Morgan Stanley's Brokerage's Biggest Asset Is An Obstacle

(Dow Jones) Morgan Stanley's plan to boost profit at Wall Street's biggest brokerage firm has one major obstacle: retail investors.

While the investment bank's trading business is firing on all cylinders again, the "flash crash" dealt its wealth-management unit--an anticipated source of future growth--a blow, as spooked clients removed $5.5 billion in the second quarter.

One of the main reasons a pullback among retail clients is damaging for Morgan Stanley is about 35%-40% of the investment bank's quarterly revenue comes from its wealth-management business. The bulk of the remaining revenue comes from the institutional securities group, which includes investment bankers and traders.

Morgan Stanley and its chief executive, James Gorman, have bet heavily on an army of roughly 18,000 brokers helping to generate a stable source of revenue. But with the company on track to miss broadly on at least one key target for its Smith Barney joint venture, the timetable for that payoff is in question.

"You have a company that is going to be suffering through a retail drought and incurring one-time expenses as they put technology [for the brokers] in place," said Sanford C. Bernstein analyst Brad Hintz.

With those obstacles, Hintz called Morgan Stanley's stock a "value trap," saying that the company's share price could "sit for a while until the skeptical investor says 'OK, Gorman is going to be able to deliver on his promises.'"

Shares of Morgan Stanley recently traded up 0.4% at $27.10 and are down 8.5% year-to-date.

A tough operating environment would stand to affect other firms that cater to retail investors such as Bank of America Corp.'s Merrill Lynch, which is Morgan Stanley's main rival within the brokerage industry. However, Merrill has boosted margins and other metrics including asset-management fees and brokerage income for Bank of America's wealth segment from a year ago. It also is fully integrated with the roughly 2,000 advisors who worked at the commercial bank prior to the deal.

Morgan Stanley has said it wants to generate a 20% pretax profit margin from the wealth-management business, along with $1.1 billion in cost savings. Through the first six months of 2010, the margin is 7%, and executives said the company may "push out" its original projection over a longer time frame.

The investment bank also originally forecast $14 billion in combined revenue from the business after integration, far above the $3.1 billion the unit posted in the recent quarter.

A Morgan Stanley spokesman said "wealth management is an important part of a long-term revenue diversification strategy built around complementary businesses focused on global capital formation and investment. You don't change your strategy every 13 weeks."

Despite the tough business environment, the company spokesman said Morgan Stanley has no plans to back down from its goal of acquiring 100% of the brokerage tie-up over time.

To be sure, Morgan Stanley is in the same boat as all of its major competitors--including Goldman Sachs Group Inc.--as volatile equity markets have dried up demand across its business lines. Retail investors, in particular, have reined in trading, putting less cash to work. Historical trends show there is no guarantee that these clients will return any time soon.

But, analysts are looking for signs of progress at Morgan Stanley Smith Barney. Since the investment bank acquired a 51% stake in the joint venture on May 31, 2009, the current third quarter represents the first comparable period to a year ago. Another potential quarter of asset outflows would be a setback for the business.

Credit Suisse analyst Howard Chen says he's looking for pretax profit margins in wealth management to remain depressed in the third quarter, but said he does expect a "meaningful expansion in the range of 15%-20%" in 2011.

Morgan Stanley has beefed up its trading operations with several hundred hires over the past two years, which boosted its overall profits and helped it beat out Goldman's earnings in the second quarter.

But company watchers say such the result isn't likely to repeat itself on a regular basis and instead, peg future growth to the wealth-management business that's made up almost entirely of the joint venture.

Anton Schutz, president of Mendon Capital Advisors, which owned 75,000 Morgan Stanley shares as of March 31, said the joint venture (which added 10,000 more brokers) is a "differentiator" and will allow the firm to "place [more] stock in retail hands, and make winning deals easier to do."