MORGAN STANLEY annual report, FY2012

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Morgan Stanley — 2012 Form 10-K

Reporting period: Year ended December 31, 2012. This is an annual filing, not a standalone fourth-quarter report; quarterly figures below are included only where useful. All dollar amounts are U.S. dollars.

Business context

Morgan Stanley is a global financial-services holding company with three segments: Institutional Securities, Global Wealth Management Group and Asset Management. At year-end it had 57,061 employees. Wealth Management reported $1.776 trillion in client assets; the firm held a 65% interest in its joint venture after buying an additional 14% stake from Citi for $1.89 billion in September.

Financial results and key metrics

  • Revenue and earnings: Net revenues were $26.112 billion, down 19% from $32.236 billion in 2011. Net income was $716 million; net income applicable to Morgan Stanley was $68 million, compared with $4.110 billion in 2011. Earnings applicable to common shareholders were a loss of $30 million, or $(0.02) per diluted share, versus $2.067 billion, or $1.23 per diluted share.
  • Debt valuation adjustment (DVA): 2012 GAAP revenue included a $4.402 billion negative DVA impact, versus a $3.681 billion positive impact in 2011. Excluding DVA, a non-GAAP measure, net revenues were $30.514 billion and diluted continuing-operations EPS was $1.64 in 2012, versus $28.555 billion and $(0.08) in 2011. DVA reflects changes in the fair value of certain borrowings arising from Morgan Stanley’s own credit spreads and other credit factors.
  • Expenses and margins: Non-interest expenses declined 2% to $25.597 billion; compensation and benefits fell 4% to $15.622 billion. Pretax results varied sharply by segment: Institutional Securities lost $1.671 billion, Global Wealth Management earned $1.600 billion (12% pretax margin, versus 9%), and Asset Management earned $590 million (27% margin, versus 13%).
  • Segment revenue changes: Institutional Securities revenue fell to $10.553 billion from $17.175 billion, heavily affected by DVA. Excluding DVA, fixed income and commodities sales and trading revenue increased 27%, while equity sales and trading revenue declined 11%. Wealth Management revenue rose 2% to $13.516 billion; Asset Management revenue increased 18% to $2.219 billion.
  • Cash flow: Operating cash flow was $24.548 billion, investing cash flow was $(12.414) billion and financing cash flow was $(11.897) billion. Cash and cash equivalents decreased $408 million to $46.904 billion. Management notes that trading and securities-financing balance movements affect cash flows; a prior-period cash-flow classification correction was made and was deemed not material to previously filed statements.
  • Balance sheet and liquidity: Total assets were $780.960 billion, up from $749.898 billion. Shareholders’ equity was $62.109 billion. Long-term borrowings were $169.571 billion, down from $184.234 billion; $25.303 billion was due within 12 months. Deposits increased to $83.266 billion from $65.662 billion. The Global Liquidity Reserve was $182 billion, unchanged from 2011; management stated the firm had sufficient liquidity under its stress tests.
  • Capital: Basel I total capital ratio was 18.5%, Tier 1 capital ratio 17.7%, Tier 1 common ratio 14.6%, and Tier 1 leverage ratio 7.1%, all higher than in 2011. The firm’s preliminary, non-GAAP Basel III Tier 1 common ratio estimate was approximately 9.5% at year-end; it was subject to final rules and regulatory model approvals.
  • Fourth quarter snapshot: Net revenues were $6.966 billion and net income applicable to Morgan Stanley was $594 million. Common-shareholder earnings were $568 million, or $0.30 per diluted share.

Material changes versus 2011

  • Revenue and reported earnings fell substantially, with the year-over-year DVA swing a major factor in reported results. Excluding DVA, management’s non-GAAP measures showed higher revenue and improved continuing-operations EPS versus 2011.
  • Institutional Securities shifted from $3.468 billion of continuing-operations income applicable to Morgan Stanley in 2011 to a $796 million loss in 2012, on a reported basis. Wealth Management and Asset Management improved their continuing-operations income applicable to Morgan Stanley to $799 million and $136 million, respectively.
  • Net interest changed from income of $356 million to expense of $199 million, reflecting lower interest income and higher net interest expense in Institutional Securities.
  • Capital ratios strengthened and long-term borrowings declined. Total assets increased, including growth in loans, customer receivables and securities available for sale.
  • Wealth Management client assets increased from $1.637 trillion to $1.776 trillion, but fee-based asset flows declined to $24.0 billion from $41.6 billion. Fee-based assets rose to 32% of client assets from 30%.

Outlook, risks and unusual items

  • Outlook: The filing gives no quantified earnings or revenue guidance. Management describes 2012 markets as modestly improved but still challenged by European sovereign debt, U.S. fiscal and debt-ceiling uncertainty, and slowing growth in emerging markets. Results remain sensitive to market activity, asset prices, interest rates, client flows and funding conditions.
  • Regulation and capital: Dodd-Frank implementation, the Volcker Rule and Basel capital and liquidity standards could raise costs, constrain activities or affect capital distributions. The Financial Stability Board provisionally assigned Morgan Stanley a 1.5% G-SIB capital surcharge. Basel 2.5 became effective January 1, 2013; the filing estimated that applying it at year-end 2012 would have reduced the Tier 1 common ratio by about 400 basis points.
  • Liquidity and credit risk: The firm relies significantly on external funding and its credit ratings. A downgrade could trigger additional collateral requirements; disclosed potential calls under specified rating scenarios reached $3.574 billion, plus $128 million at exchanges and clearing organizations in the lowest scenario shown. European peripheral exposure was $7.590 billion before hedges and $6.346 billion net of hedges.
  • Legal and mortgage matters: The filing lists numerous mortgage and credit-crisis lawsuits and investigations, some seeking substantial or indeterminate damages. Management says outcomes could materially affect results or cash flows in a particular period, even though it does not expect the proceedings, based on current knowledge, to materially harm consolidated financial condition. For U.S. RMBS, current unpaid principal subject to representations and warranties was about $20.1 billion, with cumulative losses of about $12.3 billion. A Saxon-related Federal Reserve settlement led to a $115 million provision in discontinued operations; settlement terms also included borrower relief, with total amounts not clearly stated in the filing excerpt.
  • Other unusual items: 2012 included about $280 million of increased Institutional Securities litigation expense, $350 million of severance costs, and $173 million of Wealth Management integration and acquisition costs. The effective tax rate was a 46.4% benefit, including a $142 million net tax benefit; management said the rate excluding that benefit would have been an 18.8% benefit. A January 2013 tax-law change was expected to produce an approximately $80 million tax benefit in first-quarter 2013.
  • Business changes: Morgan Stanley completed the sale of Quilter and substantially completed the sale of Saxon’s assets in 2012. It completed the sale of its remaining in-house proprietary quantitative trading unit, Process-Driven Trading, on January 1, 2013; management said PDT was not material to 2012 results or liquidity.
  • Reporting and audit: Deloitte issued an unqualified opinion on the consolidated financial statements and internal control over financial reporting. Management concluded disclosure controls and internal controls were effective at year-end.

Most important facts for investors to verify

  • Reconcile reported earnings with DVA-excluded results, including the treatment and comparability of the non-GAAP measures.
  • Review the drivers and sustainability of segment performance, particularly Institutional Securities’ reported loss and Wealth Management’s lower fee-based flows.
  • Assess liquidity quality and availability across legal entities, near-term debt maturities, rating-triggered collateral calls and the distinction between the $182 billion liquidity reserve and other cash.
  • Track mortgage-related litigation, representations-and-warranties exposure, the Saxon settlement and whether additional reserves or payments become necessary.
  • Monitor the final Basel III, Basel 2.5 and Volcker Rule requirements, their capital impact, and progress on the planned additional Wealth Management JV purchase.