Morgan Stanley's dividend, buyback pay us for our patience after quarterly missteps

Published Thu, Jul 14 20221:13 PM EDTUpdated Thu, Jul 14 20224:19 PM EDT

Club holding Morgan Stanley (MS) reported weaker-than-expected earnings and revenue for its second-quarter before the opening bell Thursday. Revenue of $13.1 billion came up short of the $13.48 billion consensus, while earnings per share of $1.39 missed the $1.53 expected by Wall Street analysts. Breaking down the top and bottom lines one more step: Non-interest revenue of $10.85 billion, down 16% year over year, missed expectations of $10.87 billion; while net interest income of $2.28 billion, up 22% over last year, was in line with expectations. Bottom line This wasn't the quarter we were hoping for from Morgan Stanley as the headline numbers missed expectations and the results under the hood were mixed. Additionally, we never like seeing regulatory fines (more on that later). That said, these results were largely priced into the stock as indicated by the reaction we're seeing, with shares down about the same as the broader market sell-off. Moreover, the diversification of Morgan Stanley's business and intense focus on balance sheet health and financial discipline will allow management to take advantage of the stock's recent decline. Management is still in a strong enough position to both raise the dividend and execute on the previously announced $20 billion share repurchase authorization. We find shares attractive at current levels, as indicated by our 1 rating, given a buyback pace of roughly 6% of MS' market cap annually, over 4% dividend yield, and about 10 times price-to-earnings valuation on 2023 estimates. We picked shares up at $74.45 earlier this month and will therefore wait for potentially lower levels before stepping back in. This decision to hold off is more about disciplined accumulation rather than a call on the stock, something we spoke to during Thursday's "Morning Meeting." Despite our favorable outlook, we are reducing our price target to $95 (implying roughly 28% upside from current levels) to reflect the weakening macroeconomic backdrop and ongoing geopolitical uncertainty. Key company metrics Before digging into the various operating segments, let's take a quick look at some key overall metrics. (We define at the bottom of this section.) Return on average tangible common shareholders' equity (ROTCE) in the second-quarter was 13.8% versus 17.2% expected. ROTCE was 14.3% ex-integration costs. Expense efficiency ratio was 74% versus 72% expected. The ratio was 73% ex-integration costs. Common equity tier 1 (CET1) capital ratio was 15.2% vs. 14.4% expected. Tangible book value per share (TBVPS) was $40.07 vs. $39.97 expected. Regarding the increased expense ratio, the firm was negatively impacted by a $200 million hit "related to a specific regulatory matter concerning the use of unapproved personal devices and the firm's record-keeping requirements". To be clear, we are not happy when we see these unexpected costs resulting from regulatory missteps by the firm. That said, on the call, management said this is a subject of industrywide scrutiny. As a result, we aren't bailing because of this but we are disappointed to see it and will monitor to ensure this is a one-off event that will be quickly rectified. Financial definitions for bank stocks ROTCE is a measure of annualized earnings applicable to Morgan Stanley common shareholders as a percentage of average tangible common equity. Expense efficiency ratio is a measure of efficiency that is calculated as total non-interest expenses divided by net revenues, lower is better on this front CET1 is a measure of bank capital versus risk-weighted assets and a sign of the bank's ability to endure financial stress TBVPS is a measure of intrinsic liquidation value that removes intangibles such as goodwill. Think of goodwill as the value of the Morgan Stanley brand. Results by segment Institutional Securities net revenue of $6.12 billion for Q2 missed expectations of $6.35 billion due entirely to weakness in Investment Banking, which was partially offset by better-than-expected performance in the Equity and Fixed Income units. Investment Banking: $1.07 billion, down 55% year over year Equity: $2.96 billion, up 5% from year-ago period, versus $2.9 billion expected Fixed Income: $2.5 billion, up 49% from last year, versus $2.19 billion expected On the call, management noted that Investment Banking was negatively impacted as "heightened volatility led clients to delay strategic actions and new issue activity." It was good to hear CFO Sharon Yeshaya say the investment-banking pipeline "remains solid." However, this part of the business remains largely dependent on market conditions and corporate confidence, which has been weakening due to the Federal Reserve's interest rate hikes to fight inflation and Russia's war against Ukraine, which has brought destabilization to Europe. Total expenses for the segment came in at $4.48 billion with $2.05 billion related to compensation and $2.43 billion non-compensation related, including that $200 million regulatory fine noted above. Wealth Management net revenue of $5.74 billion for Q2 came up short versus expectations of $5.98 billion. Asset management: $3.51 billion, up 2% year over year Transactional: $291 million, down 17%, excluding mark-to-market losses on certain employee deferred compensation plan investments Net interest income: $1.75 billion, up 39% Other: $188 million While lower asset values will impact Wealth Management (and the Investment Management segment), delivering on commentary made last quarter, management noted on Thursday's post-earnings call that in Wealth Management the firm is already seeing higher net interest income due to rising rates. Recall, net interest income is the income generated as a result of the difference between what the bank pays you in interest to keep funds with them and what they can turn around and generate on those funds. For example, the spread between what you are paid on the deposits in your savings account and what the bank charges for loans. Notably, Wealth Management added $53 billion in net new assets despite market volatility and tax-related withdrawals, a dynamic that speaks to the firm's scale and ability power to attract new assets. The decline in Transactional sales can be attributed to "a moderation of client activity from last year's elevated levels and limited new issuance." Total expenses for the segment came in at $4.2 billion, with $2.9 billion attributable to compensation and the remainder being non-compensation related, primarily driven by technology investments. Investment Management net revenue of $1.411 billion for Q2 exceeded the $1.35 billion consensus. Asset management and related fees: $1.3 billion, down 8% Performance-based income and other: $107 million Total assets under management (AUM) came in at $1.35 trillion, down 11% annually and 7% sequentially "primarily due to the decline in equity markets." Total expenses for the segment came in at $1.16 billion: $605 million compensation and $557 million non-compensation Capital Returns Morgan Stanley repurchased 33 million shares in its second quarter at an average purchase price of $82.05 per share, resulting in a return of capital to shareholders to the tune of $2.74 billion. With this, the firm has completed the $12 billion share repurchase program announced last year. But as a reminder, a new $20 billion multiyear authorization was recently announced. Furthermore, the bank's board declared a quarterly dividend of $0.775 per share, up 11% from the current $.70 per share quarterly payout, payable on Aug. 15, 2022, to shareholders of record on July 29, 2022. Speaking on repurchase activity, on the call, management referred to capital ratios (such as the CET 1 ratio) as "sacrosanct," adding they like having "excess capital for exactly this environment we're in now." We love hearing this because it means management has planned and is in position both to return capital to shareholders while navigating the incredible uncertainties facing the global economy. In thinking through the $20 billion buyback, while it will take place over multiple years (there is no expiration on this authorization), given the environment we think that's prudent as it allows management to take their time and maximize the impact, rather than rush to get it done before a deadline. Management noted that they like the idea of repurchasing shares at current levels, reminding investors that with every share retired, they also retire a $3.10 per share dividend commitment, essentially indicating that for every share repurchased at $72, the net cost to the firm is closer $69 per share (given the saved dividend). Morgan Stanley CEO James Gorman said on the call that shareholders are getting a great return without getting out of bed, given what we mentioned in our bottom line section about the firm averaging a repurchase rate of about 6% of company shares annually and the roughly 4% dividend yield. (Jim Cramer's Charitable Trust is long MS. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . 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Morgan Stanley Chairman and Chief Executive James Gorman speaks during the Institute of International Finance Annual Meeting in Washington, October 10, 2014.

Joshua Roberts | Reuters