This is the fifth post in my series on the competition for customers and capital among leading U.S. investment banks. The four banks in this strategic group are Goldman Sachs (NYSE:GS), Lehman Brothers (LEH), Merrill Lynch (MER) and Morgan Stanley (NYSE:MS). This is a time-series analysis of their search for market shares that maximize earnings after enterprise marketing expenses.
The players in today's post are Morgan Stanley with an operating income before depreciation of -$2.8 billion, in 4 out of their last 10 quarters, and Merrill Lynch with even greater losses of -$3.7 billion in 4 out of their last 10 quarters. The essence of their challenge is to spend the right amount on enterprise marketing so earnings are maximized.
THE FOUR FACTORS MODEL AT A GLANCE
The concept of maximum earnings market share is straight out of microeconomics 101. You start by expressing your company's earnings after enterprise marketing expenses as a function of its market share in a strategic group. Then you take the first derivative of this function and solve for that market share where the difference between marginal costs and marginal earnings is zero. That's maximum earnings market share, symbolized in this chart as "m hat." You will find a proof of the four factors model in my book Competing for Customers and Capital (pages 251-52). [Click on the image to enlarge]
Two of these factors (in yellow) are outside of your control: 1) the competitors' enterprise marketing expenses (f), and strategic group revenues [R]. Happily, the two factors in green are under your control: 1) your percent gross margins (g dot), and 2) enterprise marketing efficiency (x). When competing for customers, gross margin and marketing efficiency rule.
If you want to follow the logic through a detailed application to Southwest Airlines see my 14 minute Adobe Connect presentation on "The Rule of Maximum Earnings." To check the results of applying the four factors model to Morgan Stanley in a single period see my last post in this series: "Double Bull's Eye for Morgan Stanley."
MORGAN STANLEY'S MAXIMUM EARNINGS MARKET SHARE
Management's climb to maximum earnings market share was slow, but sure. In this chart you will see that Morgan Stanley hit bottom on May 31, 2005 when its actual share of gross revenues (blue) exceeded its maximum earnings share (green) by 23.3 points. In that quarter MS posted a -$1.4 billion loss, exactly half of the total 4 quarters of lost earnings referred to in the introduction to this post. Two weeks later, on June 13, embattled CEO Philip J. Purcell announced his retirement from Morgan Stanley. On June 30, 2005 John Mack was once again named the Chairman and CEO.
By February, 2007 Morgan Stanley's management team had brought maximum earnings market share up to 32.4%, just 60 basis points above its actual market share of 31.8%. They undershot a bit more in the next quarter. This was a remarkable achievement because the company's margins as a percent of gross revenues shrank from 60.0% in February 2005, to 41.6% in May 2007 - as a result of sharply increased interest expenses.
How did MS management pull this off? It's simple in theory – they held the marginal cost of enterprise marketing constant while increasing marginal earnings. But in practice it was difficult because they had to cut enterprise marketing costs per dollar of revenue by 58%, and simultaneously increase gross revenue by 139%. This chart tells the story of the impact these actions had on marginal costs and earnings.
Morgan Stanley's marginal cost (red) remained flat over this time at around $3.4 million per basis point. That's the enterprise marketing cost of the last 1/100th of a point at a 31.71% share of gross revenues. The company's marginal earnings per basis point (green) steadily increased. Looking back at May, 2005 the last one-hundredth of a share point returned just $1.9 million in operating income before depreciation. The company lost $1.5 million on that enterprise marketing transaction. Then, management initiated an upward trend that continued through February, 2007 when the difference between marginal cost, and earnings per basis point was about $100K.
MORGAN STANLEY'S MARCH TO MAXIMUM EARNINGS
Here's a more dramatic portrayal of Morgan Stanley's march to maximum earnings over the 10 quarters ended May, 2007:
Maximum potential earnings (green) ranged from a low of $0.1 billion in May, 2005 to a high of $4.2 billion in May, 2007. By then, maximum and actual earnings (red) were effectively equal. It looks like John Mack really knows how to run an investment bank.
MORGAN STANLEY'S ENTERPRISE MARKETING EXPENSES
How far out of line were Morgan Stanley's enterprise marketing expenses when Mr. Mack took the controls? This chart compares the actual, with the theoretical enterprise marketing expenses required to maximize operating income before depreciation.
Actual expenses (red) remained flat at around $7.35 billion in every quarter. In May, 2005 MS would have spent $1.5 billion (green) on enterprise marketing if it had maximized earnings. The company actually spent $7.4 billion. The gap between actual and maximum earnings expenses (green) was nearly $6 billion. Two years later the gap had narrowed to $200 million – in under-spending on enterprise marketing resources!
As I reported in "Reconsidering Citigroup: The Middle Line and 3D Marketing," Morgan Stanley management drove the company's enterprise marketing costs per dollar [CPD] of gross revenue down from $0.63 to $0.26 over the ten quarters. In the process, their normalized enterprise marketing efficiency ratio improved from $1.54 to $0.93. By May, 2007 MS paid just $0.93 cents for resources that cost an average competitor $1.00. Since this normalized efficiency ratio is a theoretical construct that cannot be observed, it cannot be managed. But the CPD can be. Still, the two are highly correlated, and in this case the correlation was +$0.90.
MERRILL LYNCH'S SEARCH FOR MAXIMUM EARNINGS
Was John Mack just lucky? He took Morgan Stanley over at the right time, as the bull market was hitting its stride. But if he was just lucky, why did Merrill Lynch's search for maximum earnings miss the mark so far?
In this chart Merrill Lynch looks like the golfer searching for a ball lost deep in the rough. Only in one quarter did management come close to maximum earnings market share. Operating in the same period, with similar resources, MER missed the mark in August, 2005 by -19.4 share points and -$1.0 billion in earnings. And again in August, 2006 by -21.5 share points and -$1.4 billion in earnings. That is to say, Merrill Lynch spent way too much on enterprise marketing resources, and its maximum earnings market share was far less than its actual share in 8 of the 10 quarters.
Unlike Morgan Stanley, Merrill Lynch made an uncertain approach to maximum earnings. As the next chart shows, the company oscillated between quarters of relatively small differences between actual and maximum earnings and quarters of large gaps. For example a $900 million earnings shortfall in August, 2005 was followed by a $1.4 billion shortfall in August 2006, and another $900 million shortfall in the next quarter. In the last two quarters, Merrill Lynch management closed in on the sweet spot. Investors don't like that kind of volatility.
Neither Goldman Sachs nor Lehman Brothers came anywhere near this close to maximizing earnings. Over the 10 quarters both GS and LEH systematically and significantly under-spent on enterprise marketing resources. How can a company under-spend on enterprise marketing? Try this fable on for size.
THE FABLE OF THE THREE BULLS
Once upon a time three baby bulls lived in a pasture with their mother. Whenever it was time to be nursed the first baby bull would say: "Mama, I want the most milk so I can grow up to be the strongest of all." She would reply: "Yes, dear." Then the second baby bull would say: "Mama, I want the least milk so I can grow up to be the most nimble of all." She would reply: "Yes, dear." The third baby bull would say: "Mama I want just the right amount of milk so I can be both strong and nimble." She would say: "How much is that, dear?"
What's the moral of this story? Spend just enough to maximize earnings, and your firm will be both strong and nimble. What do you think?