Morgan Stanley Reveals Additional Changes To Business Model After Mixed Q4 Results

+8.30%
Upside
87.96
Market
95.26
Trefis
MS: Morgan Stanley logo
MS
Morgan Stanley

Earlier this week, Morgan Stanley (NYSE:MS) reported fourth quarter results which reiterated the same trends that its competitors have detailed in their respective earnings announcements over recent weeks. [1] While the top line came under pressure from weak trading revenues, the impact was mitigated to a great extent by a surge in interest income – the result of Morgan Stanley’s growing loans-and-deposits base. Net interest income crossed the $1 billion mark in Q4 2015 from $762 million in the previous quarter and $603 million a year ago, making revenue figures for each of the three quarters identical. Also, operating expenses remained unchanged compared to the previous quarter, and as a result there was no sequential change in pre-tax profits. As investors actually expected worse, they welcomed Morgan Stanley’s results by leading the bank’s shares 2% higher over trading on Tuesday, January 19.

Morgan Stanley also reinforced its position as the best-capitalized U.S. banking giant by raising its common equity tier 1 (CET1) capital ratio to 14.1% (fully-phased in) – well above its 10% regulatory requirement. However, the excess capital coupled with the sub-par performance over the last quarter dragged down the bank’s returns of equity (ROE) figure considerably. Morgan Stanley’s ROE for Q4 2015 (adjusted for accounting changes related to debt revaluation) was 4.9% – less than half the target figure of 10%. This forced the bank’s management to detail additional changes to its business model primarily focused around shrinking its fixed income trading operations further while reducing operating expenses across division. [2]

Relevant Articles
  1. Trailing S&P500 By 31% Since The Start Of 2023, Will Morgan Stanley Stock Close The Gap?
  2. Up 10% In The Last One Month, What’s Next For Morgan Stanley Stock?
  3. Where Is Morgan Stanley Stock headed?
  4. What To Expect From Morgan Stanley Stock?
  5. What To Expect From Morgan Stanley Stock?
  6. What To Expect From Morgan Stanley Stock?

The key changes proposed by Morgan Stanley in its strategic update to meet its ROE target are:

  • Free up excess capital from the fixed income, currencies and commodities (FICC) trading division by reducing the size of risk-weighed assets (RWAs) by an additional ~$30 billion over the coming years. This will involve exiting more units that are not strategically important, and also reducing headcount for strategic units by 25%
  • Cut operating costs by reducing compensation expenses as a percentage of revenues for all divisions, shifting operations to low-cost locations where feasible, leveraging technology solutions and outsourcing additional processes. Aim is to save $1 billion in recurring costs by 2017.
  • Increase profits for cornerstone wealth management division by pushing more loans-and-deposits products, and trying to boost pre-tax margins for the division to 25%
  • Return more capital to shareholders through dividends and buybacks. This is subject to regulatory approval as a part of the Fed’s annual stress tests for banks, but Morgan Stanley is unlikely to face any major hurdles due to its excessively high capital ratio figures.

Morgan Stanley’s shares have borne the brunt of the weak ROE figures over the last two quarters, which is why they trade at a discount of 30% to their book value. The overall decline in equity market valuations over recent weeks have only made things worse. But we believe that the bank is taking important steps in the right direction to unlock value, and have a $38 price estimate for Morgan Stanley’s stock. This is roughly 50% ahead of the current market price.

See our full analysis of Morgan Stanley

Move To Shrink FICC Unit Changes Business Model 

Unlike its other major competitors in the U.S., Morgan Stanley’s new business model relies much 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. The only other global banking giant to pursue a similar strategy is UBS, which also aims to focus on wealth management and equity trading to grow profits. As seen in the chart above, we expect nearly 35% of Morgan Stanley’s total value to come from its wealth management division, followed by equity trading (27%). The FICC (fixed income, currencies and commodities) trading accounts for just 11% of the bank’s total value. This is in sharp contrast to the situation in 2006, when FICC trading revenues were responsible for nearly one-third of Morgan Stanley’s overall revenues.

Morgan Stanley’s total trading revenues for Q4 2015 were $2.4 billion (adjusted for debt revaluation gains), with the equities trading desk making $1.8 billion and the fixed-income desk making $550 million. This is marginally better than the figure for the previous quarter and a good 35% higher than the exceptionally weak Q4 2014, when total trading revenues fell to below $1.8 billion. Although concerns about China’s economic growth and the steady decline in oil prices are likely to weigh on equity trading revenues for the current quarter, the increased levels of activity in the trading industry over the first quarter of a year should boost revenues for Q1 2016.

Pushing Wealth Management Margins To 25% Will Take Effort 

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 in Q4 2012, Morgan Stanley has pushed the envelope each quarter since then and now aims margins in the 23%-25% range for 2017. [2] A benchmark for these margins is obtained from rival Bank of America-Merrill Lynch, which routinely reports a figure around 28%. But it must be remembered here that BofA’s diversified business model affords it much more cross-selling opportunities.

The highest level of pre-tax margins reported by Morgan Stanley’s wealth management division was 22.8% in Q2 2015. However, the figure nudged lower to 22.6% in Q3 and fell further to 20.5% in Q4 due to weak equity market conditions. There are some encouraging trends that emerge in the division’s performance, though. Firstly, the bank’s efforts to cross-sell more products has seen deposits jump 7% from $139 billion in Q3 2015 to $147 billion in Q4 2015. Total loans for the division have also grown to almost $50 billion – representing a sharp 31% growth compared to the figure a year ago. While this has helped fuel revenue growth, Morgan Stanley has shrunk its retail presence from 622 locations at the end of 2014 to 608 now in a bid to cut operating costs. Although we doubt that there are many more cost saving opportunities for Morgan Stanley in this business, there is definitely considerable opportunity to grow the top line. You can see how improving margins affects Morgan Stanley’s share value by making changes to the chart below.

View Interactive Institutional Research (Powered by Trefis):
Global Large CapU.S. Mid & Small CapEuropean Large & Mid Cap
More Trefis Research

Notes:
  1. Morgan Stanley Reports Fourth Quarter 2015, Morgan Stanley Press Releases, Jan 19 2016 []
  2. Morgan Stanley 4Q15 Strategic Update, Morgan Stanley Press Releases, Jan 19 2016 [] []