Morgan Stanley Pair Trade: Upgrade Carlyle, Downgrade KKR

• Shares of both The Carlyle Group LP CG and KKR & Co. L.P. KKR have lost around 45 percent since April 17.
• Morgan Stanley’s Michael J. Cyprys revised the ratings for both companies.
• While Carlyle offers compelling long-term value, KKR’s balance sheet could be a near-term risk to earnings.

Carlyle

Cyprys upgraded the rating for the company to Overweight, with a price target of $20. He mentioned that the stock offers compelling risk/reward and there is 49 percent upside to the price target.

Although the near-term environment could continue to be choppy for all asset managers, there are Carlyle-specific catalysts, including the $4b in portfolio exit pipeline, $4b in investment deployment pipeline, the recently announced share repurchase program of $200m, management’s increased focus on cost control as well as on more efficient and scalable fund strategies, Cyprys said.

With an acceleration in Carlyle’s deployment, the market is likely to “ascribe more value to future earnings potential,” the analyst wrote. He added that the company is likely to deliver strong cash generation over the next three years.

Carlyle’s shares have been underperforming and are “by far the cheapest vs. peers.” Cyprys commented.

KKR

The analyst downgraded the rating for the company to Equal-weight, with a price target of $14. He mentioned that a weaker balance sheet could exert pressure on BV growth in the near term, and delay KKR’s return to normalized +20 percent ROEs.

“We think the Street is mis-modeling KKR's balance sheet earnings, and we expect 1Q to be far more challenging than 4Q,” Cyprys wrote. He expects the company to report a loss per share of $1.51 in 1Q16, worse than the consensus expectation of a loss per share of 10c.

The shortfall is expected to result from pressures of a “large concentrated public equity position on its B/S along with negative credit and energy marks.” The analyst expects KKR to record a loss per share of 67c for full-year 2016, versus consensus expectations of an EPS of $1.74.

Volatility in KKR's earnings could increase with a greater skew to public equity positions in its funds; which constitute 42 percent of the company’s funds versus 11-27 percent for peers. This could be a headwind in the current unfavorable backdrop, the Morgan Stanley report mentioned.

KKR's ROE declined from 16 percent in 2014 to 10 percent in 2015,and could turn negative in 2016, Cyprys said.