Operating Leverage May Hurt Morgan Stanley

Since the very beginning, we’ve positively viewed Morgan Stanley’s push into the less-capital-intensive and steady wealth management business. We’ve also frequently remarked on the net interest income growth opportunity at the brokerage and wealth management firms that we cover. These two drivers have been in full effect over the last couple of years along with the company generating significant operating leverage from its expense savings initiative and turning around its fixed-income trading business.

That said, the recent environment has likely been more favorable than both we and Morgan Stanley’s own management forecast. Any turnaround in capital markets activity, asset levels, or potentially funding costs can be a negative surprise to investors due to the company’s operating leverage. Given the recently stronger-than-expected performance, we expect to modestly increase our fair value estimate for narrow-moat Morgan Stanley.

Looking at management’s targets and how 2017 has played out so far, it’s reasonable to conclude that current profitability is likely above what management would have considered normal. Going into 2017, we were expecting a slowdown in traditional investment banking activity due to political uncertainties, such as those related to U.S. taxes and trade policy. However, underwriting and financial advisory have done surprisingly well year do date, as equity markets have remained strong, long-term rates have remained low, and acquisition activity outside of the very largest deals has remained healthy. Fixed-income trading has also averaged $1.37 billion per quarter compared with management’s initial goal of $1 billion. This has led to the institutional securities segment compensation ratio being 35.5% compared with the guidance of roughly 37%.

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