EXHIBIT 99.4
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
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(1) Historical amounts have been restated to reflect the Company's two-for-one
stock splits.
See Notes to the Supplemental Consolidated Financial Statements.
1
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA)
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(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 splits.
See Notes to the Supplemental Consolidated Financial Statements.
2
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
See Notes to the Supplemental Consolidated Financial Statements.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL 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 and 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 the right to receive 1.65 shares of the Company's common
stock (the "Exchange Ratio"), and each share of Morgan Stanley preferred stock
was converted into the right to receive one share of a corresponding series of
preferred stock of the Company. The Merger was treated as a tax free exchange.
The Company
The Company's supplemental consolidated financial statements include the
accounts of Morgan Stanley, Dean Witter Discover and their 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. ("ICAP"), and NOVUS Credit Services Inc.
The Company, through its subsidiaries, provides a wide range of financial
securities services on a global basis and credit services nationally. Its
securities 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 services businesses include the operation of the NOVUS(R)
Network, a proprietary network of merchant and cash access locations, and the
issuance of proprietary general purpose credit cards. The Company's services
are provided to a large and diversified group of clients and customers,
including corporations, governments, financial institutions and individual
investors.
Basis of Financial Information
The supplemental consolidated financial statements give retroactive effect
to the merger of Dean Witter Discover and Morgan Stanley in a transaction
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. Generally accepted
accounting principles proscribe giving effect to a consummated business
combination accounted for by the pooling of interests method in financial
statements that do not include the date of consummation. The supplemental
consolidated financial statements do not extend through the date of
consummation. However, they will become the historical consolidated financial
statements of the Company and its subsidiaries after financial statements
covering the date of consummation of the business combination are issued. The
supplemental consolidated statement of changes in shareholders' equity
reflects the accounts of the Company as if the additional preferred and common
stock had been issued during all the periods presented. The supplemental
consolidated financial statements, including the notes thereto, should be read
in conjunction with the historical consolidated financial statements of Dean
Witter Discover and Morgan Stanley, included in their Annual Reports on Form
10-K for the fiscal years ended December 31, 1996 and November 30, 1996,
respectively.
Prior to the consummation of the merger, Dean Witter Discover's fiscal year
ended on December 31 and Morgan Stanley's fiscal year ended on November 30. In
recording the pooling of interests combination, Dean Witter Discover's
financial statements for the first fiscal quarters ended March 31, 1997 and
1996 and for the
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
fiscal year ended December 31, 1996 were combined with Morgan Stanley's
financial statements for the first fiscal quarters ended February 28, 1997 and
February 29, 1996 and for the fiscal year ended November 30, 1996 (on a
combined basis, "first fiscal quarter 1997," "first fiscal quarter 1996," and
"fiscal year 1996," respectively).
The supplemental 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 supplemental consolidated financial statements are prudent
and reasonable. Actual results could differ from these estimates.
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 supplemental consolidated financial statements are
hereinafter referred to as "consolidated financial statements" or
"statements."
The consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto for the fiscal year ended
1996 included elsewhere in this Current Report on Form 8-K filed by the
Company under the Securities Exchange Act of 1934 on June 2, 1997. The results
of operations for interim periods are not necessarily indicative of results
for the entire year.
Financial instruments, including derivatives, used in the Company's trading
activities are recorded at fair value, and unrealized gains and losses are
reflected in trading revenues. Interest revenue and expense arising from
financial instruments used in trading activities are reflected in the
consolidated statements of income as interest revenue or expense. The fair
values of trading positions generally are based on listed market prices. If
listed market prices are not available or if liquidating the Company's
positions would reasonably be expected to impact market prices, fair value is
determined based on other relevant factors, including dealer price quotations
and price quotations for similar instruments traded in different markets,
including markets located in different geographic areas. Fair values for
certain derivative contracts are derived from pricing models which consider
current market and contractual prices for the underlying financial instruments
or commodities, as well as time value and yield curve or volatility factors
underlying the positions. Purchases and sales of financial instruments are
recorded in the accounts on trade date. Unrealized gains and losses arising
from the Company's dealings in over-the-counter ("OTC") financial instruments,
including derivative contracts related to financial instruments and
commodities, are presented in the accompanying consolidated statements of
financial condition on a net-by-counterparty basis consistent with Financial
Accounting Standards Board ("FASB") Interpretation No. 39, "Offsetting of
Amounts Related to Certain Contracts." Reverse repurchase and repurchase
agreements are presented net-by-counterparty where net presentation is
consistent with FASB Interpretation No. 41, "Offsetting of Amounts Related to
Certain Repurchase and Reverse Repurchase Agreements."
Equity securities purchased in connection with merchant banking and other
principal investment activities are initially carried in the consolidated
financial statements at their original costs. The carrying value of such
equity securities is adjusted when changes in the underlying fair values are
readily ascertainable, generally as evidenced by listed market prices or
transactions which directly affect the value of such equity securities.
Downward adjustments relating to such equity securities are made in the event
that the Company determines 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.
5
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
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. All per share and share
amounts reflect stock splits enacted by Dean Witter Discover and Morgan
Stanley prior to the Merger, 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 SFAS No. 125 had no
material effect on the Company's financial position or results of operations.
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 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.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
2. CONSUMER LOANS
Consumer loans, classified as to type, were as follows (in millions).
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(1) Primarily reflects net transfers related to asset securitizations.
Interest accrued on loans subsequently charged-off, recorded as a reduction
of interest revenue, was $80 million and $42 million in the first fiscal
quarters of 1997 and 1996.
The Company received proceeds from asset securitizations of $2,620 million
in the first fiscal quarter of 1996. The uncollected balances of consumer
loans sold through securitizations were $13,258 million and $13,385 million at
first fiscal quarter end 1997 and fiscal year end 1996. The allowance for loan
losses related to securitized loans, included in other liabilities and accrued
expenses, was $443 million and $447 million at first fiscal quarter end 1997
and fiscal year end 1996.
3. LONG-TERM BORROWINGS
Long-term borrowings at first fiscal quarter end 1997 scheduled to mature
within one year aggregated $4,306 million.
During the first fiscal quarter ended 1997, the Company issued senior notes
aggregating $3,424 million, including non-U.S. dollar currency notes
aggregating $295 million, primarily pursuant to its public debt shelf
registration statements. The weighted average coupon interest rate of these
notes at first fiscal quarter end 1997 was 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. Maturities
in the aggregate of these notes for fiscal years ending are as follows: 1997,
$12 million; 1998, $64 million; 1999, $652 million; 2000,
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
$567 million; 2001, $21 million; and thereafter, $2,108 million. In the first
fiscal quarter of 1997 senior long-term notes in the amount of $1,724 million
matured.
4. PREFERRED STOCK AND CAPITAL UNITS
Preferred stock is composed of the following issues:
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. In addition, the Company announced that it had called for
redemption, on May 30, 1997, 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.
In the first fiscal quarter of 1997, the Company and MS plc issued 8.03%
Capital Units in the aggregate amount of $134 million which mature in 2017.
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.
During the first fiscal quarter of 1997, the Company repurchased or acquired
2.6 million shares of its common stock at an aggregate cost of $89 million and
an average cost per share of $34.50. 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, Morgan
Stanley common stock which had been held in treasury was retired.
8
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DWR, a registered broker-dealer and a registered futures commissions
merchant, is subject to the uniform net capital rule under the Securities
Exchange Act of 1934. Under the alternative method permitted by this Rule, the
required net capital, as defined, shall not be less than the greater of (a)
one million dollars, (b) 2% of aggregate debit balances arising from client
transactions pursuant to the Securities Exchange Act of 1934 Rule 15c3-3, or
(c) 4% of the funds required to be segregated pursuant to the Commodity
Exchange Act. The New York Stock Exchange, Inc. may also require a member
organization to reduce its business if its net capital is less than the
greater of (a) 4% of aggregate debit balances or (b) 6% of the funds required
to be segregated and may prohibit a member organization from expanding its
business and declaring cash dividends if its net capital is less than the
greater of (a) 5% of aggregate debit balances or (b) 7% of the funds required
to be segregated. At first fiscal quarter end 1997, DWR's net capital was $640
million and net capital in excess of the minimum required was $521 million.
DWR's net capital was 21.4% of aggregate debit balances and 21.5% of funds
required to be segregated.
MS&Co. is a registered broker-dealer and a registered futures commission
merchant and, accordingly, is subject to the minimum net capital requirements
discussed above. MS&Co. has consistently operated in excess of these
requirements with aggregate net capital, as defined, totaling $1,596 million
at fiscal first quarter end 1997, which exceeded the amount required by $1,255
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.
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 fiscal first quarter end 1997, the leverage ratio and risk-weighed
capital ratio of each of the Company's FDIC insured financial institutions
exceeded these and all other regulatory minimums.
Certain other U.S. and non-U.S. subsidiaries are subject to various
securities, commodities and banking regulations, and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. These subsidiaries have consistently operated
in excess of their local capital adequacy requirements.
6. ACQUISITIONS
In the first quarter of fiscal 1996, the Company completed its acquisition
of Miller, Anderson & Sherrerd, LLP ("MAS"), an institutional investment
manager, for $350 million, payable in a combination of cash, notes and common
stock of the Company. The Company's fiscal 1996 results include the results of
MAS since January 3, 1996, the date of acquisition.
In the fourth quarter of fiscal 1996, the Company completed its purchase of
VK/AC Holding, Inc., the parent of Van Kampen American Capital, Inc. ("VKAC"),
for $1.175 billion. The consideration for the purchase of the equity of VKAC
consisted of cash and approximately $26 million of preferred securities issued
by one of the Company's subsidiaries and exchangeable into common stock of the
Company. The Company's fiscal 1996 results include the results of VKAC since
October 31, 1996, the date of acquisition.
On April 3, 1997, the Company announced the acquisition of the institutional
global custody business of Barclays PLC ("Barclays"). The amount of
consideration for this business is to be fixed over a period of time based on
account retention. The transaction involves approximately $250 billion of
assets currently administered by Barclays, and the combination of Barclays
with the Company's global custody business would have increased
9
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
the Company's assets under administration at first fiscal quarter end 1997 to
approximately $400 billion on a pro forma basis (assuming that current clients
of Barclays agree to become clients of the Company). Barclays has agreed to
provide global subcustodial services to the Company for a period of time after
completion of the acquisition.
7. CONTINGENT LIABILITIES
In the normal course of business, the Company has been named as a defendant
in various lawsuits and has been involved in certain investigations and
proceedings. Some of these matters involve claims for substantial amounts.
Although the ultimate outcome of these matters cannot be ascertained at this
time, it is the opinion of management, after consultation with outside
counsel, that the resolution of such matters will not have a material adverse
effect on the consolidated financial condition of the Company, but may be
material to the Company's operating results for any particular period,
depending upon the level of the Company's income for such period.
8. DERIVATIVE CONTRACTS AND OTHER COMMITMENTS AND CONTINGENCIES
In the normal course of business, the Company enters into a variety of
derivative contracts related to financial instruments and commodities. The
Company uses swap agreements in its trading activities and in managing its
interest rate exposure. The Company also uses forward and option contracts,
futures and swaps in its trading activities; these financial instruments also
are used to hedge the U.S. dollar cost of certain foreign currency exposures.
In addition, financial futures and forward contracts are actively traded by
the Company and are used to hedge proprietary inventory. The Company also
enters into delayed delivery, when-issued, and warrant and option contracts
involving securities. These instruments generally represent future commitments
to swap interest payment streams, exchange currencies or purchase or sell
other financial instruments on specific terms at specified future dates. Many
of these products have maturities that do not extend beyond one year; swaps
and options and warrants on equities typically have longer maturities. For
further discussion of these matters, refer to "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Derivative
Financial Investments", and Note 8 to the 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 consolidated statements of financial
condition, which, as described in Note 1, are recorded at fair value,
representing the cost of replacing those instruments.
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 consistent with FASB Interpretation No. 39, 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.
10
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The credit quality of the Company's trading-related derivatives at first
fiscal quarter end 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 actual credit ratings are determined by external rating agencies
or by equivalent ratings used by the Company's Credit Department:
A substantial portion of the Company's securities and commodities
transactions are collateralized and are executed with and on behalf of
commercial banks and other institutional investors, including other brokers
and dealers. Positions taken and commitments made by the Company, including
positions taken and underwriting and financing commitments made in connection
with its merchant banking and other principal investment activities, often
involve substantial amounts and significant exposure to individual issuers and
businesses, including non-investment grade issuers. The Company seeks to limit
concentration risk created in its businesses through a variety of separate but
complementary financial, position and credit exposure reporting systems,
including the use of trading limits based in part upon the Company's review of
the financial condition and credit ratings of its counterparties.
See also the fiscal 1996 "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.
The Company had approximately $3.0 billion of letters of credit outstanding
at first fiscal quarter end 1997 to satisfy various collateral requirements.
11
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
INTRODUCTION
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged
with and into Dean Witter, Discover and 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 the right to receive 1.65 shares of the Company's common
stock (the "Exchange Ratio"), and each share of Morgan Stanley preferred stock
was converted into the right to receive 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
The supplemental consolidated financial statements give retroactive effect
to the Merger of Dean Witter Discover and Morgan Stanley in a transaction
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. Generally accepted
accounting principles proscribe giving effect to a consummated business
combination accounted for by the pooling of interests method in financial
statements that do not include the date of consummation. The supplemental
consolidated financial statements do not extend through the date of
consummation. However, they will become the historical consolidated financial
statements of the Company and its subsidiaries after financial statements
covering the date of consummation of the business combination are issued. The
supplemental consolidated statement of changes in shareholders' equity
reflects the accounts of the Company as if the additional preferred and common
stock had been issued during all the periods presented. The supplemental
consolidated financial statements, including the notes thereto, should be read
in conjunction with the historical consolidated financial statements of Dean
Witter Discover and Morgan Stanley, included in their Annual Reports on Form
10-K for the fiscal years ended December 31, 1996 and November 30, 1996,
respectively.
Prior to the consummation of the merger, Dean Witter Discover's fiscal year
ended on December 31 and Morgan Stanley's fiscal year ended on November 30. In
recording the pooling of interests combination, Dean Witter Discover's
financial statements for the first fiscal quarter ended March 31, 1997 and
1996 and for the fiscal year ended December 31, 1996 were combined with Morgan
Stanley's financial statements for the first fiscal quarter ended February 28,
1997 and February 29, 1996 and for the fiscal year ended November 30, 1996 (on
a combined basis, "first fiscal quarter 1997," "first fiscal quarter 1996,"
and "fiscal year 1996," respectively).
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 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.
12
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 from
other sources, such as commercial banks, insurance companies, mutual fund
groups and other companies offering financial services. As a result of recent
or pending legislative and regulatory initiatives in the U.S. to remove or
relieve certain restrictions on commercial banks, competition in some markets
which have traditionally been dominated by investment banks and retail
securities firms has increased and may continue to increase in the near
future. Such competition, among other things, affects the Company's ability to
attract and retain highly skilled individuals. Competitive factors also affect
the Company's success in attracting and retaining clients and assets by its
ability to meet investors' saving and investment needs through consistency of
investment performance and accessibility to financial products and advice. In
the credit services industry, competition centers on merchant acceptance of
credit cards, credit card account acquisition and customer utilization of
credit cards. Merchant acceptance is based on both competitive transaction
pricing and the volume of credit cards in circulation. Credit card account
acquisition and customer utilization are driven by the offering of credit
cards with competitive and appealing features such as no annual fees, low
introductory interest rates and other customized features targeting specific
consumer groups.
As a result of the above economic and competitive factors, net income and
revenues in any particular period may not be representative of full year
results and may vary significantly from year to year and from quarter to
quarter. The Company intends to manage its business for the long term and help
mitigate the potential effects of market downturns by strengthening its
competitive position in the global financial services industry through
diversification of its revenue sources and enhancement of its global
franchise. Maintaining high levels of profitable business activities,
emphasizing fee-based assets that are designed to generate a continuing stream
of revenues, managing risks, evaluating credit product pricing and monitoring
costs will continue to affect the overall financial results of the Company. In
addition the two complementary trends in the financial services industry of
consolidation and globalization present, among other things, technological,
risk management and other infrastructure challenges that will require
effective resource allocation in order for the Company to remain competitive.
The robust global financial markets experienced during fiscal 1995 and
fiscal 1996 continued through the first quarter of fiscal 1997, leading to
record revenues and earnings for the Company. The Company's operating results
have benefited from a combination of a healthy U.S. economy, continued high
levels of cash inflows into mutual funds, a relatively stable bond market, a
strong U.S. dollar, better than expected fourth quarter corporate earnings,
relatively stable levels of inflation and interest rates, despite the multi-
year economic growth and continued growth in consumer demand, and use of
credit as a payment mechanism, partially offset by the effects of continued
deterioration of consumer credit quality.
The Company's securities business, which includes asset management,
generated higher revenues than the comparable prior fiscal quarter, influenced
by strong activity in underwriting and merger and acquisition transactions and
the continuance of heightened investor trading activity in most markets. Asset
management and administration revenues also increased significantly as a
result of the Company's continuing strategic emphasis on these businesses.
Concerns over mounting inflationary pressures in the U.S. economy led the
Federal Reserve Board to raise short-term interest rates by .25% on March 25,
1997 and may lead to additional increases this year in an effort to forestall
higher levels of inflation. Higher interest rates domestically, coupled with
economic sluggishness and high rates of unemployment in Europe, may well lead
to less favorable market conditions in the future. The Company's financial
results for the remainder of fiscal 1997 will reflect whether favorable market
and economic conditions continue to persist, as well as the effectiveness of
the Company's efforts to manage costs and risk management processes.
In the fiscal first quarter of 1997, consumer demand and retail sales
increased over the comparable period of 1996, although at a slower rate than
the recent trend, resulting in growth in general purpose credit card
transaction volume and consumer loans from the first fiscal quarter of 1996.
In the first fiscal quarter of 1997, the Company continued to invest in future
growth by increasing Credit Services marketing and solicitation activities.
13
The Company achieved net income of $592 million in the first fiscal quarter
of 1997, a 14% increase over the first fiscal quarter of 1996. Primary
earnings per common share was $0.95 in the first fiscal quarter of 1997
compared to $0.83 in the first fiscal quarter of 1996. Fully diluted earnings
per common share was $0.94 in the first fiscal quarter of 1997 compared to
$0.81 in the first fiscal quarter of 1996.
SECURITIES
STATEMENTS OF INCOME (DOLLARS IN MILLIONS)
Securities provides a wide range of financial products, services and
investment advice to individual and institutional investors. Securities
business activities are conducted in the United States and in 19 other
countries and include investment banking, research, institutional sales and
trading and global asset management, and investment and asset management
products and services for individual clients. In the following discussion
amounts for the first fiscal quarter of 1996 are given in parentheses.
Securities net revenues and net income of $2,712 and $446 million in the
first quarter of fiscal 1997, represent increases of 18% and 13%,
respectively, from the first quarter of fiscal 1996, primarily reflecting
higher levels of asset management and administration revenues, investment
banking revenues and increased principal transaction trading and investment
revenues, partially offset by higher incentive-based compensation and non-
compensation expenses.
14
Investment Banking
Investment banking revenues are derived from the underwriting of securities
offerings and fees from advisory services. Investment banking revenues
increased to $521 million ($464 million), primarily reflecting underwriting
revenues which continued to remain strong. Fixed income underwriting revenues
increased, primarily from investment grade debt securities as the issuance of
long-dated debt was favorably received by investors. Equity financing revenues
also increased despite slower underwriting volumes as many companies are
sufficiently capitalized, reducing the need for equity offerings. Revenues
from merger, acquisition and restructuring activities continued to be strong
as the market for these transactions continued at unprecedented levels and
global transaction volumes remained high. Merger and acquisition activity was
diversified across many industries, with the financial services, technology,
public utility and real estate sectors contributing the greatest level of
activity. Fees from real estate transactions declined in comparison to the
high level of revenues generated in the first quarter of fiscal 1996.
Principal Transactions
Principal transaction revenues, which include revenues from customers
purchases and sales of securities in which the Company acts as principal, and
gains and losses on securities held for resale, including derivatives, were
$869 million ($823 million). Fixed income trading revenues increased to record
levels, reflecting higher revenues from investment grade debt, securitized
debt and swaps trading, partially offset by lower revenues from government
debt trading. The quarter's results benefited from increased customer activity
as well as higher volatility in the global fixed income markets as a result of
uncertainty related to the Federal Reserve Board's taking measures to curb
inflationary pressures, as well as growing uncertainty regarding the
approaching European Monetary Union. Equity trading revenues were comparable
with prior year levels, as higher revenues from cash products were offset by
lower equity derivatives trading revenues. Equity cash products benefited from
the continued flow of funds into equity-related mutual funds, as well as
increased market share of customer business. Equity derivatives revenues were
impacted by increased competition and pressure on pricing levels. Trading
revenues from commodity products represented the second highest level recorded
by the Company, surpassed only by the comparable prior year quarter. Revenues
from energy-related products benefited from high volatility, primarily in
natural gas, heating oil and crude oil. This resulted from expectations of
colder temperatures and low inventory levels in the beginning of the quarter,
followed by unseasonably warm weather and replenished inventory levels towards
the end of the quarter. Foreign exchange trading revenues rose to record
quarterly levels, primarily resulting from a strengthening U.S. dollar driven
largely by stable interest rates and economic growth in the U.S., coupled with
weaker economies and lower interest rates in Germany and Japan. This led to
higher levels of market volatility and contributed to increased customer
trading volume.
Principal transaction investment gains aggregating $56 million were
recognized in the first quarter of fiscal 1997, primarily in connection with
increases in the carrying value of certain merchant banking investments and
real estate investment gains. This compares with losses of $7 million that
were recognized in the first quarter of fiscal 1996, which primarily resulted
from the writedown of certain merchant banking equity securities.
Commissions
Commission revenues increased to $488 million ($455 million), principally
reflecting higher levels of securities transactions driven by market
volatility, continued cash flows into the equity markets from investors and
higher revenues from insurance sales.
Net Interest
Net interest and dividend revenues increased to $162 million ($144 million).
Interest and dividend revenues rose to $2,565 million ($2,119 million), and
interest expense increased to $2,403 million ($1,975 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
15
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.
Asset Management and Administration
Asset management and administration revenues include fees for asset
management services, including fees 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.
Asset management and administration revenues increased significantly to $590
million ($397 million). The majority of this increase is attributable to
revenues from VKAC, which was acquired on October 31, 1996, and from MAS,
which was acquired on January 3, 1996. Also contributing to the increase were
higher 12b-1 fees and higher revenues from international equity and emerging
market products resulting from inflows of client assets and market
appreciation. Customer assets under management or supervision increased to
$279 billion ($186 billion), including $60 billion associated with the
acquisition of VKAC as well as continued inflows of new assets and
appreciation in the value of existing customer portfolios.
Customer assets under administration increased to $152 billion ($121
billion), primarily reflecting 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.
On April 3, 1997, the Company announced the acquisition of the institutional
global custody business of Barclays PLC ("Barclays"). The amount of
consideration for this business is to be fixed over a period of time based on
account retention. The transaction involved approximately $250 billion of
assets currently administered by Barclays, and the combination of Barclays
with the Company's global custody business would have increased the Company's
assets under administration at first fiscal quarter end 1997 to approximately
$400 billion on a pro forma basis (assuming that current clients of Barclays
agree to become clients of the Company). Barclays has agreed to provide global
subcustodial services to the Company for a period of time after completion of
the acquisition.
Expenses Excluding Interest
Total expenses excluding interest increased to $1,982 million ($1,655
million). Within that total, compensation and benefits expense increased $204
million to $1,355 million ($1,151 million), principally reflecting increased
levels of incentive compensation based on higher levels of revenues and
earnings. Non-compensation expenses, excluding brokerage, clearing and
exchange fees, increased $104 million to $531 million. Approximately $39
million of this increase was attributable to the expenses of VKAC. Occupancy
and equipment expenses increased $7 million, primarily related to occupancy
costs of VKAC. Business development expenses increased $24 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 $20 million, primarily
reflecting higher consulting and executive recruitment costs associated with
the Company's increased global business activities. Information processing and
communications expenses increased $28 million, primarily due to additional
expenses related to software development, information technology equipment,
the impact of increased rates for certain data services and additional
16
employees hired during fiscal 1996. Other expenses increased $25 million,
which includes $15 million of goodwill amortization related to the
acquisitions of MAS and VKAC.
CREDIT SERVICES
STATEMENTS OF INCOME (DOLLARS IN MILLIONS)
Credit Services net income increased 18% to $146 million in the first fiscal
quarter of 1997 from the first fiscal quarter of 1996. The increase resulted
from the effects of credit card fee and interest revenue enhancements made in
fiscal 1996 and higher average levels of consumer loans partially offset by
increased levels of credit losses.
Non-Interest Revenues. Total non-interest revenues increased 17% in the
first fiscal quarter of 1997 from the first fiscal quarter of 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 26% in the first
fiscal quarter of 1997 from the first fiscal quarter of 1996. The increase was
due to higher overlimit, late payment and merchant fee revenues. Overlimit
fees were implemented in March 1996 and the amount of the fee was increased in
the fourth fiscal quarter of 1996. The increase in late payment fee revenues
was due to an increase in the amount of the late payment fee charged, an
increase in the incidence of late payments and a tightening, in the fourth
fiscal quarter of 1996, of late payment fee terms. The increased incidence of
late payments was attributable to a higher level of delinquent accounts and an
increase in active credit card accounts. The increase in merchant fee revenue
was due to growth in credit card transaction volume.
17
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 the investors for losses to 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).
Servicing fees increased 4% in the first fiscal quarter of 1997 from the
first fiscal quarter of 1996. This increase was due to higher cardmember fees,
as discussed previously, and a higher average level of securitized loans,
partially 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 Services consumer loan and short-term
investment assets and interest expense incurred to finance those assets.
Credit 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 to finance Credit Services
assets. Interest expense also includes the effects of interest rate contracts
entered into by the Company as part of its interest rate risk management
program. This program is designed to reduce the volatility of earnings
resulting from changes in interest rates and is accomplished primarily through
matched financing, which entails matching the repricing schedules of consumer
loans and the related financing. Net interest income increased 24% in the
first fiscal quarter of 1997 from the first fiscal quarter of 1996 due to a
higher average level of consumer loans, a higher yield on consumer loans and a
decline in the interest rates, including the effect of interest rate
contracts, on the Company's borrowings. The higher yield on consumer loans was
due to a shift in the mix of consumer loans to higher yielding fixed rate
loans and the effect of interest revenue enhancements made in fiscal 1996,
partially offset by higher charge-offs of interest revenue.
18
The following tables present analyses of Credit Services average balance
sheets and interest rates for the first fiscal quarter 1997 and 1996 and
changes in net interest income during those periods.
CREDIT SERVICES AVERAGE BALANCE SHEET ANALYSIS (DOLLARS IN MILLIONS)
19
CREDIT SERVICES RATE/VOLUME ANALYSIS (IN MILLIONS)
The supplemental table below provides average managed loan balance and rate
information which takes into account both owned and securitized loans.
SUPPLEMENTAL CREDIT SERVICES AVERAGE MANAGED LOAN BALANCE SHEET INFORMATION
(DOLLARS IN MILLIONS)
Provision for Loan Losses. The provision for 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 $819 million and $664 million at first fiscal quarter end 1997
and 1996. The provision for loan losses is affected by net charge-offs, loan
volume and changes in the amount of consumer loans estimated to be
uncollectable. The provision for loan losses increased 67% in the first fiscal
quarter of 1997 from the first fiscal quarter of 1996 due to an increase in
net charge-off rates. Net charge-offs as a percentage of average consumer
loans outstanding increased to 6.88% in the first fiscal quarter of 1997 from
4.44% in the first fiscal quarter of 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 the trend
may continue and the Company may experience a higher net charge-off rate for
the full fiscal year 1997 compared to fiscal
20
1996. In fiscal 1996, the Company took steps to reduce the impact of this
trend, including raising credit quality standards for new accounts,
selectively reducing credit limits and increasing collection activity. The
Company believes these credit quality improvements had a minimal impact in
fiscal 1996, but believes they may have an increased effect in fiscal 1997.
The Company's expectations about future charge-off rates and credit quality
improvements are subject to uncertainties that could cause actual results to
differ materially from what has been projected above. Factors that influence
the level and direction of consumer loan delinquencies and charge-offs include
changes in consumer spending and payment behaviors, bankruptcy trends, the
seasoning of the Company's loan portfolio, interest rate movements and their
impact on consumer behavior, and the rate and magnitude of changes in the
Company's consumer loan portfolio, including the overall mix of accounts,
products and loan balances within the portfolio.
Consumer loans are considered delinquent when interest or principal payments
become 30 days past due. Consumer loans are charged off when they become 180
days past due, except in the case of bankruptcies and fraudulent transactions,
where loans are charged off earlier. Loan delinquencies and charge-offs are
primarily affected by changes in economic conditions and vary throughout the
year due to seasonal consumer spending and payment behaviors. The Company
believes the increase in consumer loan delinquency rates at first fiscal
quarter end 1997 from prior periods was related to the industry-wide credit
conditions discussed previously. The decline in the percentage of consumer
loans past due 30 to 89 days as of first fiscal quarter end 1997 from fiscal
year end 1996 was due to the effects of a program that allowed selected
cardmembers in good standing to defer payment one month. The following table
presents delinquency and net charge-off rates with supplemental managed loan
information.
CREDIT SERVICES ASSET QUALITY (DOLLARS IN MILLIONS)
Non-Interest Expenses. Non-interest expenses remained level in the first
fiscal quarter of 1997 from the first fiscal quarter of 1996.
Employee compensation and benefits expense increased 12% in the first fiscal
quarter of 1997 from the first fiscal quarter of 1996 due to an increase in
the number of employees. Marketing and business development expense decreased
4% in the first fiscal quarter of 1997 from the first fiscal quarter of 1996.
The decrease was due to lower mailing and promotional costs partially offset
by an increase in Cardmember rewards expense. Cardmember rewards expense,
which includes the Cashback Bonus(R) Award, increased due to continued growth
in credit card transaction volume and increased cardmember qualification for
higher award levels.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets increased from $238.9 billion at fiscal year end
1996 to $267.0 billion at first fiscal quarter end 1997, primarily reflecting
growth in financial instruments owned, resale agreements, securities borrowed
and customer receivables. A substantial portion of the Company's total assets
consists of highly liquid marketable securities and short-term receivables
arising principally from securities transactions. The highly liquid nature of
these assets provides the Company with flexibility in financing and managing
its business.
21
The Company's senior management and Finance and Risk Committee, which
includes senior officers from each of the major capital commitment areas,
among other things, establishes the overall funding and capital policies of
the Company, reviews the Company's performance relative to these policies,
allocates capital among business activities of the Company, monitors the
availability of sources of financing, reviews the foreign exchange risk of the
Company, and oversees the liquidity and interest rate sensitivity of the
Company's asset and liability position. The primary goal of the Company's
funding and liquidity activities is to ensure the stability of the Company's
funding base and to provide adequate financing sources over a wide range of
potential credit ratings and market environments.
The Company views return on equity to be an important measure of its
performance, in the context of both the particular business environment in
which the Company is operating as well as its peer group's results. In this
regard, the Company actively manages its consolidated capital position based
upon, among other things, business opportunities, capital availability and
rates of return together with internal capital policies, regulatory
requirements and rating agency guidelines and therefore may, in the future,
expand or contract its capital base to address the changing needs of its
businesses. The Company has also returned internally generated equity capital
which is in excess of the needs of its businesses through common stock
repurchases and dividends.
The Company funds its balance sheet on a global basis. The Company's funding
needs for its Securities segment is raised through diverse sources. These
include the Company's capital, including equity and long-term debt; medium-
term notes; internally generated funds; repurchase agreements; U.S., Canadian,
French and Euro commercial paper; letters of credit; unsecured bond borrows;
German Schuldschein loans; securities lending; buy/sell agreements; municipal
re-investments; master notes; deposits; short-term bank notes; Fed Funds and
committed and uncommitted lines of credit. Repurchase transactions and a
portion of the Company's bank borrowings are made on a collateralized basis
and therefore provide a more stable source of funding than short-term
unsecured borrowings.
The funding sources utilized for the Company's Credit Services segment
include asset securitizations, 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. RFC, an entity included in the consolidated financial
statements of the Company, issues asset-backed commercial paper.
The Company's bank subsidiaries solicit deposits from consumers and purchase
federal funds. Interest bearing deposits are classified by type as savings,
brokered and other time deposits. Savings deposits consist primarily of money
market deposits and certificate of deposit accounts sold directly to
cardmembers and savings deposits from DWR clients. Brokered deposits consist
primarily of certificates of deposit issued by the Company's bank
subsidiaries, which are sold through the DWR account executive sales
organization and a syndicate of firms managed by DWR. Other time deposits
include institutional certificates of deposit. The Company, through Greenwood
Trust Company, an indirect subsidiary of the Company, sells notes under a
short-term bank note program.
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
22
performance is critical, such as over-the-counter derivative transactions. 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 the Company continues its global expansion and as revenues are
increasingly derived from various currencies, foreign currency management is a
key element of the Company's financial policies. The Company benefits from
operating in a number of different currencies because weakness in any
particular currency is often offset by strength in another currency. The
Company closely monitors its exposure to fluctuations in currencies and, where
cost-justified, adopts strategies to reduce the impact of these fluctuations
on the Company's financial performance. These strategies include engaging in
various hedging activities to manage income and cash flows denominated in
foreign currencies and using foreign currency borrowings, when appropriate, to
finance investments outside the U.S.
During the first quarter of fiscal 1997, the Company issued senior notes
aggregating $3,424 million, including non-U.S. dollar currency notes
aggregating $295 million. These notes have maturities from 1997 to 2012 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.
In the first quarter of fiscal 1997, the Company and Morgan Stanley Finance
plc, a U.K. subsidiary ("MS plc"), issued 8.03% Capital Units in an aggregate
amount of $134 million. A Capital Unit consists of (a) a Subordinated
Debenture of MS plc guaranteed by the Company, and (b) a related Purchase
Contract issued by the Company requiring the holder to purchase one Depositary
Share representing shares (or fractional shares) of the Company's Cumulative
Preferred Stock.
In the first quarter of fiscal 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.
Subsequent to fiscal first quarter end, the Company announced that it had
called for redemption, on May 30, 1997, all 750,000 shares of its 8 -3/4%
Cumulative Preferred Stock at a redemption price of $200 per share.
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.
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 first
fiscal quarter end 1997, the Company has never borrowed from the DWD Facility.
In April 1997, DWD renewed this facility which expires in April of 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. After the consummation of the
Merger, the Company expects that a new credit facility of the Company will
replace the Morgan Stanley Facility and the DWD Facility.
23
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 ("MSIL"), 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 senior bank credit facility to support the issuance of
asset-backed commercial paper (the "RFC Facility"). In 1996, RFC renewed this
facility and increased its amount to $2.1 billion from $1.75 billion. Under
the terms of its asset-backed commercial paper program, certain assets of RFC
were subject to a lien in the amount of $2.2 billion at fiscal year end 1996.
RFC has never borrowed from the RFC Facility.
The Company anticipates that it will utilize the Morgan Stanley Facility,
the DWD Facility, the MS&Co. Facility or the MSIL Facility for short-term
funding from time to time. RFC anticipates that it will utilize its facility
for short-term funding from time to time.
Subsequent to first fiscal quarter end 1997, the Company filed a shelf
registration statement for up to $7 billion of additional debt securities,
warrants, preferred stock or purchase contracts or any combination thereof in
the form of units.
During the first fiscal quarter of 1997, the Company repurchased
approximately 2.6 million shares of its common stock at an aggregate cost of
approximately $89 million and an average cost per share of $34.50. Prior to
consummation of the Merger, both Morgan Stanley and Dean Witter Discover
rescinded their respective outstanding share repurchase authorizations.
At first fiscal quarter end 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 $1.4 billion, are illiquid. In
addition, certain equity investments made in connection with the Company's
merchant banking and other principal investment activities, high-yield debt
securities, emerging market debt, and certain collateralized mortgage
obligations and mortgage-related loan products are not highly liquid. In
connection with its merchant banking and other principal investment
activities, the Company has equity investments (directly or indirectly through
funds managed by the Company) in privately and publicly held companies. As of
first fiscal quarter end 1997, the aggregate carrying value of the Company's
equity investments in privately held companies (including direct investments
and partnership interests) was $101 million, and its aggregate investment in
publicly held companies was $285 million.
The Company acts as an underwriter of and as a market-maker in mortgage-
backed pass-through securities, collateralized mortgage obligations and
related instruments, and as a market-maker in commercial, residential and real
estate loan products. In this capacity, the Company takes positions in market
segments where liquidity can vary greatly from time to time. The carrying
value of the portion of the Company's mortgage-related portfolio at first
fiscal quarter end 1997 traded in markets that the Company believed were
experiencing lower levels of liquidity than traditional mortgage-backed pass-
through securities approximated $1,761 million.
In addition, at first fiscal quarter end 1997, the aggregate value of high-
yield debt securities and emerging market loans and securitized instruments
held in inventory was $1,659 million (a substantial portion of which was
subordinated debt) with not more than 5%, 11% and 19% 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
24
conditions. In addition, the market for non-investment grade securities and
emerging markets loans and securitized instruments has been, and may in the
future be, characterized by periods of volatility and illiquidity. The Company
has in place credit and other risk policies and procedures to control total
inventory positions and risk concentrations for non-investment grade
securities and emerging market loans and securitized instruments.
The Company may, from time to time, also provide financing or financing
commitments to companies in connection with its investment banking and
merchant banking activities. The Company may provide extensions of credit to
leveraged companies in the form of senior or subordinated debt, as well as
bridge financing on a select basis (which may be in connection with the
Company's commitment to the Morgan Stanley Bridge Fund, LLC). At first fiscal
quarter end 1997, the Company had a loan of $225 million outstanding in
connection with its securitized debt underwriting activities. Subsequent to
this date, this $225 million loan was repaid. In addition, in connection with
its securitized debt and high yield underwriting activities, the Company
entered into four commitments to provide an aggregate of approximately $430
million in loans and had three loans outstanding in the aggregate amount of
approximately $275 million.
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. As of first fiscal quarter end
1997, the aggregate value of senior secured loans and positions held by the
Company was $210 million, and aggregate senior secured loan commitments were
$26 million. Subsequent to this date, the Company entered into six senior
secured loan commitments in the aggregate amount of $280 million.
As of first fiscal quarter end 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 $12.8
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.
25
INDEPENDENT ACCOUNTANTS' REPORT
To the Directors and Shareholders of
Morgan Stanley, Dean Witter, Discover & Co.
We have reviewed the accompanying supplemental consolidated statement of
financial condition of Morgan Stanley, Dean Witter, Discover & Co. and
subsidiaries as of first fiscal quarter end 1997, and the related supplemental
consolidated statements of income and cash flows for the first fiscal quarter
1997 and 1996. These supplemental 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, which statements reflect total assets of $224,772 million at
February 28, 1997, and 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 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.
The supplemental consolidated financial statements give retroactive effect
to the merger of Dean Witter, Discover & Co. and Morgan Stanley Group Inc.,
which has been accounted for as a pooling of interests as described in Note 1
to the supplemental consolidated financial statements. Generally accepted
accounting principles proscribe giving effect to a consummated business
combination accounted for by the pooling of interests method in financial
statements that do not include the date of consummation. The supplemental
consolidated financial statements do not extend through the date of
consummation. However, they will become the historical consolidated financial
statements of Morgan Stanley, Dean Witter, Discover & Co. and subsidiaries
after financial statements covering the date of consummation of the business
combination are issued.
Based on our review and the report of other auditors, we are not aware of
any material modifications that should be made to such supplemental
consolidated financial statements for them to be in conformity with generally
accepted accounting principles applicable after financial statements are
issued for a period which includes the date of consummation of the business
combination.
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 (presented herein), and the related supplemental consolidated statements
of income, cash flows and changes in shareholders' equity for the year then
ended (not presented herein); 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
May 31, 1997
26
Independent Accountants' Review Report
The Board of Directors
Morgan Stanley Group Inc.
We have reviewed the accompanying condensed consolidated statement of
financial condition of Morgan Stanley Group Inc. and subsidiaries as of
February 28, 1997 and the related condensed consolidated statements of income
for the three-month periods ended February 28, 1997 and February 29, 1996, and
the condensed consolidated statements of cash flows for the three-month
periods ended February 28, 1997 and February 29, 1996. These financial
statements are the responsibility of the Company's management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data, and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, which will
be performed for the full year with the objective of expressing an opinion
regarding the financial statements taken as a whole. Accordingly, we do not
express such an opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to the accompanying condensed consolidated financial statements
referred to above for them to be in conformity with generally accepted
accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated statement of financial condition of Morgan Stanley
Group Inc. as of November 30, 1996, and the related consolidated statements of
income, shareholders' equity, and cash flows for the fiscal year then ended
(not presented herein) and in our report dated January 7, 1997, we expressed
an unqualified opinion on those consolidated financial statements. In our
opinion, the information set forth in the accompanying condensed consolidated
statement of financial condition as of November 30, 1996, is fairly stated, in
all material respects, in relation to the consolidated statement of financial
condition from which it has been derived.
/s/ Ernst & Young LLP
New York, New York
March 27, 1997
27