By Joseph A. Giannone
NEW YORK (Reuters) - Morgan Stanley's wealth management business generated the most quarterly revenue since merging its brokerage with Citigroup's Smith Barney, but disappointing profit margins are trying the patience of the bank's executives.
Morgan Stanley on Thursday said second-quarter wealth management pretax income rose 56 percent from a year earlier to $322 million, but earnings were down 7 percent from the first quarter.
Net revenue climbed 13 percent from a year ago to $3.48 billion, reflecting higher asset-management fees and gains from securities sales by the division's traders. Revenue was up 1 percent from the first quarter even as market activity slowed.
Yet the pretax profit margin slipped to 9 percent from 10 percent in the first quarter, well below Morgan Stanley Chief Executive James Gorman's target of 20 percent.
"We remain very focused on margins in this business," Gorman told analysts on a conference call. "Margins must improve and do so soon."
Gorman was recruited in 2005 from Merrill Lynch, where he ran that firm's giant brokerage, to revive a struggling individual investor business still associated with its downscale predecessor, Dean Witter & Co.
More than any other investment bank, Morgan Stanley is betting on wealth management to create a financial services company that is not just profitable but also sustainable across cycles. Private client services generated more than a third of Morgan Stanley's second-quarter revenue.
Two years later, the combination of Morgan Stanley's brokerage and Smith Barney has yet to fully hit its stride.
"The margin isn't where we would like it," Chief Financial Officer Ruth Porat told Reuters in an interview. Still, she added, "We're pleased with the progress that we're making, even if we're not where we'd like to be in profitability."
Like other brokerages, Morgan Stanley has been forced to pony up ever-higher bonuses to recruit and retain advisers in the wake of the 2008 financial crisis that nearly knocked it out of business.
These talent wars have been waged at a heavy cost: Wealth management compensation in the second quarter rose 9 percent from a year earlier, eating up 62 cents of every dollar of revenue, even as the ranks of advisers shrank.
Morgan Stanley Smith Barney remains the largest brokerage by number of financial advisers -- 17,638 at the end of the second quarter, down from 18,087 three months earlier.
Porat recently said broker count could dip below 17,500 as the bank culls even more laggards from the ranks. That's a far cry from the more than 20,000 brokers employed by the companies when the venture agreement was signed in January 2009.
"We're focused on insuring that we remove lower-performing financial advisers," Porat said. "That's good for clients and that's good for our business."
Gorman told analysts the wealth management unit's costs will come down once the integration is completed next year.
The average Morgan Stanley broker achieved a new high in productivity, generating an annualized $785,000 of revenue in the second quarter, up 2 percent from the first quarter.
Client assets were up 14 percent from a year earlier to $1.71 trillion but slipped 1 percent from the first quarter, due in part to tax-season withdrawals. Advisers on average oversaw $97 million of assets, on par with the first quarter.
Merrill Lynch wealth management trails Morgan Stanley with 16,241 advisers at the end of June and total client balances of $1.54 trillion, yet it still generated more revenue -- $3.49 billion -- and its brokers were more productive with an annualized average of $894,000.
Costs are also high at the moment because Morgan Stanley is racing to complete the integration of its legacy brokerage networks, including the construction of a new technology platform by this fall. The bank incurred $98 million of integration costs during the quarter.
The bank will shift legacy Morgan Stanley advisers and then move over Smith Barney advisers during the first half of next year. Porat said integration plans are "very much on track."
Still, the brokerage is not attracting assets as planned. Clients added $2.9 billion of net new money during the quarter, down from $11.4 billion in the first quarter and well off the bank's goal of $50 billion a year.
One bright spot is strong growth in "fee based" accounts, which generate income regardless of trading activity and which are expected to be more compatible with pending regulations dictating a financial adviser's responsibility to clients.
Fee-based accounts grew 29 percent to $509 billion, or 30 percent of assets, fueled by $9.7 billion of net new money.
Morgan Stanley owns 51 percent of Morgan Stanley Smith Barney, with options to buy the rest from Citigroup by 2014.
(Reporting by Joseph A. Giannone; additional reporting by Lauren LaCapra and Knut Engelmann; Editing by John Wallace)