Morgan Stanley and Citi form largest US brokerage

The Morgan Stanley Smith Barney joint venture places Morgan Stanley squarely in the driverÆs seat; analysts expect further Citi disposals to follow.
Morgan Stanley and Citi have created a joint venture, Morgan Stanley Smith Barney, which pools Morgan Stanley's global wealth management group and Citi's Smith Barney business, Quilter in the UK, and Smith Barney Australia.

Morgan Stanley will own 51% of the JV, while Citi will own 49%. Morgan Stanley will also control four out of the six board seats and its co-president James Gorman will be chairman.

Morgan Stanley will pay Citi $2.7 billion. In a research update on Morgan Stanley issued after the deal was announced, J.P. Morgan estimates the Morgan Stanley payment places a value of $24.5 billion on the combined entity and suggests this translates into an attractive earnings multiple of 10.1 times, after accounting for synergies.

Morgan Stanley has an option to increase its stake to 65%, 80% and eventually 100% by paying fair market value at the end of the 3rd, 4th and 5th year respectively, counting from the deal closing date.

The JV excludes Citi Private Bank, Nikko Cordial Securities in Japan, Smith BarneyÆs branch-based advisers and institutional financial advisers. Morgan Stanley was advised by Wachtell Lipton Rosen & Katz and Citi by Davis Polk & Wardwell.

J.P. Morgan views the deal ôas positive for Morgan Stanley due to accretion and control of a much bigger distribution franchise that we feel is increasingly valuable in the current market malaiseö.

In a written statement Citi said it ôwill benefit from this transaction by monetising its investment in its wealth management businessö and added that at closing it will recognise a gain of $5.8 billion on an after-tax basis.

In fiscal 2008 (ending in November) Morgan Stanley wealth management had $6.4 billion in revenues, while Citi Smith Barney, in the 12-month period up to the third quarter of 2008, had $8.5 billion of revenue. The combined entity will have $14.9 billion of revenue.

In the same period, Morgan Stanley earned a pre-tax profit of $1.1 billion, while Citi earned $1.7 billion. This makes Citi slightly more profitable with a 20% margin, compared to 17% for Morgan Stanley.

Citi has $707 billion of client assets under management while Morgan Stanley has $1.034 trillion.

Citi brings to the table 11,960 financial advisers against Morgan Stanley's 8,426, taking the total to 20,390. This exceeds the approximately 16,600 financial advisers that the combined Bank of America-Merrill Lynch entity had when the merger was announced and makes Morgan Stanley Smith Barney the largest US brokerage.

The challenge for the JV will be retaining the advisers. J.P. Morgan notes: ôwe do see the integration as being very challenging and there is a risk of a culture clash and broker attritionö. Precisely to prevent such attrition Bank of America paid Merrill Lynch's wealth advisers retention bonuses in the form of upfront, self-amortising loans, skewed towards those who brought in the maximum fees and commissions. Analysts speculate that Morgan Stanley will do something similar and J.P. Morgan notes that this could be expensive.

The deal, which is expected to close in the third quarter of calendar 2009, is being widely seen as a precursor to a restructuring of Citi. Citi is scheduled to release fourth quarter earnings on January 22 and analysts are speculating there could be other asset sales and divestitures by the US bank.

Citi's share price closed 5% higher at $5.90 after the deal was announced on Tuesday US time. Morgan Stanley gained only 0.4% to $18.86.
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