Morgan Stanley (MS) Q2 2014 Earnings Conference Call July 17, 2014 10:00 AM ET
Celeste Brown - Investor Relations
James Gorman - Chairman, CEO
Ruth Porat - CFO, EVP
Guy Moszkowski - Autonomous Research
Brennan Hawken - UBS
Mike Mayo - CLSA
Christian Bolu - Credit Suisse
Eric Wasserstrom - SunTrust Robinson Humphrey
Glenn Schorr - ISI
Steve Chubak - Nomura
Michael Carrier - Bank of America
Good morning. This is Celeste Brown, Head of Investor Relations. Welcome to our Second 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 statements. 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 will now turn the call over to Chairman and Chief Executive Officer, James Gorman.
Thank you, Celeste, good morning and thank you everyone for joining us. In the second quarter 2014, we again grew our earnings on a year-over-year basis excluding DVA and excluding a discrete tax benefit in the quarter earnings increased 46%.
The fruits of our strategy were evident, with the stability of our wealth and asset management businesses providing significant ballast. The trust and partnership we have with our clients in investment banking and institutional equities offset historically low levels of volatility and reduced client activity. Our role has a strategic advisor for clients across our franchise including M&A, prime brokerage, credit, research and other deep content rich businesses positions us to benefit significantly from accelerating positive trends.
I will now take you through the six points we laid out for you in January. And then turn the call over to Ruth.
First, we continue to improve wealth management margins through cost discipline and revenue growth. For the first time since the acquisition from Citi, the remaining stake in the wealth management JV, we have achieved a greater than 20% margin in our wealth management business and record earnings since its inception of the joint venture.
We reached this level through a combination of revenue growth; our revenues grew 5% on a year-over-year basis despite reduced industry-wide transaction activity and continued expense discipline. We drove our non-compensation expenses down by 9% during the same period and our total expenses grew only 3%. We continue to expect to drive our margin to the 22% to 25% target set for the end of 2015.
Second, we have improved our ROE in fixed income and commodities and continue to optimize that business to be appropriately sized for this firm. Although, our revenues excluding DVA were flat in the first half of 2014, we have also reduced average RWAs and expenses thereby increasing ROE in this business year-to-date.
At the end of the second quarter 2014, our RWAs in fixed income and commodities were $192 billion. In addition to this systemic reduction of dead weight capital, more broadly, we have taken significant steps in commodities to improve returns.
We closed on the sale of TransMontaigne on July 1st, the first of two physical oil businesses we are selling and continue to work towards closing the sale of the other physical business later this year. And as discussed at our financials conference in early June, we are optimizing headcount and reducing grossed up balance sheet in fixed income, while maintaining a global franchise by leveraging our clearing and electronic capabilities. Our objective remains to deliver a global offering to the firm’s clients and an attractive return for shareholders.
Third, we are driving additional expense reductions and improvements in our expense ratios. In the first half of 2014, we grew our expenses by 3%, while – grew our revenues by 3% while keeping expenses flat. Our non-compensation expenses have declined while the firm-wide compensation ratio is also lower. In aggregate, overall expense ratios have improved from 79% to 76% compared to the first half of 2013. We continue to see opportunities to increase efficiency through both tactical and strategic moves, investing in technology and systems that simplify our business and position us to better serve our clients.
Fourthly, we continue to make progress regarding Morgan Stanley’s specific growth output opportunities most notably in the bank. In the last several months, we drew new production records in both mortgages and securities based lending despite sluggish demand for mortgages across the industry. Our success has been driven by the relatively low penetration of our product within wealth management versus peer firms. We have seen a network effect build within our system as financial advisors use the products and find them effective for their clients; they discuss opportunities with additional clients, the successes of them being shared throughout the system leading to more activity.
As we have said before, lending growth will enhance the stability of revenue and earnings for the firm as a whole and make our client relationships deeper and stickier. Of great importance to us, however, is that we grow our banks in a prudent and measured fashion. We have known since 2009 that we would have a very significant deposit base. And we spent the last five years investing in risk management, technology and client service.
Turning to the fifth point. We continue to steadily increase capital return to shareholders. We discussed our plans for capital returns with you on our last call in extensive detail. And we remain committed to increasing returns over time subject of course to regulatory approval. Of note, a key driver of capital returns are stable and consistent earnings, which we continue to demonstrate this quarter.
Finally, we are working towards achieving returns in excess of our cost of capital and of course, subject to our capital returns. We did achieve our target of 10% this quarter that was obviously flattered by the discrete tax benefit. However, excluding DVA in the first half of this year and last year and excluding the tax benefit of this quarter, our underlying ROE was still higher. Of greater significance, we demonstrated improved performance and momentum in many areas across the firm that are important to driving our ROEs sustainably higher including the following.
One, in investment banking, we had a very strong quarter driven by the strength in our underwriting and advisory franchises. Two, we continue to drive industry leading results in institutional equities despite lower market volumes around the world and this is due to the depth and breadth of our franchise and the partnership we have built with our clients over many years.
Thirdly, we drive our wealth management – we drove our wealth management margin higher even in a relatively subdued transaction environment. We also reached importantly $2 trillion in client assets a tremendous achievement a more than 3x the assets we held in 2006 on behalf of our clients.
Fourthly, our relative performance in fixed income was solid and we made progress towards one of our last strategic business change objectives with the closing on the sale of TransMontaigne on July 1st.
Fifthly, we also successfully raised our first major post Dodd-Frank merchant banking fund in Asia. This was coming in ahead of our expectations with significant institutional representation and with the decidedly less firm capital versus earlier funds. And finally, as Ruth will discuss in more detail, we increased our pro forma SLR estimate under the U.S. proposed rule to 4.6% up from 4.2% last quarter.
I will now turn the call over to Ruth to discuss the quarter in more detail and look forward to your questions at the end. Thank you.
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 positive $87 million with $50 million in fixed income sales and trading and $37 million in equity sales and trading.
Excluding the impact of DVA firm-wide revenues were $8.5 billion down 3% versus the first quarter. The effective tax rate from continuing operations for the second quarter was 1.6% reflecting a discrete tax benefit of $609 million or $0.31 per diluted share principally related to the remeasurement of reserves and related interest.
Earnings from continuing operations applicable to Morgan Stanley common shareholders excluding DVA were $1.8 billion. Earnings from continuing operations per diluted share excluding DVA are $0.91 after preferred dividends. On a GAAP basis including the impact of DVA firm-wide revenues for the quarter were $8.6 billion. Earnings from continuing operations applicable to Morgan Stanley common shareholders were $1.9 billion. Reported earnings from continuing operations per diluted share were $0.94 after preferred dividends. Book value at the end of the quarter was $33.48 per share and tangible book value was $28.53 per share.
Turning to the balance sheet, our total assets were $827 billion at June 30 down modestly from $831 billion at the end of the first quarter. Deposits as of quarter end were $118 billion up $1 billion versus Q1.
Our liquidity reserve at the end of the quarter was $192 billion compared with $203 billion at the end of the first quarter. The decline was primarily driven by the deployment of excess cash from deposit into loans which reduces our bank liquidity and is consistent with the bank strategy we laid out previously.
Turning to capital, this quarter the required Basel reporting regime moved to a Basel III advanced denominator whereas last quarter the required denominator was based on Basel I plus 2.5. In both quarters, the numerators calculated based on the transitional Basel III rule. Although our calculations are not final, we believe that our common equity Tier-1 transitional ratio will be approximately 13.8% and our Tier-1 capital ratio under this regime will be approximately 15.2%.
Basel III transitional risk-weighted assets are expected to be approximately $423 billion at June 30, reflecting our best estimate of the final set of reserve rules, our pro forma common equity Tier-1 ratio using Basel III fully-phased in advanced approach was 12.1% at June 30 up from 11.6% in 1Q.
Our pro form standardized ratio was 10.8% up from 10.2% in 1Q. Pro forma fully-phased in Basel III advanced RWAs are expected to be approximately $431 billion. We estimate our pro forma supplementary leverage ratio under the U.S. regulatory proposal to be approximately 4.6% at June 30 up from 4.2% at the end of the first quarter. These estimates are preliminary and are subject to revision. We continue to expect to exceed the required 5% level in 2015 including an assumption for increasing returns of capital to shareholders.
Turning to expenses. Our total expenses this quarter were $6.6 billion flat versus the first quarter. Compensation expense was down 2% versus the prior quarter. Non-compensation expense was $2.4 billion up 5% reflecting seasonal trends.
Let me now discuss our businesses in detail. In institutional securities revenues excluding DVA were $4.2 billion down 8% sequentially. Non-interest expense was $3.2 billion down 1% versus the first quarter. Compensation was $1.7 billion for the second quarter down versus the first quarter on lower revenue reflecting a 41% ratio excluding DVA.
Non-compensation expense for the second quarter was $1.5 billion up versus the first quarter also reflecting seasonality. The business reported a pretax profit of $927 million excluding the impact of DVA including the impact of DVA revenues were $4.2 billion and pretax profit was $1 billion.
In investment banking revenues of $1.4 billion were up 26% versus last quarter reflecting broad-based strength across products and regions with substantial growth in EMEA. According to Thomson Reuters, Morgan Stanley ranked number 2 in global announced in completed M&A and number 3 in global IPOs at the end of the second quarter.
Notable transactions included in advisory, Morgan Stanley is acting as defense advisor to Shire in its discussions with AbbVie regarding a potential $55 billion combination. Morgan Stanley also acted as lead financial advisor and lead left arranger on the bridge financing for Tyson Foods in its $8.6 billion acquisition of Hillshire brand.
In equity underwriting, we again evidenced the strength of our global franchise notable deals include acting as joined global coordinator and joint book runner; we priced a $3.5 billion capital increase for the National Bank of Greece. And Morgan Stanley successfully executed a $1.3 billion unregistered block trade of YPSSA amongst other international offerings.
In debt underwriting, Morgan Stanley acted as global coordinator on the successful $40 billion consent solicitation of debt securities for Pemex Finance. In addition, acting as joint book runner, the firm sourced $9.9 billion of debtor in possession financing for Energy Future Holdings.
Morgan Stanley and its partner Bank of Tokyo, Mitsubishi UFJ played a leading role in structuring underwriting and syndicating the debt facilities. Advisory revenues of $418 million increased 24% versus our first quarter results due primarily to increased activity with particular strength in EMEA and Asia Pacific.
Underwriting revenues of $1 billion increased 27% versus our first quarter results driven by equity underwriting revenues of $489 million which were up 55% versus the first quarter on higher issuance volumes in the strong market and a meaningful uptick in EMEA. Fixed income underwriting revenues were $525 million higher versus the first quarter primarily driven by higher investment grade and high yield volume.
Equity sales and trading revenues excluding DVA were $1.8 billion, an increase of 5% from last quarter. Prime brokerage revenues were up reflecting the benefit of increased client balances and the dividend season. Cash revenues remained resilient against declines in market volumes across regions. Derivatives revenues were down as lower volatility reduced client activity.
Fixed income and commodities, sales and trading revenues excluding DVA were $1 billion down sequentially driven impart by typical seasonality. Commodities revenues were down substantially from a very strong 1Q. Outside of commodities revenues in most product areas declined due to lower volatility which resulted in lower client activity.
In contrast, rates revenues were modestly higher quarter-over-quarter due to improvements in both the United States and EMEA. CVA continued to be a drag in the quarter due to the tightening of our credit spreads. Average trading VAR for the second quarter was $48 million down slightly to the first quarter.
Turning to wealth management, revenues were $3.7 billion in the second quarter up 3% sequentially. Asset management revenues of $2.1 billion were up versus last quarter reflecting the benefit of higher market levels and positive flows. Transaction revenues were essentially flat to last quarter consisting primarily of commissions of $511 million down 5% versus the prior quarter due to lower activity consistent with lower exchange volumes.
Investment banking related fees of $213 million up 18% versus last quarter reflecting higher equity and preferred stock underwriting activity. And trading revenues of $267 million down 3% versus the first quarter reflecting a decrease in fixed income trading partially offset by higher returns on deferred compensation plans.
Net interest revenue increased 7% to $578 million driven primarily by higher revenues from our bank deposit program and continued growth in our lending product.
Non-interest expense was $2.9 billion flat versus last quarter. Non-compensation expense was $762 million also flat to last quarter. The compensation ratio was 59% down versus the first quarter driven by seasonal trends. The PVT margin was 21%. Profit before tax was $767 million; total client asset surpassed $2 trillion.
Global fee-based asset inflows were $12.5 billion. Fee-based assets under management increased to a record $762 billion at quarter end representing 38% of client assets. Global representatives were 16,316 essentially flat to the first quarter. Deposits in our bank deposit program were $127 billion down versus the first quarter due primarily to outflows related to tax season. Approximately $109 billion were held in Morgan Stanley banks.
Our wealth management lending balances continue to grow reflecting the ongoing execution of our bank strategy. Our PLA balances increased $1.9 billion and mortgage balances increased $1.6 billion. Production in the second quarter was at record levels for both products.
Investment management revenues of $692 million were down 6% sequentially predominantly driven by the deconsolidation of certain legal entities associated with a real estate fund sponsored by the firm.
A number of years ago, we provided a liquidity facility for the fund and not have to consolidate revenues and capital. The liquidity facility has expired. Accordingly certain legal entities associated with the fund were deconsolidated.
The deconsolidation eliminates the related revenue as well as a portion of our non-controlling interest and is net income neutral. Additionally, the deconsolidation reduces both balance sheet and risk-weighted assets. In traditional asset management, revenues of $436 million were flat to the first quarter. In real estate investing revenues of $111 million were down 15% driven by the deconsolidation.
Merchant banking revenues were $145 million down 16% driven by lower gains in investments. Non-interest expenses were $487 million up 2% from the first quarter. The compensation ratio was 42% up versus the first quarter driven primarily by the revenue impact of the deconsolidation. Non-compensation expense was $196 million up from $192 million in the first quarter. Profit before tax was $205 million down 22% sequentially due to the deconsolidation. NCI was $7 million versus $54 million last quarter again driven by the deconsolidation.
Total assets under management increased to $396 billion driven by market appreciation and positive flows. We also successfully completed a fund raising for Morgan Stanley Private Equity Asia IV in the quarter, our first major post Dodd-Frank fund raising effort.
Turning to our outlook. While June was stronger than the first two months of the quarter recognizing the trading markets remain uncertain, we are on the view that it is too early to determine conditions for the balance – rest of the year. However, we see strength and opportunities across our businesses with several encouraging trends.
First, M&A volumes remain strong with a healthy backlog and growth in larger transactions which is our sweet spot. Last quarter, we discussed three catalysts for heightened M&A activity and they remain. Healthy corporate, cross border and activist activity suggesting M&A will remain vibrant.
Second, financing markets remain receptive with a strong pipeline in equity underwriting and a positive outlook for debt underwriting benefiting from M&A activity. Third, we are seeing an increase in activity in Europe. The second quarter was the strongest in Europe since the beginning of 2012 with notable improvement in both investment banking and fixed income product. Given the strength and breadth of our corporate and institutional client relationship, we are well-positioned to benefit from these trends and are focused on delivering for our clients.
More specific to Morgan Stanley, we are also increasingly seeing the fruits of the many steps we have taken during the last five years to better position the firm with retail wins worth noting.
First, we continue to benefit from lending growth which is supported by our leading client franchises in both wealth management and institutional securities. Given the scale of each of these franchises, we have ample opportunities with our existing clients while maintaining tight credit standards. As evidenced by the growth in our funded loan book again this quarter, we continue to execute against this opportunity and they remain significant upside. We are prudently building a balanced portfolio on our way to being the 10th largest depository in the U.S.
Second, as discussed before wealth management continues to deliver higher profitability with growing revenues on a higher PVT margin. Now, with 100% ownership of the wealth management business the operating leverage translates into a growing contribution to the firm.
Finally, the outperformance of our cash bond spreads enable us to finance the firm more efficiently that over time of course will result in additional upside.
Thank you for listening, James and I will now take your questions.
Earnings Call Part 2: