(MS) Morgan Stanley Analyst Downgrades Shares

We are downgrading our recommendation on Morgan Stanley (MS) to Underperform based on its weak second quarter results, lesser possibility of capital deployment and the expected adverse impact of regulatory restrictions.

The MUFG preferred stock conversion resulted in 38 cents per share loss during the quarter, though it enhanced the capital cushion. However, the results were substantially better than the Zacks Consensus Estimate of a loss of 63 cents.

Without the MUFG transaction, Morgan Stanley would have earned 64 cents per share from its continuing operations.

Results were aided by strong investment banking performance and revenue growth in all three business segments. However, higher interest and non-interest expenses were among the negatives.

The weak capital position is expected to restrict Morgan Stanley’s capital deployment. The company was not granted Federal Reserve’s green signal to raise dividend. Further, Morgan Stanley is expected to be a bit conservative with respect to its capital deployment as it will have to meet Basel III minimum capital ratios. However, given the lengthy implementation period of the Basel III standard, the company will not have to raise additional funds. On the whole, we do not expect Morgan Stanley to be able to enhance shareholder value in the near term.

Morgan Stanley has experienced intense pricing competition in some of its businesses in the recent years. In particular, the ability to execute securities trading electronically on exchanges and through other automated trading markets has intensified the pressure on trading commissions. The trend toward direct access to automated electronic markets will likely continue. Thus, competitive pressures are likely to affect future revenue growth prospects as its peers may seek to obtain market share by reducing prices.

On the flip side, although conversion of MUFG preferred stock into Morgan Stanley’s common stock had a severe impact on its second quarter earnings with huge non-cash charge, this eliminated a significant annual preferred dividend payment. As a result of this conversion, the company’s Tier 1 common ratio increased to the industry-leading level. Of the 290 basis point increase in Tier 1 common ratio to 14.6%, a 270 basis point jump resulted from the MUFG transaction during the quarter. We expect this transaction to make the company slightly flexible with respect to capital.

Although investment banks are facing industry headwinds on the global front, Morgan Stanley enjoys a significant competitive leverage, given a relatively consistent growth momentum in its core Institutional Securities’ franchise. Also, since the past few quarters, Morgan Stanley has been taking initiatives to restructure its financials to mitigate balance sheet risk.

The ongoing restructuring and inorganic expansion initiatives should continue to be significant growth drivers. Nevertheless, there are concerns related to the company’s financials being marred by new regulatory restrictions and intense pricing competition.

Morgan Stanley currently retains a Zacks #5 Rank, which translates into a short-term Strong Sell rating.

Among Morgan Stanley’s close competitors, JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C) reported impressive second quarter results, while the results of Bank of America Corporation’s (BAC) and The Goldman Sachs Group Inc. (GS) were shoddy.

BANK OF AMER CP (BAC): Free Stock Analysis Report

CITIGROUP INC (C): Free Stock Analysis Report

GOLDMAN SACHS (GS): Free Stock Analysis Report

JPMORGAN CHASE (JPM): Free Stock Analysis Report

MORGAN STANLEY (MS): Free Stock Analysis Report

Zacks Investment Research

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