Chicago: Morgan Stanley (MS) reported $2.7 billion in net income in 1Q18 for an ROE of 14.8%, well above the company’s targeted range of 10% to 13%. This reflects broad-based improvements across all three business segments amidst a very good market environment, according to Fitch Ratings.
On a pre-tax basis, MS earnings improved 22% from a year ago, primarily driven by higher revenues in trading and asset management and an increase in spread income, partially offset by higher expenses as compared to the year ago period. Bottom line results were also aided by the tax legislation, helping MS to report record net income during the quarter. During 1Q18, MS’s effective tax rate was 20.9%, and the company expects the full-year effective tax rate to be at the upper end of the previously disclosed range of 22% to 25%.
Overall Institutional Securities net revenues increased 18% from a year ago with strength in sales and trading and investment banking, and accounted for 55% of overall company revenues. An increase in advisory and equity underwriting revenues offset a decline in debt underwriting and contributed to an overall increase in investment banking revenues of 7% as compared to a year ago. This is the strongest percentage increase of the five U.S. banks and reflects the impact of higher M&A fee realizations, higher market volumes, partially offset by lower debt volume issuance volumes. 1Q18 results also benefitted from large debt financing provided by MS’s JV partner, The Bank of Tokyo-Mitsubishi UFG, Ltd., to Cigna in its acquisition of Express Scripts, which was the largest acquisition during the year.
MS once again demonstrated the strength of its equity underwriting and equity markets franchises, earning the top market share in both segments during 1Q18, as compared to its U.S. peers. The increase in volatility during the quarter aided equity markets results for all the banks, though MS capital markets revenues are most geared towards equity markets amongst its peers. The first quarter is typically a seasonally strong quarter, and Fitch anticipates that MS’s results may not remain at this level through year-end.
Sales and trading revenues improved 26% from the prior year reflecting higher levels of client activity, higher results in foreign exchange and commodities, partially offset by lower results in credit products and rates. As expected, VaR measures increased during the quarter, up 21% on a linked-quarter basis, roughly in line with the average for the large U.S. banks reporting to date.
Net revenues in wealth management increased 8% year-over-year primarily due to a 14% increase in asset management revenues, reflecting higher asset levels and positive flows. Results also benefited from an 8% increase in net interest income given higher interest rates and growth in bank lending. This was partially offset by a decline in transactional revenues (which includes investment banking, trading, and commissions and fee revenues) due to losses related to investments associated with certain employee deferred compensation plans. This drove the segment’s pre-tax margin to 26.5%, in line with its recently revised long-term pre-tax margin target range of 26% to 28%.
Investment Management net revenues, representing the small contribution to earnings by business segment, increased 18% year-over-year due to higher asset management revenues as a result of higher levels of AUM. Total assets under management or supervision as of 1Q18 decreased to $469 billion, up from $421 billion a year ago. During the quarter, MS closed on its acquisition of Mesa West Capital, LLC, a U.S. CRE credit platform, which manages roughly $5 billion of client assets.
MS’s overall non-interest expenses increased 10% year-over-year reflecting growth in both compensation and non-compensation expenses. This reflects costs related to higher revenues and volumes but also continued investments into technology. The ratio of compensation and benefits as a percentage of net revenues was 44% in 1Q18, and the company’s efficiency ratio was 69%, meeting its recently revised target of below 73%.
MS’s fully phased-in Basel III Common Equity Tier 1 (CET1) ratio under the standardized approach declined approximately 50 basis points on a linked-quarter basis due to growth in RWA. During the quarter, MS reported considerable growth in loans and lending commitments, up 11% on a linked-quarter basis. This is significantly higher than peers and primarily attributed to an increase in corporate lending commitments. Despite the decline, it remains strong at an estimated 15.6% at March 31, 2018 and above its U.S. peers.
In terms of the recent Fed proposal on the stress capital buffer, Fitch calculates a minimum CET1 of 15.9% for MS, which includes the stress capital losses under the 2017 severely adverse scenario and MS’s G-SIB surcharge. This could fall further assuming just four quarters of dividends and a flat balance sheet. However, we expect CCAR to remain the binding constraint for MS, as its overall results in DFAST are also materially affected by the global market shock and counterparty default scenarios. While this is still a proposal, it suggests that MS needs to manage capital more conservatively over the longer-term than absent this proposal, which we view as credit positive.
MS’s fully phased-in enhanced supplementary leverage ratio (SLR) fell approximately 10bps to 6.3% at March 31, 2018. This still compares favorably to the current minimum of 5%, as well as the proposed new minimum under the recent Fed proposal of 4.5%. Fitch expects that MS’s binding ratio under CCAR may shift from the SLR to CET1 assuming the proposals pass as currently outlined.
MS also announced a share repurchase plan with MUFG, which owns approximately 23% of MS. As part of the regular repurchase program, MS will make pro rata purchases directly from MUFG, helping MUFG maintain their ownership below 24.9%.