Morgan Stanley — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Unaudited interim statements; Deloitte performed a review, not an audit. Morgan Stanley operates Institutional Securities, Global Wealth Management and Asset Management.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Net revenues | $5.289B | $9.810B | $19.177B | $26.591B |
| Net income (loss) | $(956)M | $2.293B | $(72)M | $4.829B |
| Net income (loss) attributable to Morgan Stanley | $(1.023)B | $2.199B | $(526)M | $4.360B |
| Common diluted EPS | $(0.55) | $1.15 | $(0.32) | $1.45 |
| Net interest income (expense) | $(157)M | $145M | $(377)M | $83M |
| Non-interest expenses | $6.769B | $6.125B | $19.514B | $20.035B |
Q3 expenses exceeded net revenues; the resulting pre-tax loss was $1.480B. The effective tax rate from continuing operations was 35.4% for Q3 and 72.4% for the nine-month period, affected by discrete tax items and the geographic mix of results.
Debt valuation adjustment (DVA) is central to the comparison. Tightening of Morgan Stanley’s own credit spreads generated a $2.262B pre-tax loss in Q3 and a $3.890B loss for the first nine months on fair-value borrowings. Excluding DVA, management reported non-GAAP net revenues of $7.551B and diluted continuing-operations EPS of $0.28 for Q3; nine-month figures were $23.067B and $1.15. These non-GAAP measures are not substitutes for GAAP results.
Segments and material changes
- Institutional Securities: Q3 net revenues were $1.376B, down from $6.410B, largely reflecting DVA; pre-tax loss was $1.917B. Excluding DVA, fixed-income and commodities sales and trading improved 33% year over year, while equity sales and trading declined 8%. Investment banking revenues rose 12% to $969M.
- Global Wealth Management: Q3 net revenues rose to $3.336B from $3.226B; pre-tax income fell to $239M from $356M. Client assets were $1.768T, including $556B in fee-based accounts. Quarterly fee-based asset inflows were $7.5B, versus $9.8B a year earlier.
- Asset Management: Q3 net revenues increased to $631M from $205M and pre-tax income was $198M, versus a $118M loss. Results included investment gains.
- For the first nine months, GAAP revenue declined 28% and Morgan Stanley reported a loss attributable to the firm. Ex-DVA revenue was broadly stable year over year. The 2011 comparison also includes a one-time, non-cash $1.7B EPS adjustment from MUFG’s preferred-stock conversion and a $447M tax benefit.
Balance sheet, cash flow and capital
- At September 30, total assets were $765.0B, up from $749.9B at year-end 2011. Morgan Stanley shareholders’ equity was $61.8B; total equity was $65.2B.
- Cash and cash equivalents were $36.6B, down from $47.3B at year-end. Nine-month operating cash flow was $22.8B, investing cash flow was $(10.4)B and financing cash flow was $(22.6)B; cash decreased $10.7B. Operating cash flow reflected substantial balance-sheet and secured-financing movements, not just earnings.
- Long-term borrowings were $168.4B, down from $184.2B; short-term borrowings were $2.1B. Deposits were $70.8B, up from $65.7B. Long-term debt maturities due within 12 months were reported as $20.2B.
- The Global Liquidity Reserve was $170B, including cash and highly liquid, unencumbered securities. Management said stress testing indicated sufficient liquidity for current and contingent obligations; subsidiaries’ liquidity may be subject to legal, regulatory or tax restrictions.
- Basel I capital ratios were 13.9% Tier 1 common, 16.9% Tier 1 and 17.0% total capital; Tier 1 leverage was 7.2%. Management estimated a preliminary Basel III pro forma Tier 1 common ratio of about 9%, subject to final rules and model approvals.
Outlook, commentary and risks
- No specific earnings or revenue guidance is provided. Management described modest improvement in global conditions but cited the European sovereign-debt crisis, the U.S. fiscal cliff and slowing emerging-market growth.
- The firm completed its purchase of an additional 14% of the Wealth Management JV from Citi for $1.89B, raising its ownership to 65%. Further staged purchases are subject to regulatory approvals; related deposit transfers include $5.4B received in October 2012 and a planned transfer of approximately $54B with the remaining stake.
- Q3 included approximately $280M of increased litigation expense in Institutional Securities and $173M of non-recurring Wealth Management integration and acquisition costs. The firm also recorded an $82M out-of-period tax provision adjustment and a $109M out-of-period pre-tax gain from correcting prior hedge-accounting treatment; management said these did not materially affect prior-period financial statements.
- Legal exposure remains material and uncertain. Disclosed matters include the Cheyne SIV case, where plaintiffs alleged $713M in compensatory damages plus interest, fees and costs, and the CDIB case, where Morgan Stanley estimated potential loss up to approximately $240M plus related costs. Numerous mortgage-securities claims and representation-and-warranty matters remain pending; possible losses are not clear or estimable for many proceedings. A separate $269M Citibank judgment was satisfied.
- Regulatory change, market and credit risk, liquidity and funding access, potential rating downgrades, legal proceedings, tax examinations and valuation uncertainty are key risks. A downgrade could trigger additional collateral; the filing estimated potential calls of $2.5B under a specified Baa2/BBB scenario.
Most important facts to verify
- Reconcile the large gap between GAAP results and ex-DVA non-GAAP results, including the assumptions and hedging effects behind DVA.
- Track Institutional Securities trading and lending performance, expense trends, litigation costs and credit-loss provisions.
- Verify the timing, regulatory approvals, purchase price and deposit transfers for the remaining Wealth Management JV stake.
- Assess liquidity availability under stress, near-term debt maturities, rating-triggered collateral needs and evolving Basel III requirements.
- Review developments in mortgage-related litigation, the Cheyne and CDIB cases, tax audits and any additional loss accruals or disclosures.