Morgan Stanley (NYSE:MS), one of the leading names in the US investment brokerage industry, has recently announced its second-quarter results for the fiscal year 2014. The company seems to be entangled in litigation issues, like Bank of America (NYSE:BAC) that arose from its activities before the financial crisis set in. The wrongdoings of the institution have come back to haunt its bottom line once again in this quarter as well.
Let's take a look at the core operating results of Morgan Stanley and the future growth strategies adopted by the entity.
Morgan Stanley derives a substantial portion of its revenue base from its investment management (49%) segment, followed by wealth management (43%). The company has mainly focused its operated in the US region, which garnered 71% of the total revenue in the most recent quarter.
Over the last five years, Morgan Stanley has managed to finally beat the competition and emerged as the market leader. While the players of the industry witnessed a decline of 1% in their revenues, the company was able to register a CAGR of 7%.
Moving ahead, the company has bright future prospects on the back of encouraging trends in the merger and acquisition activity, cross-border deals and complex transactions. The company also plans to leverage upon other opportunities in the credit derivatives and its partnership with Mitsubishi UFJ Financial Group (NYSE:MTU).
Source: Morgan Stanley Fixed Income Conference Call
The company is also actively working on enhancing its return in fixed income and commodities, along with a systematic reduction in the risk-weighted assets, "RWA". RWAs were down to $192 billion in the most recent quarter, mainly driven by decreased exposure to securitization and credit spread products. Morgan Stanley is on its targeted track to trim down the RWAs to less than $180 billion by the year-end 2015. Also, the company aims to exploit the adjacencies that are present in between the fixed income business and wealth management investment banking and equity franchises.
Source: Morgan Stanley Fixed Income Conference Call
Morgan Stanley's wealth management segment continues to expand its revenue base, on the back of increased scale and substantial asset growth from $700 billion in 2006 to $2,000 billion in the second half of fiscal year 2014. This was mainly achieved due to the company's successful integration with Citigroup's (NYSE:C) wealth management business. Additionally, a better revenue mix and disciplined expense management also contributed to the staggering growth of 20% in the net interest income over the last few years.
The company is expected to sustain the revenue growth momentum as it actively implements its long-term strategy and organizes deposits into lending products. The company has set a pre-tax margin target range of 22%-25% to achieve by the end of 2015 through continued growth in net interest income, operating benefits derived from economies of scale and ongoing disciplined expense management. Further positive growth can also be achieved if interest rates increase.
The Problem Creator
While the company has shown signs of improvement in its core operations, its past wrongdoings continue to dent its earnings. In the most recent quarter, the legal costs slashed the company's profit by $53 million, or 2 cents per share. This brought down the EPS to 92 cents per share.
Recently, another mortgage-related lawsuit has been charged against the company, and it is expected that the probable loss may amount to $284 million. This is likely to translate into a dip of 14 cents per share.
Source: Morgan Stanley SEC Filings - 10-Q
Morgan Stanley's US banks are obligated to meet various regulatory capital requirements. In case of failure to meet the minimum capital requirements, action taken by the regulators can adversely affect the company. The US branches are liable to meet precise capital guidelines that cover quantitative measures of their assets, liabilities and certain off-balance sheet items.
As of June 30, 2014, the company's US banks were operating in the safety zone and had met all capital adequacy requirements. The company had achieved the status of being well-capitalized by maintaining a net cushion spread of 7.4% for common equity tier 1 capital to RWAs, capital ratio of Tier 1 capital to RWAs, total capital to RWAs and 2.8% for leverage ratio. The obligation to meet the leverage ratio of 5% will be officially implemented from 2018.
On the forefront, the litigation issues seem to be warding the investors off from investing in Morgan Stanley. The real value derived from the improvement in the core operations of the company has been hemmed in by the legal costs that continue to tarnish the image of the company.
From an investment perspective, this can be a blessing in disguise and in fact, an attractive entry point. I have employed P/TBV valuation to support my investment thesis. Since major assets on a bank's balance sheet are very liquid and have an active trading market for them, valuation based on tangible book value is a suitable measure. Based on Morgan Stanley's second-quarter tangible book value per share of $28.51, the company's P/TBV is calculated to be 0.91, as compared to the industry average of 2.22. This reaffirms the current undervaluation of the stock.
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