Despite Weak Q3, Morgan Stanley’s Balanced Business Model Supports $41 Valuation

Morgan Stanley (NYSE:MS) saw its share price sink nearly 5% over trading on Monday, October 19, after reporting a worse-than-expected performance for the third quarter of the year. ((3Q2015 Earnings Release, Morgan Stanley Press Releases, Oct 19 2015)) Investor expectations for the investment banking giant were tempered to a large extent by the weak trading revenues reported by rivals Goldman Sachs (NYSE:GS), JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) last week. But the fact that Morgan Stanley’s trading revenues took a sizable hit despite its focus on equities trading (in contrast to the larger emphasis on debt trading operations by peers) did not go over well with investors. An unexpected pre-tax loss for the bank’s investment management division in Q3 after a record performance in Q2 only made things worse for Morgan Stanley.

That said, the one-off poor performance for Morgan Stanley this quarter does not reflect the strength of its revamped business model. With the bank choosing to water down its fixed income trading division, and to concentrate its efforts on growing its wealth management operations over the years, its current structure is definitely more resilient to an increase in market volatility compared to its peers. This is evidenced by the fact that Morgan Stanley’s wealth management arm reported a year-on-year improvement in profits despite generating lower revenues compared to the year-ago period. Also, Morgan Stanley remains the country’s best capitalized banking giant by a significant margin, which should help the bank boost its capital return plans considerably early next year.

As a result of these key factors, we maintain our $41 price estimate for Morgan Stanley’s stock, which is about 20% ahead of the current market price.

See our full analysis of Morgan Stanley

Equities Trading Saw Solid Results Given The Circumstances

Unlike its other major competitors in the U.S., Morgan Stanley’s new business model relies more on equity trading operations than fixed income operations to generate value due to a conscious decision by the bank to scale down the latter. This fact is evident from the chart above, which shows that equities trading accounts for about 26% of the investment bank’s total share value compared to a figure of just 15% for FICC (fixed income, currencies and commodities) trading.

Since early 2013, Morgan Stanley’s equities trading desk has established itself as a leader in the global equities trading industry – garnering more revenues from these operations than any other bank worldwide in most quarters. This was true for Q3 2015 as well, when the bank roped in equities trading revenues of $1.77 billion (adjusted for debt revaluation gains) – almost identical to the figure a year ago. Although these revenues fell 22% sequentially, it should be noted that Q2 was the best quarter for the bank’s equities unit since the economic downturn of 2008 thanks to an exceptionally strong performance.

As for the bank’s FICC trading desk, the smaller size compared to peers meant that the overall slowdown in the industry would have a more adverse impact on the change in revenues. FICC trading revenues (adjusted for debt revaluation gains) fell from $1 billion in Q3 2014 and $1.27 billion in Q2 2015 to less than $600 million in Q3 2015 – a 40% reduction year-on-year and a decline of 53% sequentially. This in turn dragged down total adjusted trading revenues to $2.35 billion this quarter from almost $2.8 billion a year ago.

Wealth Management Maintains Profits Despite Revenue Pressure

Over the last few years, Morgan Stanley has relied heavily on its wealth management operations to provide a stable source of income in what was once seen as an extremely volatile trading-driven business model. Having achieved the self-imposed 17% margin target for the business well before the 2014 deadline, Morgan Stanley has pushed the envelope each quarter and set itself a new target of 25% to be achieved by the end of 2015. ^[1]

Although Morgan Stanley’s plans hit a bump due to adverse economic conditions in Q3, the bank did well to ensure that the margin figure did not decline much from the record levels achieved in Q2. The wealth management division saw total revenues fall from the record high of $3.88 billion in the previous quarter to $3.64 billion due to lower trading-related income. At the same time, total operating expenses fell 5% year-on-year to $2.8 billion – allowing Morgan Stanley to report a 3% improvement in pre-tax incomes compared to the figure a year ago. The pre-tax operating margin figure for Q3 2015 was 22.6% – marginally below the 22.8% figure seen in the previous quarter but well above the 21.2% level reported last year. Assuming that the overall economic environment improves slightly in Q4, Morgan Stanley should be able to achieve its 25% pre-tax margin target thanks to its improved operating efficiency.

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1. Q4 Strategic Update, Morgan Stanley Press Releases, Jan 20 2015 [↩]