It's Showtime for Morgan Stanley

Morgan Stanley (MS), which shifted strategy last year to rely more on its 18,000 brokers and less on debt-fueled risk taking, is still struggling to prove the new model works. The company failed to ride a surge in equity and bond markets in 2010, and its stock underperformed its industry average.

Shortly after taking the top job last January, Chief Executive Officer James P. Gorman said 2009 was a "year of transition" and that 2010 would be the "year of execution." Things didn't play out that way: Last October, Gorman, 52, said Morgan Stanley, the sixth-largest U.S. bank by assets, was still in a "transition period" and "remains a work in progress."

While Gorman declined to comment for this story, his October remarks didn't go unnoticed. "When a CEO says that, it means he knows he still has some near-term challenges and that he's very conscious of not trying to encourage unrealistic expectations," says Chris Kotowski, an analyst at Oppenheimer (OPY) in New York. "To me, that's better than saying reassuring things and then not delivering."

Morgan Stanley, which reports fourth-quarter results on Jan. 20, posted $3.59 billion in net income in the first nine months of 2010. Analysts now expect it to close out the year with $4.47 billion, 14 percent short of what they forecast last January. Morgan Stanley's stock fell 8.1 percent in 2010, ending the year down 63 percent from its 2007 high. That compares with an 11 percent gain for the Standard & Poor's 500 Financials Index last year, along with a 13 percent advance for the Standard & Poor's 500-stock index. The shares have risen 3 percent so far this year as of Jan. 11. "You can't take a lot of positives out of only being down 8 percent," says Douglas G. Ciocca, managing director at Renaissance Financial in Leawood, Kan., which manages $2 billion, including Morgan Stanley shares. "There may be some steak at Morgan Stanley, but there's not much sizzle."

Gorman spent much of the year steering the company away from the risk-taking model embraced by Chairman and former CEO John J. Mack, and rivals including Goldman Sachs (GS). Gorman relinquished control of hedge fund FrontPoint Partners and indicated he may dispose of more hedge fund stakes. The company's fortunes are now tied more closely to the success of Morgan Stanley Smith Barney, the largest brokerage in the world by number of advisers and client assets. In the first nine months of 2010, Morgan Stanley got 39 percent of its revenue and 15 percent of its pretax profit from the brokerage unit, which includes Morgan Stanley Smith Barney and a private bank started last year to offer loans to brokerage clients. The brokerage unit provided 16 percent of revenue and 5 percent of profit in 2006.

Morgan Stanley bought a controlling stake in Morgan Stanley Smith Barney from Citigroup (C) in 2009. Last year it faced continuing costs from unifying computer systems at the brokerage. It also had to deal with skittish investors. The unit pulled in $8.8 billion from clients through September, which meant it was likely to miss Gorman's target of more than $20 billion for 2010. In July the company cited the May 6 market crash that briefly wiped out $862 billion in equity market value for scaring away retail investors. For the first nine months of the year, the brokerage unit had a pretax profit margin of 8 percent, below Gorman's target of 15 percent.

Gorman said in December that retail investors' confidence has returned and trading has picked up. "This business will see improving margins and revenue growth as individual investors get reengaged, which is in fact what we are seeing," he wrote in a memo to employees that was obtained by Bloomberg.

Another weak spot is revenue from fixed-income trading, which was 30 percent lower than that of any of its largest U.S. competitors in the first nine months of 2010. Morgan Stanley reduced headcount in the department and committed less capital to fixed-income and equity trading as part of its shift away from risk taking.

Poor trading results masked strength in investment banking, Morgan Stanley's oldest business, which accounts for 12 percent of revenue. In 2010 the company was both the top global underwriter of equity offerings and the top global adviser on announced mergers and acquisitions for the first time since Bloomberg began compiling data in 1999.

"I believe that our stock is meaningfully undervalued, and that there will be a huge inflection point as we demonstrate to investors that our client-focused strategy is working," Gorman wrote in the December memo. Now he will have to deliver. "There's nothing you can say that's going to convince people," says Oppenheimer's Kotowski, who has a buy rating on Morgan Stanley. "It's got to be the numbers. Gorman understands that. He's a very thoughtful and realistic guy, and I don't think he's under any illusions about what he has to do."

The bottom line: In 2011 Gorman must demonstrate that his decision to lean more heavily on retail investors and less on risk taking was a smart move.

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