended August
31, 1997 from the comparable periods of fiscal 1996. In the third fiscal
quarter, higher Cardmember rewards expense was partially offset by lower
promotional expenses. The increase in the nine month period ended August 31,
1997 was due to higher Cardmember rewards expense. Cardmember rewards expense,
which includes the Cashback Bonus(R) Award, increased due to a continued
growth in credit card transaction volume and increased cardmember
qualification for higher award levels. Other expenses remained level in the
third fiscal quarter and decreased 15% in the nine month period ended August
31, 1997 from the comparable periods of fiscal 1996 due to a continuing
decrease in fraud losses.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets increased from $238.9 billion at fiscal year end
1996 to $282.5 billion at August 31, 1997, primarily reflecting growth in
financial instruments owned, resale agreements and securities borrowed. 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,
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 adequate financing
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. In the past, the Company had also returned internally generated
equity capital which was 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 and Asset Management 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, securities lending 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.
27
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 deposits issued by the
Company's bank subsidiaries. Other time deposits include institutional
certificates of deposits. The Company, through Greenwood Trust Company, an
indirect subsidiary of the Company, sells notes under a short-term bank note
program.
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 October 14, 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..................... D-1+^ AA-^
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 several 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 nine month period ended August 31, 1997, the Company issued
senior notes aggregating $6,361 million, including non-U.S. dollar currency
notes aggregating $1,040 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 August 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 $39 billion.
28
On June 2, 1997, the Company's shelf registration statement for $7 billion
of 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. In August 1997,
the Company renewed this facility which expires in January 1998.
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 third
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 $2.55 billion senior bank credit facility to support
the issuance of asset-backed commercial paper.
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 August 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, were 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 August 31, 1997, the aggregate carrying value of
the Company's equity investments in privately held companies (including direct
investments and partnership interests) was $123 million, and its aggregate
investment in publicly held companies was $584 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
29
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
August 31, 1997 traded in markets that the Company believed were experiencing
lower levels of liquidity than traditional mortgage-backed pass-through
securities approximated $2,181 million.
In addition, at August 31, 1997, the aggregate value of high-yield debt
securities and emerging market loans and securitized instruments held in
inventory was $1,625 million (a substantial portion of which was subordinated
debt) with not more than 6%, 11% and 16% 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 market loans and
securitized instruments has been, and may in the future be, characterized by
periods of volatility and illiquidity. The Company has 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 selective basis (which may be in connection with the
Company's commitment to the Morgan Stanley Bridge Fund, LLC). At August 31,
1997, the Company had three commitments to provide an aggregate of $552
million and had two loans in the aggregate amount of $198 million outstanding
primarily in connection with its securitized debt and high-yield underwriting
activities. Subsequent to this date, the Company's commitments declined by
$178 million, and $123 million of outstanding loans were repaid.
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 August 31, 1997, the aggregate
value of senior secured loans and positions held by the Company was $629
million, and aggregate senior secured loan commitments were $116 million.
Subsequent to August 31, 1997, the Company entered into one additional senior
secured loan commitment in the amount of $220 million.
At August 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 $15 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.
30
PART II. OTHER INFORMATION
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 June 25, 1997 reporting Items 5 and 7.
Form 8-K dated July 25, 1997 reporting Item 5 only.
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: October 14, 1997
32
EXHIBIT INDEX
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
QUARTER ENDED AUGUST 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 October 14, 1997,
concerning unaudited interim financial information.
15.2 Letter of awareness from Ernst & Young LLP, dated October 14, 1997,
concerning unaudited interim financial information.
27 Financial Data Schedule.
E-1