Morgan Stanley: Attractive Profile But Better Value Exists Elsewhere

Summary

• Morgan Stanley has an interesting business profile with relatively good growth prospects, especially due to its large exposure to wealth management.
• Its operating momentum has been strong and profitability is improving towards its target, with further upside coming mainly from macroeconomic factors.
• Its capitalization is strong leading to increasing capital returns. However, its current valuation already reflects this profile and better value exists elsewhere in the sector.

Morgan Stanley (NYSE:MS) has a much more attractive business profile than a few years ago, being now focused on wealth management and equities giving it relatively good growth prospects. Its operating momentum has improved after several years of weak results and should be supported from positive macroeconomic factors. Its capitalization is strong, allowing for an attractive and growing capital return policy, but this profile seems to be already reflected in its valuation. Therefore, Morgan Stanley does not appear to be particularly cheap and better value can be found elsewhere among large U.S. banks.

Company Overview

Morgan Stanley is a global financial services company. It has about 55,000 employees worldwide and a market capitalization of $84 billion. Its business is divided across three main segments, namely Institutional Securities, Wealth Management and Investment Management. Despite its global presence, about 75% of its revenues are still generated in the Americas.

Morgan Stanley is one of the largest players within the investment banking industry, enjoying a significant market share in each of its business segments. This industry is characterized by its global reach and strong competition, a profile that isn't expected to change anytime soon. Its main competitors are other global banks with large investment banking and wealth management operations, including Goldman Sachs (GS), Deutsche Bank (DB) or UBS Group (UBS).

Morgan Stanley's largest business is Institutional Securities (investment banking), accounting for about half of its revenues. Like most investment banks, Morgan has cut assets and staff in its fixed-income business following the global financial crisis and its revenue mix is now more exposed to equities and advisory, compared to its peers.

Its equities franchise account s for about half of its revenues within this business segment, the highest weight compared to other large U.S. investment banks. For instance, Goldman's generates 33% of IB revenues from equities, while Citigroup is the bank less exposed to equities (only 14% of IB revenues). This makes it highly exposed to capital markets, which are cyclical and volatile by nature leading to low visibility on its earnings power over the long-term.

Even though Morgan Stanley's main business continues to be investment banking, it has shifted somewhat its focus over the past few years towards wealth management. It has purchased the remaining stake in Smith Barney in 2013, to increase this business weight within the group. During the past year, wealth management was responsible for about 44% of Morgan's revenue, while in 2009 its weight was only 32%.

Morgan Stanley also has a smaller asset management business, which may have some growth prospects due to its relatively low size compared to its main competitors. This unit generates a small part of revenues (about 5%) and is focused on institutional customers, after the sale of the retail unit a few years ago. However, with the rise of passive investing, which is driven largely by institutional investors, high growth may be difficult to achieve and therefore this unit's weight should remain relatively low within the group in the near future.

Financial Overview

Regarding its financial performance, Morgan Stanley has been negatively affected since the global financial crisis by a challenging operating environment and litigation costs related to past misconduct. Industry overcapacity and lower volumes in capital markets have been negative for the bank's revenues, while increasing and more complex regulation has resulted in higher costs. Additionally, the low interest rate environment and higher capital requirements have put downward pressure on profitability.

Reflecting this harsh landscape, Morgan Stanley has reported relatively low levels of profitability over the past few years, but its most recent performance has been more stable. In 2016, its revenue was $34.6 billion, representing a decrease of 1.5% from the previous year. Its Institutional Securities business was the major responsible for the revenue decline (-3% year-on-year in this unit), while wealth management increased revenues by 2%, showing that its growth strategy focused on this unit has been right.

Regarding its profitability, Morgan Stanley reported a pre-tax profit of $8.8 billion in 2016, representing an operating margin of 26%. Its Institutional Securities business is the most profitable one, enjoying a pre-tax margin of 29% in 2016, compared to 22% in Wealth Management and 14% in Investment Management. Nevertheless, the bank has a $1 billion cost-cutting program ongoing, targeting higher profit margin at its wealth management business (to 23-25%) and this should be an important earnings growth driver in the coming quarters.

Its net profit amounted to close to $6 billion, down 2.7% from 2015. Its earnings per share were $2.92, a small increase due to a lower number of shares. Its profitability declined a little bit, which measured by its return on equity [ROE] ratio was 8% in the past year. Morgan Stanley's target is to have an ROE of between 9-11% by 2017, thus this should be achievable in the next few quarters from higher earnings and share repurchases, which decrease its equity base.

In the first quarter of 2017, Morgan Stanley reported a good quarter, boosted by the good performance of its Institutional Securities business. Its net revenues amounted to $9.7 billion in the quarters, up by 24% from the same period of the previous year. This steep increase is justified by a weak first quarter in 2016, but also due to good business momentum in the past few months especially among fixed income sales and trading. Its Wealth Management business also reported higher revenues (+10% in the quarter) and pre-tax margin increased to 24%, within its target range for the year. Its annualized ROE was 10.7%, a very good level of profitability.

Going forward, Morgan Stanley should continue to report a good operating performance, boosted by positive capital markets, higher U.S. interest rates that support its Wealth Management business and potentially lower tax rates.

However, these factors are not unique to Morgan Stanley, given that it also benefits other U.S. peers, making the bank very reliant on macroeconomic or political factors to have upside to future earnings potential. This means that Morgan should do more work to improve efficiency and push its business in to growth areas, like Wealth Management in Asia which has good growth prospects in the long-term, to improve its earnings organically.

Capital Return

Regarding its capitalization, like most large U.S. banks, Morgan Stanley has increased significantly its capital ratios in the past few years and has now a very strong capitalization. At the end of the first quarter of 2017, its Fully Loaded Common Equity Tier 1 [FL CET1] ratio was 16.6% and its leverage ratio stood at 6.4%. This is well above the bank's capital requirements, providing it with an excess capital position that allows it to do accretive share buybacks and pay higher dividends.

Morgan Stanley has increased capital returns to shareholders over the past few years, both from growing dividends and share buybacks since 2013. In the past couple of years, its capital return increased significantly, from $1.6 billion in 2014 to $4.8 billion in 2016, with most capital returned through share buybacks.

Morgan Stanley's solid capitalization was recently confirmed by the Federal Reserve, due to the positive 2017 CCAR results and approval of Morgan Stanley's capital return plan despite its lower leverage ratio than peers in the adverse scenario. Indeed, among the large banks Morgan Stanley had the steepest fall in the leverage ratio to 3.8% (vs. 3% required to pass), due to its large trading book which have high losses in the adverse scenario. Nevertheless, its capital position is strong enough to allow higher capital returns in the next few quarters.

Shareholders will continue to benefit from meaningful capital return, through increased dividends and share buybacks in the next four quarters. The bank announced a $0.05 increase to $0.25 in its quarterly dividend to start in the third quarter, representing an annual dividend of $1 per share.

At its current share price, Morgan Stanley has a forward dividend yield of 2.2%. This yield is not among the highest among the banking sector, but it's close to the average for large U.S. banks. This represents a dividend payout ratio of about 30%, which is quite low and has room to grow over the coming years.

Regarding its share buyback program, the bank announced $5 billion to be completed within the next 12 months, representing an increase of 43% from the previous CCAR cycle, above the market expectations. This equates to a payout ratio of about 70%, leading to total capital return higher than its annual earnings (vs. 75% in 2016). This clearly shows that both Morgan Stanley and the Fed are comfortable with the bank's capital position, making its capital return policy quite attractive for shareholders.

Conclusion

Morgan Stanley's business profile is much more attractive than a few years ago, due to its higher exposure to wealth management and equities. Its good operating momentum in the past few quarters is helping to improve its ROE and capital returns are also interesting.

Nevertheless, this seems to be already reflected in its valuation, given that Morgan Stanley is trading at about 1.22x book value, which seems fair. Therefore, there seems to be better value elsewhere among large U.S. banks, namely on JP Morgan (JPM) due to its superior quality and capital returns and on Citigroup (C) because it has a cheaper valuation providing higher upside, as I've analyzed in my previous articles here and here.

Analyst’s Disclosure: I am/we are long C. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.