Shares of investment banks Goldman Sachs and Morgan Stanley have underperformed in 2011 as investors worry about the future of their traditional business models amid a regulatory environment that seeks to reign in risky trading practices.
Both stocks are down 20% year -to-date. And those investors looking for an upside catalyst for these stocks in the near-term may not find it in second- quarter earnings, going by analyst forecasts.
A weak investment climate amid expectations of a global economic slowdown has depressed trading volumes across asset classes, while underwriting activity has also slowed.
Analysts at JPMorgan Chase expect the Fixed Income Commodities and Currency segment (FICC) revenues to drop 21% quarter-on-quarter for their coverage universe on account of slower client business across asset classes, low volatility in the credit and rates business and a shift from derivatives to cash markets. Equities are expected to show a drop of 12% quarter-on-quarter, as lower exchange-traded volumes hit commissions.
Investment banking revenue, meanwhile, is expected to show muted growth on the back of modest uptick in equity offers and deal activity during the quarter.
The lack of revenue growth overall might put the focus this quarter on expenses according to some analysts. "The critical issue for all banks will be operating earnings," said Rochdale Securities analyst Dick Bove, noting that banks have been seen higher operating expenses even as revenues have dropped. "The reported earnings might be higher. But banks have to show that they can increase operating earnings."
Morgan Stanley already has announced a plan to cut its expenses by $500 million by 2012 and has a total expense-saving target of $1 billion over the next three years. While neither Morgan Stanley nor Goldman Sachs have hinted at layoffs at their investment banking and trading units, analysts say the biggest cost driver for investment banks is compensation, making it a key lever for driving profitability.
Banks Sharpen the Ax
"With muted revenue growth a major determinant of the pre-tax profit outcome in the investment banking divisions in 2011 will be the staff cost to revenue ratio," RBC Capital analysts wrote in a note, adding that layoffs might be in the offing. "Given increasing competition and the increased use of deferrals and rising fixed salaries, the proportion of variable bonuses has fallen so the banks have more limited scope for operating leverage in our view aside from cutting headcount," they said.
Matthew Burnell, analyst at Wells Fargo Securities also expects Goldman Sachs and Morgan Stanley to increasingly tweak their compensation structure to drive profitability in 2011 and 2012. "For every 100 basis point drop in Goldman Sachs' compensation to revenue ratio, the return on equity improves by 43 basis points," said Burnell.
Indeed, investment banks are looking for ways to maximize their returns on equity, a key measure of profitability that has fallen significantly from the pre-crisis levels for the sector. Goldman Sachs delivered a return on equity of 12.2%, partly hurt by a one-time impairment charge associated with its servicing unit, but still far below the 20% levels the investment bank had once targeted. Morgan Stanley delivered only half that return in the first quarter, at 6.2%.
Banks have cut back on leverage in the post-crisis era and are holding more capital to comply with regulatory requirements, both of which have had a dampening effect on ROE and hurt stock valuations. Any marked improvement in the measure in the second quarter would likely boost the stocks, although few analysts expect any change at all, given the uncertainty of regulatory impact on their various businesses.
New rules are being written to regulate the trading of complex financial instruments such as derivatives, the financial impact of which is uncertain as banks seldom disclose details of their derivative trades. The banks also remain uncertain on how the Volcker rule that restricts them from trading with their own capital will impact their traditional role as market makers. The lack of clarity on the regulatory front in addition to a weak operating environment is expected to be a drag in the near term.
RBC Capital recently initiated coverage on the sector with an underperform rating on both Goldman and Morgan Stanley. "In the more regulated post -financial crisis world, investment banking returns are under significant pressure. GS and MS are the least diversified and therefore the most impacted by regulation," the analysts wrote. "While the stocks have been de-rated year to date, we see this to be justified given the headwinds facing investment banking and see limited absolute upside," they said, adding that they preferred diversified players like JPMorgan Chase (JPM)and Citigroup(C).
In the second quarter, Goldman is expected to report an earnings per share of $3.56 on revenues of $9.85 billion, according to consensus estimates from Reuters.
Analysts last quarter expressed concerns about Goldman's "overcapitalized" levels, fearing that it was being too conservative with capital levels and was diluting returns on equity. Barclays Capital noted recently that the management had indicated that it will continue to maintain excess capital levels to until outstanding regulatory issues are resolved.
While Goldman previously targeted a return on equity in the high-teens, it has recently refrained from doing so on account of the regulatory uncertainty. Analysts will likely focus on how it intends to reduce its excess capital.
JPMorgan recently upgraded the stock to overweight on expectations that the bank will use excess capital to buy back stock. "We had a group meeting with GS Vice chairman and Co-CEO of GS Intl.Michael Sherwood, and conclude the firm's strategy is clear and recent negative news flow impact on franchise over-discounted. Based on our own analysis we see material re-leveraging potential." The analysts expect the bank to improve return on equity through share buybacks to the tune of $27 billion - capital released as less liquid assets in its investment and lending division run off- and compensation adjustments.
Outside of earnings, CEO Lloyd Blankfein would likely remain in the hot seat on legal risks. Last month, Rochdale Securities analyst Dick Bove issued a sell rating on the stock , arguing that the investment bank could face a possible government fine based on a Senate subcommittee report that said the bank sold clients risky sub-prime mortgages and then bet against them.
Then last week, Bove issued a report that reiterated his sell rating on the stock but essentially argued that the original thesis for his rating- that Goldman could face a big government fine based on the senate committee's report - had been negated by recent information. " It is becoming increasingly apparent that a terrible wrong may have been done to Goldman Sachs, he wrote. "Evidence is now mounting that the company did not have a net short position at the crucial time under study and that the Senate Committee may have misread the numbers."
However, Bove said economic conditions were weak and the regulatory environment remained tough, and the consensus estimates on Goldman were still too high. "..as Goldman emerges from its government problems, it now faces economic issues that may cause difficulty with the stock. Any decision on the rating will be deferred until other analysts adjust their estimates on the company and the political entities begin withdrawing their attacks," wrote Bove.
18 analysts rate the stock a buy, 8 a hold and 3 have a sell or underperform rating on the stock.
Morgan Stanley is expected to report an earnings per share of 56 cents on $8.36 billion, according to consensus estimates from Reuters.
Shares of Morgan Stanley are down 20% in the last three months. Investors punished the stock swiftly last quarter as analysts adjusted their estimates to reflect the dilutive impact of a conversion of $7.8 billion in preferred shares into 385 million shares of common stock.
The bank's fixed income division has been an underperformer, while its low return on equity post the crisis has it trading at a steep discount to its book value.
"There are early signs of improvement in fixed income revenue market share at MS and we have forecast growth of 9% to 10% in 2011/12.," RBC Capital said in a note. "However, the big issue facing the Institutional Securities operation is regulatory reform. On our estimates the post-tax return on equity would be 15% pre-Basel III, but this drops to 8-10% with the new capital rules and if we include a scenario for the impact of regulation on the P&L (Volcker rule, derivatives reform and risk-weighted assets reductions). " RBC Capital has an underperform rating on the stock.
Bove at Rochdale Securities has also lowered his earnings outlook on the stock, reflecting a challenging operating environment as well as the impact of investments the company is making to improve its foundation.
"In the current quarter, it is believed that the underwriting business will be quite strong based on Morgan's standing in the league tables. The increase in M&A and the decline in junk bond rates until just a few days ago suggest that the credit business is doing well," Bove noted. "All other trading activities are expected to be flat to down slightly. The wealth management business could be flat given the weak market conditions and the asset management business still appears to be in an early stage of turning around. "
The analyst expects the firm to be impacted by some one-time costs this quarter. However, he reiterated a buy on the stock because it of its low valuation and his conviction in the management.
Brad Hintz at Sanford Bernstein also believes the selloff in Morgan Stanley may have been overdone. Hintz argues out that at current valuations, the firm is probably worth more dead than alive. "We have long argued that absent a liquidity crisis, the mark-to-market balance sheets of Wall Street trading firms support a trough valuation at tangible book value," Hintz wrote. "This is because at low valuations, an acquirer could simply liquidate the trading balance sheet, pay off the liabilities and walk away with more cash than they paid for the company. Thus, at certain P/TB levels, such as today, a broker is worth more dead than alive."
Hintz notes that the management is aggressively restructuring its fixed income business by cutting costs and investing in automation. Its remains a top player in the M&A league tables and its asset management is improving.
"Morgan Stanley stock has certainly been a disappointment. But is it a value trap? Is this a stock that looks "cheap" but has no upside potential in the long term? We argue no. Rather, MS is caught in a weak operating environment while uncertainty on the secular changes on the implementation of regulation keeps even long-term value investors paralyzed."
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