MORGAN STANLEY quarterly report, Q2 FY2010

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Morgan Stanley 2010 Q2 Form 10-Q

Business context and reporting period

Unaudited quarterly report for the three and six months ended June 30, 2010. Morgan Stanley operates through Institutional Securities, Global Wealth Management Group (including its 51% interest in Morgan Stanley Smith Barney, or MSSB) and Asset Management. The interim statements received an independent accountant’s review, not an audit.

Comparisons with 2009 are affected by MSSB being consolidated only from May 31, 2009. Retail Asset Management was sold to Invesco on June 1, 2010; its results are reported as discontinued operations.

Financial results and key metrics

  • Q2 revenue and earnings: Net revenues were $7.95 billion, up from $5.20 billion in Q2 2009. Continuing-operations pretax income was $1.68 billion, versus a $584 million loss. Net income applicable to Morgan Stanley was $1.96 billion; common-shareholder earnings were $1.58 billion. Diluted EPS was $1.09, including $0.80 from continuing operations.
  • Six-month results: Net revenues were $17.03 billion versus $8.09 billion; net income applicable to Morgan Stanley was $3.74 billion versus a $28 million loss. Diluted EPS was $2.08 versus a loss of $1.71.
  • Expenses and margin: Q2 non-interest expenses were $6.27 billion, up from $5.78 billion. Continuing-operations pretax margin was about 21% of net revenues. Compensation and benefits were $3.89 billion. H1 expenses were $12.83 billion.
  • Cash flow: H1 operating cash flow was $29.38 billion, investing cash flow was negative $19.61 billion and financing cash flow was negative $4.49 billion. Cash and cash equivalents ended June at $36.35 billion, up $4.36 billion from year-end. Operating cash flow was materially affected by changes in trading assets and liabilities and secured financing balances.
  • Balance sheet and debt: Total assets were $809.46 billion, up from $771.46 billion at December 31, 2009. Total equity was $59.16 billion. Long-term borrowings were $182.81 billion, down from $193.37 billion; short-term borrowings were $3.84 billion and deposits were $61.37 billion. Repurchase agreements totaled $185.13 billion.
  • Liquidity and capital: The Global Liquidity Reserve was $153 billion at June 30, comprising $32 billion cash and equivalents, $81 billion securities purchased under resale agreements and $40 billion Federal Reserve-eligible securities. Regulatory Tier 1 and total capital ratios were 16.5% and 17.0%; the Tier 1 leverage ratio was 6.6%. Management reported liquidity sufficient for its modeled stress scenarios.
  • Selected business indicators: Global Wealth Management client assets were $1.50 trillion, including $396 billion in fee-based accounts (26% of client assets). Asset Management assets under management or supervision were $251 billion.

Material changes versus the prior comparable period

  • Q2 net revenues improved substantially, with trading revenue rising to $3.35 billion from $1.73 billion. Investment banking revenue fell to $1.08 billion from $1.27 billion, as lower underwriting was partly offset by stronger advisory fees.
  • Q2 results included approximately $750 million of revenue from widening Morgan Stanley credit spreads on certain fair-value borrowings; Q2 2009 included approximately $2.3 billion of losses from spread tightening. This makes the year-over-year revenue and earnings comparison less representative of underlying business performance.
  • Q2 net income included a $514 million after-tax gain from the Retail Asset Management sale and a $345 million tax benefit from remeasurement of unrecognized tax benefits. H1 also included a $382 million tax benefit from treating certain foreign earnings as indefinitely reinvested.
  • H1 discontinued operations included a $951 million loss related to the planned disposal of Revel and a $775 million gain from a settlement with Discover Financial Services. The Invesco sale generated a cumulative after-tax gain of $673 million, with $514 million recorded in Q2.
  • The Japan securities joint venture with MUFG closed May 1. Morgan Stanley recorded a $717 million after-tax gain in paid-in capital from selling a non-controlling interest; this was not operating income.
  • The company’s common equity and total equity increased from year-end. Tier 1 and total capital ratios also rose from 15.3% and 16.4% at year-end to 16.5% and 17.0%.

Outlook, management commentary, risks and unusual items

  • Management described market conditions as difficult, with Q2 more challenging than Q1 and difficult conditions continuing into July. It cited investor concerns about financial regulation and European sovereign debt, among other factors. The filing does not provide numeric earnings or revenue guidance.
  • The Dodd-Frank Act was signed July 21, 2010. Management said the full effects were uncertain pending extensive rulemaking; potential effects include new requirements for trading, derivatives, capital, liquidity, resolution planning and compensation.
  • On July 1, Moody’s lowered equity credit for hybrid securities. Morgan Stanley obtained Federal Reserve approval to redeem the junior subordinated debentures underlying its CIC Equity Units; the securities would not be remarketed as originally contemplated. Long-term borrowings, net of repayments, increased about $4 billion through July 31.
  • Other unusual expenses included a $361 million Q2 charge for the U.K. payroll tax on 2009 discretionary bonuses, and MSSB integration costs of $106 million in Q2 and $206 million H1. The U.S. pension plan will cease benefit accruals effective January 1, 2011; the change reduced Q2 compensation expense by about $51 million.
  • Risk exposures include fair-value estimates with significant unobservable inputs, trading and counterparty risk, credit and real-estate exposures, and potential liquidity needs if ratings fall. At June 30, a one-notch downgrade could trigger about $1.48 billion in collateral or termination payments under certain agreements, with larger requirements for further downgrades.
  • Management identified a possible goodwill impairment if markets deteriorate for one reporting unit with about $400 million of goodwill. It also disclosed a potential $245 million loss in the Capmark-related Citibank lawsuit after an adverse ruling; Morgan Stanley planned to appeal. A Massachusetts settlement required payments of about $102.7 million.
  • Other disclosed exposures include $122.1 billion of commitments, much of which may expire unused; $67.1 billion of corporate lending exposure; and up to $858 million of additional exposure to consolidated VIEs beyond their recognized net assets and liabilities. Amounts and risk depend on contractual terms, collateral, hedges and counterparties.

Important facts for investors to verify

  • How much of reported earnings and revenue growth reflects spread-related fair-value gains, tax benefits and divestiture or settlement gains, rather than recurring operations.
  • Underlying trading performance and credit quality, including mortgage, corporate lending, monoline and counterparty exposures, and the effect of hedges.
  • Liquidity and funding conditions, including the composition and availability of the $153 billion reserve, refinancing needs, and sensitivity to ratings downgrades.
  • Progress and costs of MSSB integration, revenue-sharing arrangements with Citi, and performance of wealth-management client assets and fee-based accounts.
  • Resolution and potential financial impact of the Capmark litigation, Massachusetts settlement, Revel disposition, real-estate fund restructuring and tax examinations.
  • Implementation of Dodd-Frank and other regulatory changes, and their effect on capital, liquidity, trading activities and earnings.