Morgan Stanley: Revenue Predictability Separates From Peers

Summary:

• Morgan Stanley has successfully shifted its focus from investment banking and trading to wealth management through strategic acquisitions.
• The wealth management division provides a recurring revenue model based on assets under management, offering stability and predictability.
• The firm’s valuation has diverged from its peer Goldman Sachs due to its greater revenue stability, and it also offers an attractive dividend yield.

Introduction

Morgan Stanley (NYSE:NYSE:MS) is an interesting case study in gradual but deliberate business transformation. The iconic Wall Street investment bank is best known historically for its deal making and trading operations in products such as equities, fixed income and foreign exchange.

However, under the stewardship of the recently departed CEO James Gorman, the firm made an effective pivot to focus on wealth and investment management. Gorman’s tenure was highlighted by strategic acquisitions, such as the $13bn purchase of online brokerage E*Trade in 2020 and mutual fund provider Eaton Vance in 2021. These respective purchases expedited the business mix shift away from the historic heavy focus on investment banking and trading.

Unlike the inherently cyclical and lumpy capital markets business, wealth management provides a recurring revenue model based on assets under management or AUM. This strategic pivot has allowed Morgan Stanley to become a less cyclical business. As a result of higher revenue predictability, the firm has been rewarded by the market with a higher price multiple. This reward is particularly evident when comparing the firm against its traditional investment banking peer Goldman Sachs (NYSE:GS).

In addition, the firm remains a Wall Street giant of investment banking and trading. Higher interest rates led to a slowdown in M&A activity and trading over the past two years, but Q1 earnings showed signs that side of the house is bouncing back. The combination of a steady recurring revenue business, coupled with a cyclical markets franchise poised for a rebound makes MS look an attractive buy at this moment. Additionally, the firm pays a leading dividend in the large cap banking space, taking these factors together I feel comfortable recommending Morgan Stanley as a Buy.

Recurring Revenue

At its core a wealth management model is driven by fees earned on AUM. In its Q1 earnings release, MS reported $2.1T of fee-based client assets in its advisor channel. These fee earning assets generate a steady stream of revenue for the business in a recurring manner. As illustrated below, we can see that even during periods of higher interest rates in 2022 and 2023, the wealth business continued to grow revenue. This stands in stark contrast to the institutional securities business which can fluctuate significantly with the economic cycle. Hopefully expected interest rate cuts materialize in H2 of this year, as a reduction in rates should help kick start activity in the markets business.

It is not just revenue stability that is appealing in the wealth franchise, as we see below the division also delivers an extremely consistent and attractive mid-teens ROE.

As attractive as the business is at present, management have indicated the best is very much still to come. In January of this year, new CEO Ted Pick stated the firm is looking at dual goals of ten trillion in client assets generating a Return on Equity of 20%. The goal certainly seems attainable in the medium term, given client assets sat at $6.6T at the end of 2023. My expectation is over time the business will continue to shift to a higher revenue proportion being generated by the wealth business. The inherently more predictable and recurring nature of this revenue should give the market consideration to re-rate MS even higher than current levels.

“Our strategy is working. We have a clear path to $10 trillion in client assets across wealth management and investment management. We remain focused on supporting clients on their path to advice, deepening existing client relationships and using our scaled platform to achieve sustainable 30% pretax profits over time.” (Sharon Yeshaya, CFO)

Recent Earnings

MS reported Q1 earnings in April with EPS beating consensus by 24%, markets were pleased with the results as the stock jumped 2.5% on the day. Results were pretty clean with strong performance across all three business units. The business delivered a very impressive ROTCE of close to 20%. This strong set of results was delivered without the capital markets business shooting the lights out at 2021 levels. There is potential further room to run should deal activity continue to rebound as predicted by consultancies such as EY.

Valuation Divergence

Historically Morgan Stanley traded in-line with its nearest peer Goldman, as both business were generally capital markets focused businesses. However, as MS moved to shift its business mix to a greater wealth management focus, the markets have rewarded the stock with a higher multiple on account of the greater revenue stability. Looking at respective Q1 earnings, we can see MS deriving over 50% of revenue from wealth and investment management, with Goldman generating just 27% of its revenue from asset management.

This difference in revenue mix appears to be the primary driver of the valuation gap which has emerged between the two firms. As seen below, we can clearly see MS separating its since 2021, which coincides with the acquisitions of E*Trade and Eaton Vance.

Even with a run-up in price multiple in recent year MS still offers investors an attractive 3.5% dividend yield. The firm has grown its dividend by over 23% over the past five years while maintaining a conservative mid-50s payout ratio. The dividend screens very favorably when compared against its large-cap banking peer group. Given the importance of dividends as a component of total return, I see Morgan Stanley’s healthy yield as another important part of a buy thesis.

Risks

The most obvious risk to the business is the recent retirement of long-standing CEO James Gorman. Mr Gorman led the bank through one of its most difficult periods post the GFC. As CEO from 2010, he oversaw a tremendous rebound for the stock. Since 2010, Morgan Stanley has outperformed all of its large banking peers with the exception of JPMorgan (NYSE:JPM). Importantly, they have significantly outperformed Goldman by a whopping 100% over the period.

New CEO Ted Pick is a long-standing Morgan Stanley employee having joined the firm in 1990. My expectation is he will be unlikely to tinker with a winning formula but every transition of a long-standing and highly successful CEO entails risk the next person fails to deliver in the same manner.

Conclusion

In conclusion, I believe that Morgan Stanley is a high quality business which has tactfully pivoted its business in recent years to become a more dependable revenue generator. Management have clearly outlined ambitious medium term targets which suggest the best may still lie ahead for investors. While there are justified concerns following the ascension of new CEO Ted Pick, I am confident he will continue the navigate Morgan Stanley in the same direction of travel as dictated by James Gorman.

Financial markets have rewarded the firm with a higher price multiple in recent years as investor feel more comfortable on earnings visibility. The continued growth of recurring revenue relating to fees on wealth management assets should continue to bolster investor confidence, and warrant even higher multiples in due course. Finally, the firm boasts a very attractive dividend yield which is better than its peer group and should provide investors with a steady and growing stream of income. I initiate coverage of MS with a buy recommendation.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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