Citi-Morgan Stanley Reach Consensus

After months of debate, the tussle between Citigroup Inc. (C - Analyst Report) and Morgan Stanley (MS - Analyst Report) over the valuation of their brokerage joint venture (JV), Morgan Stanley Smith Barney, has finally come to an end. Both the firms have agreed to value the JV at $13.5 billion.

As a result, Morgan Stanley will shell out $1.89 billion for buying the 14% stake in the JV. The transaction, which will close in the third quarter, will also include the transfer of approximately $5.5 billion of deposits at no premium to Morgan Stanley

Further, Morgan Stanley would acquire the remaining 35% stake of Citi in the brokerage JV no later than June 1, 2015 and at the same valuation. This acquisition of the stake will occur in a phased manner with the next 15% to be acquired by Morgan Stanley by June 1, 2013. In total, Citi will transfer $48 billion of deposits to Morgan Stanley (as of May 31, 2012) at no premium. The agreement awaits regulator’s nod.

Citi, on the other hand, would record non-cash charges of approximately $2.9 billion after-tax ($4.7 billion pre-tax) in the third quarter of 2012. This arises from the difference in the agreed valuation amount and Citi’s carrying value of its stake in JV in its book. It would also impact Citi’s reported tangible book value and capital ratios.

Our Viewpoint

The agreement between Citi and Morgan Stanley has put to rest their disagreement, which has been continuing over the recent months. The valuation of the JV at $13.5 billion is closer to Morgan Stanley’s price than Citi’s, as the former had valued the brokerage unit at around $9.5 billion. On the other hand, Citi had earlier valued its 49% stake in the JV at around $11.3 billion, implying the valuation of the whole JV at approximately $22.5 billion. Hence, upfront it seems to be a victory for Morgan Stanley.

However, Citi too stands to benefit from this deal. It provides better clarity regarding the selling price of the remaining stake of Citi in the JV going forward. Citi will be able to rope in an additional $4.7 billion from the 35% stake sale at the same valuation in the next three years. In fact, Citi is said to have booked a higher price than that proposed by the third party appraiser, according to a Bloomberg report.

Though the deal results in Citi shelling out non-cash charges in the third quarter, the sale would ultimately help it in roping in payments which would boost its Tier 1 Common regulatory capital ratio for Basel III purposes. The current sale of the 14% stake is projected to add around 14 basis points to Citi’s estimated Tier 1 Common regulatory capital ratio under Basel III norms, according to the company.

However, as Citi’s stake in the brokerage joint venture is not included for Basel III regulatory capital purposes, its impairment related to that asset would not impact its estimated Basel III capital position.

As a matter of fact, in 2009, Citi sold off its 51% stake in Smith Barney brokerage unit to Morgan Stanley after suffering substantial losses during the financial crisis. Citi termed several businesses as non-core and is continuously winding down these units so as to streamline its business and generate adequate capital to run and expand its core franchisee as well as satisfy regulatory norms.

Sale of non-core assets at Citi is on track and at the end of the second quarter of 2012, Citi Holdings, the non-core asset portfolio, represented approximately 10% of total Citigroup assets. These runoffs ultimately reduce the company’s risk profile and free up capital that the company continues to invest in its core businesses. Hence, we believe that the stake sale is a strategic fit for Citi and such measures serve as a long-term catalyst for the stock.

For Morgan Stanley, the deal would help in lowering its volatility in earnings arising from its investment banking activities. Though this unit has been suffering from the low interest environment and tepid trading activities, it is worth noting that the company’s Global Wealth Management unit, including this brokerage JV has been the leading revenue contributor in the first half of 2012.

The announcement of the deal sent positive vibes in the market and ultimately led to both Citi and Morgan Stanley trading at a premium. Citi advanced 2.6% while Morgan Stanley moved up 3.9% in yesterday’s regular trading at the New York Stock Exchange.

Currently, both Citi and Morgan Stanley shares retain a Zacks #3 Rank, which translates into a short-term Hold recommendation.