We believe that Morgan Stanley (MS) has the weakest position amongst large cap banks in the U.S. The Financial Select Sector SPDR (XLF) ETF is up 16% YTD while Morgan Stanley's share price has appreciated only 1% since the beginning of the year. The bank is trading at a significant discount to its book value. However, the bank's poor operating performance and its inability to gain a market share in the bonds trading business, reflects the opportunity that it is missing. We recommend investors to short Morgan Stanley with a 5% stop loss. The remaining investment thesis seeks to explore the reasons why we are bearish on the stock.
Operating as a global financial services organization, Morgan Stanley provides financial products to a variety of clients, including individuals, corporate and governments. For the purpose of reporting, the company is organized into the following three business segments: Institutional Securities, Global Wealth Management Group, and Asset Management. The bank relies mostly on its Institutional Securities and Global Wealth Management Group segments. Revenues from both these segments constitute 94% of the entire revenues of the bank, with Global Wealth Management Group's revenues alone constituting 47.5%. Revenues from the Asset Management segment constituted only 6.6% of the bank's total revenues generated during the second quarter of the current year.
For the purpose of disclosure, the bank has classified the geographical regions it operates in into the following three: Americas, Europe, and the last being Middle East, and Africa and Asia. Over 73% of 2Q2012 revenues came from Americas, followed by Europe at 14%, and the Middle East, and Africa and Asia at 12%, respectively.
Recent Quarter's Performance
On July 19, 2012, Morgan Stanley reported a weak operating performance for the second quarter of the current year. The bond trading business of the bank was largely to be blamed for this disappointing performance. The bank relies heavily on fee based income, from which MS derives most of its revenues. Net revenues for the bank decreased 25% to $7 billion when compared to revenues of the same quarter last year. Net revenues dropped largely due to a decrease in revenues accruing from investment banking, trading and a decrease in the interest income earned during the second quarter of the current year. A favorable impact of $350 million resulting from the bank's debt value adjustment (DVA) was included in the turnover. Favorable impact from the DVA occurred due to changes in the fair value of the bank's debt.
The bank was able to manage its expenses well during the past one year. Other non-interest expenses decreased 17% to reach $6.01 billion. The drop in expenses was largely attributed to a 21.4% decrease in compensation and benefits paid by the bank.
The bottom line of $750 million or $0.16 per share that the company earned was far below consensus expectations of $0.43 per share. The bank's bottom line missed analyst expectations by 62.8%. When compared to the net income of the previous year, the bottom line witnessed a significant drop of 47%.
Revenues of $3.2 billion from this segment were 37% below those of the same quarter last year. The drop in revenues of this segment was attributed to a 40% decrease in the revenues coming from investment banking. The segment's results were hit hard due to the weak overall activity in the U.S. capital markets. Revenues coming from advisory services and fixed income underwriting fell by one half and one third to $263 million and $621 million, respectively. The bank's bonds trading segment performed the worst during the second quarter of the current year. This is against an 11% gain in same business of Goldman Sachs (GS). This reflects the bank's inability to grow one of its primarily businesses, in which its competitors gained a market share.
Global Wealth Management Group
With the integration of the Smith Barney operations, this segment has seen dramatic changes. Revenues of $3.31 billion from this segment decreased by a modest 4% compared to the prior year. The decrease in revenues was largely due to an 18% and 23% decrease in revenues accruing from the bank's Transactional and Trading activities, respectively. The segment's bottom line of $172 million witnessed a decline of 11% as compared to the linked quarter.
Turnover from this segment also witnessed a decline from $636 million a year ago to $456 million in the second quarter of the current year. The bank's Merchant Banking business and lower investment gain were the primary reasons for such a decline. The Asset Management segment contributed $14 million to the bank's net income, $11 million below its contributions in the previous quarter.
Capital and Liquidity Position
The bank maintains a Tier 1 capital ratio of 17.2%, as opposed to the 6% regulatory requirement. The bank's total capital ratio stands at 18.4% against the 10% regulatory requirement. Both the Tier 1 capital and the total capital ratios have improved since the beginning of the year by 100bps and 90bps, respectively. At the end of the second quarter, the book value of the bank was $31 per common share. The Tier 1 capital ratio and total capital ratio of Goldman Sachs are 15% and 18.1%, respectively.
Morgan Stanley's stock trades at a significant discount of 52% to its book value. As opposed to this, the stock of Goldman Sachs and JPMorgan (JPM) trade at discounts of 25% and 23%. The forward P/E ratio for Morgan Stanley is 7.86 times. Compared to this, the P/E ratios of Goldman Sachs and JPMorgan are 8.5 times and 7 times.