Citigroup Inc. is facing a potential multibillion-dollar writedown as it begins unwinding its minority investment in the Morgan Stanley Smith Barney brokerage.
Morgan Stanley has the right this spring to start buying Citigroup out of the joint venture, which was formed in 2009, when the sides combined Citigroup's Smith Barney with Morgan Stanley's wealth-management unit. Price is likely to be one of the main points under discussion when negotiations begin this spring, people familiar with the situation said.
Morgan Stanley Smith Barney is valued at $20 billion on Citigroup's books by the reckoning of Howard Chen of Credit Suisse — $5 billion more than it is on Morgan Stanley's, the analyst figures — thanks largely to differences in how the companies accounted for the assets they contributed.
An estimated drop in the venture's value since its launch is complicating matters, as a rocky stock market, weak economy and slow integration of the two companies have acted as a drag on the company's ability to gather new assets from clients.
As the holder of a purchase option on the venture, Morgan Stanley has an incentive to present numbers that could support a lower price. Even so, several analysts said they believe the venture is worth considerably less now than when it was formed. If reflected in an agreement, that lower valuation could leave Citigroup facing an after-tax earnings hit of as much as $1.8 billion, analysts said — which is greater than its earnings in the fourth quarter.
A writedown wouldn't be "a game changer in terms of its size," said Mike Mayo, an analyst with Credit Agricole Securities. "But it raises questions about the way Citi values its assets."
Citigroup declined to comment.
Disagreement over price isn't expected to prevent a deal, which initially would boost Morgan Stanley's ownership to 65% from 51% and reduce Citigroup's stake to 35%. Morgan Stanley has additional purchase options in coming years and is expected to take full ownership of the venture by 2014, most likely dropping Smith Barney from the name.
Full ownership of Morgan Stanley Smith Barney is a key component of Chief Executive James Gorman's thrust to reduce Morgan Stanley's reliance on its volatile sales-and-trading unit. For Citigroup, a sale will allow the No. 3 U.S. bank by assets to free up capital and exit from businesses outside its core retail- and commercial-lending focus.
When the companies announced plans for the venture in January 2009, executives from both companies were optimistic about its growth prospects. Gorman sought to expand the brokerage business as part of a bid to form a safer Morgan Stanley after the 2008 financial crisis, and Citigroup CEO Vikram Pandit said the agreement created "a peerless global wealth management business."
But in reality, it has been more prosaic. For 2011, the venture's pretax profit margin was 10%, half of Gorman's projection, while total assets under management declined by $20 billion to $1.65 trillion. Revenue, income and assets under management are all lower at Morgan Stanley Smith Barney today than when the two asset-management units were combined, according to Jeff Harte, an analyst with Sandler O'Neill + Partners.
"If you're looking at less income, it makes sense that the business is worth less," Harte said.
How much less is expected to be a point of sharp debate as the banks square off at the negotiating table, people familiar with the situation said.
Chen of Credit Suisse estimates minority-owner Citigroup has assigned Morgan Stanley Smith Barney an implied value of $20 billion, against $15 billion or so at Morgan Stanley.
The clashing views of the joint venture's worth stem from a difference in valuation and accounting methods, Chen said.
Citi's figure largely reflects the implied market value of the venture at the time of its creation, while Morgan Stanley's lower number is a product of how the company valued its wealth-management unit before the deal and the $2.7 billion of cash it paid Citi at closing.
An agreement to sell 14% of Morgan Stanley Smith Barney at a price below the figure on Citigroup's books could prompt the company to take a writedown on its remaining stake, to reflect the fair-market value implied by the deal.
A sale that valued Citigroup's stake at $7.5 billion — broadly in line with Morgan Stanley's assessment, according to a report from Chen — could result in a $2.5 billion writedown that would translate into an after-tax earnings hit of $1.8 billion using a recently projected tax rate of 28%. Citigroup made $1.2 billion in the quarter ended Dec. 31.
