Morgan Stanley (MS) Q3 2011 Earnings Report, Transcript and Summary

Greetings, and welcome to the Eaton Vance quarter three fiscal year 2011 earnings release. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instruction) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Dan Cataldo, Manager of Financial Planning and Analysis. Thank you. Mr. Cataldo, you may now begin. Dan Cataldo – Manager of Financial Planning and Analysis: Good morning and welcome to our fiscal third quarter 2011 earnings call and webcast. Here this morning are Tom Faust, Chairman and CEO of Eaton Vance; Bob Whelan, our CFO; and Laurie Hylton, our Chief Accounting Officer. Tom and Bob will comment on the quarter and then we will take your questions. The full release and charts we will refer to during the call are available on our website, eatonvance.com under the heading Press Releases. P`lease be aware that today’s presentation contains forward-looking statements about our business and 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 2010 Annual Report and Form 10-K are available on our website or on request at no charge. I would now like to turn it over to Tom.

Good morning, and thanks everyone for joining us. Eaton Vance earned $0.55 per diluted share in the third quarter of fiscal 2011, up 62% from last year’s third quarter. Even after backing out roughly $0.025 a share of investment gains recognized in the quarter, this was the highest quarterly EPS in the company’s history. We also set new record highs in terms of revenue, adjusted operating income, and net income surpassing the 2007, 2008 pre-bear market highs. As Bob will discuss in more detail, we continue to maintain a strong balance sheet with over $500 million of cash and cash equivalents and nearly $285 million of investments on our books at quarter end. We believe Eaton Vance is exceptionally well positioned for the more challenging market environment that appears to be upon us. As shown on slides two and three of the accompanying PowerPoint presentation, we finished the quarter with $199 billion in managed assets, up 15% from a year ago and down 2% from the $203 billion at the end of the second fiscal quarter. Rising stock and bond markets were a source of asset growth in the first half of the fiscal year, weaker markets were a drag on managed assets in the third quarter, more than offsetting growth from positive net flows. Our exposure to loss of assets in a market decline is mitigated by the diversity of our business, which encompasses equities, fixed income, floating-rate income and alternative investment mandates. The breakdown of our current managed assets by mandate and delivery format is shown on slides four and five. As shown on slide six, our $43.8 billion of gross inflows through the first nine months of the fiscal year puts us on pace to have our best sales year ever. The $13.7 billion of inflows in…

Thank you. We’ll now be conducting question-and-answer session. (Operator Instructions) Thank you. Our first question is from the line of Roger Freeman with Barclays Capital. Please state your question. Steven Truong – Barclays Capital: Good morning. It’s Steven Truong here for Roger. I was wondering if you can talk a little bit more about the institutional channel and some of the trends we are seeing here. You mentioned backlog looks pretty good, what is your sense in terms of the timing of the funding of this backlog? Thank you.

We’ve got visibility, I guess, I would say pretty good through the end of September. And over that timeframe, we’ve got – I guess on a, I’d say, on a gross basis something like $650 million or so of the inflows maybe half that on a net basis. As we stated on the call, these are awarded, but not funded mandates. So, on a net basis, it’s about $300 million through the end of next month, and let’s see, how is that broken down. I guess, the biggest pieces of that, again, I think as we mentioned, are our bank loans, structured emerging markets and some small cap core. Steven Truong – Barclays Capital: Okay, thank you. And my follow-up has to do with the new fund launches, you mentioned three. And where are you in terms of the distributor and putting those funds on some of the platforms? Thank you.

So, these are funds that are not yet launched. And I think one of them we expect to launch around the end of October, the other two at the end of September. So, clearly, we are not in a position today to get these on platform, so it will be a while. I would expect that we want to have them up and running on platforms, I’d say, ambitiously, by the end of the calendar year. Steven Truong – Barclays Capital: Okay, thank you.

Our next question is from the line of Michael Kim with Sandler O’Neill. Please state your question. Michael Kim – Sandler O’Neill: Hey, guys. Good afternoon. First, can you maybe just talk a little bit about the outlook for bank loan funds in the context of persistently low rates and maybe some incremental pressure on NAVs, just given some rising credit risk? And then any color into how flows are maybe tracking thus far in August?

Yeah, we’ve seen certainly a bit of a downtrend. We’ve been in a, I guess I’d say modest outflow mode the last few weeks. If you track the performance of bank loans were down I think maybe 3% or 4% on a NAV on a price basis from the peak, which would have been maybe sometime middle of last month, I am not quite sure of the timing of that, but I think it’s about 4% down from there. Good news and bad news in that, the good news is that spreads which have gotten quite tight where people were saying, look, I’ve got a LIBOR based income stream and a relatively tight spread, while that spread has now come out a little bit as prices have come down. So, there is more opportunity to earn income, to provide income at these modestly lower prices. And of course the other side of that is people have incurred capital losses as the prices have adjusted for what seems to be a pretty rapidly cooling expectation for economic growth going forward both here and abroad. I think from a fundamental perspective, I think you have to say that the corporate sector and issuers of bank loans are really in quite a strong position if we are about to enter into a significant period of economic weakness. Certainly, there has been great repair to corporate balance sheet since the 2008 market downturn, that’s no news to anybody that’s been following the markets closely. So, we feel like the underpinnings of the bank loan market in terms of the quality of the credit is quite good at the moment. We also believe it was amply demonstrated in the last downturn that bank loans can perform very well from a credit perspective given their senior status in the capital structure of the issuers and given the associated collateral that investors can approach the asset class with confident that what people expect is a period of modest or even moderately severe economic weakness. But we're in a bit of I guess recalibration phase in terms of expectations for market growth that’s has affected bank loan prices in the short run, how that sells outs I think will be determined really by how the economy performs and unless it's a severe recession, I think bank loans will prove be a good buy from current level. Michael Kim – Sandler O’Neill: Okay and then maybe just follow-up on expenses. Are there any areas where you think you can maybe tap on the breaks so to speak just assuming the markets continue to be under pressure, maybe it's new hiring or other cost, any color there would be helpful?

I think we're in pretty good shape there. We don’t have any, what I would call major spending initiative that we're in the midst of the hiring that we've done. As Bob suggested a lot of that is just short-term summer hiring in connection with an intern program. One of the nice things about our income statement is that we've got pretty significant percentage of our cost that are effectively built in stabilizers that as to say. We've got our bonus pools are primarily based on operating income levels. So, when pre-bonus operating income comes in, so does that component of our compensation. Similarly when sales go down, sales force compensation and incentive compensation, the sales people goes down and then finally the distribution payments we make either as service fees or as what we call revenue sharing payments, those typically are mostly focused on asset levels and to some degree also on sales. So, we’ve got these built-in stabilizers, but beyond that we don’t really have plans to change direction. Maybe there’ll be some incremental hiring, where the timing of that gets slow down a little bit, but certainly beyond that we’re not looking at any changes in how we're approaching our business. Michael Kim – Sandler O'Neill: Okay. Thanks for taking my questions.

Thank you. Our question is from the line of Ken Worthington of JPMorgan. Please state your question. Ken Worthington – JPMorgan: Hi good morning. So Eaton Vance has been extremely good at getting the sales force behind one or two products, it was large-cap value, then global macro, then the floating-rate products. As you look forward, you mentioned a whole host of products, but is there one or two that you think can be kind of the next global macro fund for Eaton Vance? Like one or two that you just have more confidence in, given the market conditions and market environment? Or is this going to be kind of a changing environment where you mentioned kind of you've got the products for the bullish, the bearish, and the uncertain is it going to be a different dynamic, where you see maybe a number of different products maybe all do okay in generating sales, but no big dominant force? And I guess Parametric seems like it's doing quite well. And Atlanta Capital seems like it's crushing it, so maybe one of those is the area. Thank you.

Yes, it's little hard to call. I think as you suggest it depends a little bit on how the market goes. We touched the market bottom and we go roaring up from here, and equity is the place to be. As you suggest I think Atlanta Capital equity and particularly their Focused Growth and Horizon Growth Fund, both of which are relatively small funds, $100 million or less I believe currently, which have long track records, outstanding track records, and really prime for outstanding growth. I think in that kind of market environment those could become very significant products for us. If it’s a market environment, where people are maybe more bewildered than bullish, I think the range of absolute return strategies that we have Multi-Strategy Absolute Return, Global Macro Advantage, I might suggest that that we’ll have a new absolute return strategy coming out in the fourth quarter. I think those could become a growing part of our business. If we're more of a defensive mode, there are number of fixed income areas that I think are potentially poised for growth. Our Strategic Income Fund is a fund with a long track record going back to the early 90s with high risk adjusted returns that has been a relatively strong performer, particularly in down market environment. I guess I would also point to our muni franchise. People seem to forgotten the turmoil that the muni market within six months ago or nine months ago with the Meredith Whitney call on 60 minutes, but munis for those who have been following have been performing quite well in the current environment, certainly the near-term concerns about the state of municipal finance have diminished considerably and we think that business, both the Eaton Vance more income oriented offerings as well as the…

Hey Ken, this is Dan. We don’t have that number on hand as of yet. I mean you can certainly look back and see what it was fourth quarter of last year. We do anticipate that there will be a charge because they have been having a good year. We just don’t have a number to give you. Ken Worthington – JPMorgan: Okay, worth a shot. Thanks very much.

Thank you. Our next question is from the line of Marc Irizarry with Goldman Sachs. Please state your question. Marc Irizarry – Goldman Sachs: Great, thanks. I might have missed this, but can you just talk about the comp in terms of how much of the comp bucket is variable versus maybe more fixed and then within that how much of it is maybe related to sales-based comp versus more discretionary bonus focus?

Sure. It's Bob Whelan. Thanks for your question, Marc. I’d say of the compensation, at least well over half is variable. And that component relates to the bonus accrual, which relates to how well we're doing in terms of earnings. And then there is, obviously, a sales incentive component related to our sales that also includes our affiliates. So, that's the majority of it. I think if you look at our trends in compensation year-over-year, you'll see that we tempt our based component, which is again the minority piece in line with the increase in average headcount, and again the other components varying with strong sales and with our strong earnings.

I guess I would add that the stock-based component also we view as variable that was recognized on a GAAP basis over, I guess, the five-year period. In terms of what we grant every year obviously that's somewhat depended as well on the performance of the company. Marc Irizarry – Goldman Sachs: Okay. And then, Tom, you mentioned the absolute return strategies and multi-asset class strategies as potential drivers of flows in 2012 and beyond as you rollout some new products there. Could you give just maybe a little more color on how those products will differ from what you already are out there with? Would these be funds on the at multi-asset class side that would maybe use your own funds? How should we think about those new products relative to what you have in the market with?

Well, there are three strategies that as I've talked about, one of them is a Parametric strategy that Parametric offers a variety of what they term structured equity and now structured commodity strategies and the idea was just new fund would be to combined those various strategies together with offsetting hedges so that you are pulling alpha out of multiple strategies and combining those. The nature of their strategies is such that you can do what we believe are reliable back test on the strategies. Certainly, it's been very encouraging from the back test results we’ve seen. Of course, we can’t use those back test results in marketing the fund, but potentially there might be opportunities to take that same strategy to other markets; for example, institutional, where they can get comfortable with the back test results and potentially jumpstart the assets into the strategy. The other two new funds are in different ways extensions or companion products to current offerings. We today, I think people are aware, offer an equity fund sub-advised by Richard Bernstein, who many people will recognize as the long-term Merrill Lynch strategist. That fund has been in the market since, I believe, the end of October of last year and did have roughly $500 million in assets before the market declined. The second fund to be managed or sub-advised by Rich and his team would be an all asset product. So,, the first one is potentially Global Multi-Market Equity Strategy; this is a Global or Multi-Market All Asset Strategies to investing in stock bonds and potentially other assets around the world using his top-down model. And then the third new product is what we call Multi-Strategy All Market, which is an extension of our Multi-Strategy Absolute Return Fund run by our Custom Solutions Group here…

The fee rate, if you go back in time, it’s held pretty steady, steady to up actually year-over-year and a little bit up sequentially. If you look at the mix of business, the mix of business really hasn’t changed, and then I'm looking at just equity percentage of total AUM last year versus this year is essentially 60%. We’ve seen some change in the mix because of a move towards floating rate from fixed income, but that's very slight. I think going forward, a whole bunch of factors come into play, whether it be new funds with attractive economics or some lower fee products maybe a Parametric. So, it's a little bit difficult to predict, but I think the past year has been a good indicator of us being able to maintain a pretty steady effective fee rate.

It is really quite mixed. I talked about the laddered muni opportunity, which we think has potential, big growth potential, but that's likely to be a significantly below average fee. We’re not going to get 50 basis points for managing laddered muni portfolios. As Bob mentioned, some of Parametric’s business, particularly their overlay business, where we did see some growth in the quarter, is at substantially lower than average fee. On the other hand, these absolute return products and Multi-Strategy products tend to be well above average fee and today the balance has been, some products are above average fee, some are below average fee, but the average hasn’t changed materially. We certainly don’t see that trend adjusting meaningfully anytime soon. Marc Irizarry – Goldman Sachs: Okay, great. And if I could just ask one more, where are we in the institutional cycle of redemptions from large cap value? You mentioned that there has been an improvement in performance in recent months, so maybe some of the wheels have been set in motion in terms of replacement activity there. Can you give some sense of where we are in terms of the institutional redemptions from large cap value?

Yeah, I gave just a quick look at our institutional pipeline through the end of next month and that would include large value as well as everything else. So, there is nothing imminent in terms of big departures from large value that we are aware of. And I think people are pretty well understand what the strategy is and how it works and the kind of market environment in which it should perform relatively well and when it should do perhaps less well. And I think we have done a good job of telling people that this is what we do. And without apologies saying that we believe it works over market cycles, but that doesn’t necessarily mean that it works at every given point in the market cycle. People understand that the market seems to reach the bit of an inflection point over the last couple of months. Clearly, both logic and in actual numbers would – so, this is a time when if we’re doing what we’re setting out to do that we will – we should outperform here and that’s what we are doing. So, I am hopeful, maybe naïvely so, but hopeful that the flow trend for large value will improve from here, that’s not to say that it’s performance turns down or there are still some significant investments held either in sub-advisory relationships or institutional relationships, or in various types of route platforms, where somebody says, sorry, time is up and make a decision almost irrespective of where we are in the market, but I can’t comment that, that won’t happen, but I think we are encouraged that the fourth quarter flows at least relative to the market could be better than where we were in the third quarter. If there is a big quite out of equities, I can’t comment that we won’t – that we will be immune from that, but I think generally we feel like that the performance trends takes the pressure off and buys us some time and that in the time that we’ve bought, given the market environment that we see, the more choppy market environment, we ought to shine and ultimately we don’t shine, we’re going to lose even more assets, but we’re confident that that’s certainly not the likely case. Marc Irizarry – Goldman Sachs: Thanks.

Thank you. Our next question is from the line of Bill Katz of Citigroup. Please state your question. Bill Katz – Citigroup: Okay, thanks. Just want to come back to the large cap value discussion for a moment, you mentioned that the last four months, I guess, you are outperforming on a gross basis. So, the question is how is that performance on a net basis? And more of a – how does that fund marketed into the channel? Is it on a net basis or a gross basis?

Well, just to be clear, what I was quoting was the performance over the last four months of our master composite, which I believe encompasses both funds and separate accounts and that those numbers are typically reported on a gross basis, that is, before fees. So, if it’s 90 basis points outperformance, which is what we quoted over four months, and let’s say, you’ve got a fee of, I don’t know, depending on where you are investing in, but if it’s a mutual fund, it would be – I shared, it would be, I don’t know, I don’t have the number handy, but let’s say it’s 80 basis points something like that, maybe 70 basis points. If you take a third of that away over a four-month period that will give you an indication of what the net performance would have been over the period. Again, that’s not precisely the number for the mutual fund though it wouldn’t be very far off from that. But there wouldn’t be over a four-month period, logically, there is not going to be a huge difference between gross and net, but obviously that difference will depend on the specific fee structure of whatever the individual account you are talking about is. Bill Katz – Citigroup: Okay. And then a question in terms of capital, you made some prepared remarks about contrasting 2007 and ‘08, what you did then and what you are doing now, so, a little confused. So, you stepped up the buyback into the quarter, I appreciate that. From here, are you suggesting that you guys are pretty more conservative, given the choppiness of the market or more aggressive on buyback? I am just trying to better understand the strategic direction of capital?

Bill, well Tom, its Bob. We see that as a great opportunity for us with the share price where it is, but the multiple having contracted. We think the stock is cheap, so we’ve been active in the market. We bought about 1 million shares. I think this year we’ve been – our share repurchases have increased. They have increased year-over-year. Our projection is that we will continue to be pretty aggressive in this market environment. I think we have $118 million worth of shares repurchased year-to-date and we can see that going over a good bit more.

I guess, we would contrast, where we are today versus the last time our stock was – our earnings were at a similar level. We hit new record earnings of $0.55 on a share, I think the previous peak was maybe $0.52 or something on a…

$0.52 on an adjusted basis.

$0.52 on an adjusted basis, at that time, our stock price was in the 40s and touched 50 on one day and at the end of October 2007. Lately, our stock price has been in the low 20s. We’ve got as we talked about a lot of money on our balance sheet. We have got strong cash flows and no obvious need to use that cash to support the growth of our business. We think it makes sense to return that money to shareholders and we think buying the stock in the low to mid 20s is the very attractive way for us to do that. Bill Katz – Citigroup: Just one last one, thanks for taking all my questions, a little bit of a modeling question, but I noticed that the deferred sales commission amortization continues to drop. Maybe just a little bit of an outlook there. And just to quantify what you said on the fund side, the $8 million plus, is that a better run rate, all else being equal, absent a big change in volumes?

Bill, I think that trend you are seeing in the amortization will continue. At some point we’ll get – the decline will slow, but we are selling virtually no B share product, less C share product, and no exchange funds. Those are the three contributing products to that amortization number. So, it’s likely that you’re going to continue to see declines. It’s just at some point, given a stable – assuming we have some stable level of C share sales you would expect that to bottom at that rate. Bill Katz – Citigroup: Okay. And then the fund expense, the $8 million plus, is that a good run rate?

The fund expense? Bill Katz – Citigroup: Yes.

That will depend on really the growth of the funds, which that relate to. A large piece of the fund expense is sub-advisory fees. So, to the extent, we have growth in funds that are sub-advised. And when I say that, I mean, the Bernstein products, our commodities product, the Lloyd George products, to the extent you see continued growth in those, that line item will grow. The other component in there which is also fund asset based, our fund expenses related to institutional funds that basically we collect it all in management fee. So, as those – to the extent those fund flow, you would expect that component to grow as well. So, really, it’s based on business growth, primarily specific fund asset growth. Bill Katz – Citigroup: Great, that’s helpful. Thanks for taking all my questions, everyone.

Thank you. Our next question is from the line of Cynthia Mayer with Bank of America. Please state your question. Cynthia Mayer – Bank of America: Hi, good morning. Maybe just couple of follow-up modeling questions, I don’t know who is in the release, but could you give us the ending share count number?

It may just take us a minute to dig that up. Cynthia Mayer – Bank of America: Okay. Do you want me to ask number two?

Yes, go ahead. Cynthia Mayer – Bank of America: Okay. So, then the second question is just on comp. Again, I am wondering – I was just looking back at 4Q ‘08 and it looked like – obviously things were much worse than, but it looked like that quarter, you actually reversed some comp. And I am wondering if assets were to stay a bit lower, whether it’s possible that in the first three quarters of your fiscal year, you’ve over-accrued and you would want to reverse or is comp so sensitive that it basically is fine for where you are at this point?

I think in the fourth quarter of 2008, there was such a drastic drop in the market in our last fiscal – the last month of our fiscal year October that we made a decision to bring cost down to set an expectation going into the next year thinking that the year would be okay, because 11 of 12 months were done, but we’d be starting off at such a difficult level. I think this time around we are obviously keeping an eye in the markets and one of our levers on compensation is to change what we accrue and the percentage that we pay out and we’ll obviously have those discussions. We are not sure that this market correction is of the same magnitude as the last one to warm that, but that’s definitely a lever that we have.

Cynthia, the outstanding share count at the end of the quarter was just over 117 million shares. Cynthia Mayer – Bank of America: Okay, great. Thanks a lot.

Thank you.

Thank you. Our final question is from the line of Douglas Sipkin with Ticonderoga Securities. Please state your question. Douglas Sipkin – Ticonderoga Securities: Yes, thank you and good afternoon, officially. Just wanted to drill down into the institutional flows a little bit more. Can you maybe just provide a little bit of color around how much was sort of the Atlanta Capital strength versus how much was bank loan strength?

Yes, we just have to flip to some pages here. But Atlanta Capital as we talked about at the last call won a big sub-advisory mandate, that’s funded in May and they actually from an institutional standpoint across all categories raised almost $1 billion. So, they had a lot of success there. In terms of the Eaton Vance bank loan discipline, I am just scrolling down the numbers now, but it wasn’t – that’s probably $200 million in net flows in the sub-advisory channel in bank loans. Douglas Sipkin – Ticonderoga Securities: Okay, great. Well, that’s helpful. That’s good color. And then just to follow-up on the large cap value, more specifically, just equity flows. I guess, I mean, given what you guys have sort of been saying and been saying all along, so how should we be thinking about the outflows this quarter? Is it really more a function of just the markets than more than anything else or was there actually some guys saying, hey, okay, the underperformance has gone too long for me, I’m going to look to move elsewhere?

We attributed mostly to the markets. Of course, you never know, people don’t generally tell us why it is they are redeeming or buying either way, but the timing of the increased outflow has been coincident with market declines. And as I think I hinted in my comments, very oftentimes of relative outperformance for Eaton Vance are when markets are weak. So, we think it’s pretty likely that accelerated net outflows are moving to net outflows we have seen those in recent weeks is almost entirely a function of the markets and that’s backed up by industry flow data. Douglas Sipkin – Ticonderoga Securities: Okay, great. Thanks for taking my questions.

Thank you. There are no further questions at this time. I would like to turn the floor back to management for closing comments. Bob Whelan – Chief Financial Officer: Well, thank you for joining us this morning. If you have follow-up questions, please don’t hesitate to call and we’ll look forward to speaking with you in November to report on our full fiscal year end results. Thank you.

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