Who's right — James Gorman or Vikram Pandit?
It's not surprising that the respective chief executives of Morgan Stanley and Citigroup Inc. must take another week to attempt to settle on a value for their Morgan Stanley Smith Barney LLC joint venture, given how far apart they are on the numbers.
Morgan Stanley, which owns a 51% stake in MSSB, is exercising its option to purchase another 14%, but the price has not been agreed on.
In a regulatory filing July 19, Citi estimated that its 49% stake in MSSB is worth “approximately” $11 billion, adding that it views that figure as “reasonable and supportable.” According to the Citi filing, however, Morgan Stanley was offering approximately 40% of Citi's figure, or about $4.4 billion. That puts Citi's valuation of the brokerage at more than $22 billion, while Morgan's is just less than $9 billion.
HUGE WRITE-DOWN POSSIBLE
Citigroup officials filed the 8-K document to warn regulators that the yawning gap could force Citigroup to take a large write-down in the third quarter.
Because the two companies' figures differ by more than 10%, a third-party appraiser — investment bank Perella Weinberg Partners LP — will settle the matter next week.
“Perella will look at the potential of the integrated operation, but they'll also take into account current market conditions,” said Brad Hintz, an analyst with Sanford C. Bernstein & Co. “I'm guessing Pandit's number is more right than Gorman's.”
Morgan Stanley's valuation suggests that the joint venture's profit could shrink by as much as 12% annually over the long term, according to some analysts.
David Konrad, an analyst at KBW Inc., said: “If you're bullish on Morgan Stanley, the lower amount they pay, the better. However, then you take a step back and say, this is supposed to be one of your best businesses, and you're saying it's not worth very much. It's a fine line they're walking.”
While analysts including Mr. Konrad said much of the gap can be attributed to negotiating tactics, the Morgan Stanley valuation contradicts the bullish targets it has laid out to investors.
When the venture was created in 2009, Mr. Gorman targeted a 20% pretax profit margin for the combined operation. The margin hasn't exceeded 12% in any quarter since the joint venture was created.
Two major factors have caused it to fall substantially short of that goal.
First, the integration has not gone smoothly, partly because of the migration to a new technology platform for advisers.
Neither Morgan Stanley's old mainframe system nor the server-based systems that Smith Barney and Dean Witter brokers used were scalable for the merged adviser force, so the company decided to build a new network. It's been costly, time-consuming and a major source of headaches for advisers.
“Building a new system was tantamount to telling advisers to go look for bids in the market,” Mr. Hintz said.
The second factor is retail investors' continuing aversion to risk in the wake of the financial crisis.
“The average investor still sees black swans under their beds and in their closets,” Mr. Hintz said. “This is an echo from the financial crisis; it's still much louder than many people expected.”PROFIT HAS FALLEN
The analyst said that since the merger, pro-forma annualized revenue of the combined operation has fallen to $13.5 billion, from $14.9 billion, and pretax profits have dropped to $1.6 billion, from $2.8 billion.
The question that Perella must settle is whether the potential of a fully integrated MSSB is closer to the value of the deal when it was signed or whether market conditions and the messy merger have impaired the operation permanently.
“Mr. Pandit is saying that Morgan Stanley should pay the discounted value of the fully integrated operation,” said Mr. Hintz. “I think he has the better numbers.”
In setting a valuation, there aren't many large retail brokerage deals for Perella to use as a comparison. Driven by losses at its investment bank, Merrill Lynch & Co. Inc. sold itself to Bank of America Corp. in 2008 as it faced concerns about its survival during the financial crisis. Publicly traded firms such as Stifel Financial Corp. and Raymond James Financial Inc. are significantly smaller.
Perella Weinberg spokeswoman Kara Findlay declined to comment.
Morgan Stanley's purchase of the joint venture has made it more dependent on wealth management. Revenue from that division ac-counted for 41% of the firm's total in 2011, up from 16% in 2006.
Morgan Stanley's wealth management unit has set aside at least 59% of revenue for pay every quarter since 2010, tried to cut costs as revenue dropped 2% in the first half and stopped setting targets that rely on an improvement in the markets. The firm's valuation of the joint venture implies an environment that isn't getting better soon.
“Volumes are at low levels, and there is the potential those levels won't increase materially in the intermediate term,” said Matt Burnell, an analyst at Wells Fargo & Co. “Most of these companies are trying very hard to get their cost structures as efficient as they can, but it is by definition,a relatively tech-intense and personnel-intense business.”
Mr. Burnell is among analysts who say the business may have limited returns because financial advisers are paid on a preset scale that provides them with a larger percentage of revenue than bankers or traders receive. MSSB also is competing with larger banks and independent brokerages for a small number of wealthy clients.
The joint-venture agreement gives Morgan Stanley the right to buy out Citigroup by acquiring another 15% of MSSB next year and the final 20% in 2014.
This story was supplemented with reporting from Bloomberg News.
aosterland@investmentnews.com Twitter: @aoreport
