We are upgrading our recommendation on Morgan Stanley (MS) to Neutral on strong first quarter results, capital flexibility to pursue growth initiatives, stable credit spreads and strong trading activities.
Earnings for the quarter came in substantially ahead of estimates, aided by strong investment banking performance. Adjusted earnings from continuing operations came in at 46 cents per share, up from the Zacks Consensus Estimate of 35 cents. This represents Morgan Stanley’s seventh consecutive quarter of income from continuing operation since the economic crisis.
Better-than-expected results were primarily aided by a strong investment banking performance. The increase in revenues from Global Wealth Management Group was also impressive.
The quarter also witnessed strong client franchise and improved performance in many of its businesses. However, reduced top line and higher non-interest expenses acted as headwinds.
Although investment banks are facing industry headwinds on the global front, Morgan Stanley enjoys a significant competitive leverage, given a relatively consistent growth momentum in its core Institutional Securities’ franchise.
Moreover, the company’s highly liquid balance sheet will provide flexibility to pursue growth initiatives. Also, since the past few quarters, Morgan Stanley has been taking initiatives to restructure its financials to mitigate balance sheet risk.
Despite the sluggish economic growth, Morgan Stanley posted decent results over the past few quarters aided by its systematic progress on rebuilding and refocusing. Though M&A and investment banking performances will take a while to deliver, stable credit spreads and strong trading activities are expected to be sufficient to sustain the current performance level.
Morgan Stanley’s initiatives to enhance liquidity will provide it flexibility to pursue growth plans. At the end of 2010, total liquidity was about $159 billion, up from $154 billion at the end of 2009 and $138 billion at the end of 2008. The conversion of MUFG preferred stock into the Morgan Stanley’s common stock will make it more flexible with respect to capital.
On the flip side, the implementation of Basel III is expected to restrict Morgan Stanley’s capital deployment. Moreover, following the Federal Reserve’s second round of stress tests in March, Morgan Stanley was not granted the green signal to raise dividend. We do not expect the company to be able to enhance shareholders’ value in the near to mid term.
Also, as the economic recovery continues to remain slow, cyclical pressures in the weak commercial real estate sector increases concerns over the near term and prospects for future returns. The company still has meaningful exposure to Structured Investment Vehicles and Commercial Mortgage-Backed Securities assets, which may lead to future write-downs if the current market conditions persist.
The company has experienced intense pricing competition in some of its businesses in the recent years. In particular, the ability to execute securities trading electronically on exchanges and through other automated trading markets has increased the pressure on trading commissions. The trend toward direct access to automated electronic markets will likely continue. Thus, competitive pressures are likely to affect future revenue growth prospects as its peers may seek to obtain market share by reducing prices.
Morgan Stanleycurrently retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. Similarly, Goldman Sachs Group Inc. (GS), one of Morgan Stanley’scompetitors, retains a Zacks #3 Rank.
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