Morgan Stanley - Gorman's Strategy Creates Stability And Value, And Is Already Paying Off

| About: Morgan Stanley (MS)


Morgan Stanley posted strong second quarter results, even adjusting for DVA and tax benefits.

CEO Gorman's strategy to focus on wealth and investment management creates visibility and high earnings.

The freed up capital from exiting capital-intensive businesses is already being returned to investors, creating further appeal.

Morgan Stanley (NYSE:MS) released a solid set of second quarter results which demonstrated that the company's strategy to focus on investment and wealth management businesses is paying off.

I think CEO James Gorman is doing a great job after having laid out this strategy. The greater visibility and lower risks implies that one should no longer value Morgan Stanley as a traditional investment bank. Rather it should be seen more as an investment management company which deserves a higher valuation multiple.

Second Quarter Results

Morgan Stanley posted second quarter revenues of $8.52 billion on a non-GAAP basis which excludes an $87 million benefit from debt valuation adjustments. Non-GAAP revenues were up by 2.2% compared to the year before.

The bank posted earnings of $1.88 billion on a non-GAAP basis, with GAAP earnings coming in as high as $1.94 billion after factoring in the beneficial effects from the debt valuation adjustment. Based on non-GAAP earnings metrics, the bank managed to more than double its earnings.

For the quarter, Morgan Stanley posted GAAP earnings of $0.94 per share. Adjusting for debt valuation adjustments and the positive impact of a big tax break, Morgan Stanley posted earnings of $0.60 per share which is five cents higher than analysts were anticipating.

Looking Into The Quarter

CEO James Gorman was pleased with the performance, seeing momentum within investment banking, sales & trading as well as wealth management.

Institutional securities sales totaled $4.16 billion on a non-GAAP basis, down half a percent compared to last year. This is as pre-tax income dropped by little over 13% to $806 million. Advisory revenues were healthy driven by the global M&A boom while equity sales held up fine at $1.8 billion. Weakness was seen at the FICC business, just like the rest of the street as sales fell from $1.2 billion last year to a billion over the past quarter.

Lower compensation and non-compensation expenses could not offset the impacted from trading losses related to the long term debt of the firm and a lower profit contribution from the joint venture with Mitsubishi UFJ.

The company's wealth management business had a fine quarter, posting a 5.2% jump in sales towards to $3.72 billion. Pre-tax earnings improved significantly to $767 million. Fee revenues jumped thanks to higher market levels, while earnings jumped on tight expense management.

Investment management had a solid performance as well, notably in terms of profitability. Revenues were up just 2.8% to $692 million as asset management performance was offset by lower real estate investing contributions. Yet operating earnings improved significantly to $205 million again driven by very strong cost control.

On a GAAP basis, total reported revenues jumped by a percent to $8.61 billion. Total compensation and benefits increased by two percent to $4.20 billion, while non-compensation expenses fell by 7% towards $2.42 billion. As a result, income from operations rose by 11% to $1.99 billion while net earnings improved a lot from lower tax rates.

Morgan Stanley only paid $32 million in tax thanks to a $609 million tax benefit related to the re-measurement of reserves and related interest.

A Look At The Balance Sheet, Capital And Valuation

Shares of the bank ended the week at $32.64 per share which results in shares trading at a modest discount to the common book value of $33.48 per share.

With a tangible book value of $28.53 per share, shares trade around 1.15 times its tangible book value. Given the large investment and wealth management business compared to ¨traditional¨ investment banking activities, the banks balance sheet is quite healthy. The common equity Tier-1 risk based ratio was 13.8% for the quarter.

On a trailing basis, the company has posted sales of little over $33 billion on which it posted earnings of close to $4 billion. Note that after adjusting for one-time items hitting the bottom line, the real earnings rate is much closer to $5 billion per annum. With nearly 2 billion shares outstanding and at the current price of $32.64, equity is valued at around $65 billion.

This values equity in Morgan Stanley at 2 times sales and 16-17 times reported trailing GAAP earnings and close to 13 times adjusted earnings.

A Look At The Past, To See The Future

Unlike many of its peers, it took Morgan Stanley much longer to recover from the financial crisis. Shares fell from highs of around $90 in 2007 to levels of just $10 a year later.

Shares did see a big bounce back towards $30 in 2010 but continued worries about its capital position weighted on shares which fell to levels as low as $12 by the summer of 2012 again. Later that year and in 2013 shares have steadily recovered to current levels of about $33 per share.

These past nasty surprises have really shaped the future of the company. Under CEO James Gorman, the bank has increasingly focused on wealth management and investment management which is a more stable and less risky activity to operate. These activities now make up the majority of total revenues during the quarter, with growth trends ensuring this trend is expected to continue going forwards.

Crucial in this growth was the purchase of the 35% stake in the joint-venture, also known as Morgan Stanley Smith Barney, from Citigroup (NYSE:C) in the wealth management business. The deal was closed in June of last year with Morgan Stanley paying $4.7 billion for the stake.

Final Takeaway

Myself and many other investors like the prospects and strategy of Morgan Stanley. The company has a clear and distinctive strategy to focus on wealth management and investment management, making it less dependable on capital-intensive and more volatile businesses like its trading of general FICC businesses.

This is not to say that wealth management is not a competitive business. The prevalence of lower commissions and do-it-yourself trading platform has created more competition, as has the rise of the passive investment management business.

In the light of the clear strategy, the valuation at roughly 13 times earnings based on $5 billion in adjusted earnings is quite reasonable with risks coming down. With much more capital being freed up, Morgan Stanley is able to return cash again to investors.

The $0.10 per share quarterly dividend provides investors with a 1.2% dividend yield while the company repurchased another $284 million worth of shares during the quarter, at a rate of 1.8% per annum. This combined ¨yield¨ of 3% is among the better ones being offered by the major US banks.

While banks were among the most volatile stocks over the past decade, they have been very ¨calm¨ this year. So far this year, shares have traded in a tight $28-$33 trading range, currently trading towards the high end of that range.

Trading around book value, while becoming less risky in terms of its activities on a daily basis, creates appeal. This is certainly the case given the shareholder payouts and the valuation at roughly 13 times earnings, while having a strong franchise name.

Given the recently raised dividend, I am a buyer on dips.

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