One of the ramifications of the "Great Recession" was the disintegration of the investment banking business model. Lehman Brothers, Bear Stearns, and most of the other IBs faced liquidity squeezes due to an over-reliance on short-term funding, which was in vogue at the time. At one point it wasn't clear whether or not there would be any stand-alone IBs, but it seemed likely that through consolidation the remaining firms would merge with commercial banks to ensure the long-term deposit bases that are critical in a liquidity squeeze. Instead of this happening, the surviving firms in the industry have modified their business model to co-exist in this new era of regulatory change, reduced economic expectations, and rating agency capriciousness. Because market participants hate uncertainty, Morgan Stanley (MS) trades at a price which implies a depression in the near future, and gives no credit to a new and less risky business model.
At $13.93 per share, Morgan Stanley has a market capitalization of $28.7 billion. For this price an investor gets $51 billion of tangible equity, and $62.3 billion, or $34.23 a share of equity. Now keep in mind that Morgan Stanley marks their assets to market, and as of Q1 2012 only 4% of total assets were listed as Level III assets, down 70% since the end of 2008. One would assume that a company trading at this valuation must have no franchise value, but the reality is that Morgan Stanley is the leader or right near the top in all of its key businesses. One might also think that any company trading at a 60% discount to book value was losing money or is likely to lose money at a rapid pace, but that is not the case for Morgan. In 2011 and 2010 the company earned $4.1 billion and $4.7 billion respectively, in an abysmal market environment for IBs. These included various one time charges and legal expenses which are declining at a rapid rate. In the most recent quarter the company posted income from continuing operations of $1.4 billion, or $.71 per diluted share excluding DVA, which has no real economic impact on the company.
Perhaps the valuation discount is due to Moody's likely downgrade of Morgan Stanley. The same company that rated Morgan Stanley AA3 in 2007 when the company had $31 billion in equity, a Tier 1 Common (Basel I) ratio of 7.7%, and a leverage ratio of 33, now sees fit to potentially downgrade the company three levels to Baa2, which is just above junk. Stunningly in Q1 2012 Morgan Stanley had $62 billion in equity, a Tier 1 Common (Basel I) ratio of 13.3%, and a Tier 1 Common (Basel III) ratio of 9%. Morgan Stanley has $180 billion in liquidity reserves allowing the company ample room to account for any additional collateral concerns that a potential Moody's downgrade would create. If an investor is looking for a backwards looking credit history Moody's offers an exceptional service, but for anything forward looking it is obvious that these credit rating firms are out of their element, as their dismal track record indicates.
Morgan Stanley has not gotten enough credit for the drastic reconfiguration of its business from an over-leveraged, risk taking behemoth reliant on proprietary trading, to a well-capitalized investment bank with businesses focused on producing stronger returns without the volatile risks that trading inherently brings with it. The new Morgan Stanley is built on the Global Wealth Management and Asset Management businesses, which accounted for 49% of revenue in 2011. This asset-light business has been underperforming with pre-tax returns around 11%, but the underperformance is predominantly related to increased costs associated with the integration of Morgan Stanley Smith Barney (MSSB). Included in this integration is the acquisition of 42,000 employees, and a complete IT infrastructure upgrade that has taken longer and been more costly than initially projected. The company believes that the reduction in integration expenses and slightly higher revenue from increased assets under management should increase the margin to around 15%, and when interest rates eventually do rise, this could be a 20% margin business. Generating 50% of revenue at a potential 20% pre-tax margin, it is clear that the market is not adequately reflecting the future earnings prospects of this business. It is important to note that Morgan Stanley is in the process of purchasing an additional 14% of Smith Barney, and will likely buy the rest over the next year or two, ultimately resulting in 100% ownership.
36% of 2011 revenue came from sales and trading. Morgan Stanley has excellent relationships with their clients in this business and they have been able to pick up market share as competitors retrench. By trying to focus on "flow" of capital versus taking on more credit risk, the company believes that it is working with a lower overall risk profile. The investment banking division generated 14% of revenue in an extremely lackluster environment, and due to leadership positions in M&A and underwriting; Morgan Stanley should be amongst the biggest beneficiaries of improving macro-economic conditions. The Facebook (FB) debacle has been drastically overblown by the media and sour speculators, and I believe the biggest fault lies with NASDAQ's inability to process orders that day.
Much of Morgan Stanley's additional financial strength came from capital raises out of Asia with MUFG and CIC. In the turmoil of 2011 CEO James Gorman engineered a masterstroke by converting MUFG's preferred stock to common equity. This saves the company $780MM in annual dividends and gave the company a capital base that should suffice in any regulatory environment. MUFG now owns 22% of Morgan Stanley and the two companies have various businesses with one another, leveraging their global footprints and sales staffs. In addition Gorman has vigilantly emphasized cross-selling between Morgan Stanley's wealth management and investment banking divisions. According to the company's recent investor presentation, this cross-selling has resulted in $30 billion in transaction volume for the investment bank, and approximately $5 billion in assets captured for the wealth management division.
One of the stranger characteristics about Morgan Stanley is the high correlation the stock has with European equities. The company seems to be used as a proxy for making bearish bets on Europe, but as of Q1 2012 Morgan Stanley's net peripheral European exposure was only $2.4 billion, and this includes almost ($2 billion) worth of short positions on the sovereign debt of Italy, Spain, and Portugal. It is just difficult to see where the losses are going to come from to account for the huge valuation disconnect, which is why we are continuing to buy the stock, and sell puts to take advantage of the implicit volatility in the equity options. It is very likely that the gap between intrinsic value and stock price will recede when the company is able to buy back stock aggressively. Until that occurs it is easier for short term traders to inflate CDS prices in "risk off" times in combination with shorting the stock. As opposed to allowing these short term stock prices to dictate one's opinion of the actual business, I'd suggest a dollar cost averaging program inclusive of selling puts as far out as Jan 13 or 14 even.
We believe a 12-15% ROE is within reason putting normalized earnings across a cycle at $6-8 billion. If the company is able to buy back stock at a large discount to tangible book value than I would expect substantial upside to our intrinsic value estimates. While low bank valuations are common place in the current market environment, I think the odds of these valuations staying in place 5 years from now are exceptionally low. I wouldn't be surprised if 10-20 years from now books will be written about how obvious the investment opportunities were in financials after the "Great Recession." Any positive developments on the regulatory, political, or economic arenas would accelerate the improvement of market perception, but I'm not holding my breath.
Disclosure: I am long MS.