Morgan Stanley: Earnings Concerns As New CEO Sought (NYSE:MS)

Overview

Morgan Stanley (NYSE:MS) has had a good run under James Gorman. Since becoming CEO of the investment bank in 2010, and operating in a joint CEO/Chairman capacity since 2012, Gorman has turned the firm handedly around from its well-publicized struggles during and after the 2008 financial crisis. Now an envied leader in wealth management with a materially more diversified set of revenue streams, Morgan Stanley is entering a new era: Gorman has announced his resignation as of yesterday.

The departure of a well-regarded executive is news for any public company, and especially so in this instance. Whoever the successor will end up being, they will be under a microscope for the first 8 quarters of their tenure. While it is presently unclear what the strategic priorities of the new CEO will be, I think this is a good juncture to review Morgan Stanley from a fundamental perspective in order to determine how it is positioned going forward.

Select Fundamentals

Morgan Stanley has grown significantly over the last decade, with revenues having grown roughly 84% over that time.

As with other large financial entities with significant trading and brokerage operations, there is volatility y/y. Morgan Stanley’s revenue dipped twice in the last decade and did so by 10.65% last fiscal year.

This has also come along with 5 consecutive quarters of y/y revenue decline, including 3 y/y declines in the double digits.

Unlike in 2008, these declines have not been driven by the trading side of the house. Rather, they are the combined effect of headwinds across interest income, brokerage commissions, wealth management, and investment banking fees. Trading has actually picked up steam as the rest of these business lines have seen deteriorating performance throughout the last year:

While these business units are designed to be offsetting and create more reliable revenue streams, the picture here is disconcerting because the decline is broadly pronounced across every revenue line item apart from trading. As a counterpoint to this, wealth management did receive $110 in net new inflows for the past quarter; the business may be down, but it’s not out.

This situation overall has resulted in operating income declines that far exceed operating expense growth, something investors never like to see.

Looking all the way down to earnings per share we see this play out similarly:

While declining revenues are obviously bad, the 4-digit growth in interest expense is more eye-catching. Numerically, this is a significant current and future downward pressure on profits. If the numbers continue to compound at current rates, the situation will rapidly worsen. This is progression is due to the significantly higher, and still increasing, cost of capital that we now have in the financial sector. I will evaluate this force and its drivers in more detail in the next section.

These recent financials add context for why James Gorman and the board have elected to pursue a change of management. Quite simply, there has been a sustained drop-off in the company’s performance over the past 5 quarters. This is driven by a concurrent decrease in revenues and fast-growing expenses, particularly for interest.

While net interest income has also grown throughout this period, the growth rate for interest expense is an order of magnitude higher. This makes it quite possible that the firm swings back to a negative overall yield on interest again, which it had in the quarter prior to the most recent one. At the current growth rates for this expense in particular, this makes the future potentially more worrisome than the present. This could create further downward pressure on what are already declining earnings. Whoever the next CEO will be will seemingly have their own turnaround story to contend with here, albeit one nowhere as severe as what we saw in 2008.

Cost of Capital Considerations

In this section I want to comment on Morgan Stanley’s positioning relative to its peers while commenting on a factor that has become increasingly important to its operations throughout the past year: cost of capital.

Cost of capital is always important in the financial sector because it is the base rate at which companies can borrow capital to then lend out or trade. The money gets made on the spread between this cost and the return that the firm subsequently generates from its investment operations. The number to use for gauging the cost of capital across the banking sector, and indeed the financial sector as a whole, is the prime rate.

This rate is the interbank overnight lending rate for the money market, which is the go-to source of near-term liquidity for financial institutions and quite often (but not always) large publicly traded enterprises in general. It is also the index upon which all consumer credit rates and other financial instruments are tethered to.

As is always the case, the prime rate moves up linearly with increases in the Federal Funds rate. The prime rate has more than doubled y/y and now stands at 8.25%, whereas it was only 4.00% in May 2022. This means the cost of capital has more than doubled over the last year and is going to stay elevated until rates come down.

This has changed the dynamics in the financial sector and made cost of capital a significantly more important aspect of operations and strategic positioning. In this regard, Morgan Stanley has a relatively unique footprint. Since it does not have extensive consumer operations, it does not have much in the way of standard consumer deposits that a bank such as JPM (NYSE:JPM) has. It does, however, maintain a significant level of client assets on the wealth management side – $4.56T as of last quarter. This also came along with $110B in net inflows throughout that period.

Deposits and client assets are an especially valuable thing for banks to have at the moment because they are a highly efficient source of capital relative in a time when capital is getting increasingly expensive. Consumer deposits are especially good on a relative basis because consumers don’t require a high rate of return on their deposits in order to keep them parked at the firm; a good example of this is JPM’s current savings account rate of only .01%.

This allows entities with large amounts of deposits/client assets to have a ready pool of capital to deploy and subsequently capture a higher spread on. Without consumer deposits, banks otherwise have to rely on capital held for asset management purposes or make use of leverage. Both are inferior from a spread perspective. Asset management payout structures are much more rewarding for those depositing capital, and capital acquired through loans or alternative debt structures is rapidly rising in expense due to higher rates.

With a higher cost of capital also comes a higher hurdle rate for what constitutes a successful investment; this makes risk management more challenging as you now need to maintain structurally higher yields across your portfolio overall.

As such I think that cost of capital will be a determinative factor in relative performance within the financial sector in the near-to-medium term, including for Morgan Stanley. Until rates come back down, that’s just the way it’s going to be. Given this, I will be watching to see how Morgan Stanley’s asset inflow progresses in particular as well as the continued developments in its rapidly rising interest expenses, as these are going to be core leading metrics for its capital position going forward.

Conclusion

Since the current rate environment will certainly persist through this year and potentially longer, I will be looking for Morgan Stanley – and its next CEO – to increase the firm’s operating leverage as it relates to cost of capital. The situation presently is such that earnings on interest is growing at a far slower rate than expenses on interest for the firm. Mathematically, this equation could very well flip in the near-term and create additional downward pressure on earnings. Combined with a decreasing amount of revenue, this is a disconcerting forward-looking situation. I am looking for a stabilization in this trajectory as well as continued, hopefully increasing, momentum on client asset capture. While this gets sorted out I think it’s best to consider this stock a hold.