Morgan Stanley (MS) Earnings Call Transcript & Summary

Okay. You're my last one of the day. Might be a dangerous position. However, I am very happy to have with me as our next presenter Jon Pruzan, the CFO of Morgan Stanley; and also Head of Investor Relations, I don't know where she sat, Sharon Yeshaya. We're going to go right into a fireside chat. But first, before we start, I need to read the following disclaimer. The discussion may include forward-looking statements, which reflect Morgan Stanley's management's current estimates and are subject to risks and uncertainties that may cause actual results to differ materially. This discussion, which is copyrighted by Morgan Stanley and may not be duplicated or reproduced without their consent, is not an offer to buy any security. So with that behind us...

Yes, thank you.

We will, of course, spend time on last week's acquisition of E*TRADE. But let's start at the top first, and let's talk a little bit about strategy and revisit the 2-year plan and the 2-year targets that you set back in January of this year. Because when I think back to that moment, I absolutely expected Morgan Stanley to raise their targets this year. But the amount of the increase went up and over what my expectations were. And so I'm curious, as we talk about that, as you sat down as a management team and thought about where you were taking these targets, what were the biggest points of debate along the way to those targets? And what were the important drivers of confidence in getting there?

I'll go in reverse order. I think in terms of confidence, it was just, where we're coming, '18 and '19, strong years, generally very constructive markets, not necessarily every month of every quarter but generally a positive trend in terms of both the momentum in our businesses, the scale of our businesses, our market positions, the stability of the brand and just a lot of good things that we had going on within the company. So in terms of just our confidence levels, we felt very good about our market positions and sort of where we stood. When we looked out into 2020 and potentially 2021, we thought that we would be in a more challenging revenue environment potentially, putting aside obviously what's going on in the last couple of days. But if you just looked at some of the macro indicators and GDP growth and looked at different parts of the world and different regions, we thought we'd be in a slightly more challenging revenue growth environment. We obviously took some actions at the end of '19 to rightsize the expense base to position ourselves for that environment. And we looked across the businesses. We looked at our positions. We looked at our pipelines. We looked at where we had momentum, where we were investing and where we had the ability to save some money, and we just sort of penciled those out in a sort of slow revenue growth environment, what do we think we can do on expenses and where do we think we can gain share, and sort of those 13% to 15% ROTCE target sort of fell out of that. And we felt, again, good about where we were. And we feel good about the targets. And then obviously, within wealth and also the efficiency ratio, they just sort of fell out of that exercise as well. So...

And just to be clear, when you set those targets, were those inclusive of the benefit of E*TRADE?

No. They were not inclusive of the benefit of E*TRADE. They were not in consideration of E*TRADE. Those were based on what we were seeing at the time. And obviously, we're going to revisit those at the appropriate time. We're hopeful that the deal closes in the fourth quarter, and then, obviously, we'll come back.

Perfect. Okay. So within that, that kind of 2-year strategy and continuing along the path that the firm has been on, you've articulated a very clear determination to shift the business mix further in favor of wealth and investment management. But across all the businesses implied, and you've touched on this already a little bit, is the implication you're going to do more and do it a little bit better by business. So if we could actually drill down in terms of the ROTCE benefits business by business, how you get there and what it is that you're doing better? And why don't we start with Institutional Securities?

Sure. Specifically?

Please.

Yes. I'm going to start somewhere else, just to be fair. No, I'm going to go back to the first question, and then I'll go to the individual businesses. But we had clearly made an effort to remix the balance of the revenue and the balance of the business more towards wealth and IM for quite some time for the durability of those revenues, sort of balance sheet-light, capital-light, and we've been doing it in a way, in a fashion that we weren't in any way diminishing the importance, the relevance and the strength of our ISG business. We obviously took some very important actions in '15 to restructure fixed income. But broadly speaking, we have been very conscious about how we remix the revenues. ISG is part of the DNA and the history of the firm, and it fits very well with the other parts of the business. And so we've been able to continue to shift the revenue mix. And obviously, E*TRADE takes that another step forward, potentially up to about 57% versus, call it, 25% or 26% 10 years ago. So that has been a conscious effort. We like the businesses we're in. We continue to believe that we can continue to shift that mix without shrinking the size of -- or the importance of our ISG business. And then in terms of just businesses, clearly, within ISG, over the last 5-year period, we've taken revenues from $16-odd billion to $20 billion. So we've grown revenues by 25%, and we've grown our PBT by over 60%. This business still has significant operating leverage. We were able to gain share in a shrinking market. About 8 points of share was lost by the Europeans. We picked up about half of that share. And I think we feel very comfortable with the shares that we have. We continue to believe there's opportunity and, again, longer-term opportunity in Asia as a real growth opportunity. We have a very good presence there, and we like the positions and our market shares broadly. Now when we think about sort of the future, we generally think that revenue pools of GDP in the U.S. is going to grow 2-odd percent. We would expect revenue pools to grow sort of in line with that. And then the combination of that and some market share gains continues to improve that business. IM, you've seen from a lot of the presentations we made in the past, significant new product innovation. We've added lots of new products over the last 3 years that have really driven both AUM growth and revenue growth. We're going to continue to do that. We've got CLOs coming on line. We did our first one in the fourth quarter. We've got some private credit businesses that we're launching. So we'll continue to grow that business organically. And if you just look at the metrics of just -- put aside the investment revenue for a second. If you just look at the fee revenue from AUM, we grew that about 7% last year. And I would say that that's sort of top of the industry. And we'd expect to continue to grow -- or excuse me, organically in that business. And then we did the Mesa West deal a couple of years ago, and we continue to look for a nice sort of niche-y sort of fill-ins or capabilities or products that we think we can enhance the overall franchise, and we'll continue to do that. And then obviously, wealth, we've made a big statement last week about how we feel about that business. And we really think that this is sort of -- just puts the business at a whole different level. Obviously, the capabilities that we're bringing on with E*TRADE allows us to sort of -- across all 3 acquisition channels, so the FA channel, the advisory channel; the workplace channel; and the direct channel. And then we have all the tools and the capabilities and the functionality to now support the entire spectrum of wealth customers, and we're really excited about it.

Well, so let's stay with Wealth Management for a minute, and then I will start on to E*TRADE a little bit. And in terms of putting it into the ROTE kind of picture and what it adds beyond the channels and the services and the revenue opportunity, it has -- it should have a pretty material benefit to you from an ROTE standpoint firm-wide in reducing your capital requirement. And we made our own estimate that it's about a 50 to 75 basis point potential reduction in the SCB fully phased in. So let's talk about that a little bit.

Okay. Sure. Not why we did it. Again, we did it because I think it really brings our wealth business to an entire -- it sort of puts us in a much different position to service the full spectrum of the wealth customer, and there's a lot of different opportunities. We can talk some more about the revenue opportunities. It clearly will be helpful, as we see it, to the CCAR process. It's just -- as a factual matter, it's additive to our CET1 ratio at closing by about 30 basis points. The way that CCAR process works at least this year, we'll obviously have a separate model for E*TRADE. We'll be able to incorporate that in post the closing, which we estimate to be the end of the year. And so we'll get the benefit of the E*TRADE dynamic in revenue stream in the model post-1/1/2021. It should be additive to the PPNR. They certainly don't have a lot of credit risk or market risk on the balance sheet. And they also have a securities portfolio that will generally get marked up given the rate pass in the scenario. So it should be additive. Whether it's 50 or 75 basis points, I'm not going to comment on that. But it should certainly improve our CCAR and stress-testing profile if there is an SCB, which we still haven't seen yet. We're still waiting for the directions for CCAR, and so we'll obviously have to see how that develops in the next couple of days, I assume.

That's what it sounds like. And we're going to assume that we're going down that path. So I'm curious, you just said that this isn't why you did the deal, but it's certainly very helpful to have a transaction that not only search -- suits your purposes strategically but is going to work in favor of reducing a firm-wide capital requirement because the only way to get to a very competitive return on tangible common equity over time is to get that capital requirement down. And so this puts you probably closer to 14% than 15%-plus. And I'm curious how important do you think it is to work that 14% down further over time to get to your return target.

Well, again, I think there are lots of strategic reasons why we did the transaction. Capital clearly was one of them -- or is one benefit of the transaction. And I think the way that we think about our capital profile is, obviously, we have a CET1 currently that's over 16%. We believe that, that number should be lower. But more importantly is the return on our tangible common equity. And so if we can drive appropriate returns with that capital level, it becomes less important. If we can't, obviously, it becomes more important. We put out targets of 13% to 15% for 2 years. We put out 15% to 17% longer term. Again, they were not in contemplation of the E*TRADE transaction. What we mentioned on the call last week, that this deal should add north of 100 basis points of ROTCE return when it's fully phased in. So it obviously does improve our overall profile. But we, again, believe that we can get to those targets, that the longer-term aspirational targets probably required a different environment than sort of slow revenue growth, no capital change to the requirements. And so we feel, again, pretty confident that we're on the right path towards, a, hitting our 2-year targets; and then, longer term, getting to higher targets than the 13% to 15%.

And if we stay with the acquisition theme a little bit, and then we'll talk synergies on E*TRADE. But I think it was -- I read into the January presentation that there was an appetite to make additional acquisitions. And I don't think that you or James have been quiet about an intention to add on in the Investment Management business, right? You've been pretty open about this.

Right. No. You didn't have to read into it. We actually said it.

No, there wasn't much reading between the lines. You were pretty open.

So as we say, we have been pretty -- listen, we did 2 small deals. The last couple of years, we came out of this situation where we obviously had to get our own organization in shape. We did 2 small deals, 1 in each space. We felt very good and confident about our ability to integrate transactions. We have -- obviously, have the Smith Barney experience that we've learned a lot from, and we thought we did a very nice job integrating that business. And so we were clearly focused on looking at inorganic opportunities in both wealth and IM, and this became available and we took advantage of it.

So are you done? Or is there appetite on the Investment Management side still? Or does this really kind of take the majority of management's time to integrate correctly at present?

No, I don't think we're done. It's going to take a lot of time, although, again, it's predominantly -- not predominantly, virtually all within the Wealth Management space. So it's going to take a significant amount of time from Wealth Management senior leadership as well as the firm leadership. I think we've always said that within ISG, we're not really interested in -- from an acquisitive standpoint in that space. So I would say ISG and wealth are probably off the table for a while -- excuse me, wealth is off the table for a while. And I think IM, we'll continue to look for those opportunities that either bring us product capability or some geography or something that we think we can integrate. We understand culture very well, and we understand how difficult it is to integrate large transactions in that space. So we're going to be very disciplined around it, and we've been focused on sort of the smaller opportunities.

Okay. So let's talk a little bit about some of the E*TRADE synergies. And seeing as you're the CFO, let's focus on the funding cost synergies, in particular, to start. You outlined $150 million of funding cost synergies that seem to be relatively easy to achieve. So it's over 2 years. So let's talk about why it takes 2 years.

Right. Well, again, we did say $150 million of funding synergies. And what we were describing were really 2 buckets. But we were really talking about sort of day 1, looking at their balance sheet, their mix of business -- or excuse me, their liability mix and their asset mix and ours and what we thought we can do to optimize that. And we said we thought that was $150 million. And those were really 2 buckets. One was sort of, they have $18 billion off-balance sheet. We would bring those on balance sheet, and that would represent about half of those savings. And what I mean, obviously, when you bring those on balance sheet, those -- they were getting paid for those deposits. You sort of lose that investment income, but we should be able to replace our wholesale funding with a cheaper source of funds. So we'll get a pickup on that side. And then the other was really around sort of the HQLA optimization exercise that we'll go through. We have a significant portion of our liabilities, our deposits or our wholesale deposits within the bank supporting low-yielding securities, and that's really to have contingent liquidity that's at a negative spread. We can actually use those, the liabilities and assets of E*TRADE, to replace that. And the reason why it takes time is because there's terms to a lot of our liabilities. Whether they're CDs or other things, they don't -- you can't instantly turn it, but we can do it reasonably quickly, which is why we said within 2 years, we'll be able to get all of those savings. And for example, the cost savings, we said over 3 years because those take a little bit more time. But that's sort of day 1, not really day 1 but based on the current existing balance sheet. On the call, I also mentioned, we've been growing our Wealth Management lending portfolio and, more broadly, our lending portfolio. But certainly, within Wealth Management, sort of mid-single digits, yes, in terms of growth rates. So we've been adding $7 billion, $8 billion of loans a year to that portfolio. We have generally over the last couple of years been funding that with mostly wholesale bank liabilities. One of the nice things about E*TRADE -- one of the many nice things about E*TRADE is their ability to generate cash, customer cash and deposits from their workplace business. They've captured about 15% of that cash. So they've been growing their low-cost stable deposits by sort of $7 billion or $8 billion a year. And if we can use those deposits to fund our loan growth as opposed to the wholesale, that's another incremental benefit, and we'll accrue that over time. But again, we think there's lots of different opportunities to generate incremental dollars across the combined platforms. And whether that's on the deposit side or obviously on the revenue side that we didn't try to quantify, but we do think there's lots of different opportunities.

Okay. You just blew through all 4 of my questions on the balance sheet. It was perfect.

Okay. Good.

Okay. So then let's talk about operating efficiency a little bit and the cost savings versus the leverage and the realization of scale in here. And so some of the specific drivers of pretax margin improvement, and let's talk about then kind of Wealth Management before E*TRADE and then with E*TRADE. Because you were getting into that 28% to 30% zone, and that, I assume, that was exclusive of the E*TRADE...

You keep asking. The target did not include...

I'm just being clear.

The targets do not include the contemplation of doing a transaction like E*TRADE. We felt very comfortable that we would get to 28% to 30% over the next 2 years, and that comfort was driven by -- again, this is a fabulous business. It's a scale business. And if we look at the shape and the size of what we've been doing to that business, we've had -- we got a lot of tailwind. You've seen we've been able to grow revenues consistently without growing noncomp expenses, showing you the operating leverage. We've made significant investments in our technology around our Modern Wealth management platform, and we would expect to see some benefits of those investments over the last several years. And most of that is really, again, around wealth held away, so bringing in more assets of our clients to manage, keeping our expense base quite tight on the noncomps. And then obviously, the grid is the grid. And we thought with that dynamic, and we've seen a continuation of the secular trend of brokerage assets or just generally assets flowing into fee-based accounts, that we would get to the 28% to 30% over the normal course. As we said over and over again, every dollar of incremental revenue comes in at a higher margin. So that's just sort of a normal sort of march, if you will. If you can grow your revenues, you will grow your margin.

And just to pick up on that point of the lower marginal costs, that would imply that you've shifted pretty materially to a fixed cost base in Wealth Management.

Well, I mean, again, there's 2 components. I mean there's comp and noncomp. And the comp is actually not -- the comp is very variable. It's -- again, the vast majority, not everyone, is an FA and gets paid on the grid, but the vast majority of wealth compensation is from a grid base. It's formulaic. It generally doesn't change at any given point. And we do make some adjustments every so often to the grid. We made some of those adjustments this year. But again, it is a variable cost. As there's more revenues generated in that business, the compensation moves up and down with that. On the fixed side, we've done, I think, a really good job of sort of self-funding investments, if you will. So we -- where we want to make investments in that business, which has mostly been in the technology and the platforms that we use for our advisers and their ability -- sort of digitizing, if you will, a lot of the stuff that they do, and we've been able to self-fund that within wealth by making other concessions and reinvesting that into the platform. So again, we've had a very -- we've done a very nice job of keeping the fixed expenses -- or the noncomp expense is flat. Comp is comp, but we also -- as you know, we burned off the Smith Barney retention bonuses at the beginning of last year, so that obviously came out. And so again, we feel very comfortable with the 28% to 30% margin target. That target will clearly change. As we said on the call, if you just combine the 2 companies even before synergies, you get to about a 30% margin in that business. So first, we'll get it closed, and then we'll come back. But this clearly -- their business was running at a 45%-plus margin. It's all wealth. It will be folded into our wealth business, and that will obviously have a benefit.

Okay. Perfect. Okay. So we're going to switch gears into the current market environment, which is obviously not an easy one to navigate given the last few days. But let's talk about how you're assessing what's going on in the macro as well as kind of where business activity was coming into the last week to 10 days.