Morgan Stanley Must Move Past Facebook, Downgrade

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NEW YORK (TheStreet) - After reporting the biggest bank earnings beat in the first quarter, Morgan Stanley is again an outlier on Wall Street as investors brace for its second quarter results, due on Thursday morning.

In a quarter marked by fast-falling earnings expectations and a multi-billion dollar trading loss at JPMorgan , Morgan Stanley encountered among the sector's biggest challenges as an underwriting mandate for Facebook's initial public offering fell flat and the bank faced the sharpest cuts in a sector-wide ratings downgrade by Moody's.

Now, second quarter results will help to show whether Morgan Stanley is strategically positioned to compete with larger universal banks - potentially putting a floor to battered share prices -- or whether its discount is warranted.

Morgan Stanley's earnings will reveal the impact of Moody's two notch ratings downgrade on its trading operations compared to peers like Goldman Sachs and JPMorgan, who have a stronger toehold in key trading businesses. Meanwhile, earnings will also show any fallout from Morgan Stanley's botched Facebook IPO effort, which was hindered by aggressive pricing and flawed execution on the part of Nasdaq .

"Earlier this year, Morgan Stanley won Wall Street bragging rights for leading the long awaited Facebook IPO. In making their pitch to Facebook, Morgan Stanley bankers promoted their firm's ability to distribute Facebook stock through its retail brokerage distribution channel. But blunders in the pricing process of the new issue have pulled defeat from the jaws of victory in a very public manner," wrote Bernstein Research analyst Brad Hintz, in a May note assessing the fallout of Facebook's botched IPO.

Execution will be on the minds of many as chief executive James Gorman continues to work to prove that he can deliver on Morgan Stanley's retreat from some principal trading businesses and its full force push into wealth management.

"The Morgan Stanley story has been an execution story for a long time," says Morningstar analyst Michael Wong, citing the company's push into brokerage and wealth management operations through its Morgan Stanley Smith Barney joint venture with Citigroup .

In late May, Morgan Stanley alerted Citigroup of its intent to exercise a right to purchase an additional 14% stake in the joint venture, beginning a multi-year schedule where it can build full ownership of the unit created in 2009, from a present 51% stake. In Monday earnings, Citigroup Chief Executive Vikram Pandit said that both parties within 10% on negotiating the value of the 14% stake up for grabs.

"I will be concentrating on where operating margins are going," adds Wong, who notes that Morgan Stanley and its CEO Gorman have so far been slow to realize expense synergies and an expected increase in the unit's profit margins over time. Currently the Morgan Stanley's 10% brokerage margins are roughly half of what the bank projected when first entering the joint venture.

With a brokerage unit that now is among the largest in the world, Morgan Stanley is hoping to move from capital intensive trading and proprietary investment operations into low capital and low risk businesses like wealth management, which may bolster the bank's liquidity and its return on equity, as new regulations like Basel III and the Dodd Frank Act kick in.

But in the second quarter, the unit and Morgan Stanley's trading operations may underperform as the bank reports what could be the weakest earnings and highest compensation expense ratios on Wall Street.

"We anticipate a pullback in core Institutional Securities contribution after a strong start to the year for Morgan Stanley--the primary drivers of our reduced forecast are weaker core equities and fixed income sales & trading results and muted investment banking results," wrote Credit Suisse analyst Howard Chen, who slashed Morgan Stanley's second quarter EPS expectations by nearly 80% to 10 cents, in a July 2 note.

The bank may also be challenged to cut compensation enough to match an earnings drop. Chen expects a near 60% core compensation ratio on a weaker-than-industry average 50% year-over-year drop in trading and investment banking revenue to $1.3 billion and $745 million respectively, in addition to flat brokerage earnings.

Overall, analysts polled by Bloomberg expect Morgan Stanley to earn 29 cents in adjusted earnings per share on $7.6 billion in revenue. Including accounting gains on the bank's rising credit spreads, Morgan Stanley is expected to earn 51 cents in EPS.

In first quarter earnings, Morgan Stanley beat analyst and investor estimates after its institutional securities unit reported revenue of $5 billion, on far better than expected trading results. The bank earned 71 cents in adjusted EPS in the quarter -- however on a GAAP basis, Morgan Stanley lost 5 cents a share as its credit spreads narrowed, in a sign of just how big accounting gains, called 'debit valuation adjustments,' play into earnings.

The question now is whether Morgan Stanley's trading unit can continue to show strong results, or whether an expected underperformance will materialize. For instance, a key concern is how Moody's downgrade will impact the bank's derivatives trading businesses, which unlike other Wall Street players, was likely hit by ratings cuts and could fall by 30%, according to some analyst estimates.

Also to be seen is whether Morgan Stanley's Facebook IPO mandate continued to pull investor assets into its growing brokerage unit, or if the social network's botched share listing creates asset outflows. In recent quarters, Morgan Stanley's brokerage took in client funds as its investment banking unit led the underwriting of Zynga , Groupon and LinkedIn shares. Currently, Morgan Stanley is leading the expected IPO's of Kayak and Palo Alto Networks

Morgan Stanley Smith Barney earned $3.4 billion in revenue and turned a profit of $387 million in the first quarter, both gains from 2011 levels.

Signs of progress in the strategy could help soften the blow of Moody's two-notch cut to Morgan Stanley's ratings in late June.

"Morgan Stanley has become one of the cheapest universal banks due to concerns regarding the European crisis coupled with fears over rating agency actions... We believe a catalyst for the shares is the expected July MSSB system conversions, which will further the recent trend in cost saves," writes KBW analyst David Konrad in a June 27 earnings outlook for the bank that reiterated a $21 a share price target in spite of the bank's trading value at roughly 50% of tangible book value.

"Over the past several years, the company has materially improved its balance sheet by doubling its liquidity ratios and improving its Basel III Tier 1 common ratio to approximately 8.5%," Konrad adds.

Were Morgan Stanley's earnings to come in at expectations and CEO Gorman able to show progress on margins at Morgan Stanley Smith Barney, it could help investors forget a quarter marred by a global dealmaking slowdown, ratings cuts and the fallout from Facebook's IPO. It could also put a floor on the bank's shares after then neared post-crisis lows earlier in the quarter.

"We continue to believe that valuation favors Morgan Stanley (MS − Outperform) over Goldman Sachs at this point in time, as any improvement in market fundamentals will help shift investor sentiment back toward the companies' double-digit ROE potential," writes FBR Capital Markets analyst Paul Miller, in a July 9 earnings outlook.

For more on the contrasts between U.S. bank earnings and business models, see why Warren Buffet shuns investment banks. See why Barclays' scandal was born out of a derivatives bet for more on Libor litigation.

-- Written by Antoine Gara in New York

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