Morgan Stanley (MS) Q2 2013 Earnings Conference Call July 18, 2013 10:00 AM ET
James P. Gorman - Chairman & Chief Executive Officer
Ruth Porat - Chief Financial Officer & Executive Vice President
Celeste Mellet Brown - Head of Investor Relations
Michael Carrier - Bank of America Merrill Lynch
Guy Moszkowski - Autonomous Research
Howard Chen - Credit Suisse
Michael Mayo - CLSA
Brennan Hawken - UBS
James Mitchell - Buckingham Research
Roger Freeman - Barclays
Fiona Swaffield - RBC Capital Markets
Matthew Burnell - Wells Fargo Securities
Celeste Mellet Brown
Good morning. This is Celeste Mellet Brown, Head of Investor Relations. Welcome to our SFirst Quarter Earnings Call. Today's presentation may include forward-looking statements, which reflect management's current estimates or beliefs and are subject to risks and uncertainties that may cause actual results to differ materially. The presentation may also include certain non-GAAP financial measures. Please see our SEC filings at morganstanley.com for a reconciliation of such non-GAAP measures to the comparable GAAP figures and for a discussion of additional risks and uncertainties that may affect the future results of Morgan Stanley. This presentation, which is copyrighted by Morgan Stanley and may not be duplicated or reproduced without our consent, is not an offer to buy or sell any security or instrument.
I’ll now turn the call over to Chairman and Chief Executive Officer, James Gorman.
Thank you, Celeste. Good morning, everyone and thank you for joining us. We will again review the progress we’ve made towards the six strategic priorities we delineated in January that will drive our return on equity and return on tangible equity, excluding DVA to greater than 10% and 12% respectively.
We’re pleased with the progress we made during the quarter and we met or exceeded several of the goals. Let me just go through them quickly. First was to acquire 100% of the Wealth Management joint venture. As you know we closed on the final 35% of that joint venture on the last business day of the quarter. As we’ve taken you through the benefits numerous times, I’m not going to spell them out again. Suffice it to say however the deal was a game changer for this firm and for our shareholders, now and for decades to come.
Secondly, we put out a goal to achieve Wealth Management margins through expense management and through revenue growth. In addition to owning 100% of the business, one of the key drivers for our way upside is the revenue and margin upside in the Wealth Management business. Both were higher this quarter. The margin of 18.5% represented the fifth consecutive quarter of margin improvement, excluding non-recurring costs associated with the integration in Q3 2012.
We reached our highest margin level since the first quarter of 2008. In addition, we increased our margin goals for the Wealth Management business at our financials conference in June to 20% to 22% by the end of 2015 without the benefit of high rates of markets and more than 23% if markets or rates increase. Why the increase? The margins reflect the simple math of the upside from 100% with ongoing investment in the business, using the first quarter of 2013 results as a base.
Our third objective was to significantly reduce RWAs in fixed income and commodities. We continued to make progress regarding our fixed income RWA reductions, ending the quarter at $239 billion, down from the first quarter. We continue to expect fixed income RWAs to be below $200 billion by the end of 2016.
Our fourth goal was to drive expenses lower in 2013, 2014 and beyond. We’re on track to meet our expense reduction targets and Ruth will take you through this in more detail. As you can clearly see, our expense ratios have improved as we said they would with revenue growth.
Our fifth point was to grow earnings through Morgan Stanley’s specific opportunities. We recently received approximately $16 billion of deposits in the initial wave due to us now that we’ own 100% of Wealth Management. The team is executing against our plan to prudently deploy those deposits in support of loan growth in both institutional securities and wealth management. Now that we own 100%, we can execute on more of the initiatives we have in place to better align institutional and wealth management, including a deeper partnership between the businesses and their trading days. Because order flows no longer split with our former partner, we expect deeper and more efficient markets to both our institutional and retail clients, as well as greater revenue opportunity for fixed income, in addition to the order flow benefit we discussed [with you] for Wealth Management. We’re also looking forward to launching new products and increasing the efficiency of firm funding.
So our sixth point asked, what did it all add up to? Well, despite difficult markets, our results this quarter evidenced strength and resilience. Revenues in all of our major businesses were up double digits year over year, with Institutional Securities excluding DVA, up 40% and Investment Management up 48%. In addition, we’re pleased to commence the share repurchase we announced this morning, which will offset some of the dilution relating to employee stock programs and also benefit ROE. We recently received a non-objection from the Federal Reserve to return 1% of our tier-1 capital and will execute on the buyback in the forthcoming quarters.
We’ve been on a long journey to generate stronger, more sustainable, long term returns with businesses that balance each other in volatile markets. With the acquisition of 100% of Wealth Management, that business model is solidly in place. Our Wealth Management business complements our leading institutional securities business and the adjacencies across the entire platform will drive upside for all of Morgan Stanley. We have strength across areas of fixed income and are consistently in the top three in equity underwriting and M&A lead tables with increasing momentum in fixed income underwriting. Our investment banking franchise is a leader globally and we demonstrated the power of our footprint with important cross-border deal announcements in the quarter.
I would now like to draw particular attention to our institutional equities franchise which consistently ranks top two globally in market and wallet share. In the second quarter we continued to execute extremely well against challenging markets. In the cash product we benefitted from the hybrid voice and electronic model centered around integrated client coverage. We approached this business with the delivery of research driven content, market insight, and state of the art trading technology to a wide variety of client types. Our electronic offering spends cash, synthetic cash and derivatives, and has more than doubled market share over the last three years.
In equity derivates, our team is capitalizing on the investments we have made over the last several years driven by the breadth of our client reach, deepening relationships and partnerships across the firm, and ongoing strong risk management. And last but not least, in prime brokerage with significant balances we have a practice focused on market access, service excellence and innovative solutions for clients, all leading to an outstanding performance by institutional equities this quarter.
With Morgan Stanley's global reach, we are confident there is continued upside for this business and for the firm.
Thank you. And I will now turn the call over to Ruth and look forward to your questions later on.
Good morning. I will provide both GAAP results and results excluding the effective DVA. We have provided reconciliations in the footnotes to the earnings release to reconcile these non-GAAP measures. The impact of DVA in the quarter was $175 million with $114 million in equity sales and trading and $61 million in fixed-income sales and trading. Excluding the impact of DVA, firm wide revenues were $8.3 billion, down approximately 2% versus the first quarter. The effective tax rate from continuing operations for the second quarter was 31%.
Earnings from continuing operations applicable to Morgan Stanley common shareholder, excluding DVA, were approximately $720 million which included a negative adjustment of $152 million related to the acquisition of the remaining 35% stake in the wealth management joint venture. Earnings from continuing operations per diluted share excluding DVA was $0.37 after preferred dividends. EPS included a negative adjustment of $0.08 per share from the acquisition of the remainder of the wealth management joint venture.
On a GAAP basis, including the impact of DVA, firm wide revenues for the quarter were $8.5 billion. Earnings from continuing operations applicable to Morgan Stanley common shareholders were $831 million. Reported earnings from continuing operations per diluted share also inclusive of the negative adjustment of $0.08, were $0.43 per share after preferred dividends. Book value at the end of the quarter was $31.48 per share, tangible book value was $26.27 per share reflecting a reduction of $1.49 due to the completion of the acquisition of the wealth management joint venture partially offset by earnings.
Turning to the balance sheet. Our total assets were $806 billion at June 30, essentially flat versus last quarter. Deposits were $82 billion, basically unchanged from the prior quarter. Quarter end deposits did not reflect the first tranche of deposits that are transferred to Morgan Stanley in conjunction with the acquisition of the remainder of the joint venture. The initial deposits come in on a lag basis with $16 billion transferred this week. We will receive the remaining deposits on a monthly basis through the middle of 2015.
Our liquidity reserve at the end of the quarter was $181 billion compared with $186 billion at the end of the first quarter. The decline was driven by a reduction in bank liquidity as we deployed excess liquidity to support loan growth. Although our calculations are not final, we believe that our Tier 1 common ratio under Basel 1 will be approximately 11.8%, and our Tier 1 capital ratio will be approximately 14.1%. Risk-weighted assets under Basel 1 and including the final marker risk rules are expected to be approximately $404 billion at June 30.
Reflecting our best assessment and expectations of the recently received Federal Reserve rules, our pro forma Tier 1 common ratio under Basel III was 9.9% as of the end of the second quarter. We know that this ratio reflects our best interpretation at this time and it's subject to change as we further study the new rules. We estimate our pro-forma supplementary leverage ratio to be 4.2%. This estimate reflects the most recent United States proposed regulatory rules for the numerator and the denominator and is also subject to change as we study the guidelines. We have a clearly identified path to exceed in 2015 to 5% regulatory requirements.
Turning to expenses, total expenses this quarter were $6.7 billion, up 2% versus the first quarter, with compensation expense down 3% and non-compensation expense up 11%. Relative to the expense reduction targets that we articulated in January, we remain on track as best evidenced by our expense ratios relative to our 2014 target. Recall that we expected that some of our expense reduction effort to result in $1.6 billion decline from 2012 reported expenses to 2014 full year expenses. Our $1.6 billion target was set based on revenue consistent with 2012 levels, notwithstanding our expectations for growth. Thus we further indicated that on higher revenues our variable expenses would grow, but the overall expense ratio would improve.
Our revenues excluding DVA were up 8% in the first half while expenses were up 5%. Excluding higher litigation costs, our expenses would have been up 2%. Our $1.6 billion cost reduction target on flat revenues implied an expense ratio of approximately 79% for the firm for 2014. We are at that level in the first half of 2013 and would be even better than 79% without higher litigation, with still more expense savings to be realized over time. As a reminder our target for two year target and expenses have and will likely continue to vary from quarter-to-quarter. Recall that we had some non-recurring expenses in the second half of last year.
In addition, we had severance and certain wealth management items in our result in the first half of this year. Our targets include an expectation for continued elevated legal expenses, but of course those tend to be lofty and difficult to forecast. We continue to work through our cost cutting programs and they will drive operating leverage through the end of 2014.
Let me now discuss our businesses in detail. In Institutional Securities, revenue excluding DDA were $4.2 billion down 5% sequentially. Non-interest expense was $3.4 billion, up 3% versus the first quarter. Compensation was $1.8 billion for the second quarter, down 7% versus the first quarter, reflecting a 42% ratio excluding DDA. Non-compensation expense of $1.6 billion increased 16% from last quarter, driven by increased litigation expense as well as revenue and activity related costs. The business reported a pretax profit of 4785 million, excluding the impact of DVA. Including the impact of DVA, the business reported a pretax profit of $960 million.
In investment banking, revenues of $1.1 billion were up 14% versus last quarter, with strong growth in EMEA. According to Thomson Reuters, Morgan Stanley ranked number two in global completed M&A, number three in announced M&A, number two in global IPOs and number three in global equity at the end of the second quarter.
Notable transactions included, in advisory, Morgan Stanley acted as lead financial advisor to Kabel Deutschland on the proposed €10.7 billion takeover offer from Vodafone. In equity underwriting, Morgan Stanley successfully priced the $4 billion IPO of Suntory Beverage & Food Limited. Morgan Stanley acted as joint global coordinator and [lead left] book runner on the international tranche. Our JV partner MUFG also acted as joint book runner on the domestic tranche. And in debt underwriting Morgan Stanley acted as an active book runner on Petrobras Jumbo $11 billion fixed tranche senior notes offering as well as Chevron’s $6 billion four tranche senior notes offering.
Advisory revenues of $333 million were up 33% versus our first quarter results, driven by cross border activity and improved performance in EMEA and the Americas. Equity underwriting revenues were $327 million, up 16% versus the first quarter, driven by a significant increase in IPO activity and the highest level of sponsor related activity in several years. We had strength in the Americas and Asia, particularly Japan. Fixed income underwriting revenues were $418 million, up 2% versus a strong first quarter driven by loan syndication fees.
Equity sales and trading revenues excluding DVA were $1.8 billion, an increase of 13% from last quarter. Equity revenues were up broadly across products, regions and client segments versus the first quarter. Client revenues were the highest level in over a year driven by higher market volumes, increased volatility and greater prime brokerage balances. In cash equities, the revenue increase was driven by continued strong market share and volume growth, in particular in the Americas. Derivatives revenues were up versus last quarter with strength across regions particularly in Japan and the Americas and in part driven by higher volatility. Prime brokerage revenues also increased driven by increased activity during the European dividend season and higher client balances which increased with overall market levels.
Fixed income and commodities sales and trading revenues excluding DVA were $1.2 billion. Fixed income revenues decreased versus the first quarter due to higher volatility that resulted in lower client activity. However, a reduction in our risk levels during this period helped offset price volatility. FX delivered its fourth consecutive quarter of revenue gains benefiting from ongoing strong contribution from the firm's electronic trading platform. Commodities results were up meaningfully versus the first quarter benefiting in particular from increased client activity in North American power and natural gas as well as precious metals volatility.
Generally, however, the oil liquids market which overtime has been the most important driver of our commodities business, continues to operate at historically low levels. Finally, there was a modest CVA benefit in the quarter. Other sales and trading negative revenues of $57 million compared with positive revenues of $73 million last quarter. Average trading VAR for the second quarter was $61 million versus $72 million in the first quarter driven by a reduction in risk in May in fixed income and commodities.
Turning to wealth management. We achieved revenues of $3.5 billion in the second quarter, a record level. Asset management revenues of $1.9 billion were consistent with the first quarter, benefiting from higher market levels that were offset by lower deposit referral fees due to a rate reset late in the first quarter. Transaction revenues decreased 7% from last quarter consisting primarily of commissions of $567 million which were flat to the prior quarter.
Investment banking related fees of $258 million, down 6% versus last quarter, reflecting lower new issue volumes. And trading revenues of $223 million which were down 25% versus the first quarter, reflecting the impact of lower activity due to difficult market conditions in June. Net interest revenue increased 8% to $446 million driven primarily by growth in our lending product. Other revenue increased to $139 million in the quarter, primarily due to a gain on the sale of our global stock plan business and our investment portfolio gains.
Non-interest expense was $2.9 billion, flat to last quarter. The compensation ratio was 58% versus 60% in the first quarter, reflecting a higher level of net interest income and higher non-compensable revenues in the other revenue line. Non-compensation expense was $834 million up 3% versus last quarter due to a number of expense items incurred in conjunction with the closing of the wealth management joint venture, including software write offs, branch consolidation and increased advertising expenses. The PBT margin was 18.5%. Profit before tax and the PBT margin benefited modestly from the net impact of the unusual revenue expenses in the quarter. Profit before tax was $655 million, the highest level of absolute profitability since the inception of the joint venture.
We reported non-controlling interest of $100 million in the quarter, reflecting a full quarter of earnings. Prospectively we will not have the NCI deduction.
Total client assets were basically flat to 1Q at $1.8 trillion. Global fee based asset inflows were $10 billion. Fee based assets under management increased to $629 billion at quarter end. Global representatives were 16,321 up slightly from the first quarter. Bank deposits were 127 billion effectively flat to 1Q. Approximately $70 billion were held in Morgan Stanly Bank. As mentioned previously, we received the first wave of deposits associated with the final 35% ownership this week.
Investment management revenues of $673 million were up 4% versus the first quarter. In traditional asset management, revenues of $419 million were up from the first quarter, driven by higher performance fees and asset management and administration fees. In real estate investing revenues decreased 11% versus the first quarter when the firm realized strong, principal investment gains. Due to the ownership structure of these funds, the majority of these revenues are passed to third-party Investors in the non-controlling interest line. In merchant banking, revenues were up 31% compared to the first quarter driven by higher principal investment gains.
Expenses were $513 million, up 12% from the first quarter, reflecting a change in revenue mix. Profit before tax was $160 million, down 14% sequentially. NCI was 421 million versus $51 million last quarter. Total assets under management increased to $347 billion driven net inflows of $9.8 billion.
In terms of our outlook, in the U.S, positive economic data suggests that headwinds are abating. Improving employment, signs of strength and discretionary consumer spending, a healthy outlook for housing and a declining deficit are encouraging signs for our clients and our businesses. Recent Federal Reserve guidance is also constructive, in particular its emphasis on interest rate policy. Institutional clients are repositioning in response to the Fed comments. Equity activity in the U.S. remains strong with U.S. Equity viewed as a relative safe heaven. Our M&A pipeline remains healthy with corporate clients increasingly focused on executing strategic priorities ahead of potential rising rates. And our retail clients remain engaged in the markets.
In the Eurozone our outlook for GDP remains subdued. We expect to see higher activity levels, but only relative to anemic lows in recent periods. Japanese markets remained strong and we are well positioned to give partnership with MUFG. In short we benefit from our leading positions globally, our franchise momentum continues and we are increasingly leveraging strengths within business unit to the benefit of the entire firm.
Thank you for joining us and James and I will now take your questions.
Earnings Call Part 2: