We are upgrading our recommendation on Morgan Stanley (MS) to Neutral based on its better-than-expected second quarter results. Though the Mitsubishi UFJ Financial Group Inc. (MUFG) preferred stock conversion resulted in a substantial loss during the quarter, it enhanced the capital cushion.
Morgan Stanley’s second-quarter 2011 loss from continuing operations came in at 38 cents per share, substantially better than the Zacks Consensus Estimate of a loss of 63 cents. This represents Morgan Stanley’s first quarterly loss after seven consecutive quarters of income since the economic crisis began. The company earned 80 cents from continuing operations in the year-ago quarter.
The earnings per share calculation accounted for a negative adjustment of about $1.02 per share related to the MUFG preferred stock conversion. Without this negative impact, Morgan Stanley would have earned 64 cents per share from its continuing operations.
Strong investment banking performance and revenue growth in all three business segments were impressive. The quarter also witnessed strong client franchises. However, higher interest and non-interest expenses were the headwinds.
Although conversion of MUFG preferred stock into the Morgan Stanley’s common stock had a severe impact on its second quarter earnings with huge non-cash charge, this eliminated a significant annual preferred dividend payment.
As a result of this conversion, the company’s Tier 1 common ratio increased to the industry-leading level. Of the 290 basis point increase in Tier 1 common ratio to 14.6%, a 270 basis point jump resulted from the MUFG transaction during the quarter. We expect this transaction to make the company slightly flexible with respect to capital.
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. Also, since the past few quarters, Morgan Stanley has been taking initiatives to restructure its financials to mitigate balance sheet risk.
On the flip side, the weak capital position is expected to restrict Morgan Stanley’s capital deployment. The company was not granted Federal Reserve’s green signal to raise dividend.
Further, the company is expected to be a bit conservative with respect to its capital deployment as it will have to meet Basel III minimum capital ratios. However, given the lengthy implementation period of the Basel III standard, the company will not have to raise additional funds. On the whole, we do not expect Morgan Stanley to be able to enhance shareholder value in the near term.
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.
The ongoing restructuring and inorganic expansion initiatives should continue to be significant growth drivers.Nevertheless, there are concerns related to the company’s financials being marred by new regulatory restrictions and intense pricing competition.
Currently, Morgan Stanley retains a Zacks #3 Rank, which translates into a short-term Hold’ rating. The company’s competitor, Goldman Sachs Group Inc. (GS) also retains a Zacks #3 Rank.
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