UPDATE 1-Morgan Stanley wealth unit hit by outflows

* Asset outflows of $5.5 bln in second quarter

* Net withdrawals mostly due to "flash crash" - CFO

* Unit profit rises 11 pct from Q1 to $110 mln (Adds analyst comment)

By Helen Kearney

NEW YORK, July 21 (Reuters) - Morgan Stanley (MS.N) said on Wednesday its wealth management clients withdrew a net $5.5 billion during the second quarter, dealing a setback to the brokerage giant's plans to revive and expand the business.

Withdrawals were particularly large in the United States, where net outflows of $7.9 billion suggested to at least one analyst that some clients may be unhappy with the merger of the brokerage arms of Citigroup (C.N) and Morgan Stanley.

U.S. outflows were partially offset by net inflows of $2.4 billion in overseas offices.

In the first quarter, the wealth management division, which includes a 51 percent stake in Morgan Stanley Smith Barney, added a net $9.3 billion in client assets.

"It was a tough environment for retail, especially post-flash crash," Ruth Porat, Morgan Stanley's chief financial officer, told Reuters.

Following the steep market drop in May, including the May 6 "flash crash" that sent the Dow Jones industrial average reeling nearly 1,000 points, clients grew nervous and pulled back from the market, Porat said.

Clients also typically withdraw money to pay tax bills during the second quarter, she added.

The erosion of assets will make it difficult for Morgan Stanley CEO James Gorman to achieve his goal of increasing client assets by $20 billion this year.

Porat said achieving that goal was "very much market dependent."

Alois Pirker, research director at Boston-based Aite Group, said he was skeptical of the company's explanations for the asset outflows.

"If clients were nervous, you would expect them to put their assets into money market funds but not withdraw them from the firm completely," he said.

The outflows may point to client dissatisfaction with the merger, he said. "Clients may feel that they are not dealing with the same firm anymore," Pirker said. "If this happens again next quarter then it could be a big problem."

Morgan Stanley had total client assets of $1.5 trillion at the end of June, down 6 percent from the first quarter.

MARGINS NARROW

Overall, the wealth division posted profit of $110 million, an 11 percent increase from the first quarter.

Net revenue was little changed at $3.1 billion.

Year-ago comparisons are less meaningful, since Morgan Stanley acquired control of Smith Barney from Citigroup on June 1 last year.

The pretax profit margin fell to 7 percent from 9 percent during the first quarter.

Gorman had told analysts he wants that measure of performance to reach 20 percent next year.

"This is very much a scale business, which hurts us on the downside but provides operating leverage on the upside," Porat said.

Morgan Stanley's ranks of advisers fell by 53 to 18,087 during the quarter. Average revenue per adviser also fell slightly, to $679,000 from $685,000.

The firm closed 24 brokerage branches globally during the quarter as it worked to combine Morgan Stanley and Smith Barney. It now has 881 branches.

(Editing by Derek Caney and Ted Kerr)