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Morgan Stanley Misses on Lower Revs

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Morgan Stanley’s (MS - Free Report) second quarter 2012 adjusted earnings came in at 16 cents per share, significantly below the Zacks Consensus Estimate of 44 cents. However, this compares favorably with the prior-year quarter adjusted loss of 46 cents.

Lower-than-expected results for Morgan Stanley was primarily due lower top line, partially offset by decline in operating expenses. Further, a fall in net revenues across all segments marred the company’s results.

After considering the gain from debt-related credit spreads and Debt Valuation Adjustment (DVA), Morgan Stanley reported a net income of $563 million compared with $1.22 billion in the year-ago quarter.

Additionally, earnings per share on a GAAP basis stood at 28 cents compared to a loss of 36 cents in the prior-year quarter. The loss in the second quarter of 2011 was attributable to a negative adjustment of nearly $1.02, which was related to the conversion of the Morgan Stanley’s Series B Preferred Stock held by Mitsubishi UFJ Financial Group Inc. into common stock.

Further, Morgan Stanley ranked #1 in global IPOs, while it ranked #2 in global announced and completed M&A.

Behind the Headlines

Net revenue (excluding DVA) for the quarter was $6.6 billion, down 26.3% from the year-ago quarter. Net revenue also missed the Zacks Consensus Estimate of $7.7 billion. Moreover, after taking into account the positive revenue pertaining to changes in Morgan Stanley’s debt-related credit spreads and DVA, net revenue declined 24.5% year over year to $7.0 billion.

Morgan Stanley recorded a net interest loss of $161 million compared with $68 million in the prior-year quarter. The deterioration primarily resulted from lower interest income, partially mitigated by a fall in interest expenses.

Total non-interest revenues fell 23.3% year over year to $7.1 billion. All the non-interest income components except asset management, distribution and administration fees declined from the prior-year quarter.

Total non-interest expenses decreased 16.9% year over year to $6.0 billion. The dip was attributable to lower total compensation and non-compensation expenses.

Morgan Stanley’s compensation to net revenue ratio for the reported quarter was 52%, compared with 50% in the year-ago quarter.

Segment Performance

Institutional Securities reported pre-tax income from continuing operations of $508 million compared with $1.5 billion in the prior-year quarter. Net revenue was $3.2 billion, down 37.3% from $5.2 billion in the year-ago quarter.

Global Wealth Management (GWM) pre-tax income from continuing operations was $393 million, up 24.0% from $317 million in the year-ago quarter. Net revenue was $3.3 billion, down 3.9% from $3.4 billion in the year-ago quarter, reflecting lower transactional revenues, partly offset by higher asset management fees.

Asset Management (AM) pre-tax income from continuing operations was $43 million, down significantly by 66.4% from $128 million in the year-ago quarter. Net revenue for the reported quarter was $456 million, down 28.3% from $636 million in the year-ago quarter.

As of June 30, 2012, total assets under management were $311 billion, up 5.1% from $296 billion as of June 30, 2011.

Capital Ratios

As of June 30, 2012, book value per share was $31.02, up from $30.17 as of June 30, 2011. Also, tangible book value per share was $27.70, up from $26.61 as of June 30, 2011.

Morgan Stanley’s Tier 1 capital ratio, under Basel I, was approximately 17.1% and Tier 1 common ratio was approximately 13.5%.

Dividend Update

Concurrent with the earnings release, Morgan Stanley declared a quarterly dividend of 5 cents per share. The dividend will be paid on August 15 to shareholders of record on July 31.

Performance by Peers

Among Morgan Stanley’s close peers – JPMorgan Chase & Co. (JPM - Free Report) , The Goldman Sachs Group Inc. (GS - Free Report) and Citigroup Inc. (C - Free Report) – all reported substantially better-than-expected second quarter results.

Proving pessimists wrong, JPMorgan’s earnings were a way ahead of the Zacks Consensus Estimate. Despite the huge trading loss, a marked recovery of the bond and equity market and the consequent strong performances by its business segments helped the company overcome its difficulties to a great extent.

Similarly, Goldman’s earnings also significantly surpassed the Zacks Consensus Estimate. Amid the deteriorating global markets and European debt crisis, the results were driven by the company’s prudent expense management. Yet, lower client activity levels acted as a headwind for the quarter. Likewise, the results of Citigroup were somewhat encouraging, reflecting lower loan loss provisions, higher transaction services revenues and a drop in expenses.

Additionally, another peer, Bank of America Corporation (BAC - Free Report) marginally outpaced the Zacks Consensus Estimate. Results were aided by improved non-interest income, substantial slowdown in provision for credit losses, reduced non-interest expense primarily due to the absence of the goodwill impairment charge and improved credit quality across most major portfolios. However, lower net interest income due to a weak interest rate environment was an offset.

Our Viewpoint

We expect Morgan Stanley’s initiatives to offload its non-core assets will help lower balance sheet risk and focus on less capital incentive AM and GWM segments. Moreover, its organic and inorganic growth initiatives continue to be the significant growth drivers. The company remains focused on diversifying its revenue base by expanding its footprints in economies which are not heavily impacted by the financial crisis and the current European debt crisis.

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

Further, an investor with an appetite to absorb risks related to the market volatility should not be disappointed with investments in Morgan Stanley over the long term. The company’s fundamentals remain highly promising with a diverse business model and a stable balance sheet and capital position.

Also, from the risk perspective, as Morgan Stanley cleared the toughest stress test in March, it is certain that the company would be able to withstand another financial crisis. However, we remain concerned about the company’s ability to enhance shareholder value in the near term as it did not plea for any additional capital deployment plans.

Morgan Stanley currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Also, we maintain a long-term Neutral recommendation on the stock.

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