Morgan Stanley (MS) Q1 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the Eaton Vance First Quarter Fiscal Year 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Dan Cataldo, Treasurer. Thank you. You may now begin.

Good morning, and welcome to our 2013 fiscal first quarter earnings call and webcast. With me this morning are Tom Faust, Chairman and CEO of Eaton Vance; and Laurie Hylton, our CFO. We'll first comment on the quarter, and then we will take your questions. The full earnings release and charts we will refer to during the call are available on our website, eatonvance.com, under the heading Press Releases. Today's presentation contains forward-looking statements about our business and our financial results. The actual results may differ materially from those projected due to risks and uncertainties in our business, including, but not limited to those discussed in our SEC filings. These filings, including our 2012 annual report and Form 10-K, are available on our website or upon request at no charge. I will now turn the call over to Tom.

Good morning. January 31 market closed on an exciting first quarter of fiscal 2013 for Eaton Vance. The $19.4 billion of growth sales and other inflows we realized during the quarter is a new record high, exceeding our previous record sales quarter by more than 20%. We generated $5.4 billion of net inflows, which equates to 11% annualized organic growth, a great start for us in fiscal 2013. We closed the previously announced acquisition of The Clifton Group Investment Management Company at the end of December and made progress integrating Clifton's business with Parametric during January. In December, we paid a special dividend of $1 per share and accelerated the payment of our $0.20 per share first quarter dividend. We finished the quarter with $247.8 billion of consolidated managed assets, up 24% from $199.5 billion at the beginning of the quarter. Excluding the $34.8 billion of assets acquired in the Clifton purchase, our managed assets grew 7% over the course of the first quarter on the strength of positive net inflows and favorable markets. Not included in our reported net flows for the quarter are the $1.8 billion of net inflows, or 49%-owned affiliate, Hexavest, Inc., achieved during the quarter. Since we closed the Hexavest transaction in August of last year, they have grown their managed assets from $11 billion to $14.5 billion, an increase of 32%, driven primarily by $2.7 billion of net inflows over the period. We are pleased to welcome our Minneapolis-based colleagues from the Clifton Group to the Parametric and Eaton Vance families. Led by Jack Hansen, Kip Chaffee and Tom Lee, Clifton is recognized by major institutional investors and consultants as the leading provider of futures and options-based overlay services and risk management solutions. The Clifton business complements and enhances Parametric's existing line up of…

Thank you, and good morning. In our press release this morning, we've reported adjusted earnings per diluted share of $0.50 for the quarter compared to $0.53 in the fourth quarter of fiscal 2012 and $0.47 in the first quarter of last year. Adjusted earnings differ from GAAP earnings in that we back out changes in the estimated redemption value of non-controlling interest in our affiliates that are redeemable other than fair value. As you saw in Attachment 2 to our press release, these adjustments totaled $0.09 in the first quarter of fiscal 2013, $0.08 in the fourth quarter of last year and $0.07 in the first quarter of fiscal 2012. First quarter earnings per diluted share were also adjusted for the $0.03 impact of the special dividend we declared and paid in December. The $0.03 impact of the special dividend on our earnings per diluted share calculation reflects the disproportionate allocation of distributions in excess of earnings to common shareholders under the two-class method. As Tom noted earlier, ending assets increased by $48.3 billion, or 24%, $247.8 billion on January 31, reflecting assets acquired of $34.8 million, net inflows at $5.4 billion and market appreciation of $8.2 billion in the quarter. Average assets under management increased by $19.6 billion, or 10% in the first quarter, reflecting 1 month of Clifton ownership and the partial effects to the quarter's net inflows and market appreciation. The Clifton acquisition, as anticipated, had a significant impact on both our overall effective fee rate and our effective investment adviser and administrative fee rate in the quarter. The impact of the acquisition to our overall effective fee rate, down to 59 basis points in the first quarter from 53 basis points in the fourth quarter of last year. Our effective invested advisor administrative fee rate similarly…

Thanks, Laurie. We finished the quarter with $218 million of cash and equivalents, down from $462 million at the end of the fourth quarter. The reduction was the result of the very active quarter for us from a capital management perspective. We returned an incremental $144 million in cash to shareholders in the form of a special dividend paid in December, which totaled $120 million, and the acceleration of the regular first quarter dividend, which typically would have been paid in February. We have $67 million to close the Clifton acquisition on December 31. And as Laurie mentioned, we used $43 million to exercise our call to purchase the remaining interest in Parametric related to the 2003 acquisition. We did close stock repurchases to $13 million in the first quarter due to the heavy demands on our cash. With those demands behind us, we expect to be back in the market as opportunities arise. How much of our stock we repurchased in any period will depend on a number of factors, including other uses of the cash, the stock price, the macro environment and the outlook for our business. You may have noticed that our diluted shares outstanding used in the diluted EPS calculation increased 3% from the fourth quarter. The cause of the increase was twofold. First, we saw a high-volume of employee stock option exercises in the quarter, particularly in December, due to a higher stock price in the impending tax rate increases. Second, under the treasury stock method, the diluted impact of outstanding in-the-money options increases as the average stock price for the quarter increases, a scenario that we experienced this quarter. I would expect to see a somewhat higher diluted share count again in the second quarter as the calculation is based on average outstanding shares, and we will feel the full effect of the option exercises that took place during the first quarter. Our fee capital portfolio at December 31 totaled $275 million, up roughly $10 million from the end of the fourth quarter. Redemptions in some of our maturing key [ph] Products were offset by new key [ph] Investments and our double in registered Hexavest sub-advised funds, and the new Eaton Vance bond fund. After the anticipated product launches, we would expect to see capital initiatives to be a modest use of cash over the remainder of the year. Our strong cash flow, our $300 million untapped credit facility and assets to the capital market based on our A- and A3 investment-grade credit ratings, give us ample financial flexibility to continue to invest in our business as we see attractive opportunities. That concludes our prepared comments. We'd now like to open the call up to questions.

[Operator Instructions] Our first question comes from Michael Kim with Sandler O'Neill + Partners.

This is actually James Hally [ph], filling in for Michael this morning. My first question is about the closing of the Atlanta's SMID-Cap fund last month to new investors. I was hoping you could provide some color on the mix of flows more recently between new and existing investors and kind of any lumpiness that might have happened, inflows just prior to the close. And I know with GMAR, you guys were able to reopen it after some infrastructure build out. So just curious as to whether this is a similar situation or if that strategy is really is just approaching an absolute capacity.

No, we expect it will be different this time. The assets and the strategy ultimately are limited by liquidity and the underlying stocks which really wasn't the driver with the closing of the Global Macro strategy back in 2010. So we certainly do not expect to reopen the strategy unless markets change or we see significant outflows. We have been in a modest net inflows since the time the strategy changed the both growth -- and growth and net sales are off, but continue to be positive, as you might expect. The performance of the strategy has been good. The strategy continues to be open on a limited basis to existing investors. So we will expect to see modest growth going forward. And I certainly would not encourage you to think that we're likely to reopen the strategy.

Okay, great. And then maybe one for Laurie on the comp. Obviously, you guys broke down what drove the increase but -- and in terms of the comp ratio to revenue, just wondering if this is more of a stable run rate or is it with -- revert back down to where it had been running?

Yes. I think that we're more likely to see this as sort of our new reality going forward. And keeping in mind that roughly 43% of our total compensation is variable. So to the extent that we continue to have strong sales, revenue growth and operating income growth, we're going to continue to see pressure in terms of their total compensation. So I think, in removing it to the second quarter, there are probably a few things there that are going to drop off that were unique to the first quarter, in terms of normal first quarter events, you've got first quarter resets. There are things associated with payroll taxes and funding our 401(k), et cetera. But in the second quarter, we're also going to pick up 2 additional months of Clifton compensation. So I think we're more likely to see this as a somewhat normalized run rate.

Our next question comes from Roger Freeman with Barclays Capital.

Just curious of -- within Hexavest and the strong flows that you called out. Is there anything in particular that's driving that, product-wise, that investors have been -- kind of going for?

I guess, I would highlight may be the general factors that attracted us to Hexavest, which is that they've got a very strong, long-term track record. They have a quite differentiated top-down or primarily top-down approach. And they have a generally strong position of better performance in periods of market weakness. And although we've been in the period of market strength, and that's usually the case, they've been underperforming in that environment. There are enough investors out there that are cautious about the long-term outlook that are attracted to that track record and the current positioning of Hexavest, which by the way, remains somewhat defensive. I would add to that, that the growth of Hexavest has certainly been influenced in a positive way by adding the distribution resources of Eaton Vance. And certainly, some of the inflows they've had, Eaton Vance sales team plays a significant role in that. I would also just, in closing, comment that they are in the institutional business and the nature of institutional flows is that they are somewhat lumpy. And I wouldn't necessarily expect that the rate of growth that we've seen over the last 6 months or so since we acquired them will necessarily continue for the near-term. But nonetheless, we see Hexavest as a highly differentiated and attractive manager in the global equity space. And we do see significant room for long-term growth.

Okay, that's helpful. And then on the, first, the tax advantage investing strategies. When do you think that you might see investors really focused on this? Is it a function of all the changes sinking in or is it something that happens maybe more later in the year as we kind of start to [indiscernible] ?

Yes, it's a little hard to pin that down. I think, it's a combination of things. Certainly, as equity markets go up, concerns about capital gains will rise. And so now we've seen the effect of both higher capital gains rates on wealthy taxpayers as well as now increased capital gains. So it's a little hard to say. There's naturally an increased focus on taxes and tax efficiency in, really, 2 times of year. One is as we approach the year-end, but the other one is around tax season. And we're certainly endeavoring as we approach April 15 to make sure that people for whom this is a significant consideration, which is primarily higher income, higher bracket individual taxpayers who've got significant investment income, our focus will be to make sure we're getting the message out, that there are strategies, proven strategies out there for minimizing, deferring or offsetting capital gains and that Parametric and Eaton Vance will broadly have a leading position in that -- in providing that to investors.

Okay. And just lastly, real quickly. The proposal you have down on the active ETF with the SEC, are they focusing on this now? And I think there were some issues with capacity constraints last year.

Capacity constraints within the agency.

Yes, within the agency.

I don't want to comment specifically on where things stand. I think there's been some external developments that have given us encouragement. You might have seen that the news back in December that the SEC has, in effect, lifted the moratorium on ETF, on active ETF, sorry, on approval of new active ETF that have derivatives as part of their investment strategy. I think that's one sign that, perhaps, if there was a backlog at the SEC that, that's starting to abate. And I think generally, there has been increased activity in the area of ETF in new events [ph] of applications that give us hope that if we can pull things together that we, perhaps, can get a better and quicker response than might have been possible in 2011 or 2012.

[Operator Instructions] Our next question comes from Daniel Fannon with Jefferies & Company. Gerald E. O'Hara - Jefferies & Company, Inc., Research Division: It's actually Gerry O'Hara, sitting in for Dan this morning. Just a couple of quick questions. The first is a follow-up on the first. But with the closing of the Atlanta SMID product, are there -- and the growth, clearly strong growth of the bank loan products, is there any capacity issues in those floating rate products that we might -- that we should be aware of?

There is. I would say, probably, in everything we do, there is some level of capacity that's out there. We recently went over $30 billion, if you look at all the assets we have invested in bank loans. Some of that is invested in strict bank loan strategies and some of it shows up in other places. But all told, we, I think, either beginning of this month or sometime last month, passed $30 billion, which is a fairly significant number. The overall size of the U.S. bank loan asset class is about $550 billion. So we're little over 5% of that market. Today, the team seems very comfortable that we've got ample ability to select the loans that we like, ample ability to buy and sell those as needed with adequate liquidity. But there will be a size if -- we don't know quite what that is. But certainly, not something that we expect to be up against over the next couple of quarters. But it's conceivable that given the rapid growth that we've been experiencing, that if the market doesn't grow and we continue to grow, that as we go forward over the next several quarters, this might become a real issue. As we sit today, it is not an issue. But it is certainly something that we're starting to think about. You might recall that there have been at least a couple of occasions in the past where we've gotten close to capacity in bank loans, but never actually had to implement a slowdown in business growth. We may be headed towards that, we're not there yet today. Gerald E. O'Hara - Jefferies & Company, Inc., Research Division: Okay, fair enough. One quick follow-up. Apologies if I missed it. But the $1.6 million in performance fees realized during the quarter, can you potentially give some context as to where this came from and what sort of run rate recurring outside of the fourth quarter we might expect, if any?

Yes. We generally don't have a lot of performance fees. We have this one account is generally every year in the first quarter. We've got another significant account, generally, that we have performance fees, assuming that we actually hit our target in the fourth quarter. So I don't think we really have anything that we're looking at in terms of the second quarter, in terms of [Audio Gap] performances. I wouldn't be baking that into any significant modeling.

Yes, I would just add that our business is somewhat in move -- I'd say, slowly moving more in the direction of performance fees. We have, I believe, no mutual funds that have performance fees that affect our income. But on the institutional side, there are a number of relationships. I would also point out that Hexavest has a fairly significant part of their business that includes a performance component. And also at Clifton, there is an element of performance fees that will affect their business results. Typically, those fees are paid once, annually, under a variety of arrangements, and that introduces a certain level of lumpiness to our revenue numbers, but beyond what we've seen in the past -- hard to predict, obviously, but I expect we'll be seeing somewhat more than we've seen historically.

Our next question comes from Cynthia Mayer with Bank of America Merrill Lynch.

Maybe just another question on comp. You reference sales incentives as a high class problem, but also said you expect the comp levels in the quarter are a new run rate. So I guess, is it possible to quantify the impact of sales incentives in the quarter in terms of the incremental lift? And also, looking ahead in terms of your guidance, what kind of sales level does that assume?

Yes. I don't think we're necessarily -- we're trying to project sales levels and tie the comp to that. We were just making the comment and to the extent that we have increases in sales, and we obviously had a very strong sales quarter, and then we have increases in revenue operating income, we will continue to see increase in comp. I think that, probably, not providing too much detail, but in terms of our total increase over the course of the quarter, I think that business growth is probably responsible for somewhere in the probably 34% -- maybe 35% to 40% of the total increase. So again, we've got -- there were a number of things that we're going into increase this quarter and sales growth was one component of that. I think, as you're trying to look at sequentially, if you're trying to compare fourth quarter to the first quarter, there are a number of resets. And I think that we need to keep that in the back of our minds as we're looking at the overall comp increase.

I guess, I would add one thing, and you may have a follow-up on this. But this one thing is that, one of the reasons that comp is going up is because we did this acquisition, and Laurie said earlier, that, that will increase. We had one quarter's worth of -- one month's worth of Clifton-related comp in the first quarter and we'll have 3 months of Clifton-related comp in the second quarter. But keep in mind, that's going to be offset by 3 months of revenue associated with that business. So in my mind, you have to sort of pull that out and treat that as a separate item and look at the rest of the business. And if you pull that out, from what I see, the increase is driven by, and as Laurie mentioned, 2 primary things: One is, we've had a really strong sales period, by far, the best in company's history. 20% more than we've sold than any other quarter ever. That's one factor. And the other is, sort of normal turn of the year type -- turn of the calendar year type thing related to the fact that most of our employees get increases in base salary that take effect from November 1, relating to the fact that payroll taxes reset for all companies on January 1, relating to the fact that because our income is up, income-based incentives go up. And all those things combined to make this a quarter where we felt unusual pressure on compensation. I don't expect -- we don't expect necessarily that comp rates will go down. But what we do expect is that those same kinds of pressures incrementally won't be the same in the second quarter relative to the first, as they were in the first quarter relative to the fourth.

Okay, great. And then maybe for the second question, you mentioned you did the special, you had an active capital management quarter and you're interested in buying back shares again, but all those factors did affect that. What -- so can you maybe talk a little bit about your philosophy just on share count, overall. Looking out over the year, say, are you interested in trying to keep it steady or allowing it to grow with restricted stock awards? How important is it to you to keep it steady or hold it to a certain growth rate?

We don't necessarily look to keep our share count steady. What we've looked to do is use our cash flow, use the company's free cash flow, to return it to shareholders in an intelligent and advantageous manner. We looked at where we were in December with the likelihood, which actually happened, of tax rates going up on dividends, and felt that this was a good opportunity to divert the direction in which we return cash to shareholders from being long-term primarily more focused on repurchases due in this period to be more focused on dividends. The -- and that was, I think, that was a relief, as far as I know, a universal welcome from our investors, including those who don't pay taxes. But -- so there was this onetime factor there that was a significant draw on our cash during this period that's consistent with the idea this was a special dividend, we don't expect that to recur. So we have this another high-quality problem that -- and as we significantly ramp up our dividend, we have this cash that will start to build on our balance sheet. And certainly, consistent with past practice, we think an efficient intelligent way to return that cash to shareholders is through stock repurchases. And we certainly expect that as the year progresses that we will likely see higher repurchase activity than we did -- than we saw in the first quarter. It's not driven by some goal -- we need to have 115 million fully diluted shares outstanding. It's about trying to use the company's cash resources to best return that to shareholders in the most efficient and highest value way.

Our next question comes from Greggory Warren with Morningstar.

Yes, I'm just wondering how you guys are looking at equity flows. And I see the things improved significantly, and I got to think that part of that was just the change in attitude on the part of the investors in January. But it also looks like your Large-Cap Value Fund, things are trending down, the outflow situation there over the last year. Do you think we potentially get in a situation this year where flows turn positive for equities for you guys?

I mean, it certainly could be. We were, I believe, very close to that in the first quarter. Our -- on an overall basis, just sort of big picture is we've been growing in emerging market and international equities, much of that has been strategies managed by Parametric. And we've been shrinking in U.S. equity strategies. Much of that managed by Eaton Vance, where we've had growth at Atlanta Capital that has been offset by shrinkage, primarily in U.S. Large-Cap Value, driven by our Eaton Vance teams. This is a reminder, that was a strategy that was really a big source of our growth in the 2006 to 2009 period, where we got up to $33 billion in assets. We're now down to about $13 billion. So we think that with the improvement in performance that we've seen and we're significantly ahead of our peer group average over the last 12 months, that given the pressure of a lot of the short-term oriented, performance-sensitive money, a lot of that's already gone, we think that we will see less pressure there on outflows going forward. One of the key parts of our equity strategy, of course, doesn't show up in our consolidated flow numbers and that's Hexavest. Those are all equity flows, primarily, global or global all country mandates, where we've seen an incremental, I think, $2 billion, a little over $2 billion of net flows since they became part of the Eaton Vance family in August. So generally, a better outlook. We think the Parametric strategies have performed well and continue to attract nice flows. The Eaton Vance strategies show signs of stabilizing. One, it's a manageable challenge, but one that relates to an earlier question is we have a closed, other than to new -- we've closed to new investors, I should say, our Eaton and Atlanta Capital, SMID-Cap on, which was a source of significant inflows last year. And we'll see somewhat lower flows there this year, certainly. I would also remind you that a significant part of our equity assets and franchise is what we call tax-managed and is positioned to benefit from an increased focused on tax efficiency and avoidance of capital gains distribution. Some of that shows up in our -- most of that shows up in our equity line. Some of it now also shows up in our implementation services category, which is where Parametric's Tax-Managed Core business now resides on our reporting.

Okay. I mean, it's one of those things that, I think, is -- hung over the stock a little bit in the past. People are a little bit concerned about Large-Cap Value and our take has always been that you guys have got strength throughout the organization that you can compensate for the failings of one particular fund for a period of time. And it's just good to see the trend moving in a more positive direction here. Just a quick follow-up. When we look sort of the fixed income flows, just a straight fixed income, not the floating-rate bank loan funds. It seems to have dropped a bit in the quarter? Do you think that is a reflection of sort of the disinterest we saw in fixed income the last month or so of the year? Or do you think that this was probably a more legitimate run rate as we go forward?

No, and we had a couple of things going on in the quarter. One is munis, for the reasons that we talked about, were very modestly positive and thanks -- it went through a period of net outflows during, I think, it was November and December, when the headlines were about munis, potentially, losing their tax-favored status that we went from inflows into munis to outflows. That's reversed itself, so we're back positive in January and February today, I believe, and muni flows are franchise -- are leading franchise funds, Eaton Vance National Municipal Income has very strong performance and has category leading distribution rates. So I think we're confident that we'll see a better year in munis than where we ended up 2012, the calendar year. I would also say that high-yield is an area that -- is an important business for us. I believe, we were modestly outflows and high yields in the first quarter. And I think that reflect, more than anything, a concern among some investors anyway, that the high-yield asset class is extended and bonds are priced rich. And we've seen some from reallocations of that, that hit us during the quarter. The numbers I'm looking at show that high yields, which has been nicely positive in the fourth quarter, was very modestly negative in the first quarter. So I think, we've got some room for recovery in our reported bond fund or fixed income business. I would also note that in what report as alternatives, we have a mutual fund that's actually one of our strongest -- fastest-growing income funds, called Eaton Vance Diversified Currency Income, we classified as currency and therefore, alternative. But it could also be viewed as an income strategy. It's a nondollar, low duration strategy. And it appeals to -- and I think, the yield on the iShares is something in a 4% range, I believe. But it appeals to investors that want short duration, nondollar sovereign exposure with active management of currencies that are -- exposures into currencies that are expected over the long term to appreciate relative to the dollar. So the promise there, the hope there is that you get a nice current income limited exposure to duration risk, diversification away from the dollar and the potential for price appreciation, capital appreciation and the dollar continues to depreciate against stronger currencies as it has been for the last number of years. So that's a nice product, but that shows up in the alternative category.

Our next question comes from Ken Worthington with JPMorgan Chase. Rahul Nevatia - JP Morgan Chase & Co, Research Division: This is Rahul speaking for Ken this morning. A couple of questions again on performance fees. Performance fees are $1.6 million. Was there an offset here in terms of expenses?

There would have been some. So yes. Rahul Nevatia - JP Morgan Chase & Co, Research Division: Is it possible to quantify it to some extent or...

No, I don't. Not off the top of our heads. I think, it would be a fairly modest direct offset that would show up in the same quarter, but there will be some. Rahul Nevatia - JP Morgan Chase & Co, Research Division: And you mentioned Clifton will also have some sort of performance fees, which kind of lumpy. When do Clifton's performance fees hit the statement? Is it, again, first quarter and the fourth quarter? Or is it only the fourth quarter? Any sense on that?

The biggest relationship they have that has performance fees, I believe, is tied to a June 30 performance a year. So that would fall in our third fiscal quarter. And that's helpful for us to have some staggering across the year, performance fees. We don't like the lumpiness of that any more than investors that are trying to figure out what our earnings -- true earnings power is.

Thank you. I would like to turn the floor back over to management for closing comments.

Great. Well, thank you for joining us this morning. We hope you agree with us that it was a really strong quarter from a business momentum standpoint and one that we hope to continue for the remainder of the year. And we look forward to reporting back to you at the close of our second fiscal quarter. Thank you.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.