A win for Morgan Stanley (MS) in a fight with Citigroup Inc. (C) over the value of their brokerage joint venture could show the firm is playing a losing hand.

Morgan Stanley, which has staked much of its pitch to investors on the stable earnings of its wealth-management business, is arguing that the brokerage is worth less than half what Citigroup says as it adds a 14% stake to the 51% the investment bank currently owns. Morgan Stanley's $9 billion valuation implies the joint venture's profit could shrink by as much as 12% annually over the long term, according to Goldman Sachs Group Inc. analysts.

The $13 billion gap between the two firms' valuations raises the stakes for the sale and stokes a debate on Wall Street about the future of retail brokerages. Investment bank Perella Weinberg Partners LP will provide its assessment of the outlook when it sets a valuation this week.

"If you're bullish on Morgan Stanley, the lower amount they pay the better," said David Konrad, an analyst at KBW Inc. in New York. "However, then you take a step back and say, this is supposed to be one of your best businesses, and you're saying it's not worth very much. It's a fine line they're walking."

While analysts including Konrad said much of the gap resulted from negotiating tactics, the Morgan Stanley valuation contradicts the bullish targets it has laid out to investors. Greg Fleming, who runs the wealth-management unit that includes the brokerage, has said it will reach a "mid-teens" pretax margin by the middle of 2013, requiring at least a 25% jump in earnings from last quarter.

Gorman Goal

Morgan Stanley shares are down 51% since the end of 2009 and trade at less than half of book value. Part of the reason for the discount is the low profits at the brokerage amid a trading slump and global economic weakness, said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Morgan Stanley Smith Barney is the world's largest brokerage by number of financial advisers, with 16,934 as of June 30.

Chief Executive Officer James Gorman, 54, set a 20% pretax-margin goal for the unit soon after he took the New York- based firm's top job at the start of 2010. The margin hasn't exceeded 12% in any quarter since the joint venture was created in 2009, when Citigroup sold 51% of the business. Morgan Stanley also got the right to buy the rest of the brokerage over time, with 14% available this year, 15% next year and the final 20% in 2014.

Conflicting Valuations

The failure to reach targets may explain the difference between valuations, Hintz said.

"Citi negotiated the original deal knowing the value was going to go up over time and the future pieces would be more expensive," Hintz said. "That explains almost everything in terms of the differences. One guy is saying, 'Look at what your plan was,' and the other guy's saying 'Well, that wasn't the way it worked out.'"

The venture agreement instructs the banks to value the unit as if it were a standalone, publicly traded firm, taking into account size, earnings and prospects. Gorman has said some of the brokerage's value comes from its ties to Morgan Stanley's investment bank, which can provide stock from initial public offerings and bonds from underwriting to help generate fees through sales to individual investors.

Citigroup estimated in a July 19 regulatory filing that its 49% stake was worth $11 billion and said Morgan Stanley's bid was 40% lower. That means the two banks' estimates of the total value are about $13 billion apart. Morgan Stanley will pay 14% of the total valuation for the new stake.

Wesley McDade, a spokesman for Morgan Stanley, declined to comment, as did Shannon Bell, a spokeswoman for Citigroup.

Citigroup Writedown

Morgan Stanley's valuation indicates that New York-based Citigroup got a good deal in 2009, when it sold a majority stake in the new joint venture, Charles Peabody, an analyst at Portales Partners LLC in New York, wrote in a note last month. Morgan Stanley contributed its wealth-management business to the venture and paid $2.75 billion to Citigroup. The total value of the majority stake was about $10 billion, Peabody said.

A low valuation also threatens Citigroup, which risks a writedown that could wipe out all its profit for the third quarter and serve as another embarrassment for CEO Vikram Pandit, 55, after his firm failed part of the Federal Reserve's stress test this year. The writedown could top $6 billion if Morgan Stanley's valuation is accepted. That's twice Citigroup's $2.9 billion estimated third-quarter net income, according to the average of 13 analysts surveyed by Bloomberg.

Perella Role

The firm overseeing the valuation process required after the banks couldn't agree on a price is headed by industry veteran and Morgan Stanley alumnus Joseph Perella. He has advised on mergers and acquisitions for more than 30 years, working on deals in a number of industries. Perella Weinberg is currently advising Julius Baer Group Ltd. (BAER) on the purchase of Merrill Lynch's international wealth-management business, according to Perella Weinberg's website.

Perella, 70, worked at First Boston Corp., now part of Credit Suisse Group AG, before leaving in 1988 with Bruce Wasserstein to start Wasserstein, Perella & Co. He joined Morgan Stanley in 1993, rising to head of investment banking before leaving in 2005 during the management revolt that led to the resignation of CEO Philip Purcell.

Kara Findlay, a spokeswoman for Perella Weinberg, declined to comment.

Brokerage Debate

Perella Weinberg's decision could swing the sale price of the 14% stake by almost $2 billion. It also may fuel the debate over the prospects for the brokerage industry. While firms are grappling with low market volumes and near-zero interest rates, new capital rules are increasing the attractiveness compared with riskier trading businesses.

There aren't many large retail brokerage deals for Perella to rely on. Merrill Lynch & Co., owner of the joint venture's largest direct competitor, sold itself to Bank of America Corp. in 2008 as it faced concerns about its survival during the financial crisis, driven by losses at its investment bank. Publicly traded firms such as Stifel Financial Corp. and Raymond James Financial Inc. are significantly smaller.

Proponents of the retail brokerage model, including Gorman, who ran Morgan Stanley's wealth-management unit before becoming CEO, point out the stable revenue and low capital requirements.

The division generated between $3 billion and $3.5 billion of revenue every quarter since the start of the joint venture, while the firm's investment bank swung between $2 billion and $6.4 billion. The company allocated $3.8 billion of Tier 1 common equity to the wealth-management unit last quarter, compared with $22.3 billion the investment bank commanded.

Wealth Management

Morgan Stanley's purchase of the joint venture has made it more dependent on wealth management. Revenue from that division accounted for 41% of the firm's total in 2011, up from 16% in 2006.

Matt Burnell at Wells Fargo & Co. is among analysts who say the business may have limited returns because financial advisers are paid on a pre-set scale that provides them with a larger percentage of revenue than bankers or traders receive and because the business is competing with larger banks and independent brokerages for a small number of wealthy clients.

Morgan Stanley's wealth-management unit has set aside at least 59% of revenue for pay every quarter since 2010, tried to cut costs as revenue dropped 2% in the first half and stopped setting targets that rely on an improvement in the markets. The firm's valuation of the joint venture implies an environment that isn't getting better soon.

"Volumes are at low levels, and there is the potential those levels won't increase materially in the intermediate term," Burnell said. "Most of these companies are trying very hard to get their cost structures as efficient as they can, but it is, by definition, a relatively tech-intense and personnel- intense business."

Cutting Compensation

Morgan Stanley has tried to cut compensation costs by reducing the number of brokers by more than 1,000 over the last year, raising the minimum amount of revenue an adviser must produce to avoid pay cuts and shrinking the number of trainees to 1,250 from 2,000. It is also attempting to boost revenue by offering more clients managed accounts that charge a fixed fee and pursuing customers who have more than $1 million in assets.

The firm isn't the only one courting that population. Bank of America and Wells Fargo have laid out plans to offer more products to their wealthiest clients and turn mortgage customers into patrons of their brokerage businesses.

"Everyone's beating each other up to get the same clients, which makes success in that area even more complicated in a constrained revenue environment," Burnell said. "The banks are now clearly focusing a lot more time and effort on keeping their more profitable customers, and that may be another cloud on the horizon for companies like Morgan Stanley."

'Game Theory'

Under terms of the agreement between the joint-venture partners, the gap between the banks' estimates will be divided into thirds. If Perella's estimate falls in the middle portion, the transaction price will be set at that level. If it's in the upper or lower third, the final price will be the average of Perella's estimate and the closest bank estimate, according to a procedure Morgan Stanley outlined in a May filing.

The structure of the process was supposed to dissuade either side from tendering an extreme estimate of fair value. The theory was that if one side submitted an outlier while the other offered an estimate close to what the outside appraiser would view as fair value, the former could end up with a price more than $100 million further away from its projection than the outside appraiser's decision.

Instead, each side may have wagered that the other would propose a value strongly in its own favor and that the outside appraiser would split the difference.

'Valuation Disconnect'

"In our view, part of this valuation disconnect is 'game theory' such that a wider range makes it more likely that the value will fall into the middle third," Richard Ramsden, an analyst at Goldman Sachs, wrote in a note last month.

Ramsden pegged the value at about $13 billion. That was the average of a cash-flow analysis that calculated the unit was worth $15.3 billion assuming 7% annual earnings growth and an approach that compared earnings multiples of Stifel and Raymond James (RJF), which suggested a $10.6 billion price tag for the entire brokerage. Ramsden's cash-flow analysis showed that a valuation of $9 billion implies that profits would shrink by 12% a year over the long term.

KBW's Konrad said he estimates the unit is worth between $14 billion and $14.5 billion. Burnell pegged it at the "high- teens" billion range. In January, Credit Suisse's Howard Chen estimated the value of the brokerage at $15 billion. David Trone, a JMP Securities LLC analyst in New York, said in a note the following month that the unit is worth $24 billion.

Appraisal Drama

"We don't have a lot of disclosure on the joint venture, so everyone's numbers are a little bit back of the envelope, best we can do," Konrad said. "Both sides are kind of setting up to where the middle third is a little more acceptable. If you look at the middle between the two, that comes in around $16 billion valuation for the total company."

Such a valuation could still lead to a pretax charge of more than $1 billion for Citigroup. Jason Goldberg, a Barclays Plc analyst in New York, said the writedown may reach almost $6 billion, the latest significant loss at its Citi Holdings division, which houses assets the bank is selling or winding down. Pandit has been trying to convince investors that Citi Holdings will be less of a drag on the firm's results.

The potential loss, along with the necessity of a third- party appraiser and the wide gap, has injected more drama than the firms predicted earlier this year.

"I don't think there's going to be a whole lot of mystery, frankly," Gorman said in January. "Whatever an institution has it marked at is kind of irrelevant. It's a question of what is fair-market value. And we're both mature, grown-up institutions. I think we'll quickly figure out fair-market value, and if we can't, then we'll obviously go to a third party."

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