Morgan Stanley Posts Strong Profit On Trading Growth (Update 3)

Story updated with new information throughout.

• Morgan Stanley reported a first-quarter profit of 71 cents a share, beating estimates
• Revenue came in at $8.9 billion.
• Analysts expected a profit of 42 cents per share on revenues of $7.31 billion, when excluding when excluding adjustments related to the trading price of the firms debt according to consensus estimates from Thomson Reuters

NEW YORK (TheStreet) -- It was Morgan Stanley , an expected laggard, which provided the biggest beat among the large U.S. investment banks as Wall Street's first quarter earnings season drew to a close on Thursday.

While competitors showed mixed results and mostly falling revenue, the nation's sixth-largest bank by assets reported surprisingly broad based revenue growth that significantly beat analyst expectations. Morgan Stanley reported earnings per share of 71 cents on much stronger than expected trading results that bolstered overall revenue and countered some fears heading into earnings.

Morgan Stanley's chief executive James Gorman

Morgan Stanley's beat came on expectations that its earnings would fall behind Goldman Sachs and JPMorgan Chase , who reported slightly better than expected results earlier in April, buoyed by a strong quarter-over-quarter recovery in their trading and fixed income related divisions. Those concerns proved to be unfounded as revenue at Morgan Stanley's institutional securities unit grew to $5 billion, on far higher than expected fixed income and equity trading revenue.

"Our results highlight that the firm is far more balanced and diverse today than we have been in some time," said the company's CFO Ruth Porat in an analyst call.

The bank's key equity underwriting division also overcame overall market weakness during the first three months of 2012, helping it to beat expectations. On an adjusted basis, Morgan Stanley returned to profitability after posting a fourth quarter loss -- and its underwriting of Facebook's initial public offering looms as a signal of its strengths on Wall Street.

Overall, revenue increased compared with the first quarter of 2011, reflecting rare growth on Wall Street. Excluding debt value adjustments, Morgan Stanley's revenue grew over 15% to $8.9 billion compared with this time last year.

"This quarter is further evidence that Morgan Stanley has rebounded from the financial crisis of 2008 and is in a significantly stronger position," said Morgan Stanley chief executive James Gorman in a statement.

Still, including a $2 billion accounting loss related to the increasing value of the company's debt, Morgan Stanley lost $76 million, or 5 cents a share. That debt adjustment was in-line with expectations that it would subtract roughly 76 cents from its first quarter earnings per share, according to Credit Suisse. Morgan Stanley's trading strength came as a the biggest surprise, but the bank reported other positive including smaller expenses and continued revenue growth in its brokerage operations.

"We are particularly encouraged by continued signs of sales and trading share gains as recent years rebuilding efforts are showing more material payoff, better expense control, continued positive retail client flows and the absence of new negatives," wrote Howard Chen of Credit Suisse in a note to clients.

Shares opened nearly 5% higher in early trading, but fell to a gain of over 2%, closing at $18.07, as broader markets slumped.

Morgan Stanley's earnings outweighed an expected underperformance compared to peers, on sliding equity underwriting and merger and acquisition volumes. In the first quarter, Dealogic data shows that global IPO volumes fell 64% from this time last year, while M&A activity fell 23% -- the slowest start to a year since 2004.

Those expectations proved to be unfounded, as Morgan Stanley's fixed income and equity trading units posted $5 billion in revenue, beating expectations of a combined $3.5 billion in revenue, according to Credit Suisse estimates. The firm's investment banking unit posted $851 million in revenue, also beating estimates of $750 million. While Morgan Stanley's equity trading operations compete with Goldman Sachs for tops in revenue, its fixed income trading division was expected to be roughly half the size of its peers, according to Credit Suisse estimates.

Morgan Stanley's fixed income and equity trading units posted year-over-year revenue gains of 34% and 6%, respectively. That contrasts to continued declines of 2% and 17% that JPMorgan and Goldman Sachs reported in the first quarter.

"Great trading results (on lower VaR), OK banking and wealth management numbers and solid expense trends all combined to produce the best quarter we've seen at MS in a long time," wrote Nomura analyst Glenn Schorr in a note to clients.

Like its investment banking peer Goldman Sachs, Morgan Stanley pulled back its risk in the quarter - signaling that risk taking tracked client trading flows. The firm's value at risk, a measure of the amount that its trading operations could lose in a single day, fell to $84 million from $123 million in the fourth quarter.

CFO Ruth Porat stressed that Morgan Stanley's risk reduction is more than a quarterly trend and extends throughout the bank. "Net debt was down $10 billion in the first quarter alone... we did this while improving revenue strength and capturing market share and maintaining high liquidity," said Porat, who cited the firms brokerage joint venture with Citigroup called Morgan Stanley Smith Barney as providing the deposit base to fund corporate and retail loans, diminishing the banks use of unsecured funding markets that it once relied heavily upon. Porat also said that as debts matured and weren't, liquidity of $179 billion was flat, improving the firm's financial flexibility.

It's both Morgan Stanley's brokerage and its liquidity that many investors and customers will be focusing this quarter and through 2012. After passing the Federal Reserve's stress tests earlier in 2012, Morgan Stanley will have the option to increase its 51% stake the brokerage joint venture by 14% in May. CEO Gorman said that he expects to gradually increase Morgan Stanley's stake in the venture according to a schedule created when it was formed in 2009 that would give the firm full control by 2014.

The unit earned $3.4 billion in revenue and turned a profit of $387 million in the first quarter -- both gains from 2011 levels -- as it saw continued quarterly growth and client asset inflows. An increasing ownership of the venture will continue CEO Gorman's focus on finding stable earnings sources to go with Morgan Stanley's volatile investment banking and trading businesses.

Earnings volatility and Morgan Stanley's relatively undiversified investment banking businesses compared with conglomerates like JPMorgan worried many amid sovereign debt concerns in 2011, which punished the banks shares. Some concerns linger, including a prospective three notch ratings downgrade by Moody's.

Moody's Investor Service is reviewing the ratings of Morgan Stanley and 17 of the largest U.S. banks, with the exception of Wells Fargo , for possible ratings downgrades that better reflect risks such as dealing in capital markets. Such downgrades for Morgan Stanley and its competitors could hurt relationships with key trading partners like Blackrock . In first quarter earnings, the firms chief executive Larry Fink said that he would diversify from some trading partners if they were downgraded.

For Morgan Stanley, some have highlighted its derivative trading businesses, which hasn't been put in a separate subsidiary. Prospective ratings downgrades could trigger extra payments to counterparties on 8% of the firms derivatives trades, said Porat on the investor call. She also noted that a move to cleared derivative trading and less emphasis on illiquid structured products could minimize the scope of cuts. "None of our funding has ratings triggers," added Porat.

In a March research note, Glenn Schorr of Nomura said that Morgan Stanley's diminished reliance on short-term funding and its capital stable wealth management division made prospective ratings cuts by Moody's a smallish concern. Nevertheless, if Moody's were to single out just a few banks in downgrades, Schorr noted that it could pose larger problems.

"Morgan Stanley will need to prove that the fixed income trading result in particular is somewhat sustainable, despite the traditional seasonality (with Q1 favored), and potential headwinds such as Moody's downgrade threat," wrote Bank of America Merrill Lynch analyst Guy Moszkowski in a note to clients.

Other headwinds for Morgan Stanley also remain, including its relatively high compensation to revenue ratio which was expected to be over 50% of adjusted revenue - higher than peers like JPMorgan, Goldman Sachs and Bank of America . While Morgan Stanley's compensation expense actually fell below 50% of adjusted revenue, the number increased 3% from 2011 levels and remains higher than its peers on deferred pay and high fixed compensation in its wealth management unit.

"The good report came on a better performance on both revenues and expenses," said Oppenheimer analyst Chris Kotowski in a note to clients. Morgan Stanley also reported smaller than expected non-compensation expense of $2.3 billion, to keep its overall quarterly pay and benefit expense at $4.43 billion.

Overall, Morgan Stanley entered first quarter earnings with many expecting the firm to show weak revenue and higher than industry average expense. While it was the former where the firm impressed the most, earnings signaled that a multi-year strategy carried out by CEO Gorman is starting to gain traction. "Although we are cautious regarding the sustainability of the FICC results, MS continues to deliver on equities. In addition, this was the second quarter in a row that MS beat us on non-comp expenses," noted David Konrad of KBW.

In the second quarter, Gorman will also have Wall Street and Silicon Valley's eye when Morgan Stanley leads the initial public offering of Facebook, which is expected later this spring.

For more on investment banking earnings, see Bank of America's earnings beat.

-- Written by Antoine Gara in New York.