Wealth Management Unit Helps Morgan Stanley Deliver Strong Q2 Performance

The country’s largest banks have all comfortably beaten expectations this earnings season thanks to an uptick in global debt trading activity in June. But Morgan Stanley’s (NYSE:MS) outdid its peers by reporting a net income figure which was nearly double that for the same period a year ago. ^[1] Earnings for the period were, in fact, 26% higher than those for the first quarter – a period that receives a marked seasonal boost each year. It is not difficult to see the reason for this, though, as the investment bank received a $609 million discrete tax benefit over the period which almost completely wiped out its tax expense. A better idea of Morgan Stanley’s quarterly performance comes from the fact that the pre-tax income figure of just under $2 billion was 11% higher year-on-year, but 15% lower quarter-on-quarter – in line with the trend demonstrated by its peers.

The one-time tax gain notwithstanding, Morgan Stanley reported balanced results for the quarter, with continued growth in its wealth management revenues making up for the shortfall in trading revenues. The bank’s advisory and underwriting unit also saw a notable increase in fee revenues. On the flip side, the bank reported total compensation expenses of $4.2 billion in Q2 – just 2% lower than the figure for the previous quarter. As Q1 compensation figures are high due to payments of annual bonuses, the elevated Q2 figure points to higher performance-related payouts to employees.

Improving operating margins for the bank’s wealth management unit, coupled with a better-than-expected showing by its debt trading desk, prompted us to revise our price estimate for Morgan Stanley’s stock upwards from $35 to $38.

See our full analysis of Morgan Stanley

Trading Revenues Slipped After Strong Q1 Showing

Unlike its other major competitors in the U.S. – namely Goldman Sachs, JPMorgan, Citigroup and Bank of America – Morgan Stanley’s trading business relies more on equity trading operations than fixed-income to generate value, due to a conscious decision by the bank to scale down the latter. This fact is evident from the chart above, which shows that its equities trading desk contributes almost 30% of its total share value while the FICC (fixed-income, currencies and commodities) desk is responsible for less than 15%. The bank also kept its trading operations largely out of focus over the 2010-2012 period – choosing to concentrate its efforts on its wealth management business.

This is why investors were surprised when Morgan Stanley delivered its strongest performance in more than two years in Q1 as the equities and debt trading desks each roped in $1.7 billion in revenues. However, the bank failed to replicate the success in Q2 as total trading revenues of $2.8 billion were 18% lower than in Q1 2014 and 14% lower than in Q2 2013. It should be noted here that equities trading still managed to make $1.8 billion in Q2 2014 while FICC trading revenues fell to just above $1 billion. This trend of strong equity trading revenues is definitely a good sign for Morgan Stanley’s overall business model in the long run.

Wealth Management Pre-Tax Margins Grow

Morgan Stanley’s struggle to eke out profits from its wealth management business is no secret, with the bank unable to break the trend of single-digit margin figures for two long years in 2010-2011. But it stuck to its decision to completely buy out Citigroup’s stake in the Smith Barney operations, with this being the focus of its capital plan even in 2013. Having achieved the self-imposed 17% margin target for the business well before the 2014 deadline in Q4 2012, Morgan Stanley has seen revenues steadily outpace expenses since then. Having crossed the 19% mark for the first time in Q1 2014, operating margins for the division touched an unprecedented high of 21% in Q2. This helped the division report a pre-tax income of $767 million in Q2 compared to $691 million in Q1 2014 and $655 million in Q2 2013. Considering the fact that the bank is eyeing compensation cuts for brokers in the near future, the margin figures are only expected to improve going forward (see Here’s Why Morgan Stanley Is In Two Minds About Cutting Brokers’ Pay).

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1. Q2 Earnings, Morgan Stanley Press Releases, July 17 2014 [↩]