Morgan Stanley — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. Morgan Stanley is a global financial services firm operating through Institutional Securities, Wealth Management and Investment Management. The interim financial statements are unaudited; Deloitte reported that its review identified no material modifications needed for GAAP conformity.
Financial results and condition
| Metric | Q2 2017 | Q2 2016 | First half 2017 | First half 2016 |
|---|---|---|---|---|
| Net revenues | $9.503 billion | $8.909 billion | $19.248 billion | $16.701 billion |
| Net income applicable to Morgan Stanley | $1.757 billion | $1.582 billion | $3.687 billion | $2.716 billion |
| Diluted EPS | $0.87 | $0.75 | $1.87 | $1.30 |
| Net interest income | $751 million | $913 million | $1.522 billion | $1.812 billion |
| Non-interest expenses | $6.861 billion | $6.426 billion | $13.798 billion | $12.480 billion |
| Effective tax rate, continuing operations | 32.0% | 33.5% | 30.5% | 33.4% |
- Q2 revenue increased about 7% and net income about 11% year over year; first-half revenue rose about 15% and net income about 36%. Q2 and first-half diluted EPS were higher by 16% and 44%, respectively.
- Q2 pretax income was $2.642 billion versus $2.483 billion; first-half pretax income was $5.450 billion versus $4.221 billion. The expense efficiency ratio was 72.2% for Q2 (72.1% prior year) and 71.7% for the first half (74.7% prior year). Consolidated pretax profit margin was 28% in both Q2 periods and 28% versus 25% for the first half.
- Compensation expense was $4.252 billion in Q2 and $8.718 billion year to date, up 6% and 13%. Non-compensation expense was $2.609 billion and $5.080 billion, up 8% and 6%. The filing cites higher incentive compensation, brokerage/clearing/exchange fees and other volume-driven costs; first-half costs also included higher litigation expense.
- Segment net revenues / net income applicable to Morgan Stanley: Institutional Securities, $4.762 billion / $992 million for Q2 and $9.914 billion / $2.206 billion year to date; Wealth Management, $4.151 billion / $665 million and $8.209 billion / $1.312 billion; Investment Management, $665 million / $100 million and $1.274 billion / $167 million. Year-over-year revenue growth was 4%, 9% and 14% in Q2, respectively, and 20%, 10% and 20% for the first half.
- At June 30, total assets were $841.016 billion, up from $814.949 billion at year-end, primarily reflecting higher Institutional Securities trading inventory. Loans were $97.639 billion versus $94.248 billion; deposits were $144.913 billion versus $155.863 billion; long-term borrowings were $184.112 billion versus $164.775 billion. Common shareholders’ equity was $70.306 billion, and book value per common share was $38.22.
- Global Liquidity Reserve was $188.296 billion, down from $202.297 billion at year-end, primarily reflecting lower deposits and loan growth. Management said the Firm maintained sufficient liquidity to meet modeled current and contingent funding needs. The Firm and its U.S. bank subsidiaries reported compliance with the minimum U.S. Liquidity Coverage Ratio.
- First-half operating cash flow was a use of $9.470 billion, versus a source of $16.308 billion in 2016. Investing cash flow was a source of $2.695 billion, financing cash flow a source of $7.365 billion, and cash and cash equivalents increased by $1.278 billion to $44.659 billion. The operating cash outflow included an $18.050 billion use from changes in trading assets, net of trading liabilities.
- Advanced transitional capital ratios at June 30 were 16.6% Common Equity Tier 1, 19.0% Tier 1 and 21.9% total capital; the Tier 1 leverage ratio was 8.5%. The pro forma supplementary leverage ratio was 6.5%.
Material changes, outlook and management commentary
- Institutional Securities’ Q2 results reflected stronger underwriting and equity sales and trading; first-half growth was led by fixed-income trading and underwriting. Q2 investment banking revenue rose 28%, including a 49% increase in underwriting.
- Wealth Management growth reflected higher asset-management fees and net interest income. Fee-based client assets reached $962 billion at quarter-end, compared with $877 billion at December 31, 2016; first-half fee-based asset flows were $38.7 billion versus $17.9 billion a year earlier. Net interest income increased 21% for the first half.
- Investment Management benefited from higher investment gains and carried interest. First-half investment revenue included gains and positive carried interest, compared with losses and reversals of accrued carried interest in the prior-year period.
- Institutional Securities’ Q2 net interest was negative $258 million, compared with positive $82 million a year earlier. The filing attributes pressure in sales and trading partly to higher interest costs and liquidity requirements; first-half net interest was negative $485 million versus positive $151 million.
- The Firm recorded an $86 million Q2 provision for potential U.K. VAT, interest and penalties involving VAT on intercompany services. Morgan Stanley said it was working with HM Revenue & Customs and that its review was continuing.
- Management’s stated ROE target was 9%–11% by 2017; annualized ROE was 9.1% in Q2 and 9.9% for the first half. The target is forward-looking and subject to market, regulatory, legal expense, capital and tax uncertainties.
- The Federal Reserve did not object to the 2017 capital plan: up to $5.0 billion of common-stock repurchases from July 2017 through June 2018, versus $3.5 billion in the prior plan, and a quarterly common dividend increase from $0.20 to $0.25 per share beginning with the July 2017 declaration. The Firm repurchased approximately $500 million of common stock in Q2.
- First-half tax results included $110 million of net discrete tax benefits, primarily a $128 million recurring-type benefit associated with the adoption of share-based-payment accounting guidance. The new guidance produced a $112 million tax benefit in Q1 upon award conversions.
Risks, contingencies and unusual items
- Legal exposures include multiple mortgage-related lawsuits. The filing describes potential losses in certain matters, including up to approximately $527 million, $292 million, $277 million, $240 million and $152 million in individual cases, generally plus interest, fees and costs; plaintiffs in some matters seek to expand the loans at issue. These are company estimates of possible exposure, not established liabilities.
- A Dutch tax dispute challenges approximately €124 million of withholding-tax credits, plus accrued interest. Separately, a July 2017 Italian Court of Accounts claim seeks €2.76 billion relating to historical derivatives; Morgan Stanley disputes the allegations. The filing does not establish the outcome or a probable loss for these matters.
- The Firm disclosed an energy-sector lending exposure of $11.6 billion, including $1.1 billion in loans and $2.1 billion in commitments to oil and gas exploration and production companies. It warned that further declines in oil and natural-gas prices could result in additional lending losses.
- Potential collateral or termination payments triggered by a one-notch or two-notch downgrade were estimated at $950 million and $720 million, respectively, in the funding discussion. A separate derivatives disclosure reports $1.042 billion and $401 million for those scenarios; investors should note the differing scope of the disclosures.
- Management identified market, credit, liquidity, operational, model and legal/compliance risks, as well as exposure to regulatory changes, interest rates, foreign exchange, litigation and the U.K.’s departure from the European Union. Average Q2 Management VaR increased to $51 million from $44 million in the prior quarter, primarily due to higher trading inventory.
- Future regulatory requirements include supplementary leverage standards effective in 2018 and TLAC, long-term debt and clean-holding-company requirements in 2019. The Firm said it expected to comply with the latter by the required date. Its preliminary assessment of the proposed Net Stable Funding Ratio indicated actions would be needed, with implementation details subject to rulemaking.
- The filing says revenue-recognition guidance expected to be adopted in 2018 could change the timing and presentation of certain revenues and costs, but the impact was not expected to be significant, subject to industry interpretations. CECL guidance is scheduled for 2020 and is expected to accelerate recognition of credit losses.
Important facts for investors to verify
- Whether Institutional Securities’ revenue growth can persist while managing higher funding costs, compensation and volume-related expenses.
- Progress and any revised exposure estimate for the $86 million U.K. VAT matter, as well as developments in the Dutch tax dispute and major mortgage-related litigation.
- Whether Wealth Management’s client asset growth and fee-based flows continue, and how loan growth, deposit outflows and the lower liquidity reserve affect funding.
- Capital and liquidity headroom as regulatory standards phase in, including the Firm’s planned repurchases and dividend increase.
- Subsequent developments in the Italian €2.76 billion claim and the potential credit implications of energy-sector exposures.