Citi-Morgan Stanley broker deal is full of risks

NEW YORK (Reuters) - Combining Citigroup's Smith Barney with Morgan Stanley's brokerage division would generate much-needed capital for Citi and make Morgan a top U.S. retail wealth manager, but analysts warn that such deals seldom pan out, even in good times.

Citi is expected to announce plans to combine Smith Barney with Morgan's individual investor business in a venture run by Morgan. The investment bank would pay Citi up to $3 billion in cash for a 51 percent stake in the venture, according to sources familiar with the matter.

Analysts estimate that such a deal would yield an equity boost of about $6 billion for Citi and reinforce Morgan's reliance on affluent and middle class individual investors.

Yet Wall Street mergers work better in theory than in practice, analysts said, and Morgan is making a bold bet by expanding its brokerage at a time when many Americans are dealing with the challenges of a shrinking economy.

"The newly combined company will likely face a multiyear retail downturn as it attempts the difficult effort of integrating the businesses," Bernstein Research analyst Brad Hintz told clients on Monday.

Talks between the two companies continued over the weekend. An agreement is expected to be announced this week.

If the companies agree, the venture would be a giant in the brokerage industry, with 22,000 advisers and $1.8 trillion in client assets. Bank of America Corp, which acquired brokerage Merrill Lynch 11 days ago, has 20,000 brokers and more than $2 trillion in assets.

Shares of Citi fell 7 percent to $6.28 in early trade, while Morgan shares rose 5 percent to $20.00, their highest level in three months.

Citi's plan to sell one of its better performing businesses reinforced worries among investors that the company, hobbled by massive losses in the past year, is in real distress -- despite the tens of billions of government bailout money it received.

PROS AND CONS

For Morgan, the deal will expand its earnings from retail businesses at a time when its flagship "institutional" activities -- merger advisory, underwriting and securities trading -- suffer from the continuing credit crunch.

Analysts say the combination will yield significant cost savings for Morgan. Bernstein's Hintz estimated the venture would boost the brokerage division's pretax profit margin by 7.5 percentage points to 21.7 percent.

Citi would realize significant up-front gains without having to sell the business outright -- no small consideration when there are few buyers capable or willing right now to pay Smith Barney's full value.

New accounting rules will let Citi write up the value of its Smith Barney business by about $10 billion while still letting it receiving revenue. Morgan will have an option to acquire full control of the brokerage venture over five years.

Yet analysts warned that brokerage deals almost always trigger an exodus of valued advisers to competitors, forcing companies to provide generous retention payments. And businesses don't always fit together smoothly.

"The integration challenges that Wachovia faced in its Prudential and AG Edwards roll-ups make Bernstein question the ability of Morgan management to quickly achieve the theoretical margin improvements from this combination," Hintz said.

Financial markets, meanwhile, continue to punish investors of all sizes, while a weak economy is expected to drive more clients to the sidelines. That suggests commissions and brokerage fees could remain weak.

"It will take three years to successfully merge these operations together," Hintz said. "In the meantime, the retail business will face a severe downturn."

Ladenburg Thalmann's Dick Bove noted Citi has reorganized Smith Barney's business lines and changed its focus.

"It is unclear what Smith Barney consists of at the present time. Citigroup changed the nature of the business by separating the sales force from the capital markets business," Bove told clients on Monday.

(Editing by John Wallace)