Citi could get burned by its sunny brokerage appraisal

NEW YORK Thu Jul 26, 2012 12:10am EDT

A Citibank sign on a bank branch in midtown Manhattan, New York, November 17, 2010. REUTERS/Mike Segar

A Citibank sign on a bank branch in midtown Manhattan, New York, November 17, 2010.

Credit: Reuters/Mike Segar

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NEW YORK (Reuters) - Citigroup Inc's (C.N) $22 billion valuation of its brokerage joint venture with Morgan Stanley (MS.N) reflects an extremely optimistic view of the future of Wall Street profits, making a multi-billion-dollar loss on the business more likely for Citi.

Sources familiar with the situation said Citi's appraisal works out to 50 times current one-year earnings for the joint venture, Morgan Stanley Smith Barney. The long-term average price-to-earnings ratio for retail brokers is only about 18 times.

Morgan Stanley's $9 billion appraisal is about 20 times current earnings and implies an expectation that profits will stay in a rut, even when the costs of combining the two companies' brokerages subside.

The companies exchanged appraisals as a step to set the price that Morgan Stanley, which owns 51 percent of Morgan Stanley Smith Barney, will pay to buy another 14 percent from Citigroup.

People at both companies believe an arbitrator will come down somewhere in the middle, which would still force Citigroup to take a non-cash charge to earnings to write down the value of its 49 percent of the business.

Revenue growth rates for wealth managers have fallen so much that there are few deals being made these days, much less at pre-crisis valuations, said Matthew Morris, head of corporate advisory services at the U.S. arm of RGL Forensics, an accounting and valuation firm.

Still, Morris said, "the two sides are shockingly far apart while presumably using the same valuation framework."

The yawning gap in the values is a sign of how even five years after the financial crisis started, Wall Street remains far from a full recovery.

Smith Barney became part of Citigroup in 1998 when former Chief Executive Sandy Weill turned the bank into a financial conglomerate. Weill said on Wednesday that he now believes banks should be separated from investment banks.

The subsequent joint venture was forged in the financial crisis in January 2009 when Citi looked to raise capital and Morgan Stanley sought a stable source of revenue.

Rather than have Morgan Stanley raise enough money to buy Smith Barney at once, the two parties agreed to share ownership and plan for Morgan Stanley to buy the rest in increments through 2014. Each side contributed wealth management assets, and Morgan Stanley paid Citigroup another $2.75 billion in cash to take operating control.

It was a time when financial markets were on virtual life support from the government, and there were few benchmarks for what the business was worth.

Citigroup used the deal to write up the value of its assets to what is essentially its current appraisal, which boosted some measures of its capital.

Morgan Stanley did not write up its own wealth-management assets at the time of the deal. The two sides have been poles apart in valuing the venture ever since.

Now the companies have hired boutique investment bank Perella Weinberg Partners to make a judgment of the fair value by the end of August. The schedule should allow the sale of the 14 percent slice to be complete by September 7.

Citigroup stands to gain by exaggerating its appraisal, while Morgan is motivated to do the opposite. Citi may be more likely to be the loser because its valuation is much higher than most analysts'.

There are grounds for arguing that the venture's profits will improve: Merger costs will decline, interest rates should eventually rise and customers will make contributions to their investment accounts.

But even a $15 billion valuation - about halfway between the two appraisals - would require three conditions, according to estimates by Credit Suisse analysts Howard Chen and Moshe Orenbuch. Morgan Stanley Smith Barney revenue would need to grow at a 5 percent compounded annual rate from 2010, short-term interest rates would need to rise in early 2015 and price-to-earnings multiples for brokers would have to rise from recent levels.

The brokerage has been a disappointment to both companies since it was created. Results have been beaten down by low interest rates, clients grown weary of weak investment returns and high expenses in Morgan Stanley's management of the merger.

Full-year profits for 2011, the Credit Suisse analysts estimated, were only $400 million before taxes, just 3 percent of $12 billion of net revenue and far short of the 20 percent margins once predicted by Morgan Stanley CEO James Gorman for his company's entire wealth management operation.

The $9 billion appraisal from Gorman and his team is grounded in the recent results and represents a dark view of the situation, outside analysts say.

DIFFICULT TO VALUE

Valuing the business is proving hard even for outside experts. Stock analysts' estimates have run from as little as $14 billion to as much as $24 billion.

But the analysts do not have all the information that the companies have used in their appraisals and that Perella Weinberg will use to arbitrate the dispute.

The joint venture's profits, for example, are mixed in with those from other assets in the results that Morgan Stanley reports for its Global Wealth Management unit.

Morgan Stanley Smith Barney represented an estimated 90 percent of that division's revenue in 2010 and 2011 but just 42 percent of profits. Its share of profits was so much lower because it apparently shoulders 95 percent of the expenses of the broader division.

The final appraisal is also required to factor in tax benefits, the value of which the companies have not disclosed, as well as $2 billion worth of preferred stock held by Citigroup that will eventually have to be redeemed by Morgan Stanley.

Citigroup could suffer an added insult if Perella Weinberg were to come up with an appraisal that is clearly closer to Morgan Stanley's.

That's because of a twist that investment bankers for the two sides built into the 2009 agreement: If the final appraisal is within the top or bottom one-third of the valuation gap, the firm with the value furthest away has to give up half the difference between the appraisal and the value from the company at the winning end.

If Perella Weinberg pegs the business at less than about $13.3 billion, Citi would get tens of millions of dollars less for the 14 percent stake.

The original arrangement was intended to give the two sides an incentive to narrow any valuation gap, according to a source familiar with the situation.

(Additional reporting by Jed Horowitz in New York; editing by Prudence Crowther)

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