Morgan Stanley's operating income before depreciation in the quarter ended May 31, 2007 was $4.2 billion. The company's theoretical maximum earnings also were $4.2 billion. I guess Morgan Stanley (NYSE: MS) is World Wise in more ways then we know.
BANKING'S "COST OF GOODS SOLD"
For most companies in Standard & Poor's COMPUSTAT database, available through Research Insight and Wharton Research Data Services, their income statements are "standardized" so that every revenue dollar is divided into three parts. I call these the domains of executive action:
- Cost of Goods Sold,
- Selling, General and Administrative Expenses
- Operating Income Before Depreciation.
What's the cost of goods sold for an investment bank? It depends on what you think banks do. There are two different points of view in the academic literature (see Mitchell and Onvural page 184-185). One is called the "intermediation approach" and the other (not quoted) is the "production approach."
"The intermediation approach views banks as using deposits together with purchased inputs to produce various categories of bank assets, measured by their dollar values. Total cost is defined as the interest expense of deposits, less service charges, plus the expense of purchased inputs."
I know this is not the view taken by most practitioners, none-the-less I use the intermediation approach in this analysis. In this view, interest expense is "cost of goods sold," purchased inputs are "enterprise marketing expenses" and the residual is "operating income before depreciation."
If banks actually had a zero cost of goods sold, like electronic futures exchange markets, my analysis would work just fine. But since interest expenses are a significant cost of doing business, ignoring them would cause distortions in a company's enterprise marketing efficiency and hence its maximum earnings market share.
DOMAINS OF EXECUTIVE ACTION
The following table reports the three domains of executive action as a percent of revenues for six investment banks. In order to iron out near term changes in the prime rate, the percentages are based on cumulative numbers beginning with December/March 2005 and ending with March/May 2007.
Take Citigroup (NYSE: C) for example. Its "cost of goods sold" was 39% of gross revenue. Enterprise marketing expenses were 32% of gross revenue. Leaving a residual operating income before depreciation of 29%.
J. P. Morgan (NYSE: JPM) had a very similar cost and earnings structure, though the company spent more on enterprise marketing and earned less from operating income. Also notice in this table that Lehman Brothers (NYSE: LEH) had the lowest enterprise marketing expenses as a per cent of revenue (25%).
In an earlier post in this series a viewer commented "... in a levered financial institution, a company can only prudently engage in activities which are supported by its capital and liability structure." My question was: Do Citi and JPM have significantly different capital and liability structures than the other four investment banks in this table? Judging by their much lower interest expense over ten quarters I concluded they do. As a result, I excluded Citi and JPM from this analysis of marketing efficiency and maximum earnings because they appear not to be comparable with the other four firms.
MARKETING EFFICIENCY MATTERS
Enterprise marketing efficiency is a measure of how much a company spends to generate a dollar in gross revenue. This Cost per Dollar (CPD) of revenue is as easy to calculate and as it is revealing. It includes spending on everything and everyone that can have any influence on how clients/investors perceive a bank. For the details of what's included see "Citigroup's Enterprise Marketing Expenses: The Middle Line." For a more general discussion of CPD across industries see "Gerstner's Rule in High-Tech Industries."
It cost Morgan Stanley just $0.26 to generate a dollar in revenue in the most recent quarter. Lehman Brothers was slightly more efficient with a CPD of $0.25, followed by Merrill Lynch at $0.30 and Goldman Sachs at $0.31 per dollar. Is the 5 cent difference between Morgan's and Goldman's CPD significant? Hum, let's see. Multiply Goldman's $20.4 billion revenue in the quarter ending May 31, 2007 by $0.05 and it turns out the company has a $1 billion problem. That's nearly a third of its operating income before depreciation in that quarter. Like Eddie Foy, Jr. sang in the 1954 Broadway hit The Pajama Game, 7½ cents doesn't buy a hell of a lot, until you multiply it by [some very large number].
As you might expect, enterprise marketing efficiency plays a critical role in calculating maximum earnings market share. A company that has a lower CPD pays less for resources than a competitor with a higher CPD.
ROADBLOCKS TO ENTERPRISE MARKETING
The concept of maximum earnings market share is simple and the math is Econ 101. You start by expressing a 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 for which the difference between marginal cost and marginal earnings is zero. That's maximum earnings market share. So, if it's so simple why has no one done it before? There are four powerful roadblocks to thinking about marketing at the enterprise level:
Roadblock # 1: The Apples and Oranges Problem. Most everyone reading this believes that market share is meaningful only in the case of competing brands, offering the same solution to the same customers in the same geographic market segment. Forget that micro-marketing principle. Morgan Stanley competes with Lehmann Brothers around the globe just as surely as Coke competes with Pepsi.
Roadblock # 2: The Hindsight Problem. Most everyone reading this has worked with market share as an historical artifact. It's safe to say that no one in investment banking has ever used a forecast of market share to estimate the company's future revenues. Yet, to include the effects of competition on your revenues, there is no other practical way to do it. Except by specifying a system of simultaneous econometric equations to estimate cross-elasticities. And there are not enough consistent quarterly observations at the enterprise level to pull this off.
Roadblock # 3: The Lagged Effects Problem. Everyone reading this believes marketing has carry-over effects and to exclude them is to misrepresent reality. But, enterprise marketing and micromarketing are not the same thing. Did you ever hear of anyone including the carry-over effects of R&D spending in a discounted cash flow analysis?
Roadblock # 4: The Aggregation Problem. There are two sub-texts to this one that make it a killer roadblock. First, there's the belief that "our chaps are twice as good as theirs." Of course, if that were true we'd be paying them twice as much or they'd be hired away by a competitor. Either way it's a wash. Second, there's the "we spend our money in more efficient ways than they do."
The first three roadblocks are cognitive. If you believe that these investment banks compete head to head, that the future impact of competition can best be built into you’re your plans by using market share, and that lagged effects might be nice but not necessary, read on.
What about Roadblock # 4? The effectiveness/efficiency problem is solved by the "cost per dollar of revenue" metric. But to make the math work, I've normalized the cost of marketing resources (people and programs) to $1.00. A marketing efficiency ratio greater than 1.00 means the company is inefficient. It's spending more than the group's average cost of resources. A ratio less than one means the company is more efficient than its competitors since it costs are less than the group's average.
THE FOUR FACTORS MODEL
Maximum earnings market share, symbolized as "m hat," is the square root of the ratio of four factors that drive the competition for customers in a strategic group. Two of these factors (in yellow) are outside your control: competitors' enterprise marketing expenses (f) and strategic group revenues (R). Happily, the two factors in green are under your control: your gross margins (g dot) and your enterprise marketing efficiency (x). In the competition for customers, gross margin and marketing efficiency rule. [Click on the chart to enlarge]
I provide a proof of this equation in my book Competing for Customers and Capital (pages 251-52). 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." If not, here's the result of applying the four factors model to Morgan Stanley. You can check it on the back of an envelope with a calculator.
MORGAN STANLEY HITS THE BULL'S EYE
This chart shows the underlying marginal cost and earnings schedules for Morgan Stanley in a strategic group with Merrill Lynch (NYSE: MER), Goldman Sachs, and Lehman Brothers in the quarter ended May 31, 2007. Unlike the marginal cost and revenue schedules your professor drew on the board in microeconomics 101, these are based on audited financial reports.
The upward sloping schedule in red is Morgan Stanley's marginal enterprise marketing expense per share point. Adjusted for the effectiveness/efficiency of spending, the marginal expense of the next share point is always greater then the one before. The flat green schedule is Morgan Stanley's marginal earnings per share point. At its current scale of operations marginal earnings are $354 million. This schedule is flat because I assume the difference between Morgan Stanley's actual and maximum earnings fall within a feasible range of operations that do not require a change in the firm's assets.
This next chart tells the story more dramatically. Morgan Stanley's operating income before depreciation increases continuously from 20% to 33% of the group's $85 billion quarter revenues where it earned $4.175 billion. Then it hits the sweet spot where earnings of $4.193 billion peak at a 34% share of gross revenues. Beyond that point earnings rapidly decline.
The difference between Morgan Stanley's actual and maximum earnings was just $18 million (0.4%). And, the company's marketing efficiency ratio was 0.93. Meaning they paid $0.93 for enterprise marketing resources that cost the average competitor $1.00. Seven cents doesn't sound like a hell of a lot, but it is. Morgan Stanley hit the bull's eye ... twice in that quarter.
How did the other firms do in this static analysis? Not too great. Lehman Brothers missed the mark by 9.9 share points, leaving $359 million, or 18% of earnings on the table. Goldman Sachs was off by 7.2 share points and $290 million (8%). Merrill Lynch was short 4.6 points and $109 million (3%). By the way, LEH was even more efficient that MS: they paid just $0.77 for enterprise marketing resources that cost an average competitor $1.00. While GS and MER were inefficient with ratios of $1.17 and $1.12 respectively.
DOES THIS MAKE ANY DIFFERENCE?
As a stand-alone single quarter result, some may say it's just a fascinating intellectual exercise. After all, who wouldn’t expect one of the most savvy investment banks on the planet to maximize its earnings?
So what difference does it make to you? Well, it's good cocktail party conversation for one! But, as you will see in later installments in this series, it's worth more than that. When you add a dynamic analysis of relative earnings productivity to the mix, and tie this to the trend in a company's risk-adjusted differentials, you end up with a competitive stock pricing model. And this gives you a tool to visualize new opportunities to maximize shareholder wealth in your competition for customers and capital.
Stay tuned. Same time, same place. Thanks for viewing.
~V
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