Morgan Stanley: Is It Time For A Takeout?

| About: Morgan Stanley (MS)

Morgan Stanley (MS) reported dismal 2nd quarter earnings on July 19th. While macroeconomic issues created an anemic environment for any capital markets activity, Morgan Stanley clearly suffered from uncertainty pertaining to the credit rating downgrade in the quarter. At a current price of $13.25 Morgan Stanley's market cap is only $26.2 billion versus $61.4 billion in shareholder equity. Book value and tangible book value per share are $31.02 and $27.70 respectively. The current valuation implies that the company is worth far more dead than alive, and I believe that even at double the current price Morgan Stanley makes an excellent takeout candidate for either Citigroup Inc. (C) or Wells Fargo & Co (WFC).

Excluding DVA net revenues in the quarter were $6.6 billion as opposed to $9 billion a year ago, and income from continuing operations was $0.16 per share. Compensation expenses were down to$3.6 billion from $4.6 billion last year reflecting poor business performance. Non-compensation expenses of $2.4 billion decreased from $2.6 billion a year ago. While Morgan Stanley has made substantial progress cutting costs, it is very difficult to offset such a substantial drop in revenue. While all of the banks have been hurt by a burdensome regulatory environment, Morgan Stanley and Goldman Sachs Group Inc. (GS) have seen the biggest changes in their business models. Both firms have been forced to be less reliant on proprietary trading, and focus more on less capital intensive business such as wealth management, and true investment banking.

Morgan Stanley still maintains an exceptional franchise. In the 2nd quarter Morgan Stanley ranked number 1 in Global IPOs, number 2 in Global Announced M&A, and number 3 in Global Equity. These are attractive businesses to be in because they aren't overly capital intensive, but they are very reliant on the macroeconomic environment. Capital markets activity will pick up again as confidence comes back, and even in stressed environments like we have seen over the last couple of years we have seen periods of real strength including the 1st quarter of this year. Therefore it is very important not to dwell too much on one bad quarter of performance and project that into the future.

Morgan Stanley's most attractive businesses are their Global Wealth Management and Asset Management operations, which account for nearly 50% of the company's revenues. Global Wealth Management has undergone radical changes with the integration of the Smith Barney operations. In the 2nd quarter Global Wealth Management boosted pretax margins to 12% versus 9% a year ago, and it seems likely that a 15-20% pretax margin is attainable over the next couple of years. Morgan Stanley is in the process of acquiring another 14% of Smith Barney from Citigroup and the price looks like it will ultimately be set by an arbitrator as the carrying values of the asset are quite different for both companies. Wealth Management is an extremely beneficial business to be in right now due to the stressed regulatory environment. It doesn't tie up much capital, it produces high and consistent profit margins, and there are significant scale benefits which are advantageous to a company with Morgan Stanley's wide footprint.

Our investment thesis in Morgan Stanley hasn't deviated at all since our last article on it so we thought it would be worth discussing the logic in Morgan Stanley being taken out by one of their rivals.

As we have all discovered the big five U.S. banks are all too big to fail. That doesn't mean that their shareholders can't lose everything, so I don't believe that combining Morgan Stanley with another of the large banks poses any greater systemic risk than that which already exists. The new regulatory environment has placed additional capital charges on the largest banks to reduce their leverage. While this does serve as an impediment to seeing M&A activity amongst the big 5, we believe Morgan Stanley would fit perfectly with one of the larger money center banks. Morgan Stanley has a Tier 1 capital ratio under Basel I of 17.1% and a Tier 1 common ratio of 13.5%. Their projected Tier 1 common under Basel III is just under 8.5%. This means that Morgan Stanley could be acquired at a price close to tangible book value, and not be dilutive on a capital basis to the acquiring company. This is particularly important because the big banks most certainly would not want to raise capital while their stocks are trading at such absurd values.

Consolidation makes sense in the banking sector because higher capital requirements and lower leverage make certain businesses much less attractive. Therefore cost structures must be adjusted and it is in this area where synergies would make an acquisition of Morgan Stanley worthwhile. Reducing non-interest expenses to an absolute minimum by combining technological platforms, and eliminating redundant corporate costs such as compliance, legal, administration, etc. would be hugely beneficial to boosting profit margins. One need only look at Bank of America Corp (BAC) after its expensive acquisition of Merrill Lynch to get a better feeling at what consolidation looks like. Obviously Bank of America has been burdened tremendously by Countrywide but Merrill Lynch has been solidly profitable, and the combination of the two companies has enabled much improved cross-selling. This low cost form of growth is more paramount to the industry than it has ever been, as any good business person knows that the deeper the relationship with the client, the longer you are likely to keep them. Bank of America has stabilized Merrill Lynch's funding needs, and the combined company has been able to pare down debt at an astonishingly rapid rate. When capital markets improve Merrill Lynch will give Bank of America much more leverage to maximize capital allocation, and already the combined company has garnered underwriting and M&A deals that they would never have been able to get as two separate entities.

Citigroup would make the most sense as an acquirer because Morgan Stanley has already completed the integration of the Smith Barney wealth management division to one technological platform. Bringing in 42,000 employees was an expensive and time consuming project, and as opposed to Citigroup selling Smith Barney at a price that they may not deem to be reflective of intrinsic value, it might make sense just to buy all of Morgan Stanley outright. Intertwining the investment banking operations of Citigroup and Morgan Stanley would be extremely beneficial for both sides. Citigroup has a one of a kind global presence beyond what Morgan can offer, which would expand the combined company's operations without requiring the type of capital intensive build-out that would be required if Morgan were to continue on its own. Asset management is a growing business and developing markets present a real opportunity to obtain real growth beyond what is available in North America. Morgan Stanley has exceptional relationships with high net worth clients and corporations which could be leveraged through Citigroup's commercial banking operations through an aggressive cross-selling program. Citigroup would also provide a stronger deposit franchise than what Morgan Stanley currently possess reducing reliance on a wholesale funding business model, which has proved troublesome in the past for standalone investment banks.

Wells Fargo may seem like an odd fit but management has already demonstrated a laser like focus at managing a huge integration when they bought Wachovia during the depths of the financial crisis. Wells Fargo without a doubt has the best consumer banking business of the large banks, and Morgan Stanley would provide their exceptional wealth management platform to make Wells Fargo one of the top asset managers in the country. Wells Fargo loves fee driven income streams and cross-selling, and Morgan Stanley would offer a low cost way to meaningfully increase the already dynamic earnings power of Wells Fargo's operations. Also Wells Fargo already controls roughly 1/3rd of the U.S. mortgage market and close to 10% of the deposits, so Morgan Stanley's international footprint might enable Wells Fargo to cherry pick business and client relationships that could provide another leg of growth outside of the United States in the future. Management at Wells Fargo is opportunistic and while investment banking has never been their cup of tea, they did increase their exposure with Wachovia, and Morgan Stanley could give them a world class presence far beyond what they could generate internally. Lastly it is important to consider that Morgan Stanley has altered many of its businesses already to less risky flow-driven activities that I believe Wells Fargo would understand and be comfortable with.

I understand that the supermarket banking business model has not been extremely successful in the past, but if you look at who weathered the Financial Crisis the best, one could certainly point to JP Morgan which has this type of model. Just last year we saw what one horrendously researched report by Egan Jones did to disrupt Jefferies Group Inc. (JEF) business and funding sources during a relatively mild environment, compared to what we saw in 2008-2009. Dodd-Frank has been a complete game changer and while Morgan Stanley's stock at the current price offers a truly compelling value, as a shareholder I certainly believe that a combination with one of the larger money center banks mentioned would create an extremely powerful force, particularly with the European banks pulling back as part of their deleveraging process. I doubt it will happen in the near term as there is so much uncertainty, but I'd love to see a real visionary CEO actually move forward and take advantage of buying a healthy, world class franchise at a fraction of intrinsic value while the opportunity exists.

Disclosure: I am long MS, WFC, C, BAC.

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