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Legal reserves of $1.2 billion weighed on Morgan Stanley’s (MS - Analyst Report) fourth-quarter earnings in a significant manner. The company’s earnings from continuing operations fell 79% year over year to 7 cents per share.

However, excluding debt-related credit spreads and Debt Valuation Adjustment (DVA), legal reserves and discrete tax benefit, earnings of 50 cents per share outpaced the Zacks Consensus Estimate of 43 cents. Thus, Morgan Stanley was able to continue with its trend of delivering positive earnings surprises since the last five quarters.

Shares of Morgan Stanley gained nearly 2% in the pre-trading session, indicating investors’ positive response following the earnings release. The movement of the stock price when the trading session opens will give a better idea about whether Morgan Stanley has been able to meet expectations.

Growth in net interest income and fee income were positives for the quarter. Moreover, increase in net revenue across all segments and improved asset position were the other tailwinds. However, a significant increase in operating expenses and decline in Fixed Income & Commodities sales and trading results were the negatives.

For full-year 2013, earnings from continuing operations came in at $1.66 per share, up 1% from the prior year. However, it lagged the Zacks Consensus Estimate of $2.00.

Performance in Detail

Net revenue (excluding DVA adjustments) for the quarter was $8.2 billion, up 9% year over year. Moreover, it outpaced the Zacks Consensus Estimate of $8.0 billion. After taking into consideration the negative revenues pertaining to changes in Morgan Stanley’s debt-related credit spreads and DVA, net revenue grew 11% year over year to $7.8 billion.

Net interest income was $282 million in the reported quarter, up 63% from the year-ago quarter driven by 37% fall in interest expenses. Further, total non-interest revenue increased 11% year over year to $7.5 billion. All the non-interest income components grew from the prior-year quarter.

Total non-interest expenses were $7.9 billion, up 29% from the previous-year quarter. The rise was primarily due to increase in legal reserves of $1.2 billion for mortgage-related matters.

Morgan Stanley’s compensation to net revenue ratio for the reported quarter was 51% versus 52% in the year-ago quarter.

Quarterly Segment Performance

Institutional Securities (IS):  Legal reserves of $1.2 billion led to pre-tax loss from continuing operations of $1.1 billion, compared with pre-tax income of $78 million in the prior-year quarter. Net revenue was $3.3 billion, up 8% from the year-ago quarter. Further, excluding DVA, net revenue was $3.7 billion, rising 3% on a year-over-year basis.

Wealth Management (WM): Pre-tax income from continuing operations was $709 million, increasing 26% from $562 million in the year-ago quarter. Net revenue was $3.7 billion, improving 12% from the year-ago quarter driven by rise in asset management fees and transactional revenues.

Investment Management (IM): Pre-tax income from continuing operations was $337 million, up 52% year-over-year. Net revenue was $842 million, up 41% from the year-ago quarter. The rise was driven by gains on investments in Merchant Banking and improved results from Traditional Asset Management.

As of Dec 31, 2013, total assets under management or supervision were $373 billion, up 10% from $338 billion as of Dec 31, 2012. The rise primarily reflected positive flows and market appreciation.

Capital Ratios

As of Dec 31, 2013, book value per share was $32.29, up from $30.70 as of Dec 31, 2012. Tangible book value per share was $27.21, up from $26.86 as of Dec 31, 2012.

Morgan Stanley’s Tier 1 capital ratio was 15.7% and Tier 1 common capital ratio was 12.8% compared with 17.7% and 14.6%, respectively in the year-ago quarter.

Share Repurchases

During the reported quarter, Morgan Stanley bought back nearly 7.6 million shares for $228 million. Hence, for the full year, the company repurchased approximately 12.2 million shares worth $350 million.

Earlier in Jul 2013, the company had received no objection from the Federal Reserve to buy back shares. The company has authorized repurchase of shares worth up to $500 million through Mar 31, 2014.

Performance of Other Major Banks

Among other banking giants, Wells Fargo & Co. (WFC - Analyst Report) and Bank of America Corp. (BAC - Analyst Report) reported better-than-expected third-quarter results, upholding the image of the banking sector.

Banks have been reporting strong results primarily on the back of favorable macroeconomic elements. Reduced non-interest expenses and lower provision have been the primary growth drivers for banks.

Among other major banks, BankUnited, Inc. (BKU - Analyst Report) is scheduled to release its earnings on Jan 23.

Our View

Morgan Stanley’s initiatives to offload its non-core assets for lowering balance sheet risks and shifting focus on the less capital incentive IM and WM segments are commendable. Further, the full control of Morgan Stanley Wealth Management JV will help to diversify the company’s revenue base and stabilize its earnings, going forward.

Also, in Dec 2013, the company took a step in the right direction by distancing itself from commodities operations by announcing the sale of its Global Oil Merchanting unit to Russia-based Rosneft Oil Company.

Additionally, the approval of Morgan Stanley’s steady capital deployment activities reinforces its strong capital position. There are also high chances of dividend hikes in the future, provided the company receives the Fed’s consent for the same.

Moreover, Morgan Stanley’s organic and inorganic growth initiatives continue to be significant growth drivers. The company remains focused on diversifying its revenue base by expanding footprint in economies that are comparitively less affected by the financial crisis and European debt crisis.

However, there are concerns related to Morgan Stanley’s financials being pressured by new regulatory requirements and intense pricing competition. Moreover, stringent capital norms may somewhat lower the company’s flexibility with respect to its investments and lending volumes.

An investor with the ability to absorb risks related to market volatility will not likely be disappointed with investments in Morgan Stanley in the long run. The company’s fundamentals are highly promising with a diverse business model, a stable balance sheet and strong capital position.

Currently, Morgan Stanley carries a Zacks Rank #3 (Hold).

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