MORGAN STANLEY quarterly report, Q2 FY2018

Morgan Stanley — Second-Quarter 2018 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2018. Morgan Stanley is a global financial-services firm operating through Institutional Securities, Wealth Management and Investment Management. Financial statements are unaudited; Deloitte performed an interim review, not an audit.

Financial results and key metrics

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Net revenues	$10.610B	$9.503B	$21.687B	$19.248B
Net income attributable to Morgan Stanley	$2.437B	$1.757B	$5.105B	$3.687B
Diluted EPS	$1.30	$0.87	$2.75	$1.87
Pre-tax income	$3.109B	$2.642B	$6.529B	$5.450B
Non-interest expenses	$7.501B	$6.861B	$15.158B	$13.798B
Effective tax rate	20.6%	32.0%	20.7%	30.5%

Quarterly net revenues rose 12%; net income attributable to Morgan Stanley rose 39%; diluted EPS rose 49%. For the first half, revenues rose 13%, attributable net income 38%, and diluted EPS 47%.
Expense efficiency ratio improved to 70.7% from 72.2% for the quarter and to 69.9% from 71.7% for the half-year. ROE was 13.0% and ROTCE 14.9% in Q2, versus 9.1% and 10.4%, respectively, a year earlier. These return measures are non-GAAP.
Segment performance, Q2 year over year: Institutional Securities revenue was $5.714B (+20%) and net income attributable to Morgan Stanley $1.457B (+47%); Wealth Management revenue was $4.325B (+4%) and attributable net income $876M (+32%); Investment Management revenue was $691M (+4%) and attributable net income $104M (+4%). Institutional Securities benefited mainly from higher trading and investment-banking revenue; Wealth and Investment Management benefited mainly from asset-management revenue growth.
Net interest income increased to $906M from $751M in Q2 and to $1.881B from $1.522B for the first half. The increase in interest income was largely offset by higher interest expense; the filing attributes higher rates and changes in balances and funding mix as factors.
Cash flow, first half: operating cash flow was negative $81M (versus negative $14.159B); investing cash flow was negative $9.303B (versus positive $2.695B); financing cash flow was positive $11.826B (versus positive $7.365B). Cash and cash equivalents increased $1.194B to $81.589B. Cash flows are affected by trading and financing balance movements.
Balance sheet at June 30: assets $875.875B, liabilities $795.369B, total equity $80.506B, and Morgan Stanley shareholders’ equity $79.109B. Loans, net of allowance, were $112.113B; deposits $172.802B; borrowings $192.244B. Compared with year-end 2017, assets rose from $851.733B, deposits from $159.436B, and loans from $104.126B; borrowings were broadly unchanged.
Liquidity and capital: Global Liquidity Reserve was $226.322B, up from $192.660B at year-end; average Q2 LCR was 128%, versus 121% in Q1, above the 100% minimum. Fully phased-in CET1, Tier 1 and total capital ratios were 15.8%, 18.1% and 20.6%, respectively; SLR was 6.4%. Management stated liquidity was sufficient under its stress tests.

Material changes versus comparable periods

Institutional Securities was the principal revenue-growth driver: Q2 investment-banking revenue increased 20% and trading revenue 15%. Wealth Management and Investment Management grew more moderately, led by asset-management fees.
Compensation and benefits rose 9% in Q2 and in the first half, primarily reflecting higher revenue-related incentive compensation, salaries and award amortization. Non-compensation expenses rose 10% in Q2 and 11% for the first half, including higher volume-related costs.
The lower tax rate primarily reflected the 2017 U.S. Tax Act. Q2 and first-half results included an $88M intermittent net discrete tax benefit, mainly related to new information on multi-jurisdiction tax examinations. Excluding that item, adjusted diluted EPS was $1.25 for Q2 and $2.70 for the first half; these are non-GAAP measures.
Adoption of the revenue-recognition standard increased reported Q2 revenue by $108M and first-half revenue by $191M, substantially through gross presentation of revenue and related expense; prior-year results were not restated. The adoption reduced retained earnings by $32M, net of tax.
Fee-based Wealth Management client assets reached $1.084T at June 30, up from $1.045T at year-end. Investment Management AUM was $474B, down from $482B at year-end, despite net long-term inflows; liquidity-product outflows were significant.
Share repurchases under the program were $1.25B in Q2 and $2.50B for the first half. Common shares outstanding declined to approximately 1.750B from 1.788B at year-end.

Outlook, management commentary, risks and unusual items

Management forecast a 2018 effective tax rate of approximately 22%–25%, subject to evolving interpretation and implementation of the Tax Act. Its medium-term ROE target is 10%–13%, equivalent to ROTCE of 11.5%–14.5%; both targets are forward-looking and subject to market, regulatory, expense and capital factors.
The Federal Reserve gave a conditional non-objection to the 2018 capital plan. The plan allows up to $4.7B of common-stock repurchases from July 1, 2018 through June 30, 2019 and increased the quarterly common dividend from $0.25 to $0.30 per share. The condition limits distributions to specified recent-distribution levels. The announced $0.30 dividend was payable August 15, 2018.
Management said brokerage sweep redesign generated approximately $10B of incremental deposits in higher-balance accounts during Q2 and anticipated a similar amount from further third-quarter adjustments.
Risks highlighted include market, credit, liquidity, funding, operational, model, legal and regulatory risks; competition and economic conditions; U.K. withdrawal from the E.U.; and transition away from LIBOR. The firm reported compliance with minimum LCR requirements and expected to meet TLAC and related requirements by January 1, 2019. The proposed U.S. NSFR rule could require future funding actions.
Corporate lending commitments increased; total loans and lending commitments were approximately $249.7B, up from $216.9B at year-end. The allowance for loans and commitments was $443M, versus $422M at year-end. Most Institutional Securities loans were current, but credit exposure and unused commitments remain relevant risks.
Legal matters include mortgage- and credit-crisis litigation and a Dutch tax-credit dispute. The filing identified potential losses of up to approximately $240M in the CDIB matter, approximately $240M in one mortgage matter, and larger stated potential amounts in other mortgage-related actions; some plaintiffs seek to expand claims, so possible losses may increase. The Dutch appeal concerns approximately €124M ($145M) plus interest. The filing does not state a clear aggregate reasonably possible loss across these matters.
Accounting changes included early adoption of hedge-accounting improvements (a $99M retained-earnings decrease) and reclassification of Tax Act-related stranded tax effects from AOCI (a $443M retained-earnings increase). CECL adoption, expected January 1, 2020, is expected to accelerate credit-loss recognition; its quantified impact is not provided.

Most important facts for investors to verify

Whether revenue and earnings growth persists after considering the tax benefit and revenue-standard gross-presentation effects.
Institutional Securities trading and investment-banking trends, and whether Wealth Management fee-based asset flows and Investment Management AUM growth continue.
Expense growth, compensation sensitivity to revenues, and progress toward management’s efficiency and return targets.
Credit quality and risk concentration as loans and commitments expand, including event-driven corporate lending, real estate exposures and allowance adequacy.
Execution of the capital plan, regulatory conditions on distributions, and the effect of repurchases and the higher dividend on capital ratios.
Potential legal and tax losses, future tax-rate changes, CECL implementation effects, and funding implications of regulatory changes and LIBOR transition.