Morgan Stanley: Short-Term Problems, Long-Term Growth
Summary
- Morgan Stanley's share price fell after its Q1 2021 results were reported.
- Despite the Archegos debacle, the bank is poised to perform well due to its acquisitions of E*Trade and Eaton Vance.
- It trades at a 8% discount to fair value.
When Morgan Stanley (NYSE:MS) suffered a 1.8% hit to its share price on 04/16/2021, it demonstrated the short-term irrationality of Mr. Market and the danger of missing the forest for the trees. Overall, Morgan Stanley looks set to perform well going forward, has performed well despite its setback, and currently trades at a discount to fair value.
The setback that prompted the share price fall was the Bloomberg report that Morgan Stanley lost $911 million in the Archegos Capital Management debacle. Archegos was an institutional client of many different banks, including Morgan Stanley. However, the investment management firm had $10 billion in assets but $30 billion in exposure to the stock market - exposure that was acquired through total return swaps and other risky methods. In the end, Archegos could not pay back its lenders, leading them to sell its market positions and essentially cause Archegos to collapse.
A loss of nearly a billion dollars would make any dent to investor confidence understandable. However, CEO James Gorman has dismissed the loss as immaterial - and on the basis of how Morgan Stanley performed in Q1 2021, it's hard to disagree with his assessment. After all, Q1 2021 saw Morgan Stanley generate $15.7 billion in revenue - an increase on $9.5 billion in Q1 2020, while net income for Q1 2021 was $4.1 billion, which trumps the previous year's figure of $2.4 billion. That easily offsets the loss incurred by the collapse of Archegos - a one-time event.
The key takeaway is what drove those figures - while overall results are impressive, the fact that Morgan Stanley's institutional securities business pushed net revenue up 66% is heartening news for shareholders, considering that it was this segment that lost $911 million due to the Archegos debacle. And going forward, the institutional securities business will continue to be a growing money maker for Morgan Stanley due to two recent acquisitions.
On 10/02/2020, Morgan Stanley acquired discount broker E*Trade (ETFC) and on 03/01/2021, the bank acquired asset manager Eaton Vance (EV). These acquisitions have expanded Morgan Stanley's customer base at the expense of Goldman Sachs (GS), which was also seeking E*Trade. They have also increased Morgan Stanley's client assets under the Wealth Management and Investment Management segments to more than $5.4 trillion.
These factors should leave shareholders salivating, as they have already benefited over the past year from their Morgan Stanley holding with return on equity (trailing twelve months) of 12.68%. They suggest that profitability for Morgan Stanley is likely to continue the trend that has been established over the past five years.
| Year | Interest Income ($) | Net Income ($) |
| 2016 | 7.02 billion | 5.98 billion |
| 2017 | 9 billion | 6.13 billion |
| 2018 | 13.89 billion | 8.75 billion |
| 2019 | 17.1 billion | 9.04 billion |
| 2020 | 10.16 billion | 11 billion |
Figures collated from annual reports available on Morgan Stanley's investor relations page.
Why is profitability likely to continue due to these acquisitions? Prior to the 2008 economic crash, investment banks such as Morgan Stanley and its nearest competitor Goldman Sachs (GS) were not permitted to engage in commercial consumer banking. However, with the financial crisis forcing the Fed's hand, investment banks were permitted to become commercial banks. This allowed them to access funds through borrowing by making use of the discount window that the Fed allows commercial banks to avail of.
Because they could borrow billions at low rates, investment banks were able to stabilize their operations by diversifying into other areas. They were also able to access the middle-class markets in a way they simply had not done so before. This allowed them to diversify their operations and make them stronger in the face of any potential crises that may come in the years ahead.
Of the two, Morgan Stanley seems better placed due to how its acquisitions have diversified its revenue streams. The E*Trade acquisition alone brought $3.3 trillion in wealth management assets under Morgan Stanley's purview, making it the largest wealth management player in the United States. In addition, with E*Trade comes a larger presence in online brokerage and digital banking.
As for the Eaton Vance acquisition, this adds $500 billion in AUM (assets under management) to Morgan Stanley's investment management segment, giving it a total of $1.2 trillion in AUM. Furthermore, Eaton Vance's individual and institutional accounts should dovetail perfectly with the mutual funds that Morgan Stanley offers.
Both acquisitions will bolster the wealth management and investment management segments of Morgan Stanley's business, with management projecting that the acquisitions will help both segments generate 58% of pre-tax profit on a pro-forma basis. This is a significant increase on the 26% that both segments contributed to profits in 2010, and attests to the increasing diversification from investment banking alone.
That is not to say that everything will be plain sailing going forward. Automated investment service providers such as Wealthfront can undercut larger firms such as Morgan Stanley by offering inexpensive alternatives on the wealth management front. However, Morgan Stanley's brand name, advisor network, large client base and greater capital resources all provide it with significant advantages in facing this threat.
Legal issues are another concern that Morgan Stanley still has to contend with - the bank continues to deal with the fallout of the 2015 hack when one of its employees harvest customer data for personal profit, and a data center oversight which exposed unnecessary risks. The data breach continues to be a black cloud over Morgan Stanley, one which cost it $1 million in a fine levied by the SEC and a further $60 million in settlements, and it would be unwise to assume that no further legal issues are likely to occur.
However, in the face of these issues - and the threat of further economic disruption - Morgan Stanley is well-placed to thrive. The firm did take a hit in interest income in 2020 due to COVID-19, but still increased net income for the 2020 financial year from 2019 by 21.61%. This illustrates that Morgan Stanley's diversification of its revenue streams away from the investment banking legacy business is literally paying off for the bank.
Even better is the fact that despite its steady profitability, and a dividend growth record of seven years (coupled with a dividend payment record of twenty-three years), Morgan Stanley looks to be trading at a bargain price at this time.
At close of market on 04/30/2021, Morgan Stanley traded at $82.55 per share. Chart generated by FinViz.
At close of market on 04/30/2021, Morgan Stanley traded at a share price of $82.55 with a trailing price-to-earnings ratio of 10.98 with a trailing earnings-per-share of $7.62 and a forward P/E of 12.06 with a forward earnings-per-share of $6.93. Both metrics are around the five-year average P/E of 11.89, but the current dividend yield of 1.67% is lower than the five-year average dividend yield of 2.31%. This somewhat mixed picture prompts the question of what fair value for Morgan Stanley is.
Using a modified version of the valuation technique outlined by David Van Knapp, I will first divide the trailing P/E by the historical market average of 15 to get a valuation ratio of 0.73 (10.98 / 15 = 0.73) and divide the current share price by this valuation ratio to get a first estimate for fair value of $113.08 (82.55 / 0.73 = 113.08). Then I will divide the trailing P/E by the five-year average P/E to get a valuation ratio of 0.92 (10.98 / 11.89 = 0.92) and divide the current share price by this valuation ratio to get a second estimate for fair value of $89.72 (82.55 / 0.92 = 89.72).
Next, I will divide the forward P/E by the historical market average to get a valuation ratio of 0.80 (12.06 / 15 = 0.80) and divide the current share price by this valuation ratio to get a third estimate for fair value of $103.19 (82.55 / 0.80 = 103.19). Then I will divide the forward P/E by the five-year average P/E to get a valuation ratio of 1.01 (12.06 / 11.89 = 1.01) and divide the current share price by this valuation ratio to get a fourth estimate for fair value of $81.73 (82.55 / 1.01 = 81.73).
Next, I will divide the five-year average dividend yield by the current dividend yield to get a valuation ratio of 1.38 (2.31 / 1.67 = 1.38) and divide the current share price by this valuation ratio to get a fifth estimate for fair value of $59.82 (82.55 / 1.38 = 59.82). Finally, I will average out these five different estimates to get a final estimate for fair value of $89.51 (113.08 + 89.72 + 103.19 + 81.73 + 59.82 / 5 = 89.51). On the basis of this estimate, the stock is undervalued by 8% at this time - a conclusion reinforced by the fact that the price-to-book value of the stock is 1.56, a significant discount to the securities, commodities contracts and financial investment sub-sector average of 18.08.
In summary, despite the Archegos debacle, Morgan Stanley is likely to be a long-term winner. Its steady profitability and consistent dividend record looks set to continue, supported as it is by the growth and diversification that its E*Trade and Eaton Vance acquisitions has garnered for it. And at a 9% discount to fair value, this large bank is a clear buy.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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