Morgan Stanley’s Q1 Results Show That Its Long-Term Growth Plan Is Aligned With U.S. Economic Outlook

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The first quarter of 2017 saw the Fed’s rate hike and a rally in equity markets give a boost to securities trading activity while also creating an environment conducive for wealth management operations – the ideal conditions for Morgan Stanley (NYSE:MS) to demonstrate the strength of its business model. And the banking giant did not disappoint, as it churned out what was arguably one of its strongest quarterly performances ever. [1] While the bank reinforced its dominance in the global equity trading industry, with revenues in excess of $2 billion once again, the spotlight was on its debt trading desk which saw revenues nearly double year-on-year to $1.7 billion. It should be noted that since 2010, the single biggest change Morgan Stanley implemented was a reduction in its debt trading operations to roughly one-third of its pre-recession size. This is what makes the performance of Morgan Stanley’s debt trading desk exemplary: it made more money than rival Goldman (which generated $1.685 billion) despite having a much smaller base of FICC trading assets (about $115 billion for Morgan Stanley compared to over $180 billion for Goldman Sachs).

At the same time, its wealth management division generated more than $4 billion in revenues for the first time ever, while achieving a pre-tax margin figure of 24%. This is largely due to the growing success of traditional loans-and-deposits services being offered through its wealth management division – something that significantly improves cross-selling capabilities and fee-earning potential. Taken together, the strong performance helped Morgan Stanley finally achieve its return on equity (ROE) target of 10% in Q1. This is also a notable achievement, given that Morgan Stanley has an extremely large equity base – something that makes it the best capitalized global banking giant with a common equity tier 1 (CET1) capital ratio of 16.6% (fully-phased in), but weighs heavily on its ROE figure. We maintain our $45 price estimate for Morgan Stanley’s stock, which is about 5% ahead of the current market price.

See our full analysis of Morgan Stanley

MS_Ear_PBTDiff_17Q1

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The table above summarizes the factors that aided Morgan Stanley’s pre-tax profit figure for Q1 2017 compared to the figures in Q1 2016 and Q4 2016. Notably, each of the bank’s operating divisions reported a sizable increase in revenues from both comparable quarters. The y-o-y jump in trading revenues was due to strong FICC trading revenues for the quarter, while a recovery in debt and equity origination volumes worldwide also gave a boost to investment banking fees. “All other revenues” represents gains/losses from investments and revenues for the investment management division – both of which benefited as mark-to-market gains resulted in a jump in the valuation of investments.

As could be expected, the revenue jump was accompanied by an increase in compensation expenses. Considering the fact that revenues increased 25% y-o-y, the 21% increase in compensation expenses seems justified, as employees would have received proportional performance-linked payouts. As compensation costs are seasonally elevated for the first quarter of a year, the sequential increase in this figure is also easy to explain.

Morgan Stanley Could Consider Expanding FICC Trading

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 nearly identical long-term strategy is UBS, which also aims to focus on wealth management and equity trading to grow profits. Morgan Stanley had announced cuts to its already lean FICC (fixed income, currencies and commodities) trading unit as recently as last January. [2]

Our analysis of the company shows that Morgan Stanley’s decision to focus away from debt trading led to a reduction in FICC trading assets from a peak level of almost $300 billion in 2006-07 to just $100 billion in early 2016. However, the FICC trading portfolio has been growing in size over most of 2016 – indicating that the the bank is cautiously reversing its stand against the capital-intensive business. After all, the Fed’s proposed rate hike plan should keep debt trading volumes elevated over the next couple of years, and it makes sense for Morgan Stanley to make the most of the changed outlook for the industry.

As seen in the chart below, the FICC trading desk added the most to Morgan Stanley’s top line for Q1.

MS_Ear_IBRevDiff_17Q1

 

… Especially With Wealth Management Ops Providing Stable Growth 

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 is now looking to achieve the steep target of 25% in 2017. And the bank edged closer to achieving this target with pre-tax margins of 24% for Q1 2017.

There have been three key factors behind strong growth in wealth management profits over recent quarters. Firstly, Morgan Stanley has put in considerable efforts to streamline the division over the years – saving it millions in recurring costs. Secondly, Morgan Stanley’s increased focus on retail banking offerings has seen its loans and deposits grow at a strong rate – simultaneously granting it access to a cheap source of funds and also providing it with an efficient cross-selling channel. And finally, an overall strong outlook for the U.S. economy has helped the division secure strong inflows. Coupled with improved valuations across asset classes, this helped the value of client assets held by Morgan Stanley’s wealth management arm to swell to an all-time high of almost $2.2 trillion.

MS_Ear_WM_AUMDiff_17Q1

 

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Notes:
  1. Q1 Earnings Release, Morgan Stanley Investor Relations, Apr 19 2017 []
  2. Morgan Stanley 4Q15 Strategic Update, Morgan Stanley Press Releases, Jan 19 2016 []