Brokerage to blame for Morgan Stanley's lackluster results?

Morgan Stanley, owner of the world's biggest brokerage, is struggling to prove its new model works after failing to ride a surge in equity and bond markets. The firm's post-crisis strategy of relying more on its 18,000 brokers and less on debt-fueled risk-taking has yet to lure investors to the stock, which slid 8 percent last year, underperforming rivals. As the Standard & Poor's 500 Index rose 13 percent and corporate bonds returned almost 11 percent in 2010, analysts cut estimates for the bank's full-year earnings. Chief Executive Officer James Gorman, shortly after he took over the top job last January, said 2009 was a “year of transition” for the firm and that 2010 would be the “year of execution for Morgan Stanley.” By October, that outlook had changed, as Gorman, 52, said Morgan Stanley was still in a “transition period” and “remains a work in progress.” “When a CEO says that, it means he knows he still has some near-term challenges and that he's very conscious of not trying to encourage unrealistic expectations,” said Chris Kotowski, an analyst at Oppenheimer & Co. in New York. “To me, that's better than saying reassuring things and then not delivering.” Morgan Stanley, which reports fourth-quarter results next week, lagged behind Goldman Sachs Group Inc.. and JPMorgan Chase & Co. in fixed-income trading in the first nine months, the second year it has done so. The New York-based firm, the sixth- largest U.S. bank by assets with more than 62,000 employees, backed off its profit-margin goals for the brokerage in July, blaming the May 6 market crash that briefly wiped out $862 billion in equity market value for scaring away retail investors. ‘Little Bit Longer' Morgan Stanley may post profit of 34 cents a share for the quarter, according to the average of 21 analysts' estimates in a Bloomberg survey. The average estimate fell 15 cents in the past four weeks as 15 analysts cut their projections, many citing a weaker trading environment. The firm has posted $3.59 billion of net income in the first nine months of 2010, and analysts now say it may close the year with $4.47 billion, 14 percent short of what they forecast last January. That would still be more than triple the company's 2009 profit of $1.35 billion. Mark Lake, a spokesman for Morgan Stanley, declined to comment about fourth-quarter results. “It's taking a little bit longer than management expected,” said Steve Stelmach, an analyst at FBR Capital Markets in Arlington, Virginia. “A lot of it is out of their control. If retail investors don't reengage, it's going to be tough for Morgan Stanley to do the hard work needed. If we can get a sustained recovery, that solves a lot of Morgan Stanley's problems.” Gorman Memo Gorman said last month in an internal memo to employees obtained by Bloomberg News that the firm is poised for “accelerating” progress in 2011 after facing “difficult markets” in 2010. “I could not be more optimistic about our prospects in 2011,” wrote Gorman, who declined to comment for this story. “I believe that our stock is meaningfully undervalued, and that there will be a huge inflection point as we demonstrate to investors that our client-focused strategy is working.” Morgan Stanley's stock fell 8.1 percent in 2010, ending the year down 63 percent from its 2007 high. The stock's performance compared with an 11 percent gain for the S&P 500 Financials Index and a 13 percent gain for the broader S&P 500. The shares have risen 3.1 percent so far this year. Morgan Stanley trades at 0.9 times book value, or 29 percent less than the median ratio among companies in the financials index. ‘Not Much Sizzle' Company bonds returned 10.76 percent in 2010, according to Bank of America Merrill Lynch's U.S. Corporate & High Yield Master Index. Government bonds gained 5.88 percent last year, according to the firm's U.S. Treasury Master Index. “You can't take a lot of positives out of only being down 8 percent,” said Douglas Ciocca, managing director at Renaissance Financial Corp. in Leawood, Kansas, which manages $2 billion in assets including Morgan Stanley shares. “There may be some steak at Morgan Stanley, but there's not much sizzle.” The slide came even as Morgan Stanley avoided many of the issues that plagued rivals in 2010. Goldman Sachs paid $550 million to settle a fraud lawsuit filed against the firm by the U.S. Securities and Exchange Commission. Bank of America Corp. and JPMorgan Chase have faced scrutiny from politicians and regulators over alleged improper foreclosures. Rather, the biggest obstacle was the firm's performance. While the bank made progress integrating its retail brokerage joint venture and returning its asset-management business to profitability, it didn't achieve the turnaround in fixed-income trading that many analysts and investors were looking for. Goldman Recovery The firm's overall trading market share among 10 of the largest global firms was 7.7 percent in the 12 months ended Sept. 30, up slightly from 7.5 percent in 2009 and down from 9.8 percent in 2006, according to data compiled by Kotowski. Fixed-income trading revenue for the first nine months of last year was 30 percent less than any of the bank's largest U.S. competitors. After posting equity trading revenue in the second quarter that topped all of its largest U.S. competitors, Morgan Stanley slipped to fifth place in the third quarter. Goldman Sachs, which gets 69 percent of its revenue from trading compared with 39 percent for Morgan Stanley, has had a quicker recovery from the financial crisis. After posting a Wall Street-record $13.4 billion profit last year, the New York-based firm may almost double Morgan Stanley's earnings in 2010. Investor Confidence “In 2009, you didn't want diversity, you wanted the business that was focused on fixed-income trading, because that's where all the money was, and Goldman certainly outshone Morgan Stanley in that environment,” FBR's Stelmach said. “A day will arrive when the market will appreciate Morgan Stanley's more diversified business model, and having access to the largest retail distribution network on the planet will be viewed as more of a positive than it is now.” Gorman is likely to have more success in 2011 as the trading environment and retail investor confidence improve and the firm begins to benefit from cost savings in the brokerage joint venture and hiring in its trading unit, analysts said. “We believe 2011 will be a better year for Morgan Stanley,” Doug Sipkin, an analyst for Ticonderoga Securities in New York said in a Jan. 3 note that named the firm as one of his top picks for this year. “The combination of rising interest rates and an improving tone around retail should help.” Morgan Stanley's brokerage, the largest by number of advisers and client assets, had lower profit margins last year as it faced less client trading and integration costs from combining platforms with Citigroup Inc.'s Smith Barney unit. Morgan Stanley bought a controlling stake in the brokerage joint venture in June 2009. 8 Percent Margin The margin was 8 percent in the first nine months of 2010, below Gorman's goal of 15 percent for the year. He had targeted more than $20 billion of net new client assets for the brokerage. The unit, which accounts for about a third of the firm's revenue, had inflows of $8.8 billion through September. The brokerage had its highest profit in the third quarter since the joint venture was formed. The business, led by Charles Johnston, stabilized the number of advisers after defections before the deal closed, started a private bank to offer lending products to clients and continued its technology integration, introducing a new research platform for advisers. Waiting for Investors Gorman said last month that retail investors' confidence has returned and trading has picked up. U.S. equity funds had their first inflow in the week ended Dec. 21 after investors pulled out about $90 billion over an eight-month period, according to estimates from the Investment Company Institute, a trade group in Washington. “This business will see improving margins and revenue growth as individual investors get reengaged, which is in fact what we are seeing,” Gorman wrote in his memo. “The integration of MSSB is on track and will gain speed through 2011.” Gorman spent much of the year steering the firm away from the risk-taking model embraced by Chairman and former CEO John Mack, 66, relinquishing control of hedge fund FrontPoint Partners LLC and indicating he may dispose of more hedge-fund stakes. The firm decided to sell its holdings in a New Jersey casino resort and yesterday said it will break off its largest remaining proprietary-trading group by the end of 2012 as it responds to new U.S. regulations. Japan, China The new model allows Morgan Stanley to blend a trading business that generates high margins using significant capital with a brokerage business that has lower margins and low capital requirements. The risk is the firm won't capitalize as much as peers on trading environments like the one that led to Goldman Sachs's record fixed-income revenue in 2010's first quarter. Morgan Stanley also faces the potential that wealth- management clients defect to independent advisers and online brokerages, which have taken share from the biggest firms since the financial crisis. The company has also repositioned itself in Asia, creating two joint ventures with shareholder Mitsubishi UFJ Financial Group Inc. in Japan and selling its stake in China International Capital Corp. to form a partnership with China Fortune Securities Co. Gorman brought in former Merrill Lynch & Co. colleague Greg Fleming, 47, to revamp the asset-management unit, which accounts for 8 percent of revenue. That unit posted its first pretax gain since 2007 in the first quarter and reported the second-highest margin in the last five years in the third quarter. Lower Bonuses Weak trading results masked strength in investment banking, Morgan Stanley's oldest business, which accounts for 12 percent of revenue. The firm was both the top underwriter of equity offerings and the top adviser on announced mergers and acquisitions for the first time since Bloomberg began compiling data in 1999. Morgan Stanley has told some employees to expect investment banking and trading bonuses to decline 10 percent to 30 percent from 2009, two people briefed on the matter said last month. The firm cut the investment bank's compensation pool 8 percent in the first nine months of the year to $5.3 billion. Overall, the company set aside $12 billion for compensation and benefits, or 50 percent of revenue, in the nine-month period. “The clock is always ticking, because there's just not a ton of loyalty among the intellectual capital that floats around Wall Street,” said Ciocca of Renaissance Financial. “They need to make sure they're doing the right things to attract the right people and elevate the stock price.” Sixteen analysts recommend buying Morgan Stanley compared with 13 who have a neutral stance and one who says investors should sell, according to data compiled by Bloomberg. By contrast, 23 analysts have buy ratings on Goldman Sachs, while 5 have neutral recommendations and none advise selling. “It's ultimately got to be the numbers they post,” said Oppenheimer's Kotowski, who has a buy rating on both stocks. “There's nothing you can say that's going to convince people. It's got to be the numbers. Gorman understands that. He's a very thoughtful and realistic guy, and I don't think he's under any illusions about what he has to do.” --Bloomberg News--