Morgan Stanley’s third-quarter earnings: downgraded to a hold (NYSE:MS)

Thesis

Morgan Stanley (NYSE: MS) The third quarter was not so bad, but the bank disappointed compared to expectations and its counterpart JPMorgan (JPM). Revenue exceeded expectations by approximately $327.80 million and was down nearly 14% year over year. Meanwhile, JP Morgan beat expectations and grew revenue by approximately 10% year over year. On the trading day following the third quarter results, Morgan Stanley stock lost as much as 5%, while JPM stock rose 1%.

I still believe that Morgan Stanley is a winning bank in the long run. But, if you can buy JPM and MS at a competitive valuation (in fact, MS stocks are slightly more expensive), then I think it makes perfect sense to underweight Morgan Stanley. Downgrade pending.

Morgan Stanley’s third quarter

In the period from July to the end of September, Morgan Stanley generated total revenue of $13 billion, reflecting a contraction in business of about 14% year-over-year. For reference, analysts were expecting revenue of around $13.3 billion (Source Bloomberg Terminal).

Earnings per share were roughly in line with expectations: GAAP EPS was 1.47/share versus $1.51 expected. But investors should note that during the same period a year ago, EPS was considerably higher: $1.98.

CEO James P. Gorman commented:

Firm performance was resilient and balanced in an uncertain and challenging environment, delivering a 15% return on tangible common equity… We continue to maintain our strong capital position while repurchasing $2.6 billion of shares and distributing a healthy dividend.

While investment banking and investment management were impacted by the market environment, fixed income and equities sailed well in challenging markets.

Investment banking fees down sharply

Heading into the third quarter, top US bank executives have already warned that investment banking fees are set to drop sharply, by around 50% year-over-year. But Morgan Stanley’s fees have fallen even more than the stern warning implied: down 55% from a year ago. The reasons for this poor performance are obvious: the volume and value of M&A deals have declined significantly compared to 2021, and the same argument can be made for capital markets activity (e.g. IPOs on the stock market, the subscription of fixed-income securities).

For reference, JPMorgan’s investment banking fees are down about 45%.

Mixed business results/markets

Given the enormous market volatility in the third quarter, analysts had expected a strong performance from Morgan Stanley’s markets division. While the results were solid, they were far from stellar.

Equity desk revenue was down about 14% year-over-year, due to “declining client activity” and “falling equity markets.”

The fixed income desk grew revenue about 33% year-over-year, driven by “the strength of macro products on high client engagement and market volatility.”

Strong wealth management

Arguably Morgan Stanley’s best-performing segment was wealth management, which is also the bank’s largest segment by revenue. In the third quarter, wealth management fees increased to $6.1 billion from $5.9 billion in the same period a year earlier. The segment’s pretax profit increased to $1.6 billion from $1.5 billion respectively.

Other highlights include:

pre-tax margin of 26.9% or 28.4% excluding integration charges.

higher net interest income on higher interest rates.

the firm added $65 billion in net new assets, bringing total net new assets year-to-date to $260 billion.

Downgrade to underweight

Trading at a forward P/E of around x11.5, a P/B of x1.4 and a dividend yield close to 4%, I continue to believe that the risk/reward ratio for Morgan Stanley is attractive. Moreover, anchored solely on a long-term earnings outlook, the stock should be valued at nearly $145/share.

However, investing is still a relative discipline – meaning that every opportunity must be judged against the alternatives. And an alternative to Morgan Stanley is JPMorgan.

Investors should consider that JPMorgan’s third quarter results clearly outperformed those of Morgan Stanley. And there is a major reason why this outperformance should continue: JPMorgan has a strong commercial bank, unlike Morgan Stanley. Thus, in a rising interest rate environment, JPM can take advantage of the deposit/loan interest spread. This helps JPMorgan cushion the downturn in investment banking and wealth/asset management.

Given that JPMorgan and Morgan Stanley are trading at a similar valuation, I argue that the risk/reward ratio is skewed in favor of JPM.