Morgan Stanley — Form 10-Q Summary
Business context and reporting period
Morgan Stanley is a global financial services firm with Institutional Securities, Global Wealth Management Group and Asset Management businesses. This unaudited filing covers the quarter and six months ended June 30, 2009; the company filed it on August 7, 2009. Comparisons are with the corresponding 2008 periods, except balance-sheet comparisons, which are primarily with December 31, 2008.
The quarter includes one month of Morgan Stanley Smith Barney Holdings LLC (MSSB), formed May 31, 2009 with Citigroup. Morgan Stanley owns and consolidates 51% of MSSB; Citi owns 49%. The company also sold its remaining MSCI shares in May, and reports MSCI as discontinued operations.
Financial performance
Dollars in millions, except per-share data and ratios.
| Metric | Q2 2009 | Q2 2008 | Six months 2009 | Six months 2008 |
|---|---|---|---|---|
| Net revenues | $5,411 | $6,111 | $8,357 | $13,929 |
| Non-interest expenses | $6,030 | $5,225 | $9,884 | $11,040 |
| Continuing-operations pretax income (loss) | $(619) | $886 | $(1,527) | $2,889 |
| Continuing-operations income (loss) | $(286) | $694 | $(490) | $2,104 |
| Net income (loss) | $33 | $1,159 | $(157) | $2,591 |
| Net income (loss) applicable to Morgan Stanley | $149 | $1,143 | $(28) | $2,556 |
| Common-shareholder earnings (loss) | $(1,256) | $1,062 | $(1,834) | $2,374 |
| Diluted EPS | $(1.10) | $1.02 | $(1.71) | $2.28 |
| Net interest income (expense) | $(488) | $133 | $(334) | $1,055 |
Q2 net revenues fell 11% year over year, while expenses rose 15%; the resulting pretax margin was negative. For the first half, net revenues fell 40% and expenses declined 10%, but the company moved from pretax profit to a pretax loss. Net income includes after-tax gains from discontinued operations of $319 million in Q2 2009 and $333 million in the first half. Morgan Stanley’s Q2 common-shareholder loss also reflects preferred dividends and issuance-discount amortization, including a one-time $850 million charge related to the Series D preferred-stock redemption.
- Revenue mix and segments: Q2 Institutional Securities net revenues were $2.964 billion, down from $3.875 billion; Global Wealth Management Group produced $1.923 billion, up from $1.695 billion, including MSSB’s first month; Asset Management generated $575 million, compared with $582 million. Each segment reported a continuing-operations pretax loss in Q2: $307 million, $71 million and $239 million, respectively.
- Cash flow: Operating activities used $41.469 billion in the first half, versus providing $35.221 billion in 2008. Investing activities used $3.174 billion; financing activities provided $778 million. Cash and cash equivalents ended June at $35.006 billion, down from $78.670 billion at the start of the period. The filing attributes operating cash movements largely to changes in trading and financing-related balance-sheet items.
- Balance sheet and debt: Total assets were $676.957 billion, broadly unchanged from $676.764 billion at December 31, 2008. Long-term borrowings were $186.792 billion, up from $179.835 billion; total equity was $51.463 billion. The company issued approximately $27 billion of long-term notes and repaid $24.7 billion during the first half. Short-term borrowings fell to $3.030 billion from $10.102 billion.
- Liquidity and capital: The June 30 total liquidity reserve was $158 billion, including $58 billion at the parent; average total reserves were $157 billion for Q2. Regulatory capital ratios were 15.8% Tier 1, 17.1% total capital and 6.5% Tier 1 leverage, compared with 16.7%, 18.2% and 7.1%, respectively, at March 31. The company reported compliance with applicable capital requirements.
Material changes and unusual items
- MSSB transaction: The company paid Citi $2.755 billion in cash and contributed its wealth-management businesses to the venture. Preliminary purchase accounting recorded approximately $5.029 billion of acquisition goodwill and $4.611 billion of amortizable intangible assets; valuations remained subject to adjustment. The acquired business contributed only one month of reported operating results in Q2.
- Capital actions: Morgan Stanley raised approximately $6.9 billion in gross proceeds through two common-stock offerings during Q2, increasing shares outstanding. It repurchased the $10 billion Series D preferred stock issued to the U.S. Treasury. The company agreed on August 5 to repurchase the related Treasury warrant for $950 million, reducing equity in Q3.
- MSCI disposal: The sale of the remaining MSCI stake generated $573 million of net proceeds and a $499 million pretax gain ($310 million after tax), included in discontinued operations.
- Market and valuation effects: Tightening of Morgan Stanley’s own credit spreads on borrowings carried at fair value reduced net revenues by approximately $2.3 billion in Q2 and $3.9 billion in the first half. The filing also reports real-estate losses of approximately $0.7 billion in Q2 and $1.7 billion in the first half. Event-driven corporate lending and related hedges produced a net gain of approximately $0.6 billion in Q2 and $0.2 billion in the first half.
- Expenses and taxes: Q2 compensation and benefits expense rose 25% companywide, which management attributed primarily to its assessment of full-year compensation needs and competitive pressures. MSSB integration costs were approximately $245 million, including a $124 million replacement-award charge. A $331 million tax benefit in the first half related to anticipated repatriation of foreign earnings; excluding it, the reported annual effective tax rate for the period would have been 46.2%.
Outlook, risks and contingencies
The filing provides no quantified earnings or revenue guidance. Management said the pace of the global downturn began to moderate in Q2, but described credit, real-estate and broader economic conditions as still challenging. It cited continued risks from market and economic conditions, asset prices and volatility, credit availability and ratings, client activity, competition, regulation and the company’s reputation. Further deterioration in real estate and market conditions could reduce asset values and lead to additional impairments.
- Fair-value estimates rely partly on significant unobservable inputs. Level 3 assets before cross-level netting were $59.0 billion at June 30, down from $83.6 billion at December 31; the company cautioned that market disruption can reduce input observability and valuations.
- Maximum exposure to loss from consolidated VIEs was $7.573 billion; maximum exposure from significant non-consolidated VIE interests was $10.541 billion. The company noted that these measures do not include potential hedging benefits.
- Credit-rating downgrades could trigger collateral calls. Disclosures differ by scope: a derivative-agreement note estimates approximately $616 million for a one-notch and $971 million for a two-notch downgrade; the liquidity discussion gives approximately $1.129 billion and $987 million, respectively, and explains that bilateral arrangements are included. Investors should consult the filing’s definitions and calculations.
- Legal proceedings include securities and mortgage-related claims and regulatory matters. Management said outcomes could materially affect results or cash flows in a particular period, although it did not expect pending matters to have a material adverse effect on consolidated financial condition. The filing does not provide a clear aggregate range of reasonably possible losses.
- Tax examinations in the U.S., Japan and U.K. could affect future earnings or the effective tax rate; the company said possible changes in unrecognized tax benefits could not then be reasonably estimated.
- New accounting standards on transfers of financial assets and consolidation of variable-interest entities, effective for the company in 2010, may materially change which entities are consolidated. The interim financial statements received an independent accountant’s review, not an audit opinion.
Important facts for investors to verify
- How much of reported earnings reflects recurring operations versus MSCI disposal gains, preferred-stock charges, own-credit valuation effects and other market-sensitive items.
- Final MSSB purchase accounting, goodwill and intangible-asset valuations, integration costs, and the earnings attributable to Citi’s 49% interest.
- Liquidity availability by legal entity, cash-flow volatility from securities financing and trading balances, and potential collateral requirements under further rating downgrades.
- Real-estate, mortgage, corporate-lending and VIE exposures, including the sensitivity of Level 3 valuations and the consequences of future impairments.
- Capital ratios and common-equity effects after the Treasury warrant repurchase, preferred-stock actions and increased common shares.
- Developments in mortgage-related litigation, tax examinations and the adoption of the new securitization and VIE accounting standards.