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Morgan Stanley Upgraded to Neutral

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We have upgraded our long-term recommendation on Morgan Stanley (MS - Free Report) to Neutral from Underperform. The raise is mainly based on the company’s better-than-expected fourth quarter 2011 results and its relatively stable capital position.

Moreover, we expect Morgan Stanley’s restructuring initiatives as well as organic and inorganic growth strategies will continue to be significant growth drivers. However, new regulatory requirements, elevated costs, the fundamental pressures on the banking sector and intense pricing competition are some of the concerns that are expected to mar the company’s financials over the near term.

Morgan Stanley’s fourth-quarter earnings significantly outpaced the Zacks Consensus Estimate loss. The core results benefited from the closure of various strategic actions, higher net interest income and decline in non-interest expenses. However, lower net revenues across all the segments were the primary dampeners.

Over the last several quarters, Morgan Stanley has been taking initiatives to streamline its operations and concentrate on the profitable core businesses. In October 2011, the company announced the plan to divest its mortgage-servicing unit, Saxon Mortgage Services Inc., to Ocwen Financial Corp. . We anticipate that the company will continue with restructuring strategy to align its operations with the economic environment.

Despite the sluggish economic environment, Morgan Stanley continues to grow through acquisitions. In May 2010, the company announced the completion of its joint venture with Mitsubishi UFJ Financial Group Inc. (MTU - Free Report) and remained committed to investing in Japanese market with the expansion of its investment banking and securities businesses.

Additionally, we anticipate Morgan Stanley’s decision to de-risk the balance sheet by resolving its 2-year-old legal dispute with MBIA Inc. will allow it to comply with various new regulatory requirements. This would also free up the additional capital that can be invested in the company’s core businesses.

On the flip side, Morgan Stanley’s profitability is expected be impacted by the financial reform law due to increased costs and fee restrictions over the near term. Also, the company will be less flexible with regard to business investments in the near term, given the regulatory requirement of additional surcharge for large U.S. banks with assets of $50 billion or more under Basel III.

Despite the company’s present stable capital position, we expect restrictions to continue on capital deployment activities even after another round of stress test, which is to be conducted by the Federal Reserve later this year. This time the company will have an even higher stumbling block to clear as it has significant exposure to the stressed European countries. Overall, we do not expect Morgan Stanley to be able to enhance shareholder value in the near term.

Further, we remain concerned about Morgan Stanley’s elevated cost structure. Though in December 2011, the company had announced its plan to retrench 1,600 workers in the first quarter of 2012, we do not expect this initiative to fully control the cost as the company continues to invest in its franchise.

Morgan Stanley currently retains a Zacks #5 Rank, indicating a significant likelihood of downward pressure on the shares over the near term.

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