MORGAN STANLEY quarterly report, Q1 FY2016

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Morgan Stanley — Q1 2016 Form 10-Q

Business context and period. Morgan Stanley is a global financial services firm with Institutional Securities, Wealth Management and Investment Management businesses. This unaudited quarterly report covers the three months ended March 31, 2016; comparisons are with Q1 2015 unless otherwise noted. The interim results are not necessarily indicative of full-year results.

Financial performance and position

  • Revenue and earnings: Net revenues were $7.792 billion, down 21% from $9.907 billion. Net income applicable to Morgan Stanley was $1.134 billion, versus $2.394 billion; diluted EPS was $0.55 versus $1.18. Q1 2015 included a $564 million discrete tax benefit and $125 million of DVA gains. Excluding both, prior-year net income was $1.750 billion and diluted EPS was $0.85.
  • Revenue drivers: Trading revenue fell to $2.065 billion from $3.650 billion; investment banking revenue was $1.107 billion versus $1.357 billion. Net interest income increased to $899 million from $596 million.
  • Expenses and margins: Non-interest expenses declined 14% to $6.054 billion, including compensation and benefits of $3.683 billion, down 19%. Pre-tax income was $1.738 billion versus $2.855 billion; the consolidated pre-tax margin was 22% versus 29%. The effective tax rate was 33.3%, compared with 13.6% in Q1 2015, principally reflecting the prior-year discrete tax benefit.
  • Segments: Institutional Securities net revenues declined 32% to $3.714 billion, with pre-tax income of $908 million versus $1.813 billion. Wealth Management net revenues declined 4% to $3.668 billion, while net interest income rose 21% to $831 million; pre-tax income was $786 million versus $855 million. Investment Management net revenues declined 29% to $477 million; it recorded $64 million of investment losses versus $152 million of gains, and pre-tax income fell to $44 million from $187 million.
  • Cash flow: Operating activities provided $4.138 billion, compared with $13.055 billion used in Q1 2015. Investing activities used $9.116 billion and financing activities provided $3.888 billion. Cash and cash equivalents ended the quarter at $53.638 billion, down $445 million from year-end 2015.
  • Balance sheet and funding: Total assets were $807.497 billion, up from $787.465 billion at December 31, 2015; total liabilities were $730.322 billion and total equity was $77.175 billion. Deposits were $157.591 billion. Long-term borrowings were $162.804 billion, up from $153.768 billion; $26.071 billion was scheduled to mature in the following 12 months. The quarter included $13.2 billion of long-term debt issuance and $8.0 billion of maturities or retirements.
  • Liquidity and capital: The Global Liquidity Reserve was $211.069 billion, compared with $203.264 billion at year-end. Management said liquidity was sufficient under its stress tests; the company reported compliance with the applicable 90% U.S. LCR minimum. Advanced Approach transitional capital ratios were 15.6% CET1, 17.4% Tier 1 and 20.9% total capital; the Tier 1 leverage ratio was 8.2%. Book value per common share was $35.34 and tangible book value per share was $30.44.
  • Credit and lending: Loans, net of allowance, were $88.802 billion. The loan-loss allowance increased to $330 million from $225 million at year-end, and the allowance for lending commitments rose to $201 million from $185 million. Total loans and lending commitments were $198.257 billion.

Material changes and management commentary

  • Management attributed weaker consolidated results mainly to challenging markets, particularly fixed income and commodities sales and trading and underwriting. Equity sales and trading and M&A advisory were relative strengths.
  • Fixed income and commodities sales and trading net revenues fell 56% to $873 million. Management cited lower client activity, difficult credit conditions, depressed energy prices and the absence of revenue from the global oil merchanting business sold in November 2015.
  • Wealth Management’s lower transactional revenue was partly offset by higher net interest income. Fee-based client assets were $798 billion, and quarterly fee-based asset flows were $5.9 billion versus $13.3 billion.
  • Compensation expense declined with lower revenues, lower deferred-compensation investment values and lower headcount; non-compensation expense fell mainly due to lower litigation costs. Annualized return on average common equity was 6.2%, versus 14.1% in Q1 2015 (10.1% excluding the prior-year DVA and discrete tax benefit).
  • The company repurchased approximately $625 million of common stock in the quarter and declared a $0.15 per-share dividend, up from $0.10 in Q1 2015. Management’s stated target is to improve return on average common equity excluding DVA by 2017, subject to executing its strategic objectives; this is not a quarterly earnings forecast.

Outlook, risks and unusual items

  • Credit and energy risk: Institutional Securities energy loans and lending commitments totaled $14.8 billion; approximately 60% were to investment-grade counterparties. Energy exposures contributed to increased reserves and mark-to-market losses. The filing warns that further losses could occur if commodity prices remain at or fall below quarter-end levels.
  • Legal and contingencies: The filing describes numerous mortgage-related and other proceedings, some with potentially substantial or indeterminate damages that cannot be reasonably estimated. In one mortgage case, the Second Circuit vacated a lower-court judgment and remanded for further proceedings; Morgan Stanley estimated potential loss of up to approximately $81 million plus interest, fees and costs. Other disclosed matters include estimated potential losses in certain mortgage cases and a California Attorney General action filed in April 2016. These matter-specific estimates are not a combined loss estimate.
  • Regulatory and market risks: The company reported that the Federal Reserve and FDIC identified shortcomings in its 2015 resolution plan; it must report on remediation by October 1, 2016. The filing also discusses proposed or evolving capital, liquidity, compensation and derivatives rules, and potential market effects of the U.K. referendum. A one-notch rating downgrade could trigger about $1.2 billion of incremental collateral or termination payments; a two-notch downgrade about $1.5 billion.
  • Accounting and unusual items: Morgan Stanley early adopted guidance moving unrealized DVA on certain fair-value-option liabilities from earnings to OCI; Q1 2016 included $203 million of after-tax other comprehensive income from DVA-related valuation changes. The prior-year comparison is not restated. A new consolidation standard increased assets by $131 million on adoption. Q1 2015 also benefited from the $564 million discrete tax item.
  • Other sensitivities: The filing’s modeled 12-month net interest income for U.S. bank subsidiaries declined by $202 million under an instantaneous +200-basis-point shock and by $534 million under a -100-basis-point shock. These are scenario sensitivities, not forecasts.

Most important facts for investors to verify

  • Whether revenue and earnings trends improve from the sharp year-over-year decline, especially in Institutional Securities and Investment Management.
  • How much of the earnings comparison reflects operating performance versus the prior-year tax benefit and accounting presentation of DVA.
  • Whether energy-related credit exposures, loan-loss allowances and nonaccrual loans rise if commodity prices remain weak.
  • Capital and liquidity headroom as regulatory requirements phase in, alongside debt maturities and any rating-triggered collateral needs.
  • Developments in significant mortgage litigation, the resolution-plan remediation process and other regulatory proceedings.
  • Whether Wealth Management asset flows, lending growth and net interest income sustain revenue as transaction activity and fee rates remain under pressure.