Deutsche Bank Sees 40% Upside for Goldman Sachs (Update 3)

Tickers in this article: GS MS

Updated with a differing opinion on Morgan Stanley from UBS analyst Brennan Hawken, ratings downgrades from Moody's Investor Service, reaction from Morgan Stanley and aftermarket reaction from investors.

NEW YORK (TheStreet) -- Large brokers are facing a very difficult operating environment, with weak investment banking and trading revenues, but Deutsche Bank analyst Michael Carrier sees 40% upside for shares of Goldman Sachs .

Carrier late on Wednesday cut his second-quarter earnings estimate for Goldman to $1.05 a share from $2.25, while raising his operating EPS estimate for Morgan Stanley -- netting out an estimated debit valuation adjustment of $800 million -- to 58 cents from 42 cents.

The analyst said that "in terms of the stocks, the brokers have fallen back towards 2H11 lows, & while macro risks remain, given attractive valuations & eventual political/macro progress, we view the risk/reward as more attractive & prefer GS."

Deutsche Bank is expecting the brokers' second-quarter trading revenues to decline 20% from the fourth quarter "given the tough macro backdrop, with seasonal weakness in debt underwriting (DCM) & macro weakness in equity underwriting (ECM), while M&A should be higher off of low levels," and Carrier said that with a "decent pipeline" of deal activity, investment banking "should have legs if/when trends improve."

Carrier expects the brokers to "focus on cost structures and potentially accelerate cost-cutting initiatives," but also believes investors will see "some pickup in capital deployment" through share buybacks or dividend increases, "though the macro backdrop will likely limit significant moves." The analyst expects Morgan Stanley to move forward with its purchase of an additional 14% of the Morgan Stanley Smith Barney (MSSB) joint venture from Citigroup , and for Goldman Sachs "to modestly increase buybacks."

Goldman's shares closed at $96.55 Wednesday, returning 8% year-to-date, following a 46% decline during 2011.

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The shares trade for 0.8 times their reported March 31 tangible book value of $123.94, and for 7.5 times the consensus 2013 EPS estimate of $12.93, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $11.35.

Carrier on Wednesday reiterated his "Buy" rating for Goldman Sachs while lowering his price target for the shares to $135 from $145, and cutting his 2012 EPS estimate to $10.25 from $11.50, and his 2013 estimate to $13.00 from $13.75. Deutsche Bank's price target for Goldman is roughly the firm's forward tangible book value estimate "above peers given its premium return on tangible equity, but below historical levels given macro & regulatory risk."

That's 40% upside for Goldman's from Wednesday's close, based on what Carrier calls the company's "strong relative positioning, its solid risk management, and its attractive valuation."

The analyst expects Goldman "to post a weak quarter in 2Q (EPS of $1.05, versus consensus at $2.05), driven by a weaker trading and investment banking environment (due to a weaker macro backdrop, lower markets/wider spreads, & seasonality) and pressure in investing & lending and investment management (due to lower markets/wider spreads).

Interested in more Goldman Sachs? See TheStreet Ratings' report card for this stock.

Morgan Stanley's shares closed at $13.96 Thursday, down 7% year-to-date, following a 44% decline during 2011.

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The shares trade for just over half their reported March 31 tangible book value of $27.37 and for six times the consensus 2013 EPS estimate of $2.25. The consensus 2012 EPS estimate is $1.39.

Carrier late on Wednesday reiterated his "Hold" rating for Morgan Stanley while lowering his price target for the shares by two dollars to $20, and raising his 2012 EPS estimate to $1.28 from $1.10. The analyst cut his 2013 EPS estimate by a nickel to $2.25. The price target is 0.8 times Deutche Bank's forward tangible book value estimate, "adjusted for the MSSB buy-in," and is "below peers given its discounted return on tangible equity, and below historical levels given the weak macro environment and regulatory risk."

The analyst is expecting a "noisy quarter" for Morgan Stanley because of a debit valuation adjustment, "but excluding the outsized DVA benefit of ~$800M due to spread widening, we expect MS to put up a weak quarter (headline EPS of $0.58 and ex DVA adjusted EPS of $0.40 versus consensus at $0.49), driven by weaker quarterly trends in core trading, investment banking, wealth management, and asset management."

Carrier said that despite seeing "potential for the stock long term," because of "Morgan Stanley's upside potential in wealth management and its current valuation," he was sticking with is "Hold" rating because of "some near term pressures" on the company's return on tangible equity, "the negative impact from a Moody's downgrade and to tangible book value with the MSSB buy-in, and continuing macro uncertainty."

UBS analyst Brennan Hawken said on Thursday after meeting with Morgan Stanley CFO Ruth Porat that "MS seems confident that this event will not have an outsized impact on the firm," and expects that the "primary revenue impact from the downgrade will be in its long-dated, uncollateralized interest rate derivatives, which MS has already de-emphasized."

Hawken estimates that "even if MS loses roughly half of this business it would only represent about 5% of FICC revenues," and that although "the ultimate revenue impact of the downgrade remains unclear," a "highly negative outcome is already priced into the stock."

UBS rates Morgan Stanley a "Buy," with a $19 price target, based on "0.7x our 4Q12 TBV estimate in 12 months (vs. its 10-yr avg. of 1.8x)," with Hawken saying "MS shares are cheap, even when we assume very negative outcomes from some of the exogenous issues facing the firm."

Moody's Investor Service announced late Thursday afternoon that it had "repositioned the ratings of 15 banks and securities firms with global capital markets operations," incuding a two-notch downgrade for Morgan Stanley, to a long-term senior unsecured debt rating of Baa1 from A2, with a negative outlook, while cutting its short-term rating for the firm to P-2 from P-1.

Based on Morgan Stanley's own liquidity stress tests on its March 31 trading positions, the downgrade could lead to collateral calls from trading counterparties and exchanges totaling $6.8 billion.

Relieved investors expecting a three-notch ratings downgrade sent Morgan Stanley's shares up over 3% in aftermarket trading, to $14.42.

Morgan Stanley released a statement saying that "While Moody's revised ratings are better than its initial guidance of up to three notches, we believe the ratings still do not fully reflect the key strategic actions we have taken in recent years."

The company also said that the acknowledgement by Moody's of Morgan Stanley's "long-term partnership withMitsubishi UFJ Financial Group as well as our industry-leading capital and liquidity highlight some of the transformative steps we have taken," adding that "with our de-risked balance sheet, stable sources of funding, diverse business mix and strong leadership team, we are well positioned to deliver for clients and shareholders."

Interested in more Morgan Stanley? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

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