Forget Facebook, Morgan Stanley Can’t Trade Its Way Out of a Paper Bag

Morgan Stanley
Oliver P. Quillia for
Morgan Stanley

Morgan Stanley’s big second-quarter earnings miss is a result of abysmal trading results and not a botched initial public offering of Facebookshares. Given the second-quarter results, the bank’s entire strategy of exiting some businesses in favor of underwriting and wealth management will come under scrutiny.

Earnings at the nation’s sixth largest bank by assets were weighed by far-weaker-than-expected debt and equity trading results, and a two-notch ratings downgrade by Moody’s, which propelled earnings from continuing operations nearly 80 percent lower from the first quarter.

Morgan Stanley reported total trading revenue of just $2.9 billion and earnings of $158 million, missing analyst estimates, as rating downgrades and a withdrawal of client activity likely precipitated the sharp earnings drop.

“These results are clearly very disappointing, however MS was facing a potential downgrade by Moody’s during the quarter, and that likely impacted their trading revenues,” wrote UBS analyst Brennan Hawken, in a note to clients.

The bank reported adjusted earnings per share of 16 cents and revenue of $6.6 billion, missing estimates as earnings at its trading unit tumbled on a year-over-year and sequential basis.

Analysts polled by Bloomberg expected 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 earned 28 cents in earnings per share, missing expectations of 51 cents, but reversing a first quarter loss.

In the first quarter, Morgan Stanley’s trading unit — called Institutional Securities — reported adjusted revenue of $5 billion and a profit of $1.7 billion, driving its a big earnings beat.

The unit’s weakness resulted from fixed-income trading revenue of just $770 million that was roughly half of UBS analyst Hawken’s projections and equities trading revenue of $1.1 billion, that also fell short of expectations. Still, Morgan Stanley’s investment banking revenue of $884 million, was in line with expectations, signaling that Moody’s late June ratings downgrade cast a larger pall over earnings than the negative publicity that the bank received for its underwriting of Facebook’s May 18 share listing.

With earnings overwhelmed by a big trading drop, Nomura Securities analyst Glenn Schorr wrote that it was “hard to pick out too many positives,” citing investment banking earnings and pre-tax margin improvements in wealth management as earnings highlights. “Results disappointed on a sharp decline in fixed-income trading,” wrote Wells Fargo analyst Matthew Burnell.

A key question now is whether Morgan Stanley’s trading weakness is a one-time miss or an indication of lasting issues. For instance, Moody’s ratings downgrade was estimated to impact Morgan Stanley more than competitors because the bank doesn’t hold much of its derivatives trading operations in a higher-rated subsidiary that would soften the financial impact of cuts.

As a result of the downgrade, Morgan Stanley posted $6.3 billion in additional collateral and other payments as part of trading agreements with its counterparties — primarily in derivatives trading. The bank said that it $2.9 billion was called and posted at June 30, 2012, just over a week after the Moody’s downgrade of the bank’s ratings to Baa1.

On an earnings call with investors, Morgan Stanley CFO Ruth Porat said that downgrade hit trading revenue by an estimated $225 million. “Having that ratings action addressed, now having clarity on it and having that uncertainty gone, we’re seeing real relief among clients. Clients have re-engaged,” she said.

Credit Suisse analysts led by Howard Chen expected Morgan Stanley’s trading operations to earn $2.5 billion of core revenue, amid a sharp drop in equity and debt trading revenue, that puts it far behind competitors like Goldman Sachs, JPMorgan Chase, and Citigroup, who’s second-quarter trading results generally beat expectations.

Morgan Stanley’s earnings miss also clouds progress on core initiatives like its push into brokerage operations. The bank reported improving margins at its Morgan Stanley Smith Barney brokerage unit and $3.3 billion in revenue, slightly beating estimates. Overall, the unit’s profits rose over 20 percent to $393 million, on a year-over-year basis.

Many were watching for improving margins at Morgan Stanley Smith Barney as a key to the bank’s second quarter. “The Morgan Stanley story has been an execution story for a long time,” said Morningstar analyst Michael Wong, citing the company’s push into brokerage and wealth management businesses, in an interview prior to earnings. “I will be concentrating on where operating margins are going,” added Wong.

The unit’s margins increased to 12.1 percent, indicating progress as the bank continues to fall short of 20 percent that it projected when entering the brokerage joint venture with Citigroup in 2009.

The brokerage unit, which is one of the largest in the world, is a strategic fit with Morgan Stanley’s investment banking unit, which was the leading underwriter of IPOs globally in the first half of 2012. In recent quarters, Morgan Stanley’s brokerage took in client funds as its investment banking unit led the underwriting of Zynga, Groupon andLinkedIn shares. Even after a challenged Facebook share listing, Morgan Stanley was hired to lead theupcoming IPOs of Kayak and Palo Alto Networks.

By pushing into brokerage, Morgan Stanley is also trying to move from capital intensive trading and proprietary investment operations and into low capital and low risk businesses, such as wealth management. The moves may bolster the bank’s liquidity and its return on equity, as new regulations like Basel III and the Dodd-Frank Act kick in.

Morgan Stanley also made progress in cutting compensation costs and operating expense — primarily at its institutional securities unit. Compensation expense declined by $1 billion to $3.6 billion, while non-compensation expense fell $200 million to $2.4 billion from year-ago levels. Credit Suisse analysts had expected a compensation ratio nearing 60 percent.

Chief Executive James Gorman said on an earnings call that the bank would cut headcount by 7 percent this year.

“Although global economic uncertainty remains a headwind, we are proactively positioning the firm for success,” said Gorman, in a statement released with earnings. “Our businesses showed resilience in key areas during the quarter, and we made progress against strategic goals.”

Year-to-date, the bank’s shares are off over 10 percent.

Morgan Stanley benefited less than expected from a widening of its credit spreads on the rating downgrade and negative sentiment surrounding overall investment banking and trading activity. The bank reported a $350 million gain from the increase in its credit spreads, roughly half of estimates.

—By’s Antoine Gara

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