Monday, February 24, 2020

Morgan Stanley's Sneaky E*Trade Move

In a combination of marquee names, Morgan Stanley announced it will acquire E*Trade 
Yearend has come and gone. Markets have resumed intermittent volatility.  Deals that might have been on the table last fall are ready for roll-out with fanfare. In mid-February, Morgan Stanley stealthily announced a major acquisition for the financial industry to ponder.  The vaunted investment bank, now a global financial institution under the auspices of bank regulators, reported it will buy E*Trade, the broker/dealer firm that launched an online revolution in the late 1990s. It will pay $13 billion (in Morgan Stanley stock) to E*Trade's shareholders in a deal that will close in late 2020. 

By 2020, E*Trade had evolved into more than a discount broker offering stocks online. Recall the height of the explosive dot-com era of the late 1990s. E*Trade vaulted the gates to become one of the first to sell stocks and bonds to individuals on the Internet. It did so (as it does today) with the help of eye-catching advertising.  What appears to be as a routine as the sun shining today was something revolutionary at the time. E*Trade eventually grew into a large financial institution, offering a multitude of products and owning bank entities.  

For years, Morgan Stanley and E*Trade seemed headed in different directions. One rested on the prestige of its investment banking and trading units.  The other appealed to individuals, day-traders and novice investors.  In recent years, as Morgan Stanley has emphasized its asset management business to generate badly desired revenue growth, parts of Morgan Stanley was inevitably headed into E*Trade's direction. 

Not many would have speculated Morgan Stanley had its eyes on E*Trade, although many might have wondered what would have been the response by other institutions after Charles Schwab had announced its own major deal weeks before.  Schwab agreed to acquire a peer firm, TD Ameritrade, for $26 billion. And soon afterward, Franklin Resources agreed to acquire Legg Mason for $4.5 billion. 

Morgan Stanley-E*Trade is different. The two institutions, although they competed and had parallel business activities, weren't considered peers.  Morgan Stanley is often regarded in the league of Goldman Sachs, Citigroup, Bank of America, and JPMorgan Chase. All five have global investment banking and trading operations, but all five highly value their asset management and consumer businesses more and more. (Yes, even Goldman.) All five are now regulated bank holding companies, carefully watched by banking regulators and painstakingly attuned to regulatory restrictions.  

E*Trade, too, is engaged in banking and wealth management, but targeting individuals and a customer segment that don't overlap with Morgan Stanley's.  It launched itself as a premier online, cheap-commissions broker (when others were just experimenting with it) and expanded its businesses over time. Squeezing an asterisk within its name was not an accident, but a way to spawn attention when other online brokers had pranced onto the scene. 

By the mid-2000s, it, too, had a commercial banking operation to complement all the online-trading activity. It competed vigorously with Edward Jones, Ameritrade (before its TD merger), Scottrade, and Schwab. 

By the end of 2019, Morgan Stanley (especially after periodic tumbles during the crisis) had become a major financial institution with about $900 billion in assets, $80 billion in book capital, and an $8 billion net-income earnings stream (and an admirable 10% return on book equity).  E*Trade had grown its balance sheet to $60 billion, its capital base to about $7 billion, and earnings hovering close to $1 billion. Returns on book equity were approaching 14%, quite laudable for financial institutions in 2018-19. 

Yet in this large pocket of the financial-services industry, it's often not about balance-sheet assets and equity, but just as much about "assets under management." How can and how would each continue to attract customer assets or convince customers to bring all their financial assets into their fold? 

Assets under management ("AUM") generate stable, predictable streams of fees. And they don't require balance-sheet usage and funding. Probably more important, they don't require substantial amounts of regulatory capital (based on market and credit risks). For Morgan Stanley and E*Trade, the new deal will permit the combined firms' AUM to levels above $3 trillion. (AUM includes assets in custody, assets channeled into funds of all kinds, and assets being managed passive and actively.)

Hence, their market values (the precious stock values their respective shareholders care much about) can only grow if AUM grows.  For the large bank institutions and non-bank institutions (like BlackRock, $6 trillion AUM), competition for assets is fierce, and organic AUM growth has stabilized. So why not combine two separate institutions to achieve a leap in growth?

Over the past year, the stock price of E*Trade's dividend-paying shares has bounced around often between $45-60/share. The Morgan announcement has given E*Trade shares a slight bump ($53/share). The Schwab-TD Ameritrade announcement had pushed it downward, as the market wondered about E*Trade's next step.  

Meanwhile, Morgan Stanley's share price has zoomed upward (to its current $52/share) over the past year in the same way its peers' prices have increased, as large banks have benefitted from improved earnings, stronger balance sheets, dividend increases and diverse business lines.  Yet Morgan still likely felt it needed a boost, an E*Trade-triggered boost. 

Over the past year, after Schwab and some firms announced they would reduce trade commissions to zero or near zero, everybody had to react lest they lose AUM.  As commission fees dip toward zero, companies still have to recoup revenues somewhere if only to cover operating costs and generate a profit.  As much as advertising and promotion announce firms are allowing "free" trades, nothing in the end is all that free.  

If brokerage fees slip toward nothing, firms will recover these revenues in other ways:  other banking products and asset-management and custody fees. The more assets they accumulate, the more they can digest free trading and the more likely they can offer the same customers a suite of other products (perhaps home mortgages, credit cards, loans to purchase securities on margin, loans secured by assets in the portfolio, and auto loans).

Now that the Morgan-E*Trade 2020 deal has been reported, details and approvals must come. Regulators must approve the marriage, although there are few signs that suggest--at least initially--they won't.  Like all major deals, while some applaud the merger, others will ask questions about how the two will make this work. 

1.  How will Morgan Stanley integrate the businesses, legal entities, personnel, management and operations of E*Trade? 

2.  How will Morgan Stanley incorporate the brand of E*Trade? Will it manage E*Trade as a separate investment, a wholly-owned independent subsidiary? 

Often acquirers permit their targets to operate independently until they implement a plan to rationalize and combine business lines. The E*Trade name won't disappear soon, but history suggests acquirers sometimes acquire a brand and then eventually retire it. (Remember Smith Barney and Dean Witter?)

3.  How will Morgan Stanley rationalize product offerings and pricing to existing groups of Morgan Stanley and E*Trade customers?

4.  What operating "platforms" will be used to manage assets, conduct and settle trades, hold securities in custody, and ensure that pricing and services are consistent for both Morgan Stanley and E*Trade customers?

5.  Will regulators express concern and delay approval of the deal? 

The process will take time, but approvals will likely come.  There are no monopolistic, unfair-competition implications.  Morgan Stanley's capital base, risk management groups, and overall balance sheet will be able to shoulder risks, balance sheet, and term debt from E*Trade. E*Trade's relatively modest size won't make Morgan Stanley, already considered a firm "too big to fail" (or "globally significantly important bank"), that much more of an even bigger bank to fail. E*Trade plus Morgan Stanley will become a bank that is still smaller, in many respects, than JPMorgan Chase or Bank of America.

6. How will Morgan Stanley effect the purchase? 

It will issue stock to E*Trade shareholders (stock-for-stock transaction). There is risk the deal dilutes Morgan Stanley's share for existing shareholders (reduces earnings per share), but armies of operations managers will seek to rationalize cost-cutting and redundant roles. 

7. Now what will all others do?  

Other financial institutions won't sit still. Often the marketplace and shareholders prompt institutions to prepare and deliver a response. What will Bank of America, Goldman Sachs, and JPMorgan Chase do?  Do they observe from the sideline, or do they work with advisers to consider the right strategic next step? Are there more deals expected down the road?

Tracy Williams 

See also:

No comments:

Post a Comment