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Morningstar | Morgan Stanley Seems To Have Positioned Itself for a Tougher 2019

Morgan Stanley may have positioned itself for a tough environment in 2019, which is a nice hedge with some upside optionality. Pretax operating margins of 29% in the first quarter of 2019 were down from a very strong 31% in the first quarter of 2018, but up from an average of 26% in the back half of 2018. Non-compensation expenses were about 2% lower than a year ago and nearly 5% lower than the 2018 quarterly average. Management stated that it did a lot of budgeting in the back half of 2018 when the revenue outlook became increasingly uncertain, so 2019 operating margins could surprise to the upside if a better revenue picture unfolds. We are maintaining our $52 fair value estimate for narrow-moat Morgan Stanley and assess shares as fairly valued.

Revenue had a great sequential increase, but we remain cautious over the next two years. Net revenue rebounded 20% to $10.3 billion, primarily from fixed income trading revenue recovering to $1.7 billion from $564 million in the fourth quarter. Even if we avoid a recession in the next two years, we expect relatively slow growth in the company's businesses. We're likely near the top of the cycle for the company's institutional securities business with U.S. underwriting and advisory near peak levels and trading generally being pressured by MiFID II regulations, electronification, and lack of conviction in this uncertain environment. Broadly speaking, assets look fully valued, so investment management revenue growth will be lower than in the bull market we've had over the last decade. With the Fed Funds rate in a holding pattern for 2019 and global central banks a little more accommodating than six months ago, net interest income will likely decelerate. That said, even if earnings growth is tepid, Morgan Stanley can sustain healthy returns, such as the annualized return on equity of 13.1% and return on tangible common equity of 14.9% that the company had in the quarter.

One area that we were hoping to see more improvement was in the wealth management segment's compensation ratio. We were expecting to see a 0.5%-1% improvement in the compensation ratio from the rolloff of retention notes related to the Smith Barney merger. However, the compensation ratio of 56.1% was the highest its been in about two years. The culprit seems to have been the company's deferred compensation plan that appears in both the company's revenue and compensation lines. Given the rebound in asset prices in the first quarter, the compensation ratio was unusually elevated. We wouldn't be surprised if the compensation ratio decreases to 54%-55% for the remaining quarters of the year.

Morgan Stanley is hoping for some incremental growth from its acquisition of Solium Capital, an employee stock plan manager. The general idea is that employees who use the company's stock plan service may use Morgan Stanley's wealth management service. Goldman Sachs is also taking a similar strategy of expanding its wealth and investment management services by leveraging its Ayco business that works with corporate executives as an inroad to serve a corporation's employees.