Morgan Stanley: A 95% Payout Ratio Is Overshadowed By Weak IB Revenues

| About: Morgan Stanley (MS)

Summary

For CCAR 2016, we expect a total payout ratio of 95%.

The improving credit environment is of little help; ECM and M&A are still weak.

MtM portfolio is still an issue.

CCAR 2016

With CCAR 2015, Morgan Stanley (NYSE:MS) increased its dividend by 50% to $0.15 (20% payout) and its share repurchase request to $3.1bn (44% payout).

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Source: Bloomberg

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Source: Bloomberg

For CCAR 2016, we expect a share repurchase program in the $3 -3.5bn area (67% payout), and a 20% increase in the quarterly rate from 2015. We also expect another $0.05 dividend increase to $0.20 (28% payout). This would bring its total payout toward 95%, on our estimates.

We note that MS has the highest capital ratios of the money center banks and showed marked improvement in DFAST results.

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Source: Barclays Research

The improving credit environment is of little help; ECM and M&A are still weak

Although capital market conditions have deteriorated over the past year, they are slightly improved from the first quarter, with the FICC (Fixed-Income, Commodities and Currency) division being a particular strength. Within the FICC, the High-Yield segment has seen the most q/q improvement with materially increased issuance in high-yield bonds (+139% q/q pro-rated till end May) albeit of a very low Q1. Morgan Stanley is traditionally thought of as a play on FICC, however, MS management is currently pursuing the new strategy. The company is aiming to shrink the FICC business with FICC RWAs expected to decline to $110bn from $136bn at YE2015. In addition, MS FICC business mix is geared to Securutized Products - the segment, which was significantly weaker than the High-Yield and the Rates in 2Q16. Finally, MS may have another review of its FICC and shrink it further, in our view. Hence, by contrast to Deutsche Bank (NYSE:DB) and Barclays (NYSE:BCS), the improving FICC environment should not have a significant positive impact on MS revenues.

Furthermore, investment banking revenues are still very weak. According to Dealogic, MS had the second worst quarterly performance among its peer group - its total IB revenues declined by 19% q/q, while total industry revenues were flat q/q.

Source: Dealogic, JPM Research

Source: Dealogic, JPM Research

Source: Dealogic, JPM Research

MtM portfolio is still an issue

One of the main reasons of MS's underperformance in trading revenues (vs its key peers) is a large mark-to-market portfolio of credit assets. In 1Q16, MS FICC results were particularly due to its large MtM portfolio of low-rated credit assets.

Source: Company data, Renaissance Research

According to SG Research, the MTM portion of the energy portfolio represents c.11% of CET1 capital, so not insignificant, while the total MTM portfolio is larger when non-energy assets are included. It is the main reason, why MS's FICC revenues consistently underperform those of its US peers.

The 8.0x - 10.0x forward P/E range

MS has been trading in the 8.0x - 10.0x forward P/E range since mid-2015 (excluding the sell-off in Feb-16).

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Source: Bloomberg, Renaissance Research

The consensus estimates have been declining since 2015, and we believe there is still a downside risk to the 2016E earnings, given that the sell-side still expects a strong recovery for the remainder of 2016. Should the consensus lower its forecasts by 20%, the 8.0x - 10.0x forward P/E range would correspond to the $19-25 levels.

Valuation

Morgan Stanley is trading below the sector's regression line. However, we note that all IB/money center U.S. banks are trading at a discount to the sector.

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Source: Bloomberg, Renaissance Research

Click to enlarge

Source: Bloomberg, Renaissance Research

Bottom line

We do agree that Morgan Stanley looks cheap on a P/B basis, while CCAR 2016 results should give a boost to the stock, in our view. Having said that, we believe there is still a downside risk to the 2016E earnings, given the challenging capital market conditions. ECM and M&A are still weak, while the improving credit environment will not have a significant positive impact on MS revenues. In addition, MS's FICC revenues will consistently underperform those of its US peers due to a large MtM portfolio of low-rated credit assets.

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