Morgan Stanley Earnings Call Insights: Incremental Margins and Market Forecast

Morgan Stanley (NYSE:MS) recently reported its fourth quarter earnings and discussed the following topics in its earnings conference call.

Incremental Margins

Howard Chen – Credit Suisse: With respect to expenses, the cost reduction targets in a flattish revenue environment, is a really strong statement and a helpful benchmark for us. I am curious James, how do you broadly think about the incremental margins or returns in a potentially better revenue environment? For example, if revenues were up 10% with a similar business mix, how much do you think will drop to the bottom line?

James P. Gorman – Chairman and CEO: That’s not one I am going to wing. Let me put pencil to paper. We’ve been operating so much under that basis that there won’t be increased revenues. Obviously the world is going to evolve, so at some point that’s not true. But our approach has been, what can we control? How do we drive up margins in a flat revenue environment and obviously through the expense line is how we are doing that. By definition, if we hold the line on our fixed costs which I think we are being very disciplined about on a go forward basis, one would assume the incremental dollar revenue will throw up a higher incremental margin than the previous dollar revenue. But I’ve got to go and – we’d have to go and look at it business by business.

Howard Chen – Credit Suisse: We saw some really nice expense control within Global Wealth Management, specifically compensations, you’ve noted in the past the limited flexibility you might have due to the grid like comp structure. So, I’m curious what’s driving that comp accrual lower in 2012 and how sustainable should we think about it?

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Ruth Porat – EVP and CFO: The main driver of the reduction and the comp ratio is the fact that we are done with integration, as we’ve talked about on so many calls over the years the integration expense was running ballpark $80 million to $100 million a quarter until we completed in integration at the end of the second quarter, then dropped down in the third and fourth quarter taper down, that’s one major benefit. The second is that as a result of being on one platform we’re able to consolidated a number of back offices and management layers, the items that we outlined really on the third quarter call. So, that’s sustainable as well. I think the fourth quarter compensation benefitted a bit by what is typical year-end true-up, true down, sometimes that benefits the comp ratio, other times it doesn’t, I think it’s fair to say near term the ratio is likely to be in the 60% range, but very much to your point, there are a couple of drivers that will reduce that comp ratio, more one, if it’s for continuing to build out the lending product, the lending product if non-compensable revenue does provide a lift to the margin, that alone drives the margin into the 50s, and then again a better operating environment, in particular, any kind of rate increase had meaningful benefit to the margin and the business and that helps as well. So, we’re good at where we are here, hold you kind of in the first quarter near term to that 15% margin for the reasons I described with upside.

Howard Chen – Credit Suisse: Then just finally for me. Can you discuss your wholesale funding plans over the next two years; I think you have maybe $45 billion-ish maturing through 2014. How much would you let rolled off and how do you think that funding schedule potentially changes if you buy in the rest of the JV this year?

Ruth Porat – EVP and CFO: Sure there a couple of variables to that. We are obviously sitting here as I noted with liquidity at higher levels about $189 billion. So there is some flux in there. We have reduced outstanding indebtedness outstanding debt this year on secured debt by $19 billion very much to your point about the changing composition of the balance sheet. Then as we buy-in the balance of the Wealth Management business, the deposits, as I think you know, come on – we will get about $15 billion when we complete the 35% but the balance of it comes on ratably over a two year period of time. The total size of those deposits is ballpark $140 billion, a part of which will be used to support growth in the institutional business. So the three components of it will be Wealth Management lending, institutional lending and other bank appropriate businesses moving into the bank. As we do that we get dollar for dollar substitution reducing unsecured debt requirements and replacing them with deposit funding. So all of those provides a bit of flexibility with respect to the magnitude of unsecured debt and wholesale funding that will be required on a go forward basis.

Market Forecast

Glenn Schorr – Nomura: I appreciate the further detail on the RWA line down. I guess a two part is, I’m assuming that it’s all passive but if you look at it, it would and it does imply and you guys are by no means alone here, there is $80 billion of RWA that are clogging up the system that have no real revenue impacts. So the two-parter is, one, can anything in the market conditions change that to make there be a positive or negative revenue impact or are we kind of locked and loaded and just waiting for line down? Part two is, what does RWA wind-down plan imply at all? Does it have revenue implications for fixed-income as that plays out?

Ruth Porat – EVP and CFO: So Glenn, when we put out the initial forecast for our risk-weighted assets and RWA reduction, we were looking at, there are obviously three levers, there’s passive mitigation, active mitigation and model approval. The guidance last summer was primarily based on passive mitigation, just scheduled roll offs or maturities of positions. It had some active, but it was primarily passive. What we’ve done through the back half of 2012 was accomplished through active mitigation. In other words, we pulled forward some of the passive mitigation that was embedded in that earlier forecast, but it was through active mitigation that we ended the year at $280 billion of risk-weighted assets and we were able to pull forward our forecast by a year. The way we’ve been accomplishing the active mitigation is really with minimal P&L impact and that’s the way we are continuing to look at it. We’re really reducing capital behind positions that are in areas that are not revenue accretive longer-term.

Glenn Schorr – Nomura: So just making sure I got it right, anyway you sliced that that’s the RWA run-off, good or bad market conditions; it’s going to have no revenue impact?

Ruth Porat – EVP and CFO: I said its minimal revenue impact. That’s the way we’ve been looking at it and I think you had one another part of your question I didn’t quite address. The reason we’ve been able to accomplish this pull forward is this is as you know a real priority for us. We have strict governance around it. Our senior leadership team is very committed to it and that’s enabled us to pull forward through active mitigation, more reduction in 2012 and set us up for this decline as we’re looking at in ’13 and beyond at minimal P&L impact.

Glenn Schorr – Nomura: Ruth, you had mentioned the 43% true comp ratio at ISG, I’m assuming that was the year and not the quarter, correct?

Ruth Porat – EVP and CFO: Correct.

Glenn Schorr – Nomura: That’s come down and I think that shareholders be cool with that. We’ve seen some stuff in the press about changes on the deferral, not something normally that I’d ask you to comment on, but I’m just curious on the impact on future periods on the change in deferred. I’ve seen this happen in the past with some other companies, how much of a contingent liability does that create on the go forward or is it not material to the overall story?

Ruth Porat – EVP and CFO: Well, there are a couple of things in terms of the compensation structure. So, we did change the comp structure again this year. We raised the total compensation level at which deferrals start, so over 82% of people don’t have deferrals, it’s really – think of it as those who are in the earlier parts of their careers, so it’s really for the more senior people that we have deferrals and vesting schedule is still over three years and it’s the combination of cash and equity, which we think further enhances alignments of interest. But as we’ve talked about on calls last year, we said the absolute amount of deferrals would be going down, it is continuing to go down, the actual amount of deferrals in 2013 is lower than 2012 and the aggregate amount continues to decline. I think, important, as James noted in his comments, when you combine that with the actions we’ve taken reducing headcount base and benefits are also meaningfully low. We’re paying 6,000 fewer people in 2013 and then you add that to things like location sourcing. So kind of that sixth element of that if that’s where you framed it is declining.

Glenn Schorr – Nomura: Then last one for me. Commodities specifically and I appreciate the environment has been has been a soft one but I have seen it everywhere. Is the business actually changed such that maybe it doesn’t fit inside a broker-dealer anymore, in other words would private equity be a better owner? It seems curious if you would allocate, I’m sure you won’t but I will try the risk weighted assets associated with. It feels like wow, three out of four quarters this year were pretty soft. In other words in your mind is it cyclical versus something changed?

Ruth Porat – EVP and CFO: Yes. There were some quite specific issues in the environment that affected commodities this quarter in particular. I mean as you know well our business is both physical and trading and it’s also primarily oil and power and when you combine storm related dislocation, continued backwardation with lower prices affecting our storage business and then lower volatility we had a series of things that resulted in basically de minimis revenues and commodities this quarter very unusual one over time. So we do think there is quite a cyclical element to it, storm related element to it, however you want to frame it.

James P. Gorman – Chairman and CEO: I would just add, firstly to put the quarter in context. The second quarter was also challenging. You have to go back to 1995 I think to find quarters like that. So it was fairly average. These businesses don’t turn back quickly on a dime good or bad and we have a tremendous commodities business, tremendous team. They had an average environment, difficult environment, difficult quarter and we moved on past that. On the broader strategic things I mean if we could find a structure that was more advantageous for everybody, we’d do that and obviously, as we’ve said publicly, we are open to that. But this is not because we’d only integrate business; we are just constantly looking at the combination of capital liquidity, funding and the mix of those three things and trying to figure out the best way to move forward.

A Closer Look: Morgan Stanley Earnings Cheat Sheet>>