Morgan Stanley — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. The filing is unaudited; Deloitte performed an interim review, not a full audit.
Business context
Morgan Stanley is a global financial services firm operating through Institutional Securities, Wealth Management and Investment Management. This summary compares Q3 and year-to-date results with the corresponding 2015 periods; balance-sheet comparisons are with December 31, 2015.
Financial results and key metrics
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net revenues | $8.909bn | $7.767bn | $25.610bn | $27.417bn |
| Income before tax | $2.381bn | $1.474bn | $6.602bn | $7.056bn |
| Net income applicable to Morgan Stanley | $1.597bn | $1.018bn | $4.313bn | $5.219bn |
| Diluted EPS | $0.81 | $0.48 | $2.11 | $2.51 |
| Net interest income | $1.003bn | $0.762bn | $2.815bn | $2.056bn |
| Non-interest expenses | $6.528bn | $6.293bn | $19.008bn | $20.361bn |
| Effective tax rate | 31.5% | 28.7% | 32.7% | 24.1% |
- Profitability: Reported consolidated pre-tax margin was 27% in Q3 versus 19% in Q3 2015, and 26% in both nine-month periods (rounded). Annualized return on average common equity was 8.7% for Q3 and 7.7% year to date.
- Cash flow: Nine-month operating cash flow was $7.814bn, versus cash used of $7.963bn in 2015. Investing activities used $14.988bn and financing activities used $5.411bn. Cash and cash equivalents were $42.552bn at September 30, down from $54.083bn at year-end 2015.
- Balance sheet and liquidity: Total assets were $813.9bn, up from $787.5bn at year-end; total equity was $78.5bn. The Global Liquidity Reserve was $197.1bn, compared with $203.3bn at year-end. Management said liquidity was sufficient under its stress tests and the firm met the minimum U.S. LCR requirement.
- Debt and funding: Long-term borrowings were $163.9bn, up from $153.8bn; short-term borrowings were $0.9bn, down from $2.2bn. Deposits were $151.8bn, down from $156.0bn. Long-term borrowings had a weighted-average maturity of 5.9 years. The firm issued $27.5bn and repaid or retired $22.9bn of long-term borrowings in the nine-month period.
- Capital: Transitional Common Equity Tier 1, Tier 1 and total capital ratios were 16.8%, 18.9% and 22.0%, respectively, compared with 15.5%, 17.4% and 20.7% at year-end. The Tier 1 leverage ratio was 8.3% at both dates.
Material changes and segment performance
- Q3 net revenues rose 15% year over year and Morgan Stanley net income rose 57%. Year-to-date net revenues fell 7% and net income fell 17%.
- Institutional Securities: Q3 net revenues rose 17% to $4.553bn, with sales and trading improvement partly offset by lower investment banking revenue. Nine-month revenue fell 12% to $12.845bn, reflecting weaker trading and underwriting. Fixed-income sales and trading was stronger in Q3; year-to-date fixed-income and equity trading revenue declined.
- Wealth Management: Q3 net revenues rose 7% to $3.881bn; nine-month revenue was essentially flat at $11.360bn. Higher net interest income supported results, while asset-management fees and commissions were weaker year to date. Client assets reached $2.090tn, versus $1.985tn at year-end; fee-based client assets were $855bn.
- Investment Management: Q3 net revenues rose to $552m from $274m, helped by positive carried interest versus a prior-year reversal. Nine-month revenue fell 5% to $1.612bn amid weaker investment performance; fees were relatively unchanged.
- Q3 compensation expense increased 19% to $4.097bn, reflecting deferred-compensation investment values, carried interest and higher incentive compensation. Non-compensation expense fell 15% to $2.431bn, primarily due to lower litigation costs. Nine-month total expenses declined 7%, mainly reflecting lower compensation and non-compensation costs.
Outlook, risks and unusual items
- Comparability: Morgan Stanley early adopted a rule that moved unrealized debt valuation adjustments (DVA) on certain liabilities from trading revenue to other comprehensive income beginning January 1, 2016; 2015 was not restated. Q3 2015 included $435m of positive DVA, and the nine-month 2015 period included $742m. Excluding DVA, prior-year diluted EPS was $0.34 for Q3 and $2.27 for the nine-month period; excluding both DVA and a $564m discrete tax benefit, nine-month 2015 EPS was $1.98.
- The firm targets improving return on average common equity, excluding DVA, by 2017, subject to execution of strategic objectives; the excerpt does not state a numerical target. The 2016 capital plan received a conditional Federal Reserve non-objection and permits up to $3.5bn of repurchases from July 2016 through June 2017, with a quarterly common dividend increased to $0.20. The firm repurchased $1.25bn in Q3 and $2.5bn year to date.
- The Federal Reserve requested an additional capital plan by December 29, 2016 to address weaknesses in the firm’s capital-planning process. Future capital distributions could be restricted if the issues are not satisfactorily addressed.
- Credit risk includes energy-sector lending: Institutional Securities energy loans and commitments totaled $13.0bn, down from $15.9bn at year-end. The filing says further losses could arise if oil and other commodity prices remain at or fall below quarter-end levels. The total allowance for loan losses increased to $287m from $225m.
- Material contingencies include mortgage-related litigation and other legal matters. Disclosed potential losses include up to approximately $240m in the CDIB matter and various mortgage cases with stated potential exposures, some of which may increase; these estimates are not a prediction of outcomes. The firm says some possible losses cannot currently be reasonably estimated.
- Other risks include U.K. withdrawal from the EU and related market and regulatory uncertainty; proposed liquidity, capital, commodities and resolution rules; and the U.S. Department of Labor fiduciary rule, with implementation beginning in 2017. Hedge-fund investments of approximately 28% of their reported fair value could not be redeemed because gates had been imposed.
- Unusual items included a $25m impairment charge in Q3 related to an oil terminal facility, and approximately $35m of year-to-date losses on solar investments. The firm also redeemed $2.8bn of trust preferred securities during Q3. After quarter-end, long-term borrowings increased approximately $2.2bn net of maturities through October 31.
Important facts for investors to verify
- Reconcile Q3 and year-to-date earnings against the prior-year DVA accounting change and the $564m prior-year discrete tax benefit.
- Review the capital-planning weaknesses, the December 29 resubmission deadline and any effect on distributions or the repurchase plan.
- Assess energy-sector exposures, allowance growth, oil-price sensitivity and changes in loan credit quality.
- Review the status, accruals and potential range of loss for the identified mortgage, credit-crisis and other legal proceedings.
- Track liquidity-reserve levels, funding and debt maturities, regulatory liquidity requirements, and whether gated fund investments remain restricted.