Top executives at Morgan Stanley (NYSE:MS) are reportedly exploring ways to slash compensation costs for its wealth management business in a manner that does not negatively impact the division’s revenue potential.  As cutting salaries across the board will clearly hurt the division’s long-term profitability, the bank is looking to reduce pay for underperforming financial advisors and is likely to drastically reduce joining bonuses to new advisors. The move is a part of CEO James Gorman’s organization-wide cost cutting plan which targets a compensation ratio of 55% for the wealth management business – down from the division’s reported compensation ratio of 60% in Q1 2014.
Morgan Stanley’s wealth management unit has become the cornerstone of its business model over recent years – generating about 44% of the bank’s total revenues and accounting for 57% of its total pre-tax income in 2013. But opportunities to squeeze out more value from the operations still exist owing to its rather high compensation ratio figures. After all, compensation costs for the wealth management unit is responsible for more than half of Morgan Stanley’s total employee-related expenses even though financial advisors form only about 30% of its total workforce. The task of reducing these expenses, though, is easier said than done, as we detail in this article.
We maintain a $35 price estimate for Morgan Stanley’s stock, which is roughly 10% ahead of its current market price.
Improving Profitability For Wealth Management Operations Presents A Substantial Upside . . .
Since Morgan Stanley acquired a majority stake in Smith Barney from Citigroup in January 2009, the large brokerage business emerged as the best candidate for the investment bank to ensure a steady revenue stream in what was earlier a business model with highly volatile revenues. Over the years, the focus on these operations increased as the bank acquired a 100% stake in the unit and re-christened it Morgan Stanley Wealth Management. But it has been a bumpy ride, with the bank struggling to integrate its legacy wealth management business with Smith Barney – leading to pre-tax margins of less than 12% between 2009-2012. Efforts to improve revenues (see Three Ways Morgan Stanley Can Grow Its Wealth Management Business) coupled with a revamped structure saw margins cross 19% by Q1 2014.
But all these efforts did not do much to improve compensation ratios, which remained between 60% and 62% between 2009 and 2013. Now, the wealth management operations make around $3.7 billion in revenues each quarter. So the current compensation ratios signify payouts of almost $2.2 billion to employees. In comparison, Morgan Stanley’s institutional securities and investment management operating divisions report compensation ratios around 40%.
While the more human-intensive wealth management operations cannot target similar compensation ratios, a figure of 55% certainly looks achievable. The five percentage points improvement translates to quarterly savings of just under $200 million – or roughly $800 million a year. Going by Q1 2014 results, this represents a pre-tax operating margin of 23.5% for the wealth management division. As you can see by making changes to the chart below, such an improvement presents an upside potential of 7% to our price estimate for Morgan Stanley.
. . . But Things Could Go Very Wrong In Case Of A Misstep
The problem with cutting compensation for brokers is that it will only make things easier for competitors to poach them in this extremely competitive environment for the wealth management industry. As brokers usually take their clients’ business along with them, this would mean a loss of customers for Morgan Stanley – putting downward pressure on the portfolio of client assets managed by it.
To put things in perspective, suppose that the annual rate of growth of Morgan Stanley’s client assets is 2% in the future instead of the 3% we currently estimate in the chart below. Such a change shaves off roughly 5% from our estimate for the bank’s share value. And things can get much worse than this, if the client assets end up declining due to a number of brokers jumping ship. This would explain why the bank is exploring options like cutting pay for poorly performing brokers (so that there is negligible impact on the client base even if they leave the company) and reducing joining balances for experienced new hires (which on many occasions ends up costing Morgan Stanley more than all potential revenues from hiring).Notes:
- Morgan Stanley eyes compensation cuts for financial advisers: sources, Reuters, Jul 1 2014 [↩]