Morgan Stanley FICC Trading, Upside in Asset Management

Morgan Stanley (NYSE: MS) is a global financial services firm that is engaged in four distinct business areas: investment banking, sales & trading, wealth management for high net worth individuals and asset management. It competes with other global financial services firms like Goldman Sachs (NYSE:GS), Citigroup (NYSE:C), UBS (NYSE:UBS) and Credit Suisse (NYSE: CS).

We believe that sales & trading is the largest driver of value for Morgan Stanley. We estimate that bonds, currencies & commodities trading constitutes around 26% of our $21.54 price estimate for Morgan Stanley’s stock, with equities trading contributing around 20%.

Difficult Trading Environment in 2010 …

Morgan Stanley’s Q3 net revenues from fixed income sales and trading was $846 million, as compared to $2 billion in the same quarter last year. In the fourth quarter, trading volumes and liquidity have been down in the Bonds, Currencies & Commodities segment, also known as FICC (Fixed Income, Currencies & Commodties). This is largely due to sovereign debt risk and interest rate volatility in Europe. ^[1]

Morgan Stanley’s yield on trading assets for FICC decreased to around 0% in 2007 due to the economic downturn. However, it recovered to 2.14% in 2009 as the economic environment improved. As volumes increase and returns improve across asset classes, we expect the Morgan Stanley’s yield on FICC trading to follow an increasing trend, reaching nearly 3% towards the end of the Trefis forecast period.

However, if the recent downfall in FICC trading extends into the first few quarters of 2011, this can provide a downside to our forecasts. If Morgan Stanley’s yield of FICC trading falls below 2% in 2011 and increases to around 2.5% by the end of our forecast period, it would mean a downside of around 8% to our current price estimate for Morgan Stanley’s stock.

… But Potential Upside from Asset Management

We estimate that Morgan Stanley’s Asset Management division accounts for around 7% of our $21.54 price estimate for Morgan Stanley’s stock. This division has been doing well in 2010. In Q3 2010, the revenues from this division was around $800 million, around an 80% increase from the same quarter last year. For the first 3 quarters, the total revenues from this division is $1.86 billion, around 125% increase from the same period last year.

The outlook for 2011 looks positive for this division with Morgan Stanley raising $1 billion for its first corporate mezzanine fund. This makes Morgan Stanley only the fifth firm since January 2009 to launch a mezzanine fund in excess of $700 million. The fund looks to focus primarily on fixed income securities issued by middle market companies where the company believes that there will be a supply/demand imbalance for capital over the next few years leading to higher yields on the bonds issued by this segment. ^[2]

For the Asset Management division, the fee as % of Assets Under Management (AUM) decreased from 0.7% in 2005 to 0.2% in 2009, with Morgan Stanley cutting fees to hold on to clients in an increasingly competitive market. However, it increased to 0.5% in 2009 and, going forward, we expect it to further increase to around 0.6% in the coming years, with the economic recovery increasing commissions.

If the company reports strong results for the Asset Management division in the first few quarters of 2011, there could be upside to our forecasts. If the fee improves from 0.6% to around 0.8% by the end of our forecast period, it would mean around 5% upside to our current price estimate for Morgan Stanley’s stock.

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1. Earnings Preview: US Investment Banks Suffer 4Q Trading Decline [↩]
2. Update: Morgan Stanley Mezzanine Fund raises Nearly $1 B, WSJ Online, January 12, 2011 [↩]