Friday, August 10, 2012

Morgan Stanley: Can It Please Analysts?

A financial institution strives hard to get it right--stay out of the headlines, focus on core businesses, hire talented people, manage risks, oversee diverse sources of revenue, rationalize costs and allocate capital properly. And despite all efforts, the institution is not a darling among equity analysts, investors, and market watchers.  Analysts and the markets sense something is amiss. They recognize  the organization is fine-tuned and structured appropriately. They reason the right managers are at the top managing a complex, global business. But they sense an undetected vulnerability. The bank experiences a periodic, surprising earnings stumble, and the market declares degrees of doom. The company is admired, its history revered, but analysts are biased toward a high probability that losses will occur from nowhere.

Sounds like Morgan Stanley. While some financial institutions have been whipped soundly in business headlines the past few years (Goldman Sachs, Bank of America, Citi, and JPMorgan Chase), Morgan Stanley has managed to hover in the media background, yet it hasn't managed to generate sterling results and win the respect of those who study every move, step and dollar earned of major banks.

The bank, in some ways, is still recovering from spirited in-house battles from over a decade ago, when the leadership then, under CEO Philip Purcell, tried to reshape it from an upper-crust investment bank to a financial super market. Those were the days of a new strategy when the firm, after affiliating itself with retail giant Dean Witter, sprouted a national network of brokers, while trying to maintain its entrenched standing as a top investment bank for the top half of the Fortune 500.

Morgan Stanley, too, is recovering from the debacles that led to the financial crisis in 2008-09. Complex, exotic mortgage securities caused debilitating setbacks at Lehman, Bear Stearns, Citi and Merrill Lynch.  Morgan Stanley was also pummeled by piles of CDOs on its balance sheet. 

Some old-time Morgan bankers (and partners) wished Morgan had long ago retreated to its days of pure investment banking, without regard to or worry for an expansive retail network. Sales & trading would exist as a complement to corporate-advisory work. And retail brokerage would be done, well, in another hemisphere. Old-timers preferred deep relationships with corporate behemoths, rather than moms and pops. After the in-house strife years ago, Morgan Stanley has been on a consistent, steadfast path seeking to become bankers and brokers for moms, pops, uncles, aunts, General Motors and Facebook.

Its mission is clearer, and its ambitions known. Yet somehow it occasionally trips up and reports earnings that would embarrass its peers. When others report modest declines in trading revenues, for example, it reports unseemly, unexpected losses in trading. When others have blockbuster quarters in earnings, it slips in with mediocre profts.

As a result, there are always ongoing rumblings about its stock price and its prospects for being able to compete with the creme de la creme of banks. (Its stock had climbed above $20/share in early spring, but has since plummeted to less than $14/share.) Ratings agencies, just as they did with other large banks a month ago, have battered the bank, too, placing it on "negative" watch lists and assigning it near-junk ratings (as Moody's did recently).

To its credit, Morgan Stanley, under the leadership of current CEO James Gorman, tells its story with much more confidence. While earnings are not emitting shining rays, it has done all things possible to reduce leverage, build up capital, avoid embarrassing front-page lawsuits, and do what is popularly known as "de-risking" its balance sheet. Its balance sheet is now about 10% smaller than it had been two years and is now supported by an equity capital base of over $60 billion. It has taken aggressive steps to reduce the likelihood of "a run on the bank" (by reducing reliance on short-term funding).

In recent weeks, it has reaffirmed its desires to take greater control over its joint venture with Citi running the branch network Smith Barney. It has also re-engineered, just like its peers at Goldman Sachs and JPMorgan, to prepare for Dodd-Frank and Basel III regulation. It unloaded without fuss its enormously successful hedge-fund-like, black-box trading group.

Furthermore, somehow the institution, in whatever current state of being it is in, seems to have survived in the way Bear Stearns, Lehman and Merrill didn't. In 2008, the other three fell like dominoes; trading floors everywhere whispered, wondering if Morgan Stanley were next.  It wasn't. 

Hence, it fumes that it gets little credit. Investors and analysts applaud the restructuring moves, but it's all about the earnings, they counter. In the most recent quarter (second quarter, 2012), Morgan Stanley blamed a 48% drop in trading revenues (mostly from fixed-income activity) on its nearly 50% decline in earnings and its paltry 2% return on equity--yet another quarter where analysts insist they were caught off guard.

Morgan Stanley managed to win an enviable role in the Facebook IPO during the quarter. The coup was a tribute to its highly regarded technology-banking team in Silicon Valley. Many thought Goldman Sachs and JPMorgan had inside routes to the top role. But even this most anticipated IPO in years had slip-ups. Now regulators, market pundits and investors are playing a Facebook blame-game of figuring out whether Nasdaq incurred real systems mishaps or whether Morgan Stanley led in mis-pricing the shares on day one.

What can Gorman and lieutenants do to win favorable sentiments from analysts, investors, and ratings agencies?

First of all, it will need to get the ROE to rise above 10% and stay there. There is inevitable volatility in this industry, so earnings won't grow quarter after quarter. But the market wants to see some semblance of stability, even among investment banks where fees from M&A and equity underwriting can evaporate overnight.

Second, the market wants to see if Morgan Stanley, like its peers, has real solutions for the oncoming onslaught of regulation.  Will the bank be able to generate revenues and returns with reduced risks, reduced leverage, stiff capital requirements, more transparency, and no longer the opportunities to ride the momentum of "prop trading"?

Third (and arguably most important in the eyes of some), the market wants to see if the firm can control costs, control risks, and reduce the likelihood of the unexpected, huge loss.

Some analysts have called for more aggressive steps. Break up the firm into separate units: the retail brokerage, the investment bank, international banking, and hedge-fund trading, says prominent bank analyst Michael Mayo, who last week reasoned that doing so could double the stock price. 

Seize more of Smith Barney and pour more resources (people, brokers, and capital) into the brokerage and wealth-management businesses, say others.

Become a large-scale version of a boutique like Lazard? That means selling off other parts and maintaining the Morgan Stanley brand for a niche investment-banking business, compete with Lazard, Greenhill, Evercore, and other boutiques and beat them with more capital, an international presence and a corporate-loan unit. More easily said than done.

Continue to pare down businesses into the few where it is a market leader or what it sees as the best potential for growth? That seems to be the likely strategy or the one Morgan senior management is running with at the moment.

Go behind closed doors, and you can bet that senior management is frustrated that with all the tweaking, it continues to hustle to try to get it right. However, it is smugly satisfied that it won't bow out in a Lehman- or Bear Stearns-like way.

Tracy Williams

See also:

CFN:  How Does Goldman Do It? Feb-2010 

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