Many analysts attribute a certain price-to-earnings ratio to a company based off of the company's return on equity. This is very logical but at times it can cause temporary dislocations in business pricing, because businesses are far more than just earnings, and it is essential to understand the assets and liabilities as a potential forecaster of future earnings or resource conversions. I prefer looking at net asset values and projecting future earnings using comparable companies' histories, with similar opportunities and assets. Morgan Stanley (MS) is a perfect example of a business that has underperformed from an earnings perspective, while it has been making the painful but prudent decisions to restructure the business. It has traded at one of the most depressed valuations in the industry due to its lethargic ROE but brighter days are on the way, and the stock still has reasonable upside. Clearly, the best buying opportunities were when the stock was cheaper, but for the patient investor, I believe 13-15% per annum upside over the next 3-5 years is a very realistic scenario from current prices.
CEO James Gorman was dealt a very difficult hand when he took over the firm in the midst of the Financial Crisis. The investment banking business model became almost obsolete due to constantly changing regulatory changes and capital requirements. Also, the consolidation that occurred made Morgan Stanley a relative lightweight in comparison with some of its larger peers, in an era where scale and synergies are the keys to the game. Gorman acted decisively, scooping up an attractively priced deal to acquire the Smith Barney business from Citigroup (C), and he entered into a capital bolstering joint venture with Mitsubishi Financial Group. These moves weren't going to be seamlessly integrated, but over time the idea is to allow Morgan Stanley to be a bigger player in the wealth management industry, which offers higher margins and lower capital requirements. Most things being done right now with the banks are based on capital, as various businesses are no longer viable because in the past they required tremendous leverage, which is no longer acceptable and I believe that this is a net-positive from the increased regulatory scrutiny in the industry.
I know that I might be in the minority, but I believe that ultimately Morgan Stanley will attain a 13-16% return on equity within the next several years. This will require the wealth management business to represent well in excess of 50% of pre-tax profit, so due to the lower required capital, this would have a dramatic impact on ROE. Secondly, Morgan Stanley needs to either scale up in the Institutional Securities business, which can be accomplished through additional hiring, or perhaps look to divest the capital intensive FICC business to a larger firm if it can attain reasonable pricing. A divestiture would provide Morgan Stanley with a huge surplus of capital, which could then be used either to scale up further in wealth management, or return capital to shareholders. The stock price would either rise as a result of the deal, or if not, the capital would allow Morgan Stanley to buy back the stock of its attractive wealth management-centric firm, at around book value, which would be absurdly cheap for this high-margin business. The advisory businesses in Institutional Securities are fine to hold on to and play to Morgan Stanley's strengths in great relationships and competencies in those businesses across the globe. I know that they are completely different industries, but this business strategy is similar to when IBM divested its hardware business to focus on higher margin software and services. The 13-16% ROE projection does not assume these steps are taken but instead only necessitates higher margins on wealth management, and a slightly better macroeconomic environment, which would bolster the Institutional Securities business.
On July 18, Morgan Stanley reported relatively strong 2nd-quarter financial results with net revenues, excluding DVA of $8.3 billion, up from $6.6 billion one year ago at the same time. Income from continuing operations applicable to Morgan Stanley was $1.0 billion, or $0.43 per diluted share, compared with income of $562MM, or $0.28 per diluted share a year ago. This year's earnings included a negative adjustment of approximately $152MM, or $0.08 per diluted share, related to the purchase of the remaining interest in the Morgan Stanley Smith Barney Joint Venture. Excluding DVA, income from continuing operations applicable to Morgan Stanley was $898MM, or $0.37 per diluted share, up from $337MM or $0.16 per diluted share, a year ago. Revenues in all businesses were up double digits from the same time last year.
Institutional Securities net revenue excluding DVA was $4.171 billion and pre-tax income from continuing operations excluding DVA was $785MM, up from pre-tax income of $138MM in the 2nd quarter last year. Advisory revenue was $333MM compared with $263MM a year ago, while equity underwriting revenue of $327MM increased from $283MM a year ago. Fixed income underwriting revenue was $418MM compared with $338MM a year ago. FICC and trading net revenue was $1.2 billion, up from $771MM a year ago. Equity sales and trading net revenue was $1.8 billion, up from $1.3 billion YoY. Based on the strength of the Mitsubishi UFJ Morgan Stanley Securities Joint Venture, Other revenue was $140MM, compared with $41MM in the year-ago period. The Institutional Securities business is very much flow-driven, and will tend to do much better when confidence is higher. Risk weighted assets have gotten down to $239 billion, and the company targets them being below $200 billion by the end of 2016, which will ultimately result in reduced capital requirements for Institutional Securities, and more specifically, FICC.
Wealth Management net revenue was $3.531 billion and the pre-tax margin was 18.5%, resulting in pre-tax income of $655MM. Bank of America's (BAC) wealth management business has pre-tax margins in the high 20', but is more seasoned and integrated than Morgan Stanley's, so over time I believe that 25% pre-tax margins should be the minimum long-term goal. Second-quarter financial results were up from net revenues of $3.196 billion and pre-tax income of $410MM in the 2nd quarter of last year. Asset management fee revenue of $1.9 billion increased 4% from last year's 2nd quarter due to an increase in fee based assets. Total client assets were $1.8 trillion, while client assets in fee-based accounts were $629 billion, representing 35% of total client assets, so there is certainly room for improvement. Transactional revenue of $1.0 billion increased from $908MM a year ago. Although Morgan Stanley has the largest financial advisor force by numbers, the company is materially underperforming in terms of pre-tax margins in relation to its competitors. A lot of this has to do with the issues that the joint venture incurred in combining the Smith Barney operations with the Morgan Stanley business. Management has put a tremendous amount of effort into improving performance and progress is being made. Now that Morgan Stanley has consolidated the remaining portion of the business, I'd expect to see the rate of improvement increase.
Investment Management had net revenue of $673MM with assets under management or supervision of $347 billion. Pre-tax income for the quarter was $160MM, up from $43MM at the same time last year, and the pre-tax margin was 24%. Assets under management or supervision on June 30, 2013 of $347 billion, increased from $311 billion a year ago. The business had positive net flows of $9.8 billion in the quarter.
Morgan Stanley boasts some of the strongest capital ratios in the industry with a Tier 1 capital ratio under Basel I of 14.1%, and a Tier 1 common ratio of 11.8% at June 30, 2013. The company estimates its pro forma Tier 1 common ratio under Basel III at 9.9%, as of the end of the 2nd quarter. Book value and tangible book value per share were $31.48 and $26.27, respectively. Due to the 35% increased ownership interest in MSSB, tangible book value per share reflected a decline of roughly $1.49. Morgan Stanley also received no objection from the Federal Reserve Board to buy back up to $500MM of the company's stock, in addition to its $0.05 per share quarterly dividend. This is the news that shareholders have been waiting for and unsurprisingly the discount-to-book value continues to decline with the stock price rising. Stock buybacks will be highly accretive in my opinion, up to about 1.1-1.2 times book value, but higher future dividends also seems quite likely.
Initially James Gorman's goal is to get to a 10% return on equity. That would peg normalized earnings power at approximately $3.148 a share and obviously stock buybacks at current prices would be highly accretive. A simple 10 multiple on earnings would put the stock at about $31.50, which is about 13.5% higher than the current price of $27.76. I believe book value adjusted for dividends and not including stock buybacks, will grow at a minimum of 10% over the next 5 years, and assuming no change in the valuation, this would provide double-digit returns to shareholders. A 15% return on equity would put normalized earnings at $4.72, which would put the target price at $47.25 based on that same multiple, and obviously the net asset value would compound at a greater rate. I really don't see a lot of downside to Morgan Stanley even after the rally, in terms of taking a permanent loss of capital, but the upside is still quite good. The business model is far safer than it was in the past, and one day the market will appreciate that, and potentially assign a higher multiple. James Gorman needs time to implement his plan and as long as his focus is on maximizing returns on capital, and building per-share value, I believe he is the right man for the job.