As Morgan Stanley finishes integrating its brokerage joint venture with Citigroup Inc and considers spending $10 billion to buy the whole business years ahead of plan, investors are anxiously awaiting signs that the long-promised profit machine will finally start to purr. Since agreeing to buy Citi's Smith Barney in 2009, Morgan Stanley executives have told shareholders that returns from the retail brokerage, the world's largest, will soar and create a more consistently profitable bank. Investors are still waiting.

From the end of 2009 to the end of last year, client assets climbed by $89 billion, or 5.7 percent, to $1.65 trillion, even as volatile markets continued to spook clients. Revenue per adviser rose to $755,000 last year from $692,000 in 2009.

Yet the integration is taking longer than expected and market conditions remain difficult years after the financial crisis. Low interest rates, fearful investors and a wave of broker departures also hurt results.

Greg Fleming, the head of Morgan Stanley's wealth management unit, last year scaled back the original pre tax profit margin target of 20 percent to the mid-teens.

Those targets are pretty bold because a retail brokerage firm, if they're operating reasonably well, will bring about a 12 to 15 percent return, said Stanley Crouch, chief investment officer of Aegis Capital Corp, whose clients own Morgan Stanley shares. Twenty is a pretty big number, especially with all the integration challenges it's been having.

Morgan Stanley spokesman James Wiggins said the bank stands by its mid-teen target for next year, once costs are reduced.

Morgan Stanley Smith Barney is a joint venture controlled by Morgan Stanley, which owns 51 percent, with an agreement to buy the rest of Citi's 49 percent stake in three pieces over the next three years. Morgan Stanley Chief Executive James Gorman is eager to buy the entire 49 percent this year if he and Citi CEO Vikram Pandit can agree on price, sources familiar with the matter have said. Analysts estimate Citi's stake is worth about $10 billion.


Gorman and other executives have blamed underperformance in the wealth management unit on a host of factors, from low interest rates and muted client activity to contractual broker-pay obligations and elevated integration costs.

But with the U.S. economy picking up speed and Morgan Stanley approaching the final stages of an integration process that executives say will reduce costs by $500 million a year, some investors say those arguments are starting to carry less weight.

I think management makes a lot of assumptions and has a certain degree of arrogance, says Crouch, and I think they're in for a very rude awakening.

The outcome of the integration will either be a testament to Gorman's mastery of the retail brokerage industry or a stain on his record. The executive came to Morgan Stanley in 2005 with a mandate to revive its individual investor business, which was rooted in the former Dean Witter.

Gorman, a former McKinsey consultant who once ran Merrill Lynch's brokerage empire, won praise for turning Morgan Stanley's hulking, middle-class brokerage operation into a more productive, blue-blooded money-maker. It helped him win the job of CEO.

But the retail brokerage model has been challenged since the 2008-09 financial crisis, as investors generate less income and low interest rates have removed an important source of revenue.

In addition, some investors are leaving brokerages owned by investment banks in favor of independent advisers, who don't have conflicts of interest when it comes to selling securities that they also underwrite or want to remove from their balance sheets.

The next six to 12 months will decide the future of the retail brokerage business and the wealth management industry because right now, it's not working, says Crouch. The old way is not going to fly.

The integration has cost more and taken longer to complete than planned, thanks to early missteps in trying to use Morgan Stanley's existing technology to manage client assets and sell investment products. Management eventually decided to install new technology across the whole franchise.

The project, about eight months behind schedule, hit another snag last year when the new technology could not accommodate Smith Barney's lucrative managed funds business. Technical glitches led management so slow down the integration process and perform additional testing. Morgan Stanley began moving thousands of its brokers onto the new system last fall and finished in February. Melding the two organizations costs about $80 million to $100 million a quarter, but those expenses are expected to lessen after the end of the year. Once the integration is complete, Morgan Stanley can combine nearby wealth management branches.

Reducing the number of branches will lift pre tax margins to 15.4 percent next year, with integration costs dropping to zero and non-compensation costs declining by another $300 million, Credit Suisse analyst Howard Chen predicts. We expect to see meaningful margin expansion as management completes the heavy lifting of the integration and are no longer running two engines in the car, said Chen.


Nomura analyst Glenn Schorr says the business can reach a 20 percent margin easily when integration costs fall and as risk-averse clients start putting money back to work in stocks and other lucrative products. Rising interest rates would also boost income.

(A) better market environment, a better rate environment, they'll get the margin boost at some point. People just wanted it sooner rather than later, Schorr said.

Another expense that will fade: the cost of nine-year retention bonuses extended in 2009 to star brokers. Analysts estimate they reduce margins by some two to three percentage points. But that means the brokerage may not be able to earn more than an 18 percent margin, even in good times, for another five years.

And while U.S. stock prices have rebounded, there are other hurdles to clear. Retail investors on the whole remain stuck on the sidelines, as indicated by net withdrawals from mutual funds, while the U.S. Federal Reserve has said it will likely not raise benchmark rates until 2014.

Investors are in wait-and-see mode. Morgan Stanley was promising to get this done much faster, so people are more skeptical now, said Paul Gulberg, a brokerage analyst at independent research firm Portales Partners.

Many analysts predict long-suffering investors will ultimately see the full earnings power of the brokerage, but whether that happens in 2013 is another matter.

I am confident in Morgan Stanley and that management team's ability to execute this plan -- the integration, the cross-sell, the cost-takeouts, the retention of top advisers, said Schorr. They'll get there.

(Reporting By Lauren Tara LaCapra and Joseph A. Giannone, Editing by Ben Berkowitz and Steve Orlofsky)