Morgan Stanley — Q3 2018 Form 10-Q Summary
Business context and reporting period
Morgan Stanley is a global financial services firm operating through Institutional Securities, Wealth Management and Investment Management. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2018; the comparable periods are the three and nine months ended September 30, 2017. Deloitte & Touche performed an interim review, not a full audit.
Financial and operating performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net revenues | $9.872 billion | $9.197 billion | $31.559 billion | $28.445 billion |
| Net income attributable to Morgan Stanley | $2.112 billion | $1.781 billion | $7.217 billion | $5.468 billion |
| Diluted EPS | $1.17 | $0.93 | $3.92 | $2.79 |
| Net interest income | $936 million | $783 million | $2.817 billion | $2.305 billion |
| Pre-tax profit margin | 29% | 27% | 30% | 28% |
| Expense efficiency ratio | 71.1% | 73.0% | 70.3% | 72.1% |
| ROE / ROTCE | 11.5% / 13.2% | 9.6% / 11.0% | 13.1% / 15.1% | 9.8% / 11.3% |
Q3 revenue increased about 7% year over year and net income about 19%. Nine-month revenue increased about 11% and net income about 32%. Higher revenues and a lower effective tax rate contributed to earnings growth. The consolidated effective tax rate was 24.4% for Q3 and 21.9% year to date, compared with 28.1% and 29.7%, respectively, in 2017; management primarily attributed the lower rates to the Tax Act.
- Institutional Securities: Q3 net revenues were $4.929 billion, up 13%; net income attributable to Morgan Stanley was $1.120 billion, up 15%. Investment banking and sales and trading improved; fixed-income trading was nearly flat, with weaker credit results offset by strength in commodities and other products.
- Wealth Management: Q3 net revenues were $4.399 billion, up 4%; attributable net income was $913 million, up 31%. Growth in asset-management revenue and net interest income supported results; transactional revenue declined 6%.
- Investment Management: Q3 net revenues were $653 million, down 3%; attributable net income was $80 million, down 30%, mainly reflecting lower investment gains.
Non-interest expenses rose 5% in Q3 to $7.021 billion and 8% year to date to $22.179 billion. Compensation and benefits increased with higher revenues and salaries; non-compensation costs reflected higher activity-related expense, technology investment and the gross presentation of certain costs following a new revenue-accounting standard. Lower litigation expense partially offset these increases.
Cash flow, balance sheet, debt and liquidity
- For the first nine months, operating cash flow was $14.484 billion, versus cash used of $8.549 billion in 2017; investing cash use was $14.066 billion and financing cash provided was $13.362 billion. Cash and cash equivalents ended at $92.481 billion, up from $80.922 billion at year-end 2017. Cash flows are substantially affected by movements in trading and secured-financing balances.
- At September 30, total assets were $865.517 billion, compared with $851.733 billion at December 31, 2017. Loans, net of allowance, were $109.983 billion, versus $104.126 billion; deposits were $175.185 billion, versus $159.436 billion; and borrowings were $190.889 billion, versus $192.582 billion.
- The Global Liquidity Reserve was $214.848 billion, up from $192.660 billion. The average Liquidity Coverage Ratio was 135% for Q3, above the 100% minimum; management reported that liquidity stress tests showed sufficient liquidity for modeled current and contingent funding needs.
- Regulatory capital ratios at September 30 were 16.7% Common Equity Tier 1, 19.0% Tier 1, 21.6% total capital and 6.4% supplementary leverage ratio. The firm reported compliance with applicable requirements. Its medium-term ROE target is 10%–13% and ROTCE target 11.5%–14.5%.
Material changes, outlook and risks
- Management’s 2018 capital plan provided for up to $4.7 billion of common-stock repurchases from July 1, 2018 through June 30, 2019, subject to regulatory conditions, and quarterly dividends of up to $0.30 per share. Q3 repurchases were $1.180 billion; the declared Q3 dividend was $0.30 per share.
- Revenue from Contracts with Customers was adopted January 1, 2018. It increased reported revenues and expenses by $280 million each for the first nine months; management reported an $8 million net reduction in revenue from gross-presentation and timing effects. Prior-year figures were not restated. Adoption and other accounting changes produced a net $306 million cumulative increase to retained earnings, including a $443 million reclassification of stranded tax effects from AOCI.
- Loans and lending commitments increased to $231.556 billion from $216.931 billion at year-end, primarily reflecting growth in Institutional Securities. The allowance for loans and lending commitments was $432 million, up from $422 million. Management expects lending activities to continue to grow, while noting borrower, collateral and economic risks.
- Management identified uncertainty around future regulatory requirements, including the proposed U.S. Net Stable Funding Ratio; proposed capital stress buffers and leverage rules; CECL implementation, expected January 1, 2020; and the transition away from LIBOR, whose full effects on contracts, systems and financial instruments remained unclear. U.K. withdrawal from the E.U., market volatility, credit exposures, operational and legal risks, and potential rating downgrades are also discussed.
- Legal matters include mortgage-securitization and credit-crisis litigation and a Dutch tax-credit dispute. The filing identifies potential losses of up to approximately $240 million in the CDIB CDS matter, $240 million in one mortgage-loan trust matter, and $126 million and $277 million in two FGIC matters, plus interest, fees and costs; possible ranges could increase in some cases. The Dutch dispute concerns approximately €124 million (about $144 million) plus interest. The firm states that some legal exposures cannot be reasonably estimated and that material losses may arise.
- Q3 other comprehensive income included a $743 million loss from changes in debt valuation adjustment, contributing to a $988 million total OCI loss for the quarter despite higher net income. This reduced comprehensive income applicable to Morgan Stanley to $1.183 billion.
Investor verification priorities
- Reconcile reported earnings growth with the lower Tax Act-driven effective tax rate and discrete tax benefits; distinguish GAAP from non-GAAP measures.
- Assess the sustainability of Institutional Securities trading and investment-banking gains, Wealth Management asset-based revenue and flows, and Investment Management performance-fee and investment gains.
- Review the quality and concentration of growing lending exposures, commitments, credit allowances and nonaccrual trends, including event-driven and real-estate lending.
- Verify liquidity and funding resilience, including the Global Liquidity Reserve, LCR, deposit composition, borrowing maturities and sensitivity to rating downgrades.
- Track material litigation and tax contingencies, regulatory capital changes, CECL adoption and LIBOR-transition exposure.