Morgan's earnings rock but clouds linger
Morgan Stanley blew away second-quarter expectations but the company warned that the market selloff is causing some weakness and lower credit quality may pressure Discover down the road.
NEW YORK (CNNMoney.com) - June is shaping up to be a tough month for Morgan Stanley as increased volatility in the equities markets put pressure on the company's trading business, the company's financial chief David Sidwell said Wednesday.
Speaking at the company's second-quarter earnings call with analysts, Sidwell said while the first half of 2006 reflected favorable markets which translated into solid earnings growth, trading conditions have worsened. But he stressed that it's too early to determine whether the weakness will be a protracted problem for Morgan Stanley (up $2.75 to $59.77, Charts).
"We're very optimistic going into the second half," he said. "It's too early to say the markets are experiencing a fundamental shift as opposed to a speed bump."
Sidwell's comments echoed the general concern within the securities industry after competitors such as Goldman Sachs (Charts) and Lehman Brothers (Charts) recently cautioned that the weakness in the markets, if prolonged, could begin to hurt profitability down the road. Despite much better-than-expected reports from both companies, investors hammered the stocks on concerns that a weaker market would result in a dry up equity offerings - a key business for investment banks.
Morgan Stanley, the third largest securities firm by market value, also blew away earnings estimates in the second quarter, as its tumultuous turnaround efforts over the last year began to payoff. The company reported net income of $1.96 billion, or $1.86 a share, in the three months ended May 26, up from $928 million, or 86 cents, a year earlier.
Net revenue rose 48 percent to a record $8.9 billion, fueled by sharp gains in nearly every business.
Weakness ahead for Discover
But a 34 percent increase in the revenue from Morgan Stanley's Discover credit card unit - a business that many on Wall Street have speculated could be spun off - took the company by surprise. Credit card balances rose 4 percent to $48.5 billion, while loan charge-offs fell sharply.
Sidwell said the business benefited from continuing strong credit quality and low bankruptcies following the new bankruptcy legislation that took effect last year.
While a positive development, Sidwell warned analysts that credit card losses should rise and bankruptcy levels should return to normalized levels as the company moves into 2007.
"The credit environment is going to turn around at some point," he said. "While conditions are still favorable, we do feel that credit costs are going to increase from this low level into 2007."
But he said Morgan Stanley will continue to grow out the Discover Card business by trying to attract merchants to accept the card.
It was the fourth straight quarter of improving results under chairman and chief executive John Mack, who joined Morgan Stanley on June 30 last year. He replaced Philip Purcell, amid a shareholder rebellion that was sparked by years of disappointing financial and stock performance as well as unpopular management changes that puzzled Wall Street.
But the stock has significantly lagged its competitors.
Time to play catch-up
So far, Morgan Stanley is up 8.7 percent since June 30 of 2005 -- when Mack took the reins - while Goldman Sachs is up 38.3 percent, Bear Stearns has gained 23 percent and Lehman Brothers is up 21.5 percent.
David Trone, securities industry analyst at Fox-Pitt Kelton, said in a research note that perhaps investors may be more inclined to lift shares of Morgan Stanley, now that the company has proven that the turnaround under the new CEO is working.
"We believe it is safe to say that CEO John Mack has been a positive influence on its primary business, institutional securities," he said. "We continue to believe MS shares are more compelling than peers, and perhaps this result will convert some of the skeptics."
And Dick Bove, analyst at Punk, Ziegel & Co., said that investors should focus on the changes Mack has brought to the company by building a stronger commodities trading business, improving its retail sales operations - which were credited for some of Morgan's earnings upside this quarter - and lifting the company out of turmoil.
"We're trying to emphasize this company is back," Bove said. "It's where all the other brokers are at and now (its stock) should do what the other brokers are doing."
Bove said he has a $73 price target on the company and while it may be a tough market environment for the brokerage industry in general going into the summer, he advised investors to buy into any weakness.
Neither Fox-Pitt Kelton's Trone or Punk, Ziegel & Co.'s Bove own shares of Morgan Stanley and their respective firms do not have an investment banking relationship with the company.
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