Morgan Stanley gains from Citi deal will take time

NEW YORK (Reuters) - Morgan Stanley's (MS.N) earnings will get pinched this year as it takes the first step toward acquiring Citigroup Inc's (C.N) Smith Barney brokerage business, but analysts say the deal will make Morgan more stable and more valuable.

Morgan and Citi announced on Tuesday that they will combine their brokerages. After a payment to Citi of $2.7 billion, Morgan will have a 51 percent stake in the joint venture, Morgan Stanley Smith Barney. Morgan is expected to acquire full control in phases over the next five years.

The combination of Morgan's brokerage with its larger rival, expected to be completed in the third quarter, will erode Morgan's earnings this year and next and won't boost per share profit until 2011, Sanford Bernstein analyst Brad Hintz said.

Hintz said the continuing market slump will reduce commissions and fees generated by individual investors. He sees Morgan earning $3.25 a share this year and $3.58 in 2010.

Analysts on average expect Morgan to earn $2.36 a share in 2009 and $3.39 next year, according to Reuters Estimates.

Shares of Morgan Stanley were down 5.9 percent to $17.75 in early trade. Citi stock fell 14 percent as investors worried about the bank's prospects, with massive credit losses forcing it to cede control of Smith Barney and shed other businesses.

Fox Pitt Kelton analyst David Trone was more bullish than Hintz, saying the deal with Citi will boost Morgan earnings in 2010 by 2 percent. The deal values Morgan's brokerage at $8 billion.

Credit Suisse analyst Susan Katzke told clients the deal will boost Morgan's book value but reduce its capital ratio. The deal values Smith Barney at $12 billion to $14 billion, or 11 to 13 times trailing earnings, an appropriate discount given the times, she said.

BENEFITS

The joint venture will move Morgan closer to its goal of deriving half of its funding from stable sources. The combined business will have the world's largest army of brokers, though a close second in terms of client assets to Bank of America, the new owners of Merrill Lynch.

In an environment where IPOs are rare, mergers are scarce and trading risk must be toned down, brokerage is an attractive business. Expanded retail revenue could also reduce the cost of Morgan credit default insurance and boost its stock valuation.

Citi and Morgan executives said the combined brokerages will generate a pretax profit margin of 26 percent as markets improve, up from a 19 percent today, fueled by cost savings. The two brokerages currently handle client accounts with a combined $1.7 trillion in assets.

Past brokerage deals have fallen short of expectations and proven costly as acquirers heaped riches on top advisers to keep them from jumping ship.

On Tuesday, Citi and Morgan officials declined to comment on retention payments, but analysts warned Morgan could announce a merger-related charge of $1.1 billion.

That said, Morgan's efforts to create a larger retail brokerage business "should prove to be a solid investment," Hintz said. Fox-Pitt's Trone expects the deal will improve the market's views on Morgan and its outlook.

Morgan "will likely be viewed as back on the offensive," Trone said. "This could well signal that its crisis of confidence is behind them."

(Editing by John Wallace)