Morgan Stanley Is Deeply Undervalued Despite Awful Earnings

Morgan Stanley (NYSE:MS) announced its results for the second quarter of the year last Thursday, and the numbers clearly showed that the bank is dealing with some big problems. At first glance it appeared as though the bank’s performance improved significantly from last quarter, but that impression is squashed almost immediately when the accounting adjustment from a revaluation of its debt (DVA) is factored in.

The global investment bank’s unadjusted Q2 2012 revenues of $6.6 billion are well below the $8.9 billion figure for both Q1 2012 and Q2 2011 with declines seen across all of its business segments. ^[1] While the quarter was expected to be a difficult one for investment banks, Morgan Stanley took a particularly bad beating from the two-notch ratings downgrade from Moody’s late last month.

See our complete analysis for Morgan Stanley

We revised our price estimate for Morgan Stanley’s stock downwards from $23 to $19. Our primary reasons for the substantial reduction in the bank’s share price are:

• Moody’s rating downgrade is expected to cost Morgan Stanley at least $6.3 billion in additional collateral and/or payments. This would essentially increase the bank’s funding costs considerably in the future – something which will result in a reduction in yield figures across its operating segments.
• Morgan Stanley continues to have a significant exposure to the peripheral European nations. The bank’s unhedged exposure to these economies at the end of Q2 was $5.4 billion – with almost 90% being accounted for by Italy (54%) and Spain (36%). The deteriorating situation in Europe makes a large chunk of this exposure questionable – leading us to cut our growth estimates for Morgan Stanley’s trading yields and asset growth in coming quarters.

Notably, our new estimate is still nearly 50% above current market prices – something we believe is because of significant pessimism among investors toward the financial sector in general and investment banks in particular.

Bad Times And Worse Luck, Hit Trading Operations

Global capital markets have been going downhill for a large part of 2012 with conditions similar to those during the second half of 2011 keeping volatility high and investors shy. The bond trading business for investment banks was expected to be impacted the most by the turmoil in Eurozone. Morgan Stanley’s results only validate the belief. And the additional burden from a downgrade in ratings downgrade only exacerbated matters.

Debt trading revenues fell by nearly half compared to Q2 2011 while remaining almost flat compared to Q1 2012. Equity trading revenues of $1.2 billion shrunk 16% from the figure for the previous quarter, and more than a third from the number for the same period last year. But these reported figures include debt revaluation adjustments of $350 million, -$2 billion and $244 million for Q2 2012, Q1 2012 and Q2 2011 respectively – something which shows that operating revenues from trading fell drastically this quarter.

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1. Morgan Stanley Reports Second Quarter 2012, Morgan Stanley Investor News, Jul 19 2012 [↩]