This Barron’s feature on MS and GS focuses on the differences between
the two firms in valuation and business model. At current prices, MS
strikes me as the better deal.
http://online.barrons.com/article/SB123698562029125353.html
›Goldman Sachs and Morgan Stanley are Wall Street's sole
standouts. Both could thrive as markets pick up.
March 16, 2009
By ANDREW BARY
Yes, Virginia, there still is life on Wall Street.
After a year that saw the bankruptcy of Lehman Brothers and forced mergers involving Bear Stearns and Merrill Lynch, Goldman Sachs and Morgan Stanley seem on course for a profitable first quarter and full year, despite a terrible economy and depressed global stock markets. The investment community is warming to the financial giants after bashing their shares last year. Morgan Stanley (ticker: MS) is up 58%, to 25, in 2009, making it the top-performing big financial, while Goldman (GS) has risen 17%, to $98. In contrast, shares of Bank of America (BAC) and Wells Fargo (WFC) have tumbled more than 50%.
Goldman and Morgan Stanley aren't burdened by the hefty consumer-debt and commercial-loan portfolios that are hurting their banking rivals. And both have bolstered their relationships with institutional traders in the important bond, equity, commodity and foreign-exchange markets, as formerly formidable rivals have perished, stumbled or become preoccupied with boosting their capital to remain going concerns.
Despite the gloom enveloping much of the credit market, debt underwriting has surged this year. Financially healthy companies have rushed to take advantage of historically low rates and to finance takeovers. [E.g. Roche-DNA, PFE-WYE, and MRK-SGP.] And more companies are employing Goldman and Morgan Stanley, whose standing has risen among investors, in part because both value virtually all their assets at market prices, leaving them less vulnerable to write-downs than banks, which carry most of their assets at face value.
"Capital-market activity is a bright spot...while consumer credit appears to be deteriorating by the day," wrote Goldman Sachs equity analyst Richard Ramsden in a client note last week, in which he put Morgan Stanley on the firm's Conviction Buy List.
"The competitive landscape has changed," Goldman's chief financial officer, David Viniar, said last month. "Some of our competitors are no longer there. Others are very inward-focused because they are having their own problems. So there are just opportunities every day in the franchise doing stuff for our clients -- taking risk, distributing risk." Goldman and Morgan Stanley executives declined to comment for this article.
Look at what has happened on Wall Street. Lehman is gone. Bear Stearns is part of JPMorgan (JPM). Merrill Lynch merged into Bank of America, which bought Merrill for its retail brokerage network, not its institutional business. Citigroup (C) is wounded. Most European banks are on the ropes, including UBS (UBS), which has been scorched by enormous U.S. mortgage losses. A year ago, about a dozen financial heavyweights were scrapping for U.S. debt, equity and advisory business. Now there may be just three committed and deep-pocketed rivals: Goldman, Morgan Stanley and JPMorgan.
Don't be misled, however: While they are doing better than their competitors, not everything is rosy for Goldman and Morgan Stanley.
"Basically every company...every industrial company in every industry in every country in the world is doing badly," Viniar said last month. Institutional and retail-client activity is down, formerly profitable areas like merger-advisory work and initial public offerings are off sharply or moribund. Once-lucrative asset-management arms are getting stung by market declines. The value of real-estate, mortgage and private-equity holdings continues to deteriorate.
There also is continued talk of a potential brain drain, as key people quit to join investment-banking boutiques or hedge funds now that big firms are trimming compensation, partly in response to criticism from Washington over pre-2008 Wall Street's noxious combination of enormous bonuses and excessive risk. However, it is hard to have sympathy for big financial firms, particularly Goldman. The average compensation for its 30,000 employees last year was still $360,000, although that is down from about $660,000 in 2007, when CEO Lloyd Blankfein took home $70 million.
The firms dislike acknowledging the benefits they derive from various government liquidity programs, including $10 billion each from the Troubled Asset Relief Program (TARP) and a less-publicized bond-guarantee program from the Federal Deposit Insurance Corp. that has produced more than $20 billion of cheap financing for both Morgan Stanley and Goldman since it began in October. The two are among a handful of large financial outfits that Washington probably has deemed too big to fail. At the same time, both firms are hunkering down, reducing risk and maintaining liquidity, with the aim of surviving a tough first half. That would position them to take advantage of an economic and market recovery in late 2009 or 2010.
All this reassures jittery investors. Amid a broad rally in financial stocks last week, Morgan Stanley jumped 48% and Goldman, 30%. There could be additional upside this year, with Morgan Stanley topping $30 and Goldman hitting $110 or more. And the stocks could go a lot higher if business conditions and earnings rebound (although the deeply depressed shares of banks and life insurers could rally even more in any recovery).
Morgan Stanley now trades at 10 times projected 2009 earnings of $2.48 a share, and Goldman fetches 12 times estimated 2009 net of about $8. But getting a precise fix on results is tough in this market.
Many investors now value financial companies based on shareholder equity, or book value. Morgan Stanley trades for 83% of its $30 book value and 92% of its tangible book value of $27. (Tangible book excludes acquisition-related goodwill and other intangible assets.) Goldman trades for 100% of book value of $98 and 1.1 times tangible book of $88.
Both stocks are up sharply from their lows but way below their highs. Morgan Stanley bottomed at $6 this past October before a $9 billion investment from Japan's Mitsubishi UFJ Financial eased concerns about its capital adequacy, while Goldman bottomed at $47 in November. Morgan's 52-week high was near 52, while Goldman's was 203.
Roger Freeman, a Barclays analyst, has targets of $30 on Morgan Stanley and $100 on Goldman. Freeman, who sees the firms taking bigger write-downs than most of Wall Street does, expects Morgan to earn 25 cents a share in the current quarter, rather than the consensus forecast of 36 cents. Similarly, he predicts that Goldman will earn 80 cents, not the consensus figure of $1.35.
Both firms switched to calendar-year reporting after they became commercial banks last year; previously, their fiscal years ended in November. As a result, next month they will report profits for both the March quarter and for just December 2008. Wall Street suspects they may paint the December numbers in as red a hue as possible, to set the stage for a stronger 2009 that would let the firms pay employees better.
How much can each firm be expected to earn when the markets return to a more normal state? The days of 20%-plus return on equity probably are over, as regulators and the markets force lower levels of financial leverage and risk. Morgan Stanley wants to generate a 12%-to-15% return on equity over the current cycle. This year's return could be 10% or lower. Investors probably would be happy to see 10%, which would translate into $3 a share in profit. Goldman had a 32% ROE in 2007, when it earned a record $24.73 a share, but the figure fell to 5% in 2008, as profit slid to $4.47.
Goldman lately has commanded a higher valuation, relative to book value, than Morgan Stanley because it is one of the Street's few firms that largely avoided the mortgage and real-estate disasters that buried Bear Stearns, Lehman and Merrill Lynch. Goldman's brass, led by CEO Blankfein, is considered sharper than Morgan's. Its trading and investment-banking franchises also are considered stronger. Some call Goldman "Wall Street's A Team".
Goldman's investment-management arm, once a poor cousin to Morgan Stanley Asset Management, now is much larger and more profitable than its rival, which has been battered by neglect and weak performance. Reviving the asset-management business is an important priority of Morgan Stanley CEO John Mack.
As they scramble to revive, the longtime rivals are employing dramatically different strategies.
Morgan wants to slash risk by virtually abandoning proprietary trading (in which the firm's own money is used) and reducing "principal transactions" -- investments in real estate and private equity. Instead, it will focus on trading for clients and bolstering fee-based businesses; it took a step toward that recently, when it agreed to merge its retail brokerage unit with Smith Barney, Citi's larger retail network. The goal is to get at least 50% of revenue from non-institutional businesses.
The firm hopes a lower risk profile and more stable earnings will garner a higher valuation. One investor familiar with Morgan Stanley's top managers says that CEO Mack, having been burned by the firm's mortgage and trading troubles in 2007 and 2008, is shifting gears.
"He's reformed. It's almost an AA [Alcoholics Anonymous] kind of thing. He wants to have the best balance sheet in financial services and to reduce proprietary trading. He wants more predictable earnings and doesn't want to run a de facto hedge fund," this investor says. Call it the revenge of ex-CEO Phil Purcell, who advocated that approach, to the dismay of Morgan Stanley veterans, when he ran the firm from 1997 to 2005.
Goldman Sachs, in contrast, believes it has the talent to prudently do proprietary trading and make real-estate, private-equity and other investments.
Investors are pleased that both Goldman and Morgan significantly shrank their balance sheets in late 2008, while boosting capital. Goldman's assets fell to $885 billion from more than $1 trillion in its fourth quarter while Morgan Stanley's slid to $658 billion from $987 billion.
Key capital ratios, including tangible common equity and Tier 1, look good, relative to those of major banks, especially because Goldman and Morgan Stanley value almost all their assets at market prices each quarter, reducing the possibility of nasty surprises. Goldman's tangible common equity ratio was 4.8% on Nov. 30, and Morgan Stanley's was 4.4%, above those of the major commercial banks, which average around 3%.
Morgan Stanley, for instance, has taken some big write-downs already, valuing senior commercial mortgage-backed bonds at less than 50 cents on the dollar and alt-A home mortgages, which are a notch above subprime, at below 40 cents on the dollar.
Both companies are benefiting from government initiatives to pump liquidity into the markets, including a program that lets many financial companies sell debt with maturities as long as three years and backed by the FDIC. Morgan Stanley has issued $23 billion of such debt; Goldman, $25 billion. Although banks pay a fee of as much as 1% for it, the FDIC guarantees amounts to a subsidy. Without it, the companies likely would have to offer interest rates two to three percentage points higher to attract buyers. So, the two may be getting a subsidy of $500 million or $750 million a year.
The aim of the program, which began in October, is to trim bank-funding costs and encourage consumer and business lending. Goldman and Morgan Stanley, however, make few loans, save for the kind that many in Washington detest -- those for job-killing mergers like the pending Pfizer/Wyeth combination.
As part of their comeback plans, both firms are reining in costs, sometimes rather comically. Morgan Stanley, which is seeking $2 billion in cost cuts this year, now charges employees at its Manhattan headquarters a monthly fee of $40 to use an on-site, state-of-the-art gym that had been free.
Employees now must fly coach on domestic airline flights, although John Mack still flies on a corporate jet -- for security reasons, the firm says. Mack will be making one concession this year: He'll have to pay for personal trips on the corporate jet. Morgan has cancelled 75% of its conferences for the year and says the others will be "100% content" -- no golf or tennis outings and no big-name entertainment.
Goldman wants employees visiting New York to stay at the Embassy Suites it owns next to the new headquarters it is building in lower Manhattan. Bye-bye, Ritz-Carlton.
Surrendering free tee times and plush sheets won't do much for Wall Street's ugly image on Main Street. But it shows that Morgan Stanley and Goldman are at least making attempts to adapt to the new financial realities. Combined with the decline of their competitors, that makes them good bets for investors now.‹
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