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(Reuters) - Morgan Stanley (MS.N) agreed to buy the rest of a brokerage joint venture from Citigroup Inc (C.N) at a lower-than-expected price valuing the business at $13.5 billion, a win for Morgan Stanley although it faces challenges to boost the operation's profits.
The brokerage business was meant to stabilize Morgan Stanley's revenue during economic cycles but has not been nearly as profitable as the investment bank had hoped. Costs have run over and technology problems have dogged the joint venture since its inception.
"Morgan Stanley has fabulously disappointed investors with the execution of its integration plans," said Brad Hintz, a former Morgan Stanley treasurer who is now a bank analyst at Bernstein Research.
The banks restructured the deal so Morgan Stanley can buy Citigroup's 49 percent stake faster than previously planned. The price they agreed to will trigger a $2.9 billion after-tax charge for Citigroup, which was holding the business on its books at a much higher value. That charge would wipe out analysts' third-quarter profit forecast for the bank.
But it will also allow the banks to move past the negotiating table and focus on plans to fix their businesses.
Morgan Stanley's wealth management business is a key component of its strategy to smooth out earnings, which have been highly volatile over the past several years, and to delve deeper into more reliable revenue streams.
Its wealth and asset management revenue now represents half of net revenue, up from 31 percent in 2007, and its wealth management division has been delivering quarterly revenue in a range of $3 billion to $3.4 billion, even in a flat interest rate environment.
But to achieve its goal of boosting wealth management pretax profit margins to a "midteens" range by June from the current 12 percent, Morgan Stanley will have to deliver on aggressive cost-cutting targets.
At a Barclays conference on Tuesday, Morgan Stanley Chief Financial Officer Ruth Porat said that she and other senior executives "remain resolute" on meeting their profit goals by mid-2013. Eventually, when market conditions improve, management expects the business to deliver margins of 20 percent or more.
"The business provides a stable revenue stream with margin upside," Porat said.
The CFO detailed plans to cut expenses by $300 million a year to reach profit targets, and noted that Morgan Stanley's return on equity will increase as it buys a greater stake in Morgan Stanley Smith Barney, since the bank is already holding capital against 100 percent of the business, but had only been taking in 51 percent of its profits.
However, Porat also said the bank expects to take a charge this quarter to reflect the declining value of old software, as well as expenses related to staff cuts and office consolidation.
Morgan Stanley and Citigroup agreed to the joint venture in 2009 in the wake of the financial crisis. Morgan Stanley, the majority owner, had always expected to buy out Citigroup, but it was unclear how much it would have to pay.
The two parties had brought the matter to an independent arbitrator for an appraisal when they could not agree on a price. But the decision announced on Tuesday was made by the two banks and not the arbitrator, Perella Weinberg Partners, a source familiar with the matter said.
Under terms of the agreement, Morgan Stanley will buy another 14 percent of Morgan Stanley Smith Barney now and will buy Citigroup's remaining 35 percent stake by June 1, 2015. Each transaction will be based on the $13.5 billion valuation, and client deposits will be transferred to Morgan Stanley at no premium. The deal is subject to regulatory approval.
For Citigroup, the sale is another step in Chief Executive Vikram Pandit's campaign to bolster capital levels and shed assets that are not part of a long-term business plan. Those assets, known as Citi Holdings, have declined from a height of $898 billion in the first quarter of 2009 to $191 billion at the end of June.
"As we have shown, the more we put the past behind us, the more we can focus on our future, which is in the core businesses in Citicorp," Pandit said in a statement.
The charge that Citi will have to take amounts to about 99 cents a share, which would wipe out the 99 cents a share of earnings that analysts, on average, had estimated Citigroup would report for the third quarter.
However, the charge will not affect Citigroup's capital levels under Basel III regulatory measures, the bank said in an 8-K filing with the U.S. Securities and Exchange Commission on Tuesday. Morgan Stanley's forthcoming $1.89 billion cash payment to increase its stake will also boost Citi's estimated Tier 1 common regulatory capital ratio by about 14 basis points under Basel III.
The outcome of the dispute was keenly awaited by Wall Street because it could offer clues on expectations of future profitability in the brokerage sector, which has been suffering through low interest rates and weak trading activity for several years.
Morgan Stanley Smith Barney is the biggest brokerage in the United States with nearly 17,000 financial advisers and $1.71 trillion in assets, so its value is seen as a barometer for the industry.
The deal was seen as a win for Morgan Stanley because the final value came in closer to its initial $9 billion valuation of the business than to Citi's $23 billion balance-sheet valuation.
"It was a bad transaction for Citi, but the market has known it was probably going to go against them for awhile, so at least it brings closure," said David Trone, a bank analyst with JMP Securities. "Sometimes you just want to sell something and you'll take whatever price you can get."
Both companies' stock prices rose on the news. Citigroup shares were up 2.61 percent at $32.66, and Morgan Stanley shares were up 3.85 percent at $17.25 at the close of trading on Tuesday afternoon on the New York Stock Exchange.
Morgan Stanley CEO James Gorman has made the case that the sheer scale and breadth of the business, combined with overlaps in lending, investment banking and trading, will give the firm an edge and allow it to meet its profit targets.
But after a dozen quarters of lackluster performance, investors have become impatient. Mike Mayo, a CLSA analyst, recently upgraded Morgan Stanley shares to "buy" partly because of shareholder pressure on management to deliver better returns.
At the conference on Tuesday, an investor poll said Morgan Stanley Smith Barney reaching its profit target next year was a "very important" factor in whether to own Morgan Stanley shares.
Although the company's low appraisal for the value of Morgan Stanley Smith Barney was largely viewed as a negotiating tactic, it also raised additional questions about how profitable the business can be over the long term, analysts said.
"Morgan Stanley got a great bargain here in the transactional sense," said Trone. "The problem is, this is a key unit for them, and now they're going to have to spend the next several years convincing the Street that it's worth more than ($13.5 billion)."
Editing by Gerald E. McCormick, Dan Wilchins, Matthew Lewis and Edmund Klamann