Morgan Stanley: Yen for Japanese Investment

Shares of Morgan Stanley (MS) rallied sharply Monday, bringing the battered investment bank back from the brink after it was able to renegotiate a much needed $9 billion deal with Mitsubishi UFJ Financial Group (MTU) . Weekend negotiations required substantial encouragement from the U.S. Department of the Treasury and a guarantee that the Japanese bank s stock would not be diluted if the government later injected more capital into Morgan Stanley.

Morgan Stanley's stock was wracked by panic selling last week, plunging 58% to close Friday at $9.68 a share. That imperiled the deal with Mitsubishi UFJ struck Sept. 29. The original agreement would have had the Japanese bank acquire 9.9% of Morgan Stanley's common stock at $25.25 a share, for a total of $3 billion, and pick up $6 billion of perpetual convertible preferred stock with a 10% dividend and a conversion price of $31.25 a share.

After obtaining necessary regulatory clearances, the two sides recast the deal over the weekend, Under the revised transaction, Mitsubishi UFJ got $7.8 billion of perpetual non-cumulative convertible preferred stock with a 10% dividend and a conversion price of $25.25 per share, and $1.2 billion of perpetual non-cumulative non-convertible preferred stock with a 10% dividend. By eliminating the common stock, the Japanese bank avoided assuming a dominant ownership position that would have required further time-consuming regulatory approvals. It will get 21% ownership of Morgan Stanley.

Before the revised deal was announced, influential banking analyst Richard Bove wrote Friday that the Japanese stake and Morgan Stanley's estimated $50 billion in reserves would allow it to keep operating.

"The risk, however, remains in this stock if the company's assurances are not accepted by the market," he wrote Friday, when he also cut his 12-month price target to $19 a share.

"My position on this company taken down to its most basic concept is as follows: the company must have the ability to roll over its debt and operate with counterparties in the market on a daily basis," Bove wrote Saturday. "If it can do this, it will survive and ultimately thrive. If it cannot, it faces a difficult future. An injection of $9 billion in cash will not resolve the problem. The company's debt must be guaranteed."

Wall Street's anxiety was certainly high before the new deal announcement. David Trone, at Fox-Pitt Kelton Cochran Caronia Waller, said the company was caught in market currents beyond its control.

"Morgan Stanley shares have been under extraordinary pressure as of late, for no apparent fundamental reason, as we estimate liquidity, the balance sheet, and long-term earnings prospects are sound," he wrote Friday. "However, as we've seen with Bear Stearns and Lehman, once the fear virus has infected the story, it is tough to shake."

He said confirmation of the Mitsubishi deal "could help the psychology, but we are not holding our breath."

It's almost safe to exhale.

Bottom Line: Hold
The financial sector is rife with uncertainty, and while this is good news, many risky variables remain.

Royal Bank of Scotland: Anarchy in the U.K.

A British government rescue plan ensured the survival of the Royal Bank of Scotland (RBS), but its American depositary shares sank Monday in a knock-on effect from European trading.

The United Kingdom on Wednesday announced the skeleton of a bailout plan that would effectively partially nationalize the country's worst-hit banks, and added details Monday.

CreditSights analyst Simon Adamson on Monday wrote, somewhat facetiously, that years of criticizing the German Landesbank system that conferred government ownership needed to be rethought.

"We failed to realize that, in fact, the Landesbank sector was a blueprint for the future of European banking, and that far from embracing privatization, the way forward was to move towards a system of government guarantees and state mandated lending policies," he wrote.

Gallows humor aside, he said the Financial Services Authority, Britain's principal financial regulator, has put teeth in the notion that banks need higher capital ratios, and that subsequent over-capitalization would help restore confidence. Under the rescue package, RBS would have a Tier 1 capital ratio of 12%, up from 8.6% to "remove any concern about their ability to manage through even the most severe recession."

But RBS shareholders paid a huge price for the rescue. The bank agreed to raise $34.5 billion, with the government taking an $8.6 billion stake and public investors making up the difference. The bank had a barely successful $34 billion secondary offering earlier in the year, and the size of the capital raise opens the door to a much larger government stake, with the same degree of share dilution.

Last week, after the initial bailout announcement, BNP Paribas analysts Olivia Frieser and Axel Swenden wrote that the government had proved it was willing to do whatever was necessary to provide a measure of stability, but added that "fundamental concerns remain about the U.K. economy and the impact this will have on the banks."

Bottom Line: Hold
Extraordinary times have merited extraordinary measures, and U.K. banks are a test case for government intervention. The stock is worth about 10% of what investors bought it for a year ago, but bottoms have proved elusive in the past.

Chesapeake Energy: Feeling Gas Pains

Investors gassed up on shares of Chesapeake Energy (CHK) on Monday, the first trading day since its chief executive was forced to sell almost his entire stake in the company to meet a margin call.

Aubrey McClendon called the humiliating measure "involuntary and unexpected" in a prepared statement posted on the company web site.

"In no way do these sales reflect my view of the company's financial position or my view of Chesapeake's future performance potential," the CEO said. "I have been the company's largest individual shareholder for the past three years and frequently purchased additional shares of stock on margin as an expression of my complete confidence in the value of the company's strategy and assets."

Chesapeake, based in Oklahoma City, is the largest natural gas producer in the country, and gas prices have been falling along with oil prices as the global financial crisis gathered momentum. Figures from the U.S. Department of Energy show a 32% decline in U.S. average wellhead prices from June to September, and Chesapeake's stock ahs dropped correspondingly.

That's pushed the company to announce plans to slash capital spending by about $1.5 billion for 2009-10, its second major Friday announcement ahead of its investor and analysts meeting, scheduled to start Wednesday.

Despite the cut, Jefferies & Co. analyst Biju Perincheheril wrote Monday that asset sales will still be required for the company to stay above water, and that "nothing is certain in the current environment." Chesapeake is seeking to sell a 25% stake in its Marcellus Shale operation as part of efforts to raise $2.5 billion to $3 billion.

Fadel Gheit, at Oppenheimer & Co. warned that scarce credit Chesapeake has already drawn down the last of its revolving credit line could leave heavily leveraged energy companies less able to hedge against oil and gas price fluctuations.

The strange logic of the crisis may wind up being a net benefit to Chesapeake if it can weather the rough patch, wrote BMO Capital Markets analyst Dan McSpirit.

"While we believe pressure will remain on commodity prices in the immediate term, we look to the credit crisis as a way of helping put a floor on prices in the periods ahead, however curious a statement that makes," he wrote Monday. "The energy business remains capital intensive. Credit facilities in place today are limiting factors to growth. Today there is no debt capital (or equity) beyond it. Less capital means less production means higher prices, at least theoretically."

Kenneth Carroll, an analyst at Johnson Rice & Co., says the worst-case scenarios have already been priced into the stock, and believes Chesapeake is ready to heat up anew.

"Operationally, things continue to click for CHK though they are not immune to falling commodity prices and spending plans are moving down with gas prices," he wrote. "Rumored liquidity issues simply do not exist though management's forced stock sale is certainly disappointing. In the end, the stock sale has no direct impact on company operations or future prospects and we continue to believe the selling pressure of the last few trading days is over done."

Bottom Line: Buy
Energy stocks will stay volatile, but a cold winter and continued solid performance could warm a risk-tolerant portfolio.