Morgan Stanley (MS) offers one of the best risk/reward opportunities in the financial sector. New capital and regulatory hurdles have dramatically transformed the business to a safer, but less profitable enterprise. For example, Morgan Stanley has roughly doubled its capital base and liquidity since 2010. This has pretty astounding ramifications considering Morgan Stanley was not a small company before, and the business mix has shifted more towards wealth management, with full investment banking and trading capabilities. By becoming less reliant on trading, Morgan Stanley could eventually be valued at higher multiples than it was in the past, even if the company doesn't reach the high ROE levels of the past. Brokerage revenue made up 51% of all sales last year, which was up from 28% in 2008, to put the transformation in perspective, and I believe that the brokerage revenue percentage should continue to increase as Morgan Stanley continues to scale up. It is also important to note that Morgan Stanley was actually one of the better performers during the Financial Crisis, despite enlarged trading operations under John Mack, and I'd argue that the company's major issue was capital and liquidity at that time. CEO James Gorman and CFO Ruth Porat are taking the right steps to make the company a safer and more consistently profitable franchise, and I believe that investors buying at current prices will be well-rewarded over the long-term.
On April 18th, Morgan Stanley reported net revenues of $8.2 billion for the 1st quarter of 2013, up from $6.9 billion in Q1 2012. Income from continuing was $1.0 billion, or $0.50 per diluted share, compared with a loss of $79MM, or a loss of $0.05 per diluted share, one year ago. To get a better feel of actual operating results it is necessary to eliminate the Debt Valuation Adjustment, which was $317MM this year, and $2 billion last year. Excluding DVA, net revenues in the Q1 2013 were $8.5 billion, compared with $8.9 billion in Q1 2012. Adjusted income from continuing operations to Morgan Stanley was $1.2 billion, or $0.61 per diluted share, compared with net income of $1.4 billion, or $0.71 per diluted share in Q1 2012. For Q1 2012, including discontinued operations; net income was $0.49 per diluted share, compared to a net loss of $0.06 at the same time last year. Non-interest expense was up 7% sequentially, to $6.5 billion, while compensation expense was $4.2 billion this quarter including $132MM related to severance. Non-compensation expense was down 6% from last quarter.
The Global Wealth Management Group had net revenues of $3.5 billion and pre-tax margins of 17%, generating pretax income of $587MM. Morgan Stanley has put a huge emphasis on cost controls and it is very positive that these efforts are starting to bear fruit, but clearly there is more work to do for the company to get to 20% pretax margins. Bank of America's (BAC) Merrill Lynch division has generally achieved in excess of 20% pretax margins, so I believe it to be an attainable goal for the franchise. Average annualized revenue per representative was $851,000 in the current quarter, and the unit had net inflows of $15 billion. The Global Wealth Management business is very important for Morgan Stanley because it offers very high potential returns on a smaller amount of capital, which is increasingly important with the new regulatory and capital rules.
Institutional Securities net revenue excluding DVA was $4.4 billion, up 22% sequentially, for a pretax profit of $1.147 billion. The division had a weak quarter in fixed income and commodities sales and trading. Morgan Stanley has the smallest FICC division of the major U.S. banks and it is unclear whether or not they have the scale to earn an adequate return on invested capital, so this will be very important to watch, as Morgan Stanley might find that it is better to allocate capital in other directions. The company reduced risk-weighted assets in the division to $253 billion at the end of the 1st quarter, down from $280 billion at the end of the 4th quarter. For now I believe Morgan Stanley can improve performance due to the fact that there is less competition than there was in the past. Underwriting revenues and equity sales and trading saw very strong performance in the quarter. Investment banking revenues of $945MM were down 23% sequentially, but according to Thomson Reuters, Morgan Stanley ranked #2 in global complete M&A, and #3 in global equity at the end of the 1st quarter. The Asset Management division reported net revenues of $645MM with assets under management or supervision of $341 billion. Pretax income came in at $187MM, which was down from $221MM last quarter, but up from $128MM one year ago.
Total assets were $801 billion at the end of the 1st quarter, up from $781 billion at the end of the 4th quarter. Deposits were $81 billion and this number will be substantially higher once Morgan Stanley does indeed consolidate all of MSSB. In the 1st quarter, Morgan Stanley received a non-objection in the CCAR process to their request to use $400MM of excess capital to buy the remaining 35% of the MSSB joint venture from Citi. This will allow Morgan Stanley to consolidate the entire venture onto the balance sheet and it should have a positive long-term impact on margins. The company has increased its liquidity reserve to $186 billion, from $182 billion at the end of the 4th quarter to make sure it has adequate liquidity for acquiring the remaining stake in MSSB. Morgan Stanley is now in its 3rd year partnering with Mitsubishi UFJ, to create one of the strongest financial networks in Japan, where a new monetary impetus from the central bank, is causing a resurgence in activity. The joint venture enables clients with truly global capabilities for M&A, advisory and trading. Morgan Stanley is well-position to pick up market share in many of its businesses over time as competitors abroad retrench.
The company is exceptionally well-capitalized with a Tier 1 common ratio under Basel I of approximately 11.5%, and a Tier 1 common ratio of approximately 13.9%. Morgan Stanley estimates that under Basel III its Tier I common ratio was 9.8% at the end of the 1st quarter. While the company is focused on integrating MSSB, which has been very difficult due to an outdated IT infrastructure and divergent cultures, once the deal is closed I believe that it is possible Morgan Stanley will seek approval for a stock buyback. This would clearly be highly accretive at anything close to current prices, and just the expectation of a buyback, whenever it does occur, could cause the stock to more closely approximate intrinsic value.
Morgan Stanley ended the 1st quarter with 1.960583 shares outstanding, so at a recent price of $20.47, the market capitalization is roughly $40.13 billion. Morgan Stanley ended the 1st quarter with a book value of $31.22 and a tangible book value of $27.39 per share. Many of Morgan Stanley's businesses will do better with higher interest rates and of course a stronger global economy, but I believe a 10-13% ROE is easily attainable even in the current environment. This would position the company to earn between $3.12-$4.00 a share, on a normalized basis. It is important to note that for many of the banks it has not been business as usual, because they have had to take drastic measure to get into compliance with the new rules and regulations. Morgan Stanley has about 25% of its assets as a liquidity reserve, which obviously could be used more productively in the future. Down the line, I believe Morgan Stanley is very capable of attaining a return on equity of 15% once more. I believe the recent decline in price provides a nice opportunity to accumulate some Morgan Stanley stock. I believe it is the best play of the pure investment banks, and 5-7 years from now, there can potentially be a rich-reward for those willing to deal with the uncertainty of the current investment climate.