Morgan Stanley Second Quarter Earnings, Time For A Breakout?

Key Points

• Markets are changing their nature, affecting bank stocks as the core of financial markets. Morgan Stanley shows to be no exception, as its second quarter 2023 earnings results show.
• While the usual 'cyclical' departments slow, there is one resilient profit center offsetting all other slowdowns and management is betting on a doubling for the near future. 
• Some may not be actual costs, but adding these figures back may show investors why analysts see the stock higher.

As measured by the VIX (CBOE Volatility Index), volatility in broader equity markets has compressed significantly over the past year. 2022 saw an average VIX above 25%, historically high and massively more volatile than 2023's downtrend toward 15% and below.

This trend could imply some negative news for investors in the financial sector, especially those within banks that generate significant revenue from capital markets, especially those exposed to investment banking and sales and trading.

As banks and other financial entities kick off this summer's earnings season, investors and traders will look to dissect what the big banks in the United States are doing. Especially now that volatility trends are changing and business activity is further compressed due to the FED raising interest rates.

The FED has decreased liquidity across markets to cool down a heated economy (seen in rampant inflation rates), making for less deal-making and investing. Morgan Stanley NYSE: MS is reporting its second-quarter 2023 earnings in the pre-market hours of Tuesday morning, showcasing how much this new environment can affect the sector.

Blows and Cushion 

The profitable beverage of choice for banks is - and always will be - volatility. When markets and economies move at larger and faster clips, more loans and fees can be generated from this sector's core services. Within its press release, Morgan Stanley showcases just how much these newer compressed volatility metrics can affect financials.

Net sales and trading revenues declined by as much as 22% over the past twelve months, directly related to the downtrends in the VIX levels. Surprisingly, Morgan Stanley's investment banking department finished the year relatively flat during a time when other names suffered double-digit declines in these departments.

Banks like Citigroup NYSE: C and Wells Fargo NYSE: WFC reported similar declines in sales and trading. However, Morgan Stanley stood undefeated in investment banking. The critical differentiator leading Morgan Stanley to carry one of the most attractive valuations and analyst consensus upside is found in the bank's record wealth management revenue generation.

At the beginning of the year, management had released their intention to double fees and revenue generated from wealth management services. Considering that net new client assets grew to $90 billion and generated record net revenues of $6.7 billion, investors can celebrate that management is fulfilling its promises.

By expanding wealth management assets, the firm can further fuel and expand on how they monetize these funds. Revenue for this segment was up 16% over the year, bringing investors closer to the day they may see management's goal of $12 billion. This segment is also significantly disconnected from the business cycle.

So, while trading and investment banking can feel the economy's swings, wealth management may be the profit center that investors can rely on no matter what happens to markets.

Hidden Upside

The astronomic performance in wealth management saved top-line revenue. However, there is gold to be found within the avalanche caused by the losing departments in the bank. Layoffs have been a central discussion amongst markets, concerning employees just as much as investors.

Due to drying deal-making and trading activity, the finance industry has been forced to lay off thousands of employees. Morgan Stanley was no exception, and these layoffs brought on a wave of severance package costs. These costs ultimately affected the bank's bottom line (earnings per share). Still, they also made the stock's future look even brighter.

A $308 million severance cost charge was accumulated by Morgan Stanley, a consequence of laying off more than 3,000 thousand jobs during the quarter. Considering that these costs are not a part of everyday core business activity, investors can now begin to work the wonders of adjusted earnings.

When these costs are added back to reflect the 'real' earning power of the firm, investors arrive at EPS closer to $1.43 compared to the reported $1.25. This hidden charge add-back may be why the stock is advancing by as much as 1.2% during the pre-market hours of Tuesday morning.

As markets realize things are not that bad inside Morgan Stanley, they are beginning to reward the stock with higher valuation multiples to express higher perceived quality. Morgan Stanley analyst ratings suggest the stock should be closer to $95.44, a target that implies a subsequent 10.5% rally from today's prices, which may be adjusted after analysts realize the nature of 'real earnings' as portrayed above. Investors can initially lean on these targets and results and cushion any further uncertainty with a current 3.6% dividend yield.