The investment banking industry has undergone a revolution of sorts as large players such as Lehman Brothers, Bears Stearns, and Merrill Lynch has been consolidated into large commercial banks, and regulatory changes have forced adjustments to the business model. Morgan Stanley (MS) has taken radical steps to raise capital to meet new regulatory requirements, and to adjust the business model towards asset and wealth management, while maintaining a strong position in core investment banking business such as advisory and trading. Moving forward I'd expect Morgan Stanley to maintain a less-risky business model than prior to the Great Recession based on its higher capital ratios and lower leverage. Returns on equity will not be as high but the quality and consistency of earnings should allow the company to be a solid compounder of book value, providing attractive returns for equity investors at current prices.
Morgan Stanley has built one of the strongest wealth management businesses in the world that will only get stronger when it acquires the remaining 35% interest in Morgan Stanley Smith Barney (MSSB) from Citigroup (C). Morgan Stanley finally exceeded its mid-teen pretax margin goal for the division and assuming reasonable revenue growth I'd expect for margins to increase to 20% in a few years. Wealth Management is a great business for Morgan Stanley because it is asset-light and highly scalable, with much higher returns on capital than the institutional securities business. MSSB has faced numerous problems in unifying into one IT infrastructure and has lost some large producers, but overall the business is well intact. The reality is that long-term inflation boosts asset values and the money management business is well situated to benefit.
Morgan Stanley took aggressive steps to reduce risk-weighted assets from a peak of $500 billion, to roughly $280 billion at the end of the 4th quarter. On the 4th quarter earnings conference call CEO James Gorman announced that by 2016 the company intends to reduce risk-weighted assets to $200 billion, down from $390 billion in the 3rd quarter of 2011, which would result in only tying up about $18 billion of capital in comparison to $35 billion before. This should set the stage for both a higher return on equity and capital returns to shareholders. To further facilitate improving profitability, the company has worked aggressively to cut costs, and expects 2014 full year expenses to be down $1.6 billion assuming flat revenues and markets. The company has reduced the employee count by 6,000 in the last 12 months, which has reduced fixed salary and benefits costs materially. The company is also adjusting its real estate footprint to focus more on regional centers, and to exit non-core locations. The company is working to improve its cross-sell between Institutional Securities and Wealth Management. Morgan Stanley has raised $83 billion in deposits, which it intends to more aggressively lend, as the company feels that in Wealth Management its lending product penetration is 500 basis points below its peers. These steps would be incremental to margins and earnings if Morgan Stanley can execute them successfully.
Morgan Stanley ended the 4th quarter of 2012 with a book value of $30.65 and a tangible book value of $26.81. James Gorman stated that assuming no change in market conditions, the company is well-suited to generate returns on equity of 9-10%. When the economy picks up steam I see no reason why Morgan Stanley can't generate returns on tangible book value of 13-16%, which would result in normalized earnings power of around $3.48 per share. At a recent price of $22.38, Morgan Stanley offers a normalized earnings yield of 15.5%. With the changes to the business model that have been made, there is very little doubt that Morgan Stanley will be in a position to return a sizeable amount of capital to shareholders in a few years, while the focus in this year's CCAR will obviously be the attempted closing on the remaining interest in MSSB.
On January 18th Morgan Stanley reported 4th quarter earnings where it had firm-wide revenues of $7.5 billion, excluding the impact of DVA. Non-interest expense was $6.1 billion, down 10% versus the 3rd quarter. Compensation expense was $3.6 billion, down 8% from Q3. Non-compensation expense was down 13% sequentially to $2.5 billion, highlighting the improvements that Morgan Stanley has been making towards improving its operating efficiency. Earnings from continuing operations applicable to Morgan Stanley common shareholders were $547MM, or $.28 per diluted share after preferred dividends. The balance sheet grew by $17 billion sequentially to $782 billion, and the company maintains a liquidity reserve of $182 billion. The Tier 1 common ration under Basel I is around 14.7% and the Tier 1 capital ratio is about 17.9%. The pro-forma Tier 1 common ratio under Basel III was 9.5% as of the end of the 4th quarter, putting MS in compliance with the new regulatory capital requirements.
Despite a large rally in 2012, financials as a whole are still out of favor and are by far and away the cheapest sector of the market. Morgan Stanley is one of the finest franchises in the investment banking industry, and the astute investor still has the opportunity to buy shares at a considerable discount to tangible book value. The headwinds which have pressured earnings will not last forever, nor will the horrible sentiment that has persisted since the U.S. Financial Crisis. Efficiency improvements and a better economy should lead to a large increase in earnings in 2013. Tangible book value will continue to grow and the more conservative capital structure should protect shareholders in future financial crises. I believe that within 3 years Morgan Stanley could comfortably trade between $35-$40 a share assuming a valuation no greater than 1 times book value at that time. These low-risk, high-reward opportunities don't last forever and should be fully taken advantage of by the prudent investor.