Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended May 31, 2007, for Morgan Stanley, a global financial services firm. The Company operates through four primary segments: Institutional Securities, Global Wealth Management Group, Asset Management, and Discover. A significant corporate event occurred on June 30, 2007, with the completion of the spin-off of Discover Financial Services; consequently, Discover results will be reported as discontinued operations beginning in the third quarter of fiscal 2007. The financial statements are unaudited and reflect all normal recurring adjustments.
Key Financial Metrics
| Metric | Three Months Ended May 31, 2007 | Six Months Ended May 31, 2007 |
|---|---|---|
| Net Revenues | $11,523 million | $22,504 million |
| Net Income | $2,582 million | $5,254 million |
| Earnings Per Share (Diluted) | $2.45 | $4.96 |
| Total Assets | $1,199,993 million | $1,199,993 million (Period End) |
| Shareholders' Equity | $39,511 million | $39,511 million (Period End) |
| Cash and Cash Equivalents | $31,786 million | $31,786 million (Period End) |
| Long-Term Borrowings | $171,932 million | $171,932 million (Period End) |
| Return on Average Common Equity | 27.5% (Annualized) | 28.7% (Annualized) |
Material Changes vs. Prior Period
- Revenue Growth: Net revenues increased 32% for the quarter and 31% for the six-month period compared to the prior year, driven by record investment banking revenues and strong sales and trading results in fixed income and equities.
- Profitability: Net income rose 40% for the quarter and 54% for the six-month period. Diluted EPS increased from $1.75 to $2.45 for the quarter and from $3.23 to $4.96 for the six-month period.
- Expense Increases: Non-interest expenses increased 31% for the quarter and 24% for the six-month period, primarily due to higher compensation costs linked to increased revenues and accruals for deferred compensation plans.
- Segment Performance:
- Institutional Securities: Recorded record income before taxes ($2,965 million for the quarter), up 55% year-over-year, driven by record investment banking and equity sales and trading.
- Asset Management: Income before taxes increased 16% to $306 million, with net revenues up 68% due to higher investment revenues and asset management fees.
- Discover: Income before taxes decreased 38% to $333 million, primarily due to a higher provision for consumer loan losses and the absence of favorable bankruptcy legislation impacts seen in the prior year.
- Discontinued Operations: The six-month period included a $168 million pre-tax gain from the sale of Quilter Holdings Ltd. The prior year six-month period included a $125 million loss related to the sale of the aircraft leasing business.
Guidance, Outlook, Risks, and Unusual Items
- Discover Spin-off: The Company completed the spin-off of Discover Financial Services on June 30, 2007. Future results will exclude Discover operations, which will be reported as discontinued operations.
- Legal Contingencies:
- Coleman Litigation: The Florida Court of Appeal reversed a $1.578 billion judgment against the Company in March 2007. While the Company maintains a $360 million reserve, the upper end of the potential exposure range could exceed $1.4 billion if the judgment is ultimately upheld on further appeal.
- IPO Allocation Matters: The U.S. Supreme Court ruled in June 2007 that federal securities regulation prevented an antitrust suit related to IPO allocations, effectively dismissing those claims.
- Credit Quality (Discover): The managed net principal charge-off rate increased to 4.24% for the quarter. The Company expects charge-off rates to remain relatively low, reaching between 4.0% and 4.5% by the end of fiscal 2007.
- Capital Management: The Company repurchased approximately $2.6 billion of common stock during the six-month period. As of May 31, 2007, $3.4 billion remained under the current share repurchase authorization.
- Accounting Changes: The Company adopted SFAS No. 157 (Fair Value Measurements) and SFAS No. 159 (Fair Value Option) effective December 1, 2006, resulting in cumulative effect adjustments to retained earnings.
Investor Verification Checklist
- Discover Spin-off Impact: Verify the pro forma financial impact of the Discover spin-off on future earnings and balance sheet composition.
- Coleman Litigation Reserve: Monitor the status of the Florida Supreme Court petition regarding the Coleman litigation and potential adjustments to the $360 million reserve.
- Consumer Loan Losses: Track the trend in Discover's net charge-off rates and the adequacy of the allowance for loan losses against the 4.0%–4.5% guidance.
- Compensation Costs: Assess the sustainability of non-interest expense growth, particularly compensation accruals tied to record revenues.
- Capital Ratios: Review the adjusted leverage ratio (17.5x at May 31, 2007) and compliance with SEC Consolidated Supervised Entity (CSE) capital requirements.