Morgan Stanley — 2012 Second-Quarter Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. The interim financial statements are unaudited; Deloitte reported that its review identified no material modifications needed for GAAP conformity. Morgan Stanley is a global financial-services firm with Institutional Securities, Global Wealth Management Group (GWM) and Asset Management businesses.
Financial performance and position
Unless noted, amounts are in U.S. dollars; financial statement amounts are in millions.
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Net revenues | $6,953 | $9,207 | $13,888 | $16,781 |
| Income before tax from continuing operations | $940 | $1,970 | $1,143 | $2,871 |
| Net income | $750 | $1,406 | $884 | $2,536 |
| Net income applicable to Morgan Stanley | $591 | $1,193 | $497 | $2,161 |
| Earnings applicable to common shareholders | $564 | $(558) | $446 | $188 |
| Diluted EPS | $0.29 | $(0.38) | $0.23 | $0.13 |
| Net interest | $(161) | $(68) | $(220) | $(62) |
| Non-interest expenses | $6,013 | $7,237 | $12,745 | $13,910 |
- Q2 net revenue fell about 24% year over year; six-month revenue declined about 17%. Q2 pretax margin was about 13.5%, compared with 21.4% a year earlier.
- Q2 non-interest expenses fell 17%; compensation and benefits declined 21%. For the six months, expenses declined about 8%.
- Q2 results included a $350 million benefit from widening Morgan Stanley credit spreads on borrowings (debt valuation adjustment, or DVA). Excluding DVA, management reported net revenue of $6.603 billion and continuing-operations diluted EPS of $0.16, versus $8.963 billion and $(0.46) in Q2 2011. The six-month DVA impact was a $1.628 billion loss; excluding it, net revenue was $15.516 billion and continuing-operations diluted EPS was $0.87, versus $16.726 billion and $0.13 in 2011. These are non-GAAP comparisons.
- Segments, Q2: Institutional Securities revenue was $3.234 billion and pretax income $508 million (16% pretax margin), versus $5.159 billion and $1.485 billion (29%). GWM revenue was $3.305 billion and pretax income $393 million (12%), versus $3.440 billion and $317 million (9%). Asset Management revenue was $456 million and pretax income $43 million (9%), versus $636 million and $168 million (26%).
- Cash flow, six months: Operating activities provided $15.866 billion, compared with $5.174 billion used in 2011; investing activities provided $121 million and financing activities used $20.539 billion. Cash and cash equivalents ended at $42.006 billion, down $5.306 billion from year-end.
- Balance sheet, June 30: Total assets were $748.5 billion, compared with $749.9 billion at year-end; total equity was $71.6 billion. Long-term borrowings were $167.8 billion, down from $184.2 billion. Total liabilities were $676.9 billion.
- Capital and liquidity: Basel I Tier 1 common, Tier 1 and total capital ratios were 13.6%, 17.2% and 18.4%, respectively; Tier 1 leverage was 7.1%. The Global Liquidity Reserve was $173 billion. The company said it had sufficient liquidity under its stress tests.
Material changes and unusual items
- Institutional Securities was pressured by lower investment banking and trading activity. Q2 investment banking revenue fell 40%; fixed-income and commodities sales and trading revenue excluding DVA fell 60%, reflecting weaker client activity and fewer structured transactions. Equity sales and trading revenue excluding DVA fell 36%.
- GWM revenue declined modestly as transactional revenue and commissions weakened, partly offset by higher asset-management fees and net interest. Fee-based client assets were $526 billion, 31% of total client assets; quarterly fee-based net inflows were $4.1 billion, down from $9.5 billion.
- Asset Management revenue and pretax income fell, principally because of lower investment gains, including Merchant Banking and certain consolidated real-estate funds. Assets under management or supervision were $311 billion, versus $296 billion a year earlier.
- The 2011 common-share loss and diluted EPS comparison were affected by a one-time, non-cash $1.726 billion charge related to conversion of MUFG preferred stock into common shares. 2011 results also included $471 million in Q2 Monoline-related gains and a $447 million six-month tax benefit. These items reduce comparability with 2012.
- Q2 Institutional Securities results included a $300 million out-of-period hedge-accounting gain, partly offset by a $224 million loss on related derivatives, for a net reported impact of $76 million. Management said the prior-period effect was not material; hedge accounting was subsequently corrected and redesignated.
- A Moody’s downgrade on June 21 triggered approximately $6.3 billion of potential collateral and other calls; $2.9 billion had been posted by June 30. A further $0.8 billion was called and posted through July 31. The filing describes further potential calls under additional downgrade scenarios.
- Quilter’s sale closed April 2 and generated a $108 million pretax gain. Saxon’s asset sale was substantially completed in Q2; remaining operations were expected to wind down during 2012, with further costs anticipated.
Outlook, risks and contingencies
- The filing gives no general earnings or revenue guidance. Management cited the weak and volatile second-quarter environment, including European sovereign-debt concerns, a slowing U.S. recovery and slower emerging-market growth. An updated 2012 financial outlook prompted a $160 million reduction in previously accrued discretionary compensation.
- Management’s preliminary estimate was that the Basel III Tier 1 common ratio could be about 9% at year-end 2012, subject to final rules, regulatory model approvals, earnings and mitigation actions. This is a forward-looking, non-GAAP estimate, not a guarantee.
- Regulatory requirements remain in transition, including Basel III and Dodd-Frank rules; management said their eventual effects on costs, capital, liquidity and business activity are difficult to predict.
- At June 30, total commitments disclosed were $139.1 billion, including primary lending commitments and forward-starting reverse-repurchase and securities-borrowing agreements. Commitments may expire unused and do not equal expected cash funding needs.
- Material litigation includes claims with stated potential losses of up to approximately $811 million in the Cheyne SIV matter, $269 million in the Capmark matter and $240 million in the CDIB matter, before applicable interest, fees or costs. The company contests claims; outcomes and total exposure are uncertain. The filing also discusses mortgage-related litigation and other proceedings.
- Tax examinations are ongoing in the U.S., U.K. and Japan. Morgan Stanley said it could not estimate the amount or effective-tax-rate impact of possible changes in unrecognized tax benefits over the next 12 months.
- Fair-value estimates require judgment: Level 3 assets were $26.3 billion and Level 3 liabilities $8.1 billion before specified netting. Market disruption or less observable inputs could change valuations.
Important facts for investors to verify
- How much of reported earnings and revenue reflects DVA and other non-recurring or timing-related items, particularly the hedge-accounting correction and discontinued-operation gains?
- Whether trading, investment banking and client activity recover, and whether GWM fee-based flows and Asset Management investment performance improve.
- The cash, capital and rating impact of collateral calls, including further downgrade scenarios and the post-quarter $0.8 billion call.
- Final Basel III requirements and model approvals versus management’s preliminary approximately 9% year-end capital-ratio estimate.
- Progress, appraisal value and regulatory approval for Morgan Stanley’s proposed purchase of an additional 14% of MSSB from Citi; closing was expected in September 2012.
- Developments in material mortgage and other litigation, tax examinations, Saxon wind-down costs, and the company’s ability to maintain liquidity and manage its substantial commitments.