There seems to be no end to the speculation surrounding the purchase price of 14% stake in Morgan Stanley Smith Barney Holdings LLC (MSSB) – the brokerage joint venture (JV) between Morgan Stanley (MS) and Citigroup Inc. (C). On Tuesday, both Morgan Stanley and Citigroup announced an extension of the independent evaluation period till September 10. The original deadline was August 30.
As per the terms of the JV, Morgan Stanley (currently holding 51%) will buy another 14% stake from Citigroup by the end of this quarter. Nonetheless, with a difference of over 10% between the valuations done by each company, an independent arbitrator – Perella Weinberg Partners LP – will now be evaluating the fair market value (FMV). However, the original deadline did not provide the arbitrator sufficient time.
Calculation of FMV
While determining the FMV, both Morgan Stanley and Citigroup had taken into consideration various factors including operating profit, assets under management and the share prices of other brokerage companies. Yet, there was a significant difference between them.
According to the regulatory filings, the overall value of the JV is $9 billion for Morgan Stanley, while Citigroup valued the same at $22.5 billion. Hence, now the independent arbitrator would come up with the FMV.
If Perella Weinberg’s FMV lies between the values calculated by both these companies, then this price would be taken. However, if the independent arbitrator’s FMV is higher, then the average of this value and Citigroup’s value will be taken as the overall price of the JV (as Citigroup has the next highest value). Now, if the independent arbitrator’s FMV is lower, then the average of this value and Morgan Stanley’s value will be taken (as Morgan Stanley has the next lowest value).
The Background Story
Way back in June 2009, Morgan Stanley and Citigroup entered into an agreement to form MSSB. The JV included Morgan Stanley’s Global Wealth Management (GWM) Group and Citigroup’s Smith Barney, Quilter in the UK, and Smith Barney Australia.
As per the terms of the deal, Morgan Stanley exchanged 100% of its Global Wealth Management business for 51% stake in the JV. Likewise, Citigroup exchanged 100% of its Smith Barney, Smith Barney Australia and Quilter units for a 49% interest in the JV and paid $2.75 billion to Morgan Stanley.
The terms also stated that after three years, Morgan Stanley would have options to purchase additional interest in the JV from Citigroup. However, Citigroup would continue to hold a significant interest in the JV till 2014.
In January 2012, Morgan Stanley submitted its capital plans to the Federal Reserve for the stress test that included buying of additional 14% stake in MSSB. This proposition of the company received the Fed’s approval in mid-March. Hence, in June, the company issued a notice that initiated a 90-day process to determine the purchase price.
Conclusion
The JV missed the profit targets set by Morgan Stanley on the back of low interest rate environment and sluggish trading activities. Further, the company is expected to incur higher merger related expenses. Hence, these could be one of the reasons for low FMV.
In the first half of 2012, Morgan Stanley’s GWM Group, which includes MSSB, recorded net revenue of $6.7 billion, making it the largest revenue contributing segment. Further, the stake buy would also reduce the earnings volatility related to the company’s investment banking operations.
For Citigroup, divesting its stake in MSSB is a step closer towards improving its capital ratios and concentrating on its core operations, especially after its capital plan was rejected by the Fed. However, if the FMV of the independent arbitrator is nearer to Morgan Stanley’s price tag, then Citigroup would incur a substantial charge in the third quarter of 2012.
Currently, Morgan Stanley retains its Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain our long-term ‘Neutral’ recommendation on the stock.
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