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Morgan Stanley (NYSE:MS)

F2Q07 Earnings Call

June 20, 2007 11:00 a.m. ET

Executives

David Sidwell - CFO and EVP

Analysts

Guy Moszkowski - Merrill Lynch

William Tanona - Goldman Sachs

Mike Mayo - Deutsche Bank

Douglas Sipkin -Wachovia Securities

Michael Hecht - Banc of America

Meredith Whitney - CIBC World Markets

Roger Freeman - Lehman brothers

Steve Warden - J.P. Morgan Chase

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Operator

Welcome to the Morgan Stanley Conference Call. The following is a live broadcast by Morgan Stanley, and is provided as a courtesy. Please note, that this call is being broadcast on the Internet through the company's website at www.morganstanley.com.

A replay of the call and webcast will be available through the company's website and by phone until July 20, 2007. This presentation may contain forward-looking statements. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the day on which they are made, which reflects management's current estimates, projections, expectations, or beliefs; and which are subject to risks and uncertainties that may cause actual results to differ materially.

Factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to the underlying assumptions and expectations related to the spin-off of Discover Financial Services, proving to be inaccurate or unrealized.

For a discussion of additional risks and uncertainties that may affect the future results of the company, please see “Forward-Looking Statements” immediately preceding Part 1, Item 1, “Competition” and “Regulation” in Part 1, Item 1,”Risk Factors” in Part 1, Item 1A, “Legal Proceedings” in Part 1, Item 3, “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part 2, Item 7, and Quantitative and Qualitative Disclosures About Market Risk” in Part 2, Item 7A of the company's annual report on Form 10-K for the fiscal year ended November 30, 2006.

Management's discussion and analysis of financial condition and results of operations and risk factors in the company's quarterly on form 10-Q for the quarterly period ended February 28, 2007, and other items throughout the form 10-K, and the company's 2007 current reports on form 8-K.

The information provided today may also include certain non-GAAP financial measures. The reconciliations of such measures to the comparable GAAP figures are included in our annual reports on Form 10-K, our quarterly reports on form 10-Q, and our current reports on 8-K, which are available on our website www.morganstanley.com.

Any recording, rebroadcast, or other use of this presentation in whole or in part is strictly prohibited without prior written consent of Morgan Stanley. This presentation is copyrighted and proprietary to Morgan Stanley.

At this time, I would like to turn the program over to David Sidwell for today's call.

David Sidwell

Thanks you Operator, and thanks everyone for joining us today. As you've seen from our press release, we achieved record net revenues, profit before tax, income, and earnings per share from continuing operations.

We are very pleased with these results, as they reflect execution of our strategic growth plans and strong trading performance and client execution in very favorable markets. Markets were strong, and provided good opportunities. Concerns early in quarter about, whether issues in the Subprime market were going to spread dissipated.

Equity markets rose, credit spreads and emerging markets and other markets tightened. The dollar weakened against most currencies, and there was a high level of client activity including in the M&A and financing markets. These factors more than offset the impact of increasing rates around the world.

Let me begin with an overview of our firm-wide results, which are outlined on pages one and two of the financial supplement. Second quarter income from continuing operations was $2.6 billion, which is a record. Record earning per share from continuing operations was $2.45 per share, versus $2.40 in the first quarter.

Diluted earnings per share were $2.45. This compares to $2.51 in the first quarter, which included $0.11 per share in our discontinued operations line related to the sale of Quilter.

Return on equity from continuing operations was 27.5%. Net revenues were a record at $11.5 billion, 5% higher than in the first quarter, which was our previous quarterly record. Total non-interest expenses was $7.6 billion, up 7%. The largest component, compensation benefits expense was $5.2 billion, up from $5 billion for compensation to net revenue ratio of 45%.

Non-compensation expense was $2.4 billion, up 13%, driven primarily by higher professional services and marketing and business development expenses, related to the high level of business activity across all business segments following the traditional seasonal slow down in these types of expenses in the first quarter. And non-compensation to net revenue ratio was 21% this quarter.

Year-to-date, the non-comp ratio is at 20%, a significant improvement over the 23% ratio for the same period last year. Our year-to-date tax rate for continuing operations was 33%, consistent with last year's normalized rate.

Now let me discuss business segment specifics. Turning to Institutional Securities, detailed on page 5 of the supplement, we were very pleased with our results for the quarter. The strength and diversity of our franchise was evident in the quarter, as a sequential drop in fixed income sales and trading was offset by record revenues in investment banking and equity sales and trading.

During the quarter, we moved to real estate investing business from Institutional Securities to Asset Management, to reflect how we now manage this business. The prior results have been restated for this change. Real estate advisory and certain passive limited partnership interests remain in Institutional Securities.

Institutional Securities net revenues of $7.4 billion were our quarterly record, up 4% from our previous record in the first quarter. Non-interest expenses of $4.4 billion increased 4%, driven by the high level of business activity. Profit before tax at $3 billion, also a record, was up 4% from the first quarter's previous record. And the margin of 40% was flat with last quarter.

And finally, we achieved a strong return on equity at 35%. Looking at page 6 of the supplement, investment banking revenues reached a record $1.7 billion, a 65% increase from the first quarter. All categories were significantly higher, versus last quarter and one year ago. Advisory revenues increased 94% to $725 million, which set a record for the firm. Our M&A backlog remains very strong, up sequentially and up even more significantly year-over-year.

Equity underwriting revenues were up 64% to $493 million, our second highest quarter ever. Our equity backlog is up significantly from the first quarter and last years' second quarter, with a strong pipeline of equity offerings across geographies. Fixed income underwriting revenues were a record at $486 million, up 35% from the first quarter driven by M&A and LBO activity.

Our debt backlog also is up quarter-over-quarter and year-over-year. We continue to be optimistic about the prospects for investment banking, and our ability to provide advice, capital and distribution capabilities on behalf of our clients.

Also on page 6 of the supplement, you can see that we had a strong sales and trading quarter, with total revenues of $5 billion, down 9% from our record first quarter. Please note that we have modified our disclosure by adding another sales and trading category. The sum of equity, fixed income and other sales and trading equals the sum of principal trading, commissions, our net interest income on the Institutional Securities income statement on page 5.

Equity sales and trading revenues of $2.2 billion were a record slightly higher than our previous record last quarter, reflecting strong revenue growth across client businesses in all regions which more than offset lower revenues from robust levels last quarter in principal strategies.

Cash equities revenues were up 20%, driven by rising stock market industries and strong client volumes across all regions. Derivative revenues increased 2% to a new record, because of higher client flows and new deal activity across all regions.

Financing products increased significantly during the quarter, driven by increased seasonal activity in Europe and growth in client business, given the favorable market conditions. This was a record quarter in prime brokerage, with revenues up substantially on both new accounts and the 17th consecutive quarter of growth in global client balances.

In fixed income sales and trading, $2.9 billion in revenues was our second best quarter ever, down 16% from our record first quarter results, which included favorable positioning in the Subprime Mortgage Market. We saw healthy trading performance and good levels of client activity across our fixed income business, across regions.

Looking at the results by product area, interest rate and currencies dropped slightly. We have record results in emerging markets. Most emerging markets rallied, and credit spreads tightened to historic lows during the quarter, providing good trading opportunities.

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In addition, there were significant from structured transactions. Credit products declined 24% from a record in the first quarter, which included record securitized product revenues driven by favorable positioning in the Subprime Mortgage Markets. The decline this quarter was driven by lower volumes and volatility in the mortgage markets.

This decrease was partially offset by record corporate credit results, driven by large structured transactions and trading activity. Commodities decreased 22%, driven by weaker positioning revenues in electricity and natural gas and less revenue from structured transactions across all business lines, offset somewhat by strong oil liquids performance that was flat with the first quarter.

Principal transaction's investment revenues were $396 million, a $46 million increase. The increase was primarily driven by mark-ups of principal investments, real estate limited partnership investments, and the revenue growth associated with certain employee deferred compensation and current investment plans to reflect the returns on such plans in both revenues and compensation expense.

Over the quarter while we increased the level of risk, on average we operated at a lower value of risk level than last quarter. Aggregate average trading and non-trading value of risk was down $5 million to $87 million. With decreases in equities and commodities risk and slight increases in foreign exchange and interest rate and credit spread risk. As well as to reduce co-relation within the portfolio which increased the diversification benefit.

Period end aggregate trading and non-trading value of risk rose to $93 million. As we increased risk exposure during the last two part of the quarter to balance the level of risk without view of market opportunities and the needs of our clients. Stress testing scenarios, which help us manage less liquid risk showed a similar trend over the quarter. We continued to allocate more economic capital to our Institutional Securities businesses which is another measure of our increasing risk as well as the increasing scale of this business segment.

In the quarter total loans and commitments rose by $26 billion, compared to where we were last year at this time. Total loans and commitments, net of hedges have increased by $34.4 billion or 167%. Non-investment grade loans and commitments have increased by $25.3 billion.

We continue to see considerable opportunities to bundle services providing solutions for client's need including event lending as we grow our Leveraged Finance business. The current market plays to our strength through the spectrum of services we provide to our clients, including advising, structuring transactions and distribution capabilities.

Now turning to page 8 of the financial supplement and our Global Wealth Management business. This quarter represent our best quarter in terms of net revenues since 2000. Revenues reached $1.6 billion up 9% from the first quarter and is our third best revenue quarter reflecting higher commissions due to continuation of the favorable market, increased asset management revenues largely from higher balances in fee-based accounts, higher net interest due to the growth in the bank deposit program as well as gains from investments in memberships and exchanges. Non-interest expenses of $1.4 billion were up 7% reflecting higher incentive-based compensation costs associated with improved performance as well as higher professional services, marketing and business development costs from the seasonally lower first quarter.

Profit before tax of $269 million was up 17% and profit before tax margin increased to 16% from 15%. Return on equity increased to 41% reflecting the improved profit before tax as well as slightly lower capital requirements. This business continues to build on its momentum showing improvements in many areas.

On page 9, you can see this in a number of productivity measures. Net new assets of $8.7 billion represented our fifth consecutive quarter of client inflows and the highest it has been since we started tracking this metric. Assets in the $1 million plus household segment increased by $33 billion and a 71% of our total client assets base versus 65% at this point last year. Total client assets increased to $728 billion and fee-based access represented 29% of the total.

Our FA headcount is up to over 8100 producer. Average production increased to a record $814,000 per global representative as we continue to attract and retain high quality producers. Total client assets per global representative also reached a record high of $89 million. Our banks deposit program continued to grow ending the quarter to over $18 million, on-track to achieve our goal of $20 billion by year-end.

We had another successful product launch in coordination with Asset Management. The Morgan Stanley emerging markets debt fund with sales of $1.3 billion. Finally the introduction of more lending products to our clients continues. For example our portfolio loan account which was introduced in November reached over $1 billion in credit line.

Let me turn to our Asset Management business which now includes the results for our real estate investing business formally reported in Institutional Securities. We decided to move this business from our Investment Banking division strategically aligning it with Asset Management alongside our equities, fixed income and alternative offerings to clients, as real estate has matured and become a primary alternative asset class.

The Asset Management business overall, we posted $9.3 billion of positive flows for the quarter. Our third consecutive quarter positive flows are more than double the first quarter. This positive trend in that flows along with strong market performance have contributed to our record assets under management of $560 billion at quarter-end, up 7% from last quarter which is evidence of the progress we are making on our key initiative and the momentum being built in the business.

As you see on page 10 of the supplement net revenues of $1.5 billion were a record and up 10%. Income before taxes was $306 million down 20%, profit before tax margin was 20%, and return on equity decreased to 23% driven by an increase in expenses and higher capital usage. Management and administration fees increased 10% to $844 million largely driven by higher assets under management in our core traditional equities and fixed income businesses as well as higher incentive fees in our alternatives business.

Principal transaction investment revenues of $588 million were 11% higher than last quarter. This quarter includes $308 million in revenue from real estate and $183 million from private equity with notable trend in our on going Asia Private Equity business as well as from the wind down portfolio. These numbers include the gross-up in employee deferred compensation related to these businesses, which are offset by an equivalent gross-up in compensation.

Principal transactions investment revenues will be a growing but lumpy in nature part of our revenue as we build our real estate, private equity and infrastructure businesses. Expenses of $1.2 billion were up 22% driven by a number of factors. Higher compensation was a result of higher revenues, the continued investment in the business across the core alternative, private equity and infrastructure, and the gross-up of employee deferred compensation plan. In addition, there were increases in professional services and brokerage and clearing expenses driven both by the increase in asset management and administration fees and the recognition of up front costs associated with the launch of products in our fixed income and infrastructure businesses. Our expectations for the 2007 full year had been for PBT margins to be around 20% as we invest in our strategic growth initiative.

With the transfer of the real estate investing business to this segment and the strong principal transactions investment revenues in the first half of the year, we believe the margin could come in a few points better.

Turning to page 11 of the supplement, you can see assets under management or supervision increased by $39 billion to the end the quarter at a record $560 billion. The alternative category now includes real estate investing, private equity and infrastructure partners; in addition to the hedge fund and other alternative offerings previously disclosed in this category.

We had $9.3 billion in total net inflows, which marks our third consecutive quarter of net asset inflows. Positive net flows were driven by strength in the non-U.S. channel with $4.1 billion of inflows, institutional liquidity with $3.5 billion, $1.8 billion in the America's intermediary channel and $1.3 billion in the U.S. institutional channel. Retail liquidity outflows were $1.5 billion. Morgan Stanley branded retail fund flows were slightly positive in the quarter for the first time in six years, driven by sales of $1.4 billion from our emerging markets domestic debt closed-end fund. The majority of which was distributed through our Global Wealth Management sales force.

In addition to the impact of positive flows across market channels, we saw the benefit of strong markets. We continue to broaden our products offerings and launch an incubated 15 new products including five in alternatives, six in equities, and four in fixed income. We will continue to launch products to meet the needs of our clients. For example, our recently launched FX Alpha Plus Risk Controlled fund, part of a new suite of alternative strategies, raised over $1 billion from European clients in the three months since launch.

In summary, we are pleased with the traction we are getting with our investments for long-term growth, including product expansion and alternative and the progress we are making in developing our private equity and infrastructure businesses. Results for our Discover business are detailed on pages 13 and 14 of the supplement. Financial information and statistical data follow on page 15.

Profit before tax decreased 10% to $333 million from last quarter. While net revenues of $1 billion were up slightly, expenses of $702 million were up 8%, driving the decrease in PBT.

Looking first at revenues, interest income increased 2% to $970 million due to high interest spread. The yield was up slightly from last quarter and the cost of funds was stable. Non-interest revenues increased by $39 million to $596 million. While fees were flat, gains on securitizations were higher as we did more securitizations than in the first quarter. Net credit income was down 6% to $439 million. The increase in interest income was offset by the provision for loan losses, which was $531 million was up 10%, reflecting an increase in charge-off to 4.24% from 4.05% in the first quarter.

In addition, the reserve release of $6 million was lower than last quarter. The consumer credit environment in the United Kingdom remains challenging. During the quarter, we took $16 million increase in reserves related to implementation of higher minimum payment requirements on certain accounts. In the UK, the net charge-off rate of 6.5% increased 5 basis points from the first quarter. Having said this, across the entire portfolio, 30-day delinquencies decreased to all-time lows. And while there was a pick up in U.S. bankruptcy filings during the last months of the quarter, filings still remained below normalized levels.

Consistent with the industry, our U.S. bankruptcies have not returned to higher levels as quickly as we had expected. It is likely that Discover will finish 2007 at the lower end of the previously expected charge-off rate range of 4% to 4.5% for the full year.

Turning to expenses, non-interest expense increased 8%, driven by higher professional services fees and other expenses; including $20 million in spin related expenses, split equally between our U.S. and U.K. businesses, and higher VISA and MasterCard litigation legal fees.

Discover anticipates an additional $30 million in expenses to be incurred as a standalone company in the second half of 2007, related to the spin. Marketing and business development costs were flat relative to the first quarter, are tracking up 8% for the first six months versus the same time last year.

Discover expects marketing and business development spending to be higher in the second half of the year. Although, full year spend will be similar to 2006.

Period end receivable showed sequential organic growth for the fifth consecutive quarter, due to increased net sales volume and stable payment rates. In some, our U.S. business is performing well, with sales and receivables expected to continue to grow, and strong credit performance expected to continue. While loan losses are expected to gradually increase as bankruptcies trend towards more normal levels.

In the UK, we are working hard to limit the impact we are facing due to the adverse credit environment, which has produced a significant profit before tax loss of $64 million in the quarter, following a loss in the first quarter.

As I previously mentioned and as discussed in its Form 10, Discover will incur a higher funding cost and certain compensation cost, as it operates as a standalone company.

Finally, regarding the spin-off of Discover. We are on track to complete the spin on June 30 with attributable capital of approximately $5.4 billion. Beginning in the third quarter, Discover's June results will be reported in discontinued operations, and prior period results will be reclassified to that line.

Certain overhead costs previously charged to Discover in periods prior to the spin will be reallocated to the continuing businesses, and restated in previously issued financial statements. These charges are approximately $20 million per quarter. Discover will be issuing a supplemental earnings release for the second quarter later today.

Finally, we expect Morgan Stanley's effective tax rate from continuing operations will decrease slightly and share count will be slightly higher following the spin.

During the quarter, Morgan Stanley repurchased approximately 18 million shares of its common stock for approximately $1.4 billion. And year-to-date, we have repurchased approximately 33 million shares of common stock for approximately $2.6 billion.

With respect to the pace of repurchases, we evaluate and balance the needs of our business for additional capital to invest in organic growth and make attractive acquisitions with our objective over time of offsetting the dilutive impact in equity compensation to employees.

We have $3.4 billion remaining under our current board authorization. Finally the outlook. The markets have generally remained very healthy, despite recent interest rate hikes and weakness in U.S. residential mortgage markets. Global liquidity remained strong, with large pools of uninvested capital, and the capital markets continue to have a brisk level of activity.

I mentioned earlier, that our investment banking pipelines across advisory, equities and fixed income are strong. In addition, the level of client activity in our sales and trading businesses remains strong. Obviously, results in our principal investment activities will depend on the overall level of the markets.

While I cannot predict our short-term performance, we will have very tough comparisons given the significant strength we demonstrated in the first six months of 2007. Any slowdown, will lead to a tough sequential comparison. In addition, the third quarter tends to be seasonally slower, both on the retail and institutional side.

Having said that, we remain optimistic about the future for Morgan Stanley. We continue to invest in the long-term growth of our businesses, and believe we are well-positioned to deliver value to shareholders, as we implemented our strategy to capture the substantial growth opportunities we see around the globe.

So, that's the end of my formal remarks, and I'll very happily take your questions.

Question-and-Answer Session

Operator

Ladies and gentleman, please stand by for the question-and-answer portion of today's presentation. Thank you, your conference will resume momentarily. The first question comes from the line of Guy Moszkowski with Merrill Lynch.

Guy Moszkowski - Merrill Lynch

Good morning David.

David Sidwell

Good morning Guy.

Guy Moszkowski - Merrill Lynch

I was wondering if you could talk through the rationale on the funded and committed loan balances up 41% with the hedges up only 15%, so your net position is obviously up considerably granted more of that growth in investment grade. But, again, may be you can talk through the rationale for increasing your net unhedged exposure by quite a bit?

David Sidwell

Okay. So let me provide the context which is really the business context. As you know, we have been very focused on building out the product offerings for our clients, and we continue to see very good opportunities to provide solutions to our clients, and that would include advisory services, M&A broadly, as well as providing of leveraged finance and ultimately distribution.

That is really the context for this business. If you remember we identified this as an area that we had not invested sufficiently in, and we have been making that investment.

We have been as a result of that growing the balances that as are as a result of continuing that activity. Obviously to the extent that we can hedge the exposure we do. Obviously we actively risk manage the portfolio in terms of making sure that we maintain very high credit standards. We, in all cases understand how the extension of credit fits within the overall strategy for the clients, and the revenues we get from this bundled service. And finally, we focused on our ability to distribute.

So, this increase, while I know on paper it looks very significant, is part of what has been an essential part of continuing to develop the business in support of our clients.

Guy Moszkowski - Merrill Lynch

Thanks for that. Moving onto, more broadly, the deployment of excess unallocated capital. Obviously you brought that balance down I guess on an average basis for the quarter, pretty meaningfully from about $5.1 billion to about $4.2 billion. May be you can just comment at a very high level of how you think about the split between redeploying some of that in the businesses in the quarter versus sort of net share repurchase?

David Sidwell

Okay. There has been no change in philosophy, which I think is a good place to start. I think you've heard me say a number of times that every quarter, we look at the future expectation around the generation of equity which is primarily through earnings as well as on exercise of options, but it's primarily earnings, the uses of capital which would include our dividend payments, and also both the organic and acquisition needs of our various businesses.

And obviously as you say when you look at the second quarter, you had a mixture of uses of capital across our institutional business and our asset management business as we did that.

So what we do each quarter is look at our expectations going out and determine an amount of share repurchases that we feel comfortable with. And that determination also considers the price of our stock. So that we very actively manage our capital base and we actively manage our share repurchases within the context of the approval we receive from our board which was to buyback $6 billion worth over the 18 months period till the end of June 2008.

Guy Moszkowski - Merrill Lynch

And David just a follow up on that, in terms of how we should think about the reduction in excess capital that you achieved during the quarter. How would you divide that reduction of almost $1 billion up between the net share repurchase and redeployment into the business?

David Sidwell

Well actually as you know the amount we repurchased. You also know the amount that we paid in dividend. And the math is simple. You can see that we deployed for instance in Institutional Securities an additional on average $2.8 billion. We deployed an additional $400 million in asset management.

Guy Moszkowski - Merrill Lynch

Yeah, okay. I am just trying to get the idea that since the net reduction is less than those amounts, there must be sort of a calculus more or less, as to, where you got the share repurchase and the payment of the dividend.

David Sidwell

Those are the other ingredients you need to do the math.

Guy Moszkowski - Merrill Lynch

Okay. I won't beat the horse on that one. The final question I have for you is, can you just give us a sense for the international revenue contribution ex-Discover, and perhaps if we could just grow it down to just the institutional business to what percentage would that be?

David Sidwell

Overall as you know our Discover business is primarily a US business. We are again using our year-to-date revenue, which I think is a better place to go using our full firm 58% of our businesses in the US. That has actually decreased from around 60% to 61% in '06.

Europe has seen the increase and that Europe is around 30%, it was around 26%, and the balance is Asia, which has been around 12% consistently in both timeframes. To be honest, I haven't done the math to take out the Discover revenues, but on balance, they've had revenues of just over $1 billion in the quarter. So I don't think it changes these trends usually.

Guy Moszkowski - Merrill Lynch

Okay great. Thanks very much David. I appreciate it.

David Sidwell

Sure.

Operator

Thank you, sir. Our next question comes from the line of William Tanona with Goldman Sachs.

William Tanona - Goldman Sachs

Hi David.

David Sidwell

Hi.

William Tanona - Goldman Sachs

You know obviously investment banking was very, very strong this quarter and you have highlighted your record investment banking pipeline. But I guess was there anything in this quarter that was of meaningful significance one or two deals that we should be thinking about and as we kind of look ahead to the next couple of quarters. I know it's a record pipeline but is it realistic to kind of just assume that this is a new run rate?

David Sidwell

Well I think I'd always make the caveat that the actual timing of when the pipeline shows up in revenues is always subject to the specifics of any deal. I think the point I would make across all of the investment banking businesses whether with advisory, equity or debt was the diversification and that would include across all of the regions did really very well. I would say that the pipeline is also very well diversified.

William Tanona - Goldman Sachs

Okay and then if we can switch gears a little bit and go towards the Investment Management business. I know you guys have been targeting people to a low 20% margins but I think that was kind of everybody's expectations was that would be prior to the reallocating of the business from securities into investment management. So looking at that I was surprised to see margins going down so dramatically considering that you had some investment gains there and given the hedge funds that you had purchased and I know you kind of gave us updated guidance but why is the core business margins going down so dramatically it appears?

David Sidwell

Well I think that and I hope we've been recently fair about this. This was why we had actually said that the margin would trend to 20% over the last couple of quarters when we have given guidance is because we are continuing to make investments not just in our Private Equity business which as you know we are just in the process of building the team there, in building out the team in our infrastructure funds business, but also given the nature of the range from the acquisitions or some of the alternatives. I think, we also indicated that the payouts would be higher compared with revenues in the near-term as we earn our provisions in a number of those transactions. So, I think our expectation was that margins were going to be lower. I think you are right that the investment revenues have benefited from just a very robust market conditions and that's why I said a little bit ago that we would expect the margins to potentially be a few points higher than the 20% guidance that we had given and that obviously includes the benefit of moving the real estate investing business into this business.

William Tanona - Goldman Sachs

Okay. And as you think about this business in a little bit of a longer term perspective given knowing all the investments that you are making. I mean how long do think it is before you actually start seeing industry like margins particularly as you move more into these alternative space?

David Sidwell

I think we are talking three to five years. I think that's what Owen said when we spoke at a conference couple of months ago. And I think obviously we have actually received the benefit of this fairly significant investment gains and obviously by nature they are going to be fairly lumpy. So, at the movement from this sort of 20, low 20's margin to get to the high 20's low 30's it's definitely going to take some time.

William Tanona - Goldman Sachs

Okay and then on the flow side can you give us some color as to how much of that came from alternatives and you mentioned a bunch of new fund launches and so just to get a perspective as to where those fund flows are coming by product.

David Sidwell

Of the $9.3 billion about a third was in real estate and the other largest component was from core.

William Tanona - Goldman Sachs

Great. And then lastly, in terms of non-compensation expenses, I know historically we have always seen seasonality on the revenue side but also on the non-comp side with non-comp expenses being higher in the back half of the year what would be your kind of expectations for this year on the non-comp side?

David Sidwell

Well I think we have seen obviously extremely strong revenue environment over the first half of the year and to the extent that, that pace would continue, certainly many of the expenses are related to the level of activity whether in brokerage and clearing whether it is in some of the T&Es as people travel around the world to get the business. I think that you're right the first quarter tends to be the lowest and you see an improvement during or an increase over the rest of the year. We are trying to stay very focused on having a non-comp to revenue ratio be a little better than it was last year. But I think what's important to realize is that we continue to invest in people in the space needed to house those people relate to technology as we are very optimistic long-term about the markets we're operating in.

William Tanona - Goldman Sachs

That's helpful. Thanks David.

David Sidwell

Sure.

Operator

Thank you, sir. Our next question is from the line of Mike Mayo with Deutsche Bank.

Mike Mayo - Deutsche Bank

Good morning.

David Sidwell

Hey Mike.

Mike Mayo - Deutsche Bank

Just to clarify, are your backlogs at record levels or just up from the first quarter?

David Sidwell

They are up substantially, and to be candid, I don't have a long enough file back in history to make sure when I use the word record. So, they are up substantially, both from this time last year and from the first quarter.

Mike Mayo - Deutsche Bank

Okay, so in recent history they are record at least.

David Sidwell

They are very good.

Mike Mayo - Deutsche Bank

Then another follow-up; your non-U.S., 42% outside the U.S., what was the growth rate of the U.S. versus non-U.S.?

David Sidwell

The growth rate was obviously higher in Europe than in the U.S. As I said, Europe is about 30% of our business, the U.S. 58%. So, by definition the growth rate is higher in Europe than in the U.S.

Mike Mayo - Deutsche Bank

At linked quarter, was that true? In other words, your revenues were up about 5% linked quarter, what were they up linked quarter right outside the U.S.?

David Sidwell

Actually looking at the 6% months, the trends were stronger in the first three months in the second half in terms of the growth in Europe. But again, I just think that given the nature of our business and where we bought trading revenues, I personally preferred to use it for the longest time series I can. So, I feel better with the year-to-date data than single quarters.

Mike Mayo - Deutsche Bank

And, do you have any target of where you think non-U.S. might go, especially with the spin of Discover, it's going to be close to half non-U.S.?

David Sidwell

Over time, we believe that the market opportunities in the emerging markets are very significant and the pace of growth in those markets can be and are likely to be significantly higher than they are in the U.S. and developed Europe. Obviously in the near-term, the profit pulls in the U.S. and developed Europe by definition are much larger. So, you are going to see us continuing to invest in both the developed markets and the emerging markets. So, actually how this mix will change overtime is really going to be a balance of the opportunities.

But we are, just so I leave no doubt here, we are intent on investing outside of U.S. and developed Europe and I think you've heard us talk about the investment we are making in China, the investment we are making in India as we got out of our joint venture arrangements, investment we are making in East Europe and we continue to stay very focused on Latin America. Russia has been a very significant area where Morgan Stanley and Russia is a full service firm and feels and looks like a very full service firm. So, we are very committed to developing non-U.S. and non-developed Europe business.

Mike Mayo - Deutsche Bank

And lastly, the brokerage business obviously you are doing some things on your own revenues to refer up. But how is the environment?

David Sidwell

It's actually I think of the environment in Wealth Management really from two perspectives. One is, ad business and I think that if James was on the phone, he would say that the business is definitely stabilized. But, when you think about the term over that the firm went through, that obviously resulted in attrition of some very good people and difficulty to recruit talent as you saw from the fact that we increased our FA count to H-100, and that was an increase over the first quarter. That reflects both our success in retaining people and in recruiting people. That's very important.

The second aspect is that we continue to focus on developing the products that are of interest to our clients for the fact that when we launched this emerging market's debt product in the quarter, it was so successful with our Wealth Management clients, a massive demonstration of the types of things we are trying to do. As we target this $1 million plus household range. It's going to be very important to offer them product they want.

The third aspect of the environment is obviously the market at whole. And I think we've been very pleased with the level of investor activity. Also I would highlight that in terms of the mix of our business on fee the amount of fee-based business is a proportion to total is also higher than it's ever been and that's a very important metrics going forward.

Mike Mayo - Deutsche Bank

Thank you

Operator

Thank you, Sir. Our next question comes from the line of Douglas Sipkin with Wachovia.

Douglas Sipkin -Wachovia Securities

Yeah, hi, good morning. How are you?

David Sidwell

Hi, good morning Doug.

Douglas Sipkin -Wachovia Securities

Just a couple of questions here. First off, on the equity trading business. Just hoping you can may be shed some light on how big of the factor be sort of extension products, either 130 or 30's are starting to be common. What sort of opportunity can that be for you guys and on the prime brokerage sides given that you are pretty much the leading firm in world.

David Sidwell

Well, prime brokerage as I said, we had record results this quarter on the growth in both balances and new clients. So, prime brokerage is something that we view as a very strategically important business. We think that we have a leadership position in the market, and we are going to continue to invest in prime brokerage to support our clients.

Douglas Sipkin -Wachovia Securities

I mean just 130 -- 30 is that a significant long-term opportunity for you guys or sort of an incremental positive?

David Sidwell

To be honest, I am sorry I just don't have that detail on my fingertips.

Douglas Sipkin -Wachovia Securities

Okay. No problem. And then just moving over to the retail segment. Obviously you guys have made a lot of strides there. Just looking for a couple of points, one; margin 16%, can you just update us on what your targets for that are, and two; given that you really have turned the business around 180, I mean are you guys in a position maybe you would start considering growing inorganically in that segment?

David Sidwell

Look we're incredibly pleased with getting the margins to 16%. And I think what is relevant here is that it was 15% in the first quarter, and we feel that we have reached a level of stabilization, which is important.

We continue to develop the products array to support our clients and that includes new products offerings by the emerging markets, [Debt] offering. We continue to be very focused on extending into products where we have not had very large balances like banking products, lending products. I mentioned one of them in my prepared remarks. And we continue to stay very focused on additionally penetrating the million plus household range, both with new clients and increasing share of our existing clients.

To some degree that would depend on further growth in people, and so we're very optimistic with the headcount increases that we saw this quarter.

It's going to be combination of those factors which is going to enable us to increase our margins overtime. We've had an extraordinary pace of improvement over the last 15 months since James joined. I don't think the pace is necessarily going to continue as fast, although we remain very optimistic that we're going to get to where we need to get.

On the question of inorganic opportunities, I think we will continue to consider those opportunities. I think you've heard me talk about our willingness to do that in the past, and obviously now the US business is stabilized. We are very focused on developing international, private wealth management business and we would love to have a larger private bank for instance in Europe.

Douglas Sipkin -Wachovia Securities

Okay. And then just finally how should we be thinking about the potential change in the SEC role or a lack thereof around fee-based accounts. I mean how if at all will that impact Morgan Stanley's wealth management business?

David Sidwell

The short answer is, we don't believe it will have a significant impact. Probably the major reason is that, the clients that we have using this product, we believe that those clients will move their assets in to different products. And secondly which is more defensive answer, it's a relatively small percentage of our assets, 5% would be an upward number for that.

Douglas Sipkin -Wachovia Securities

Great. Thanks for taking my questions.

David Sidwell

Sure.

Operator

Thank you, sir. Our next question comes from the line of Michael Hecht with Banc Of America.

Michael Hecht - Banc of America

Hey David. Good morning. How're you doing?

David Sidwell

Good morning.

Michael Hecht - Banc of America

I know you are with us till the end of the year, but congratulations on your announcement of your recent retirement

David Sidwell

Thank you very much. Although you know I wouldn't retire if it was going to be these record results every quarter.

Michael Hecht - Banc of America

Right. And I just wanted to come back on the ROE. I mean on overall basis this quarter 27.5%, 34% for the non-Discover businesses. But I am just trying to think about the new continued [ops] ROE we given that Discover was only 16% ROE. Do have like what the ROE was excluding Discover, I guess kind of including the excess capital you guys have.

David Sidwell

I can obviously do the math for you, which is, it's basically, if you allocate which I think is the right way of doing this all of the unallocated capital to the securities businesses. You will see that that changes ROE by a couple of point. So the 27.5 would move to 29.5.

Michael Hecht - Banc of America

Okay. Great that's helpful. On the asset management business, do you have a run rate margin for that business excluding the investment gains, and I guess incremental expenses obviously you referred to just kind of stripping that out.

David Sidwell

I am sorry would you repeat that question, please.

Michael Hecht - Banc of America

Sure. On the asset management side kind of a run rate margin excluding the investment gain this quarter?

David Sidwell

We don't think we have the business that way, I think is the right answer. As we have now focused on building our private equity business, building our alternative business, building our infrastructure business as well as moving in real estate, I think we recognize that there was going to be some lumpiness in the way those revenues come in. And so, I think that while we are very focused on improving margins overall, we are doing that by looking overall as oppose to trying part the business into sub parts.

Michael Hecht - Banc of America

Okay. That's fair enough. Just to come back on the retail margin this quarter. I mean it's 16% this quarter versus 15% last quarter, and it just seems they are tracking higher than we expected and even increasing kind of more quickly. So, should we be thinking about the first half margins here as more of a run rate, and any change in terms of timing and longer term goals you guys have been thinking about in that business.

David Sidwell

Well we would hope that 15 is a sort of new floor, its probably the way I think of it, but we'd expect to do better than that. But obviously, we want to make sure we are making the right investment in the business. But we would obviously update you if we see anything that would impact margin from making additional investments. But I think we believe that it should be possible at this point to have a margin higher than 15.

Michael Hecht - Banc of America

Okay. And then just one more follow-up on retail. Can you talk a little about the recruiting trends for brokers, and how aggressive you guys are being today, and then any color just on the competitive environment you are seeing?

David Sidwell

Well, a part of the reason that our headcount has increased in wealth management has been that we've continued to match the pace of recruiting that we had been seeing in the first quarter, and also that we've continued to see a decrease in the level of attrition. Obviously, we would expect to continue to recruit going forward, and we make sure that we feel comfortable with the compensation arrangements that we make with the people that we bring on board.

Michael Hecht - Banc of America

Okay, that's fair enough. And then just last question, I just wanted a follow-up on Discover, the $30 million of incremental expense you talked about second half. That's a second half run rate and does that include allocation of Morgan Stanley overhead in funding costs or what's kind of in there?

David Sidwell

The $30 million does not include that funding costs, and is the incremental cost like consulting and other costs to do all the things they need to do to continue to operate as a standalone company.

Michael Hecht - Banc of America

Okay I got it. Thanks.

David Sidwell

Not allocations from us.

Michael Hecht - Banc of America

Got it. Okay. Thanks a lot.

Operator

Thank you, sir. Our next question comes from the line of Meredith Whitney with CIBC World Markets.

Meredith Whitney - CIBC World Markets

Hi David, how are you?

David Sidwell

Excellent thank you. And you?

Meredith Whitney - CIBC World Markets

I am good, thank you. I wanted to ask you to go all the way back to the beginning of the call and ask you a related question on Guy's comment and then tie it back to last quarter's conference call when you were gracious enough to talk about the velocity of the loan balances.

And if you could provide similar commentary this quarter and update if things have changed materially or things are identical, that would be helpful. And then also you talked about the full product solution for your clients. And it is remarkable on terms of the market shares that you and Goldman possess in Global M&A.

Can you talk about how the ability to do this has solidified your market share in these businesses over the last even two years? I mean could you give some qualitative comments talking about the advantages of this strategy?

David Sidwell

Okay.

Meredith Whitney - CIBC World Markets

Be helpful, thanks.

David Sidwell

Let me start with your first question which was about the velocity, and I would say there has not been from our perspective a significant change in that on balance for three months was the guidance I gave in the first quarter and I'd say that, that term holds true.

Today, obviously our strategy here is to distribute this product. In terms of how important these activities are to the M&A markets; they are extremely important. Because if you look at where advice is being given, it is in the category that is then requiring financing. So if we had not put resources against this sector both in terms of client coverage in terms of the clients who are originating these activities and also make sure we were aligning the our advisory business and our leveraged lending with that. I don't think you would have seen us as successful as we have been over the last couple of years. This was a very important part of our strategic growth initiative and to be candid we would be nowhere near as well placed in terms of the lead tables and that would include equities because IPOs tend to be the excess strategy.

Meredith Whitney - CIBC World Markets

Okay and then just one follow-up on that, which is you guys have a good reputation over it's management can you talk about then if a larger commercial bank would want to come and tend to offer the same type of packaging and full resource product offering. Let's say you or Goldman would, what you are seeing in the market place and very decidedly what you are not doing versus what they are doing and getting into even some of the bridge equity commentary and then I am done.

David Sidwell

Okay, that was a big question. Look these are incredibly competitive markets and the competitors, and you can see this from the lead tables are clear and that include at the top of the table the commercial banks and then the investment banks at the lower to large commercial banks. You obviously are competing with people who are providing advice, providing capital and providing distribution in the way we are. So, a lot of this depends on your client relationship, on your ability to structure transaction and we believe that we are very good at doing that, but ultimately what we believe is important in terms of what is our balance sheet is making sure that we understand the credit and that we maintain very high credit standards. And that is something that we are extremely focused on doing, because ultimately, what is important is the quality of the credit.

Meredith Whitney - CIBC World Markets

So then, any commentary on the bridge equity?

David Sidwell

I am trying to answer it more broadly and just as there is market here is, there is a market dynamic, and we are very careful about the credits that we participate in and those that we don't. And I think that it's been obviously have a lot of commentary around credit standards, the documentation standards, the evolution of this market and so I am trying to answer in a broader way saying that we will be very selective about where we participate to make sure it meets our standards.

Meredith Whitney - CIBC World Markets

Alright, thanks so much.

Operator

Thank you, ma'am. Our next question comes from the line of Roger Freeman with Lehman Brothers.

Roger Freeman - Lehman Brothers

Hi, good morning David.

David Sidwell

Hi Roger.

Roger Freeman - Lehman Brothers

I guess if we look at fee-based asset in the global Wealth Management business, fee-based asset is a percent of total client asset, it's looks like it declined a bit in a quarter, sequentially first time really in a while, at the same time commission revenues as a percent of non-fee-based assets increased a little more and they have been. Was there any mix shift that you can point to in the quarter in terms of retail clients becoming sort of more active on the trading front that would explain these moves?

David Sidwell

No, I don't think there is anything to add versus the trend. The trend actually, I find that I stay very focused on, if you look at for instance, the accounts with greater than $1 million, that increased to…

Roger Freeman - Lehman Brothers

That's right, that one did increased.

David Sidwell

So, I just think that in any one quarter, you are always going to see some mix but I think the overall trend we feel very good about.

Roger Freeman - Lehman Brothers

Okay, and then I guess just a follow-up on your commentary around the growth in FAs in the quarter, sequentially that was up a fair amount more than the sequential increase in the first quarter and I guess I am in the impression that the total for the year would remain relatively flattish, sort of net of attrition. Is that not the way to think about this? Is this a second quarter jump and outsize one, and maybe relative to incoming classes or anything to think about that?

David Sidwell

As I said in my prepared remarks actually, you are absolutely right. We had targeted 8000 as being the number when we lost time in this but because of the fact that attrition has slowed down and we continue to recruit, I think that we would expect to see numbers higher than H-137 that we had at the end of the quarter.

Roger Freeman - Lehman Brothers

Got it, okay. And then, just more broadly speaking, with respect to alternatives, obviously you have been active in making some acquisitions in that area over the last few quarters, are you seeing increases in evaluation, can you comment obviously some of the other large brokerage having been bulking up in that area too from a demand side, does that certain push evaluations for these alternative asset managers up?

David Sidwell

I think we feel extremely positive about the acquisitions and interest that we've taken some point has gone extremely well, balance down as another example of something that's gone extremely well. Obviously, there is a huge demand for these assets in the marketplace but we consider an asset by asset look at the management team, look at the potential, and obviously price is one of the factors that we would consider but I think we feel very good about the transactions that we've entered into so far.

Roger Freeman - Lehman Brothers

Okay, and then lastly you commented how fixed income benefited last quarter from sort of favorable positioning from hedging standpoint in the mortgage area. How would you characterize your positioning in the mortgage space in the second quarter? Were you down just more as a function of declining activity in the market and some marks or was there sort of negative positioning bending the wrong way?

David Sidwell

The first quarter we really did benefit from the market conditions in Subprime as I mentioned spreads didn't really move a whole lot during the second quarter, so there were lower opportunities. We certainly did not loose money in this business.

Roger Freeman - Lehman Brothers

Got it. Okay, alright, thanks a lot.

Operator

Thank you, sir. Ladies and gentleman we do have time for one final question and our last question today comes from the line of Steve Warden with J.P. Morgan Chase.

Steve Warden - J.P. Morgan Chase

Hi David.

David Sidwell

Hey, good morning.

Steve Warden - J.P. Morgan Chase

I just have some specific questions on the Discover spin. I happened to notice that in your average equity, common equity the capital allocated to Discover went some like $5.5 billion to $5.3 billion? So, when we think about this, is that the capital that will go away with Discover? Is there a little bit of reduction in the capital?

David Sidwell

I think the number is going to be around 5-4.

Steve Warden - J.P. Morgan Chase

5-4, okay. And then, I just wanted to clarify, its my understanding that if they get a big settlement in the VISA MasterCard exclusionary damages too, like the first $700 million goes to you, is that correct?

David Sidwell

My suggestion will be, you look at the Form 10 for all of the details of this.

Steve Warden - J.P. Morgan Chase

What I was just trying to get at basically is that, are you going to pay any of the ongoing legal costs associated with the pursuit or is that all going to be born?

David Sidwell

That I can answer, that is paid by Discover and is used in and will be used in the calculation of the proceeds that get available to be slipped between us and Discover.

Steve Warden - J.P. Morgan Chase

I see, okay so was it, thank you.

David Sidwell

Okay. Thanks everyone very much and we look forward to either speaking with you in the quarter if not on the next quarters earnings call. Thank you very much.

Operator

Ladies and gentlemen thank you for your participation in today's conference. This does your conclude your presentation and you may now disconnect. Have a wonderful day.

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Source: Morgan Stanley F2Q07 (Qtr End 5/31/07) Earnings Call Transcript

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