updated 12/19/2006 3:47:42 PM ET 2006-12-19T20:47:42

Morgan Stanley Inc., the second-biggest investment house on Wall Street, said Tuesday it will shed its Discover credit-card business in a bid to pump up shareholder value.

Speculation has swirled for years that Morgan Stanley would split off the No. 4 credit-card brand to focus on its prime investment banking, brokerage and trading operations. Shareholders have urged Morgan Stanley to revive plans to carve out Discover because it’s been steadily losing ground in a crowded field of larger competitors.

Morgan Stanley — which also reported Tuesday that its full-year profit rose 51 percent to $7.45 billion in 2006 — said it will spin off Discover sometime next year. The transaction will be as a 100 percent tax-free dividend to shareholders, with no ongoing ownership retained by Morgan Stanley. The company said Discover has about $5.2 billion in equity.

The move comes as rival Visa International plans to go public in 2007, following in the footsteps of Mastercard Inc.’s banner listing earlier this year.

“When I came back here, the firm was in turmoil and this was one of our best businesses at the time,” said Chairman and Chief Executive John Mack. “With the performance we’ve seen in our other businesses, and the firm having momentum, Morgan Stanley and Discover can go their own paths and create more value for shareholders.”

Mack, who was formerly president of the company, was faced with questions about Discover upon his dramatic return to Morgan Stanley in 2005. Former CEO Philip Purcell had flirted with the idea of a spinoff to hold back a shareholder revolt, and his eventual ouster prompted the board to bring Mack back.

There has always been complaints Discover didn’t fit into Morgan Stanley’s financial model. Mack told Wall Street in August 2005 he would keep Discover under Morgan Stanley’s corporate umbrella, and instead planned to overhaul its retail business to appease shareholders clamoring for a stronger performance.

Morgan Stanley Chief Financial Officer David Sidwell said the outlook for Discover is bright. The announcement of the spinoff comes at a time where credit card companies are white hot — Bank of America Corp. earlier this year acquired MBNA Corp. for $35 billion, and shares of Mastercard have doubled since their May 2006 debut.

“Overall, Discover had a great year,” he said. “This enabled us to make the announcement that we are spinning off Discover. We think it is well positioned to be a strong, stable stand-alone company.”

Discover’s fourth-quarter profit more than tripled to $199 million. By comparison, Morgan Stanley’s retail brokerage profit rose to $171 million from $84 million last year.

And the company expects further potential for expansion in the business. A landmark Supreme Court ruling upheld an antitrust suit against Visa and Mastercard that allows all retail banks to issue competing cards from Discover and American Express Co.

AmEx has so far struck a number of high-profile deals to put its brand in the hands of more consumers. However, Discover has been slow to expand its payment network, and only recently began to take a more serious look at building its international operations through an acquisition.

The spinoff is expected to cost Discover up to $50 million in higher funding and overhead costs. The spinoff is expected to add up to $95 million per year in costs for Discover, and the company sees some $40 million of overhead savings annually.

The deal was praised by stock analysts on Wall Street.

“This doesn’t come as a surprise, it is another one of Mr. Mack’s strategies that is a beneficial way of going ahead to increase profits,” said Louise Westerlind, an analyst with Boston-based financial consulting firm Celent LLC. “This is a quite interesting deal. You never know where it takes the company, but this is all about Mack making changes and quickly trying to turn the company around.”

However, Fitch Ratings cut Morgan Stanley’s credit outlook to “negative,” noting Discover generates substantial cash. The unit produced its strongest annual results ever in 2006, with profit up 72 percent to $1.6 billion on $4.3 billion of revenue.

This helped lift Morgan Stanley’s full year profit to $7.07 per share, up 55 percent from last year, while revenue surged 26 percent to $33.86 billion. Wall Street projected earnings of $6.77 per share on $33.73 billion of revenue, according to analysts polled by Thomson Financial.

During the fourth quarter, the company said strong investment banking and trading pushed fiscal fourth-quarter profit above analyst expectations. The company reported profit available to common shareholders for the three months ended Nov. 30 fell 11 percent to $2.19 billion, or $2.08 per share, from $2.47 billion, or $2.32 per share, in last year’s fourth quarter, which benefited from a one-time gain of about $700 million related to the sale of the company’s aircraft leasing business.

The latest results include a 27 cent-per-share income-tax benefit, while results last year included a 29 cent-per-share tax benefit.

On a continuing operations basis, Morgan Stanley reported a fourth-quarter profit of $2.21 billion, or $2.08 per share, up from $1.75 billion, or $1.64 per share, a year earlier. Revenue rose 24 percent to $8.62 billion from $6.96 billion a year earlier. Analysts expected earnings of $1.77 per share on $8.3 billion in revenue.

Morgan Stanley rose $1.45, or 1.8 percent, to $81.82 in afternoon trading on the New York Stock Exchange. Since Mack rejoined Morgan Stanley in June 2005, shares have risen about 62 percent.

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