Morgan Stanley

AMERICAS BROKERS & ASSET MANAGERS

MS.N MS US

EQUITY RESEARCH AMERICAS

MS: No Quick Fix for FICC

November 2, 2010 Relative rating Remains Target price Remains Closing price November 1, 2010 Potential upside

Senior Management Meeting

Neutral
USD 28.00 USD 24.68 +13.5%

Management Sees the Biggest Gaps in Rates and FX The biggest gaps versus peers are in the rates (mostly a footprint issue) and FX (mostly a platform issue) businesses, which likely stem from the fact that resources were allocated away from the client flow franchises and toward structured credit and structured rate products (as well as prop trading) in the middle of the last decade. Closing Gaps via Key Relationship Hires, Which Takes Time Management thinks they are about 9 months into a revamp that could take about two years (all in). To be clear, they are not trying to be in all FICC businesses and not trying to completely close the revenue gap, but are taking a logical approach of regaining client wallet share through the addition of key relationship hires (~65% of new hires have been sales people). 200 bps in FICC Market Share = $3 Billion in Revenues MS is shooting for a 200 bps improvement in FICC market share over time (+$3bn in annual revenues). To put this in context, we estimate that MS has averaged about $2bn in clean FICC revenues over the past 7 quarters, so adding ~$750 million per quarter would be a 37% increase & would add close to 12 cents in quarterly EPS and about 150 bps to the firm’s ROE. Staying Neutral on the Stock We think management has a credible plan to rebuild the trading franchise, which should lead to market share and revenue improvement over time; however, given that we think ROEs will likely remain sluggish in the near term, as the rebuild will take time, we remain Neutral.
Year end:12-2009 Currency USD 2009a Actual Old 2010e New Old 2011e New Old 2012e New

Research analysts Brokers & Asset Managers Glenn Schorr, CFA glenn.schorr@nomura.com +1 212 298 4074 Keith Murray keith.murray@nomura.com +1 212 298 4257 Deborah Altman, CFA deborah.altman@nomura.com +1 212 298 4259

See Appendix A-1 for analyst certification and important disclosures. Analysts employed by non-US affiliates are not registered or qualified as research analysts with FINRA in the US.
Company data: See page 2 for full company data and two-year price/index chart

Net Income (m) EPS (stated) EPS (adj.) PE (adj.) ROE stated (%) ROE adj. (%) Price/Book Value

(907) (0.77) (0.93) 9.1 NM NM 1.1

3,083 2.36 2.28 10.8 7.3 7.3 0.8

4,269 2.50 2.50 9.9 8.7 8.7 0.7

5,492 3.00 3.00 8.2 10.5 10.5 0.7
Nomura Securities International, Inc.
Relative rating: For details of Nomura’s relative rating system see text at the end of this publication

Source: Company data, Nomura estimates

18 25 20 15 0.14 0.16 0. Sector % 1m 2 -2 -3 3m -8 -14 -12 12m -26 -33 -23 Market data Market Cap (m) Units Outstanding (m) Float (%) Dividend Yield (current year) 34477 1397.22 0. Market % Rel.10 10 0.00 Source: Datastream.SCALE) Source: DATASTREAM Source: Datastream Performance Year end:12-2009 Absolute % Rel.08 0.24 0. 2010 Key data on Morgan Stanley Rating Stock Sector Neutral Bullish Price and price relative chart (two year) 40 35 30 0.Nomura | AMERICAS Morgan Stanley November 2. Nomura estimates 2 .H.20 5 0.12 29/10/10 0.06 OND J FMAMJ J ASOND J FMAMJ J A SO MORGAN STANLEY U:MS/SP5EFIN(R.0 89 0.

Other Opportunities to Leverage the Franchise In addition to enhancing distribution capabilities via the Morgan Stanley Smith Barney retail platform and leveraging off the strength of key investment banking relationships. about half that of Citi. management made it clear that there are no quick fixes for closing the gaps and they think they are about 9 months into a revamp that could take about two years (all in). and in covering key corporate clients. with the firm only a little more than one-third of the way through a two-year improvement process (though they have completed about 70% of hiring plans). it would add about $3 billion in annual FICC revenues. Jack Di Maio. they are taking a logical approach of regaining client wallet share through the addition of key relationship hires (roughly 65% of new hires have been sales people). as the entity has been operating as a JV since the middle of 2009. This would add close to 12 cents to Morgan’s quarterly EPS run rate and about 150 bps to the firm’s ROE. For example. with 15% share. which is a positive in the context of more-stringent capital rules under Basel III. Unfortunately. but this will take time. so adding $750 million would be a 37% increase. they are not trying to be in all FICC businesses and not trying to completely close the revenue gap (MS generated ~$6 billion in clean FICC revenues so far this year. Institutional Securities. and asset marks) over the past 7 quarters. which should lead to improved market share and higher revenues over time. any time soon). Staying Neutral on the Stock We think management has a credible plan to rebuild Morgan’s trading franchise. Gains in market share can make a meaningful difference to the bottom line. convertibles. management answered the question about the potential for a longer buy-in timeline for the remaining 49% of Morgan Stanley Smith Barney. management made it clear that the FICC franchise remains a work in progress. The biggest gaps versus peers are in the rates (mostly a footprint issue) and FX (mostly a platform issue) businesses. we estimate. which should lead to market share and revenue improvement over time. Still. or $750 million per quarter. as the business is not a simple plug-and-play model. we estimate that Morgan has averaged about $2 billion in clean FICC revenues (ex DVA. if Morgan can pick up another 2% in market share (they are not trying to be among the leaders. 2010 No Quick Fix for FICC We recently met with Co-President. and Currency. assuming that next year’s FICC revenue pool is in the $150 billion range. Credit. We don’t think this more staggered approach would impact the business or financial advisors much. where it thinks revenues should account for a larger piece of the pie than they currently do. Management definitely wants to own 100% of Morgan Stanley Smith Barney eventually. which likely stem from the fact that resources were allocated away from the client flow franchises and toward structured credit and structured rate products (as well as prop trading) in the middle of the last decade. Colm Kelleher and Global Head of Rates. and BAC). To put this in context. They are adding the right people. which would allow for better capital flexibility to deal with Basel III (the next option to purchase 14% is at the end of May 2012). we believe. JPM. A 200 bps Improvement in FICC Market Share = $3 Billion in Revenues Management thinks there has been some positive traction (they think the market reacted too positively to the firm’s 2Q10 results and too negatively to their 3Q10 results) and they think their FICC market share has improved to 6% from a low of 5%.Nomura | AMERICAS Morgan Stanley November 2. After taking a step back and looking at some of the key strengths in Morgan Stanley’s Institutional Securities segment (like its strong investment banking franchise and improved equities franchise). CVA. we think ROEs will likely remain 3 . Some Color on Capital Flexibility Related to the Smith Barney Deal Finally. but they are not boxed in on the timing. To be clear. We would expect to see a focused build in the emerging markets. Instead. management sees opportunities in equity derivatives.

Fig. Peers are in FICC Given Morgan’s strengths in investment banking and equities. On a positive note. that leaves FICC as the relative weak link. we remain Neutral. management sees meaningful gaps in the rates and FX businesses. management is confident that Morgan is back to being a top-3 player. On the flip side. Morgan has a solid credit trading franchise. Morgan Stanley’s franchise remains a top player. convertibles. Despite the stock’s low valuation (~1. GS equity revenues include equities trading. 1: 2010 YTD Adjusted Equity Trading Revenues ($ in billions) $8 $7 $6 $4 $4 $4 $3 $3 $2 $0 GS MS JPM BAC C Adjusted Equity Trading Revenues . We think this part of the capital markets business held up well. equities commissions. CVA. On the investment banking front. though it is unlikely that Morgan will ever go back to being a duopoly with Goldman. On the positive side. where disclosed. 2010 sluggish in the near term. Specifically.Nomura | AMERICAS Morgan Stanley November 2. as it ranks #3 in year-to-date Equity Capital Markets (according to Dealogic) and #1 in IPOs. in prime brokerage. and essentially set it aside from the discussion. as the business has changed and client balances are less concentrated post the Lehman bankruptcy.0x tangible book value).2010 YTD ($ bn) Note: Equity revenues have been adjusted for DVA. In equities. especially in investment grade. They are adding the right people. The soft spot in equities is in the derivatives space. which it is focused on closing. and management made it clear that it is definitely a work in progress. as the business is not a simple plugand-play model. Putting Morgan’s Institutional Securities Group in Context While investors have been focusing on where Morgan Stanley’s capital markets businesses are coming up short versus peers. and is also #3 in M&A. but we think the business has mostly recovered and its revenue profile is in line with most of its global peers (see Figure 1). As a result. and securities services revenues. and in covering key corporate clients. when the structured products market came to a halt in the downturn. the franchise definitely took some lumps (especially prime brokerage) during the downturn. Morgan did not have the resources to capitalize on activity in the flow businesses. We would expect to see a focused build in the emerging markets. management feels they have past the low point in 4 . we think. Management thinks that the issues currently facing Morgan’s FICC franchise stem from the fact that resources were allocated away from the client flow franchises and toward structured credit and interest rate products (as well as prop trading) in the middle of the last decade. Source: Company data and Nomura estimates Largest Gaps vs. and asset marks. even through the downturn. and also a decent and disciplined leveraged finance business. we think it’s important to take a step back and look at the different pieces of the business. where management thinks revenues should account for a larger piece of the pie than they currently do. management thinks the firm’s FICC revenue market share fell to as low as 5%. but this will take time. management pointed out that Morgan’s long-established commodities franchise remains very healthy. First. As a result.

while the gap in FX is more of a platform issue. we estimate that Morgan has averaged about $2 billion in clean FICC revenues (ex DVA. management has identified rates. FX. management is confident that they have developed a much better risk discipline than in the past and you won’t see them swinging for the fences (they are fine not being in every business. the focus is on hiring the right people and rebuilding relationships with clients one at a time. management has restructured its relationship management effort (senior management is spending a good chunk of its time on actively managing important relationships) and roughly 65% of new hires have been sales people. CVA.Nomura | AMERICAS Morgan Stanley November 2. Management does not think the FICC franchise faces any profound issues. so getting boots on the ground is key. it would equate to about $3 billion in annual FICC revenues. so adding $750 million would be a 37% increase. To achieve the gains in share. or $750 million per quarter. as proper client coverage is key. just the ones they can be good at). but Colm and Jack highlighted that the firm is only about 9 months into a rebuild that could take around two years to reach fruition. management thinks rates and FX are the key spots within FICC. where disclosed. With Colm’s background in rates and Jack‘s background in credit (including 5 . To put this in context. Along these lines. FX. 2010 share and are back to about 6% (with the top global players at about 15% of the pie). In addition. In general. Source: Company data and Nomura estimates Rates. This would add close to 12 cents to Morgan’s quarterly EPS run rate and about 150 bps to the firm’s ROE. and Emerging Markets Are Key Initiatives In addition to enhancing distribution capabilities via the Morgan Stanley Smith Barney retail platform and leveraging off the strength of key investment banking relationships. FICC market share has improved ~100 bps). and emerging markets as key areas to build. management thinks that the total revenue pie was about $175 billion last year. equity derivatives. we estimate. Equity Derivatives. if Morgan can pick up another 2% in market share. They are convinced that more clients want to spread business across more counterparties. though revenues remain a fraction of most global peers (see Figure 2). Fig. and asset marks) over the past 7 quarters. Management feels like Morgan is definitely getting traction with the biggest accounts (as noted above. but suffered more from a misallocation of resources in the past and the need to scale-up client relationships. 2: 2010 YTD Adjusted FICC Trading Revenues ($ in billions) $18 $16 $14 $12 $12 $10 $8 $6 $4 $2 GS C JPM BAC MS $6 $12 $11 $15 Adjusted FICC Trading Revenues . CVA.2010 YTD ($ bn) Note: FICC revenues have been adjusted for DVA. An Additional 2% Market Share in FICC Could Be $3 Billion in Revenues Specifically in FICC. Management feels like the gap versus peers in the rates business is due to a footprint issue. and asset marks. Assuming that next year’s pool is a smaller $150 billion.

Morgan could get a kicker if it can continue to add some market share. it appears that on a y/y change in comp per average headcount basis. Management also thinks that investors were a little too bullish on Morgan’s 2Q10 results and a little too bearish on 3Q10 results. Management feels like they are in the same position as other firms this year and are not boxed in by the build out. Results need to be thought of in the context of a slow and deliberate rebuild that is only a little more than one-third of the way through. In addition. which also made results appear weak. and equity trading -13%. So Why Did 3Q10 Appear to Be So Soft? If Morgan is making progress on its build out and picking up some market share. especially one that was actively hiring earlier in the year. Morgan has less exposure to some of the businesses that fared well in 3Q10 (like rates and high yield). while the US peers were +7% in FICC and +43% in equities)? Management made the point that 3Q10 was a difficult trading backdrop (equity trading volumes were down 20-25%) and that firm’s with low market share will post lackluster results in low-activity environments. As markets normalize (and management indicated that activity levels have normalized a bit so far in 4Q10). Looking at Figure 3. why were 3Q trading results seem so disappointing (FICC revenues –24% q/q. Also. the trend is a tough one for any broker. Given the Build Out. However. we think they can get the franchise to produce at a high level over time. They attribute this to the fact that a good portion of hiring has been below the MD level and they have slowed the pace of hiring as industry revenues softened. This just means that Morgan will have less comp flexibility in 4Q10 than Goldman. but the improvement won’t necessarily be linear.Nomura | AMERICAS Morgan Stanley November 2. ex DVA. many investors are wondering whether Morgan is facing a bit of a comp issue this year. 6 . 2010 high yield). we would note that through 3Q10. Does Morgan Stanley Have a Comp Issue This Year? Given the significant hiring in the trading franchises and the sluggish capital markets revenue market environment. Morgan Stanley’s Institutional Securities Group stacks up well versus the peer group. Morgan’s Institutional Securities Group had accrued the equivalent of 69% of 2009 fullyear comp (ex the UK bonus tax) versus 81% at Goldman.

7 . the First 9 Months of 2009 MS JPM BAC GS C 0% -5% -10% -12% -14% -16% -17% -17% -17% -19% -21% -24% -26% -29% -33% Y/Y Ch an ge in Total Cap ital Markets Revenues* Y/Y Ch an ge in Comp Exp ense** -30% -15% -20% -20% -22% -25% -22% -35% Note: Total capital markets revenues includes investment banking. as the entity has been operating as a JV since the middle of 2009. Comp expense for MS is based on Institutional Securities Group. Headcount for C. the put is then off the table. 2010 Fig. DVA. Comp expense for C and BAC is a Nomura estimate using a comp ratio of 38% in 2009 and 37% in 2010 based on Securities Banking and Global Banking and Markets revenues. We excluded the UK bonus tax from 2010 comp expense.Nomura | AMERICAS Morgan Stanley November 2. Management definitely wants to own 100% of Morgan Stanley Smith Barney eventually. equity trading. Comp expense for GS is based on the total firm. Citi has the right to put the remaining stake in the JV to Morgan Stanley in 2015. some (including us) have questioned whether the purchase of the remaining 49% of Smith Barney starting in mid-2012 would limit Morgan’s flexibility. Headcount for GS is based on the whole firm. However. and FICC trading revenues adjusted for CVA. Headcount for JPM is based on its Investment Bank. which makes us think Morgan is less limited than many believe. Comp expense for JPM is based on its Investment Bank. respectively. but they are not boxed in on the timing. if Morgan just buys in the additional 14% (and they might also choose to buy in the deposits they don’t own) that is available in 2012. 3: Comp and Headcount Changes for the First 9 Months of 2010 vs. MS. where disclosed. We don’t think this more staggered approach would impact the business or financial advisors much. This would allow Morgan to then take its time buying the remaining 35% if it needed to preserve capital for other reasons. Source: Company data and Nomura estimates The Structure of the Smith Barney Deal Allows for Flexibility With investors very focused on the impact of Basel III on capital ratios and parsing out which firms might have excess capital. Management gave some color around how the deal is structured. Under the deal terms. and asset marks. and BAC are Nomura estimates.

is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International. Nomura Securities International. Valuation Methodology Our $28 price target for Morgan Stanley is based on 1. Inc had a non-investment banking securities-related services client relationship with the company during the last 12 months. Nomura International plc or any other Nomura Group company. hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report.0x our forward four-quarter tangible book value estimate of $28. (2) no part of my compensation was. 2010 Appendix A-1 Analyst certification I. Glenn Schorr.Nomura | AMERICAS Morgan Stanley November 2. 8 . which reflects our expectations for high single-digit ROEs in the near term. Inc. credit spreads.00. Important Disclosures Morgan Stanley (MS US) USD 24. availability of funding. general economic conditions.. makes a market in securities of the company. and wealth management flows. The benchmark for this stock is the S&P 500 Financials Index. asset prices. Risks which may impede the achievement of the target price Risks to our $28 price target for Morgan Stanley include regulatory risk. Nomura International plc or its affiliates in the global Nomura group has a significant financial interest in the issuer.68 (01-Nov-2010) Neutral (Sector rating: Bullish) Nomura International plc or an affiliate in the global Nomura group is a market maker or liquidity provider in the securities / related derivatives of the issuer. Nomura Securities International Inc. Nomura Securities International. capital markets activity levels. Inc has received compensation for non-investment banking products or services from the company in the past 12 months.

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