Morgan Stanley: Head Count Reductions Not Nearly Robust Enough

| About: Morgan Stanley (MS)

Yesterday, Morgan Stanley (NYSE:MS) announced plans to lay off 1,600 people in its institutional securities business. The white-shoe investment bank expects the cuts to affect senior bankers and traders, or approximately 6% of the unit's head count. The goal is to "do more with less," as the compan weans itself of less productive senior employees during a market downturn.

According to the Wall Street Journal:

For Morgan Stanley, the layoffs in the institutional securities group follow a recent shuffling of the leadership of the investment banking and trading business. In November, the firm said it would elevate Colm Kelleher, formerly co-head of the unit with Paul Taubman, to its sole head after he essentially won a horse race to lead the business. The firm has been under pressure to deliver better results within the business, particularly from its disappointing bond-trading unit. It is in the midst of scaling back riskier parts of its fixed-income trading operations and aims to reduce risky assets by about one-fifth by the end of 2014 as it copes with poor returns for the business and higher global capital requirements under new regulations.

The announcement is a recurring theme on Wall Street, as Goldman Sachs (NYSE:GS) announced it was scaling back its two-year analyst program and Bank of America (NYSE:BAC) divulged a mass layoff of up to 16,000 people by year-end 2012. Given the rapid deterioration in its top-line revenue, Morgan Stanley may not have a choice. Through the nine months ended Sept. 30, 2012, its revenues of $19.2 billion were down approximately 28% in comparison to the $26.6 billion it achieved during that same period in 2011. Revenues from its trading operations, down 52% during the review period, were the company's biggest disappointment.

Meanwhile, it experienced a net loss from operations of $337 million through nine months ended 2012, vs. a profit of $6.6 billion during the same period in 2011. That said, in my opinion, its stated headcount reductions are not nearly robust enough to rightsize the company.

Announced Headcount Reductions Not Robust Enough

The "rule of thumb" is that a well-managed investment bank should maintain its compensation and benefits expense at 50% of core revenue, or lower. Morgan Stanley's has been around 51% historically.

  • Compensation expense was 61.3% and 47.3% of non-interest revenues for the nine months ended Sept. 20, 2012, and nine months ended 2011, respectively.
  • For the trailing 12 months ended through Sept. 30, 2012, non-interest revenues were $25.1 billion; compensation expense was $15.9 billion, or 63% of non-interest revenues. The company would have to cut compensation expense by $3.3 billion, or approximately 21%, to bring it in line with industry standards (50% of revenues).
  • I would expect the lion's share of the cuts to come from its institutional securities group where fixed income trading is housed. However, for the math to work, Morgan Stanley would have to reduce headcount and/or salaries in other parts of the business as well.

Adopt a Partnership Culture

In each business there is an inflection point where efficiencies from headcount reductions outweigh the benefits. If revenue continues to trend downward, Morgan Stanley senior management will have to adopt a culture and compensation arrangement more akin to a partnership. Senior executives will have to accept a lower-than-normal base salary in lean years for a bigger upside when business results are more robust. No longer able to use Morgan Stanley as a vehicle for personal gain, of course some bankers will decide to leave. However, convincing talent to remain loyal to the firm amid tough times is part of CEO James Gorman's job description.

As we wrote in a previous article, "Long-Term Unemployment And The 'Pain Ahead,'" big ticket items like housing and autos that drive the economy are expected to remain anemic going forward. Morgan Stanley's core business of M&A advisory and capital raising is cyclical in nature, and should mirror the continued decline in the U.S. economy. That said, I recommend avoiding the stock long term until the company can prove that it can maintain profitability by reducing expenses in line with its deteriorating revenue stream.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.