Morgan Stanley (MS) Q1 2014 Earnings Conference Call April 17, 2014 8:30 AM ET

Executives

James Gorman – Chairman, Chief Executive Officer

Ruth Porat – Executive Vice President, Chief Financial Officer

Celeste Brown – Investor Relations

Analysts

Glenn Schorr – ISI

Guy Moszkowski – Autonomous Research

Brennan Hawken – UBS

Mike Mayo – CLSA

Steve Chubak – Nomura

Matt O’Connor – Deutsche Bank

Michael Carrier – Bank of America Merrill Lynch

Jim Mitchell – Buckingham Research

Devin Ryan – JMP Securities

Celeste Brown

Good morning. This is Celeste Brown, Head of Investor Relations, and welcome to our First Quarter Earnings call. Today’s presentation may include forward-looking statements which reflect management’s current estimates or beliefs and are subject to risks and uncertainties that may cause actual results to differ materially. The presentation may also include certain non-GAAP financial measures. Please see our SEC filings at morganstanley.com for a reconciliation of such non-GAAP measures to the comparable GAAP figures and for a discussion of additional risks and uncertainties that may affect the future results of Morgan Stanley. This presentation, which is copyrighted by Morgan Stanley and may not be duplicated or reproduced without our consent, is not an offer to buy or sell any security or instrument.

I will now turn the call over to Chairman and Chief Executive Officer, James Gorman.

James Gorman

Thank you, Celeste. Good morning everybody and thanks for joining us. Before I comment on our performance this quarter, I’ll discuss our thoughts on capital returns both for this year and for the medium to long term. The recently completed CCAR was a significant inflection point for us. As you know, we secured a non-objection to increase our capital returns. We respect the CCAR process and made significant investments in that process over the past several years and we have a program specifically focused on continuing to raise the bar each cycle.

In 2013, we asked for and received a non-objection to maintain our dividend and the ability to purchase the balance of the wealth management business. In mid-2013, we applied for our first buyback since 2007 of $500 million. In this latest CCAR, we applied to double the dividend, our first increase since 2007 and a $1 billion buyback. We intend to (indiscernible) to our capital request in future years.

Going forward, we will look to drive our dividend yield to at least levels commensurate with the broader S&P, which has historically been around 2%, sustained by growing earnings from wealth and investment management. In fact, an 80 to 100% payout on just the earnings from wealth and investment management suggests an annual dividend at two or three times our recent increased level just based on 2013 earnings and share count.

In addition to growing our dividend substantially, we expect to continue to increase our buyback with a focus on both mitigating employee issuance and reducing our share count. Share buybacks will make up the difference between dividends and the total payouts which we intend to drive toward 100% of churn earnings over the next several years. Now clearly when we can do this is obviously a function of regulatory approval.

Turning now to the businesses in the first quarter, in challenging markets for institutional and retail investors, we drove our revenues and PBT higher across our three business segments versus a year ago as we continued to execute against our strategic plan. Ex-DVA, our revenues were up 4% versus the first quarter of 2013 while our expenses were up 1%. Our expense ratios improved across the segments and our overall earnings per share grew 13%. In fact, ex-DVA our earnings grew despite a significantly higher tax rate than a year ago.

ROTE from continuing operations excluding DVA improved as well to 9.8% while ROE improved to 8.3%, up 130 basis points and 80 basis points year-over-year respectively. We continue to work towards sustainably higher ROEs across all of our businesses through the execution of our strategy with a particular focus on growth in the bank, which we believe is substantial, as well as on a fixed income ROE and our broader firm-wide expenses.

I look forward to your questions at the end of the call. I’ll now turn it over to Ruth to discuss the results in detail.

Ruth Porat

Good morning. I will provide both GAAP results and results excluding the effect of DVA. We have provided reconciliations in the footnotes to the earnings release to reconcile these non-GAAP measures.

The impact of DVA in the quarter was positive $126 million with $76 million in fixed income sales and trading and $50 million in equities sales and trading. Excluding the impact of DVA, firm-wide revenues were $8.8 billion, up 7% versus the fourth quarter. The effective tax rate from continuing operations was 33%. Earnings from continuing operations applicable to Morgan Stanley common shareholders excluding DVA were approximately $1.3 billion. Earnings from continuing operations per diluted share excluding DVA were $0.68 after preferred dividends. On a GAAP basis including the impact of DVA, firm-wide revenues for the quarter were $8.9 billion, earnings from continuing operations applicable to Morgan Stanley common shareholders were $1.4 billion, reported earnings from continuing operations per diluted share were $0.72 after preferred dividends. Book value at the end of the quarter was $32.38 per share and tangible book value was $27.41 per share.

Turning to the balance sheet, our total assets were $835 billion at March 31. Deposits at quarter-end were $117 billion, up $4 billion versus 4Q. Our liquidity reserve at the end of the quarter was $203 billion compared with $202 billion at the end of the fourth quarter.

Turning to capital, although our calculations are not final, we believe that our common equity Tier 1 transitional ratio will be approximately 14.1% and our Tier 1 capital ratio under this regime will be approximately 15.6%. Risk-weighted assets are expected to be approximately $398 billion at March 31. Reflecting our best estimate of the final Federal Reserve rules, our common equity Tier 1 ratio using the pro forma Basel III fully phased in advanced approach was 11.6% at March 31. Our pro forma standardized ratio was 10.2%. We estimate our pro forma supplementary leverage ratio under the recent U.S. regulatory proposal to be approximately 4.2%. For reference, under the prior methodology, our supplementary leverage ratio is 4.5%, up from 4.2%. These estimates are preliminary and are subject to revision.

We continue to expect to see the required 5% level in 2015, including an assumption for increasing returns of capital to shareholders despite the Fed’s recently announced more demanding requirements. In addition to the mitigation items we highlighted on the fourth quarter call, we see opportunities to mitigate the recent inclusion of the CDS long add-on through steps such as compression, re-hedging, and roll down.

Turning to expenses, our total expenses this quarter were $6.6 billion, down 18% versus the fourth quarter due to significantly lower legal expense, seasonality, and our focus on cost reduction. Compensation expense was up 8% versus the prior quarter on higher revenue. Non-compensation expense was $2.3 billion primarily reflecting lower legal expenses, seasonality, and cost management.

Let me now discuss our businesses in detail. In institutional securities, revenues excluding DVA were $4.5 billion, up 21% sequentially. Non-interest expense was $3.3 billion, down 29% versus the fourth quarter. Compensation was $1.9 billion for the first quarter, up versus the fourth quarter on higher revenue, reflecting a 41% ratio excluding DVA. The decline in non-compensation expense to $1.4 billion primarily reflected significantly lower legal expenses. The business reported a pre-tax profit of $1.2 billion excluding the impact of DVA. Including the impact of DVA, revenues were $4.6 billion and pre-tax profit was $1.4 billion.

In investment banking, revenues of $1.1 billion were down 17% versus last quarter, reflecting seasonality. Results represent strong performance for our first quarter across all products. According to Thomson Reuters, Morgan Stanley ranked number one in global announced M&A and number two in global IPOs and global equity and equity linked at the end of the first quarter. Notable transactions included: in advisory, Morgan Stanley acted as advisor on the five largest transactions, including as exclusive financial advisor to WhatsApp on its $16 billion sale to Facebook – this transaction reflects Morgan Stanley’s continued leadership in the largest and most complex transactions in the technology sector; and as exclusive financial advisor to Suntory Holdings in its acquisition of Beam Inc. for $16 billion. This continues our leadership in cross-border activity as well as in Japan.

In equity underwriting, Morgan Stanley acted as joint global coordinator for the $2 billion IPO of Altice Group. This is the largest ever IPO of a cable operator in EMEA. Morgan Stanley also recently acted as lead financial advisor to Altice Numericable on its acquisition of Vivendi’s phone unit, SFR, including acting as joint book runner on its €16 billion of non-investment grade acquisition financing.

In debt underwriting, Morgan Stanley also acted as active book runner for Exxon Mobile Corporation’s $5.5 billion offering of senior unsecured notes. This transaction is Exxon’s first U.S. dollar senior unsecured debt offering.

Advisory revenues of $336 million declined 25% versus our fourth quarter results due primarily to seasonality. Announced advisory transactions were up significantly versus a year ago. Equity underwriting revenues of $315 million were down 24% versus the fourth quarter driven by lower global market volumes and typical seasonality. Fixed income underwriting revenues were $485 million, essentially flat to the fourth quarter as market activity remained at very high levels. Equity sales and trading revenues excluding DVA were $1.7 billion, an increase of 13% from last quarter. Revenues were strong across regions and products driven by higher client activity. Case revenues were up driven by increased volumes in all regions. Prime brokerage revenues were up significantly driven by higher balances and robust client portfolio management activities. Derivatives revenues grew as volatility trended higher.

Fixed income and commodities sales and trading revenues excluding DVA were $1.7 billion, up significantly from the fourth quarter. Revenues increased significantly in all major products. Commodities saw broad-based strength across the energy complex driven by extreme weather in North America and increased client demand. Revenues outside of commodities were driven higher by seasonality and strength in credit products. Average trading VAR for the first quarter was $50 million, essentially flat to the fourth quarter.

Turning to wealth management, revenues were $3.6 billion in the first quarter. Asset management revenues of $2 billion were up versus last quarter, reflecting the benefit of higher market levels at the beginning of the period and positive flows. Transaction revenues decreased 10% from last quarter, consisting primarily of commissions of $540 million, down 6% versus the prior quarter due to fewer trading days; investment banking-related fees of $181 million, down 12% versus last quarter, reflecting a lower U.S. equity underwriting calendar, most notably with fewer closed-in funds; and trading revenues of $275 million, down 15% versus the fourth quarter, reflecting lower gains in deferred compensation plans.

Net interest revenue increased 2% to $539 million driven primarily by higher revenues from our bank deposit program and continued growth in our lending products. Other revenue decreased to $62 million from $110 million. Net interest expense was $2.9 billion, down 3% versus last quarter. The compensation ratio was 60%, up versus the fourth quarter due to seasonality. Non-compensation expense was $762 million, down 13% versus last quarter due to the absence of an impairment charge as well as continued expense discipline.

The PBT margin was 19%. Profit before tax was $691 million. Total client assets surpassed $1.9 trillion. Global fee-based asset flows were $19 billion, a record level. Fee-based assets under management increased to a record $724 billion at quarter-end, representing 37% of client assets. Global representatives were 16,426, essentially flat to the fourth quarter. Bank deposits were $132 billion, down $1.6 billion versus the fourth quarter. Approximately $108 billion were held in Morgan Stanley banks.

We continued to grow our wealth management lending balances and increase our penetration rates with our retail client base. Our mortgage balances increased 10% and our PLA balances increased 9%, while our committed undrawn PLA facilities grew at an even more rapid pace.

Investment management revenues of $740 million were down 12% from the fourth quarter. In traditional asset management, revenues of $437 million were up 2% from the fourth quarter driven by higher market levels and client flows. In real estate investing, revenues of $131 million were down 18% driven by lower investment gains. Merchant banking revenues were $172 million, down 32% driven by a tough comparison to very strong investment gains in the fourth quarter. Expenses were $477 million, down 6% from the fourth quarter due to declines in compensation and non-compensation expenses.

Profit before tax was $263 million, down 22% sequentially. MCI was $54 million versus $46 million last quarter. Total assets under management increased to $382 billion driven by market appreciation and increased flows.

Turning to our outlook, as we begin the second quarter, our investment banking pipeline is strong across all products. M&A is particularly robust. The pipeline is growing with an increase in activity from EMEA and Asia. On the financing side, the flow is healthy for both equity and fixed income underwriting. With respect to sales and trading, overall economic and market conditions continue to be favorable for equities; however, the challenges that weighed on certain parts of fixed income markets for much the quarter persist. On the retail side, trading activity is consistent with levels we saw in the first quarter, though we enter the tailwind from higher equity markets. In addition, we continue to have momentum with FA adoption and client penetration is increasing, an important driver of growth, profitability, and increased earnings consistency.

Over the last several years, we have assiduously worked to reposition our businesses in a way that is aligned with regulatory change. We have made the tough decisions, provided metrics to demonstrate our progress, and have a suite of businesses that are complementary.

Thank you for listening, and James and I will now take your questions.

Earnings Call Part 2:

• Q&A with Morgan Stanley CEO