Raymond James Financial Inc (RJF) — Q3 2016 Earnings Call Transcript

Good morning. Thank all of you for joining us on the call. As always, we appreciate your time and interest in Raymond James Financial. After I read the following disclosure, I'll turn the call over to Paul Reilly, our Chief Executive Officer, and Jeff Julien, our Chief Financial Officer. Following the prepared remarks, they will ask the operator to open the line for questions. Certain statements made during this call may constitute forward-looking statements. Forward-looking statements include, but are not limited to, information concerning future strategic objectives, business prospects, anticipated savings, financial results, industry or market conditions, demand for our products, acquisitions, our ability to successfully hire, integrate financial advisors, the anticipated results of litigation and regulatory developments, our liquidity and funding sources, or general economic conditions. Words such as believes, expects, anticipates, projects, forecasts, and future or other conditional verbs, as well as other statements that necessarily depend on future events are intended to identify forward-looking statements. There can be no assurance that actual results will not differ materially from those expressed in those forward-looking statements. We urge you to carefully consider the risks described in our most recent form 10-K and subsequent forms 10-Q, which are available on the SEC's website at SEC.gov. During today's call, we'll also use certain non-GAAP financial measures to provide information pertinent to our management's view on ongoing business performance. These non-GAAP measures should not be considered replacements for and should be read in conjunction with the corresponding GAAP measures. A reconciliation of these non-GAAP financial measures to the most comparable GAAP measures may be found in the schedule accompanying our press release. With that, I'll turn the call over to Paul Reilly, CEO of Raymond James Financial. Paul?

Great. Thanks Paul and good morning everyone. I feel like it's kind of boring after watching the Republican Convention the last few days. We hit our 114th quarter of consecutive profitability which wasn't, I guess, a huge surprise. But the great thing about Raymond James, I think, is that we're very steady. As I look at the quarter, I think the first reaction, I mean, it's just a very solid quarter in a very volatile environment this last quarter. If you look from the big picture, all the strategic drivers of our business look in good shape. Record net revenues of $1.36 billion, up 3% over last year's quarter and 4% sequentially; record client assets under administration of $534.5 billion, up 7% over last year's quarter and 4% sequentially; record number of financial advisors, up 327 over last year and 69 sequentially; record net loans of $14.8 billion, up 23% over last year's quarter and 3% sequentially; and record financial assets under administration of $71.7 billion, up 2% over last year's quarter and 4% sequentially. And these are the drivers that you really look for in the forward-going business. As many companies have struggled to grow revenue, we've continued to grow revenue which I think is a good long-term indicator and all these records are really driven by organic growth and the market. So these are without some of the acquisitions that we announced that are coming up. Speaking of those acquisitions, as you know, we're not a very acquisitive company, but we look at opportunities where there's a culture fit, they drive our strategy, we believe they can be implementable and at a good price we believe for shareholders. We're going to be closing hopefully a couple during this quarter. The first one we've talked about is the acquisition of the U.S. Private Client Service unit at Deutsche Bank or our Alex Brown Division as we'll call them, closing. We're on track for our September closing. 92% of the advisors are signed and reviving the name of the 200-plus-year-old brand is very exciting to us. We closed on Mummert and Company, which expands our M&A practice in Europe, which we think is a very positive strategic development. And we just got a vote from the shareholders of 3Macs, MacDougall McDougall MacTier in Canada where 100% of the shareholders and 100% of the advisors signed on to join us. That should close sometime in the September timeframe. That's a 175-year-old partnership, again sharing our culture that has decided to join Raymond James. So we're excited about it and we welcome all these groups to the Raymond James family. First, I'm going to turn to the financial results. We had record consolidated quarterly net revenue of $1.36 billion, up 3% over last year's quarter and 4% sequentially. Our net income of $125.5 million is down 6% over last year, but if you exclude the acquisition-related expenses, adjusted net income of $134 million was slightly flat, slightly up from last year's quarter and up 3% sequentially, fully diluted EPS of $0.87 and on an adjusted basis $0.93, up 3% sequentially. All four of our core businesses contributed to growth. The Private Client Group, the Asset Management, and the Bank all had record quarterly net revenue. Capital Markets only missed a record quarterly net revenue by $9 million. We continued with disciplined expense management. Even with that, in the numbers, we have been affected by a number of expenses: $13.4 million of acquisition-related expenses. We had elevated legal and regulatory expense. The biggest part of that was the settlement with the State of Vermont which was essentially related to the historic FINRA-related AML issue that we accrued in the previous quarter. We believe we've been in good shape on that. We brought on a few quarters ago a new Chief AML Officer. We've installed Mantas, one of the leading AML systems, and according to the vendor, really in record time and have it up and running. We've added 50 additional associates. Simultaneously in our expense numbers, we've been working heavily on the DOL and they're all within our current expense numbers as shown. I believe we've shown good expense management with this revenue growth. If I turn to the segments, the Private Client Group first, record quarterly net revenues of $900.5 million, up 1% over a year ago and 2% sequentially. These were driven by the market and assets, but also very strong recruiting, retention, and growth in fee-based assets. Our fee-based assets now represent over 40% of the client assets. Pretax income of $81.9 million, down 5% over last year and down 2% sequentially, driven by a number of things. First, very muted transactional fees which I think you've seen throughout the industry during this quarter as the markets have been very, very uncertain. Also, as previously discussed, impacted by regulatory and litigation costs. Recruiting remains robust. Retention is keeping with our high historic levels. In fact, I've seen the industry reports saying that recruiting was down 40%. We certainly don't see that here at Raymond James. Turning to the Capital Market segment, net revenue of $251.6 million was up 8% over last year and 6% sequentially. Pretax profits, $32.8 million, up 79% over last year's quarter and 17% sequentially. Again, not against a very strong benchmark quarter, if you look at the contributors to that, there's really an outstanding quarter for our fixed income including public finance, given the marketplace. Brexit volatility, flight to safety, we believe all contributed to volumes and record trading profits which we don't estimate will sustain this level of quarterly profits into next quarter. ECM continued to struggle, really through the first five calendar months of the year, as everyone did in June. Volume activity picked up significantly, both in M&A and underwriting, making the quarter better than the last quarter, but certainly overall not a benchmark quarter. Backlog for ECM continues to be constructive for the next quarter. With reasonable market conditions, we have a positive outlook for the Equity Capital Markets. Asset Management, record quarterly net revenues of $100.9 million, up 2% over last year's quarter and 4% sequentially, with pretax of $32.5 million, up 3% over last year's quarter and 4% sequentially. We have record assets under management of $71.7 billion, again driven by market appreciation, increased managed account utilization, and a very robust recruiting. Those inflows and growth more than offset some institutional outflows for Eagle Asset Management. RJ Bank had another strong quarter, record net revenues of $126.6 million, up 22% over last year's quarter and 1% sequentially. Record pretax income of $88.9 million, up 14% over last year's quarter and 4% sequentially. Our loans hit a record of $14.8 million, another good forward-looking quarter. We've had a resilient net interest margin, which I'm sure Jeff will touch on, and our loan-loss provision of only $3.5 million indicates that credit quality remains good. So with that I will give some guidance later, but I'm going to turn it over to Jeff to provide some more line item details. Jeff?

Thanks, Paul. The consensus model for the quarter was fairly accurate. The majority of the line items were within 1% or 2% of actuals. Not a lot of line items to focus on here, but I will touch on a few. On the revenue side, it's pretty close percentage-wise, but a big absolute number, about $16 million ahead of the consensus model. PCT driven by the higher asset fees and the volatility that we had in June with the uncertainties surrounding the Fed move and the Brexit vote actually helped institutional commissions, both equity and fixed income. So we had a pretty good June in that regard. Similarly, in Investment Banking, we had somewhat of an underwriting recovery in June, although the run rate for the quarter is still low by historical measures. However, we did recover somewhat in June to a reasonable number. That somewhat surprised, I guess, some of the models a little bit on the Investment Banking side as M&A was fairly flat and jumping all the way down to trading profits. Paul’s talked on that. This was, I think, sort of an outlier good quarter for us in trading profits. I'd like to think not. Maybe we'll get better, but I certainly think that all the stars were in line here for us to hit a number like that in trading profit. It was a pleasant surprise, even for us, to see the magnitude of that by the end of the quarter. A lot of it, again, happening in June, and then the other revenues that's driven, as you can see in the detail in the press release, largely by Private Equity valuation gains of $13 million this quarter. More than half of that, by the way, goes to a non-controlling interest down below. So it's not all ours. On the expense side, numerically again the biggest absolute is comp. But that's generally tied to the revenue growth that we had in the quarter. Communications, info processing was a little higher than our $70 million a quarter type run rate that we've been guiding towards. But I still think that the $70 million-ish number is still probably pretty good going forward. This quarter happened to be slightly elevated, but it's been right around that number all year. More than offsetting that overage, business development continued to be lower than it has historically, recently at least. Even though it's down to $36.5 million for the quarter, we still think the high $30 millions or low $40 million range is probably a good run rate level for that, at least for now. The Bank loan-loss provision was a lot lower than people expected. We did have $450 million of net loan growth in the quarter. Interestingly, more than half of that was retail-related banking, which is securities-based loans and mortgages which carry much lower provisions than C&I and commercial real estate loans. That caused a lower provision than you might otherwise think with that much loan growth for the quarter. We had some minor movement up and down in some of the credits, but they generally netted against one another. On the other expenses, Paul has already talked about some of the legal regulatory things. Just to be clear on what he said, we had accrued the AML situation defined from last quarter. That was all accrued as of March, but this newer case, the Vermont situation, which is public information out there now, all came up in this current quarter. When you look at all those factors and the various regulatory matters, I guess we've sort of said that legal regulatory was elevated by around $10 million. Again, similar to what we had told you for the December quarter earlier in the year. The tax rate for the quarter is still below 37%, as equity markets continue to rise. Actually, we got the fixed income market help as well this particular quarter. We continue to get the benefit from our corporate on life insurance investments as those gains are non-taxable. Let me address a couple of the ratios that we follow. The comp ratio for the quarter was 66.9%, which is good relative to our 68% target. That really, as I say, had to do mostly this quarter with revenue mix as you get trading profits, interest earnings, PE gains, and some of those things that don't have huge amounts of variable comp associated with them. That helps the comp ratio. Even on the year-to-date basis now, we're at 67.5%. We feel pretty comfortable with that relative to our 68% target. The pretax margin for the quarter on a non-GAAP basis was 15.6% and year to date, 14.8%. I think we're kind of thinking that we should have a 16% target now in this environment. Again, we would've been close to that potentially without some of these abnormal expenses in legal and regulatory. But we had some help in some other areas. That margin probably is accurate for the quarter. We're still optimistic that we can head towards a 16% pretax margin as we head to the end of the year. We'll readdress that target as we get into our FY17 budgeting. On the ROE, again on a non-GAAP basis for the quarter was 11.4% and 10.7% for the year to date. That kind of versus our 11% to 12% range target. We're kind of right in the middle of that and hopefully again we can start trending toward the higher end of that range as we go to the end of this year and look at our budgeting for next year. Capital ratios were all in the press release. I don't need to talk about those. I think you know there are multiples of minimum regulatory requirements. I do want to make a couple of other points before I turn it back to Paul. One is on the acquisition expenses; we've been guiding or thinking we would have somewhere between $25 million and $30 million related to the Alex Brown or Deutsche Bank acquisition soon to be Alex Brown. We are actually incurring higher IT costs, higher legal costs than we thought. We still have 5 or 6 side agreements that are still being worked on that will be part of the closing process with Deutsche Bank which is running up some legal bills and we've had some real estate costs and other things. By the time we get done, we think that number's probably going to be in the high $30 millions rather than the $25 million to $30 million. I know that doesn't impact our non-GAAP results, but it's real money to us. It's shareholder money that's being spent. So we do watch very closely. Another point to make is that you saw the average share count actually decline this quarter versus the preceding quarter. That just shows you the result of the share buybacks in January and February earlier this year which more than offset control dilution for the quarter. Lastly, we had our note offering in July. I think all of you are aware we did close on $500 million for 10 years at 3.625% and $300 million for 30 years at 4.95%. We replenished the liquidity that we used for retiring the debt in April of $250 million that we will be using for the Alex Brown transaction which is about somewhere in the $500 million range. We will then be back at what we'll call a conservative level of liquidity which will put us in a position to take advantage of opportunities, whether it's our own stock price or whether it's acquisitions or other things that come up at that time. That will, as I think Paul mentioned, have a depressed net interest earnings obviously for the quarter we're in and the foreseeable couple of quarters as that's added $8.25 million per quarter of interest costs going forward. With those remarks, I'm going to turn it back over to Paul for a little bit of a forward look.

Thank you, Jeff. First, I want to discuss the segments and provide an overall perspective. In the Private Client Group, we are benefiting from record assets, which is a positive trend for us. Our recruiting efforts in the Private Client Group remain strong, and we are maintaining our historic retention rates. Consequently, the revenue trend appears favorable there. We expect to finalize the acquisitions of Alex Brown and 3Macs around September. While the timeline might shift, that is our goal. These acquisitions will affect revenue, but our strategy does not involve cutting costs immediately. Our focus is on integrating the teams, retaining advisors, ensuring stability, and then adjusting costs accordingly. Although they are smaller acquisitions, they may impact margins, particularly in the short term, but we view them as solid investments. Additionally, we could see an upside if transactional revenues increase, both through syndicate and Equity Capital Markets, as well as in the overall equity markets. However, market predictions are challenging. On the Capital Markets front, our fixed income and public finance backlogs look promising, and we believe they will continue to do so. However, the trading profit of $30 million is a record and unlikely to be sustained; we hope that market fluctuations do not interfere too much. The Equity Capital Markets side shows a promising underwriting and M&A backlog, and the underwriting calendar looks more favorable than it has in a while. While there may be some challenges in public finance, we anticipate potential benefits in Equity Capital Markets. In Asset Management, assuming a stable market, we expect continued growth, facilitated by strong recruiting efforts. RJ Bank remains well-positioned, with credit quality holding steady. The Bank represents about 34% of our equity target, which aligns well with our expectations. Therefore, we anticipate loan growth to mirror corporate growth rates moving forward. I anticipate many questions about the DOL, and I’m open to discussing that. However, clarity is still lacking. Our teams have been working diligently with a top law and consulting firm to navigate this complicated legislation. We have generated numerous options but are awaiting specific DOL guidance that was provided this summer. We are actively engaging with fund families and others, and we expect to have more details or at least some direction on our next call. It’s crucial for us to fully understand the rule and its lengthy guidance before we can provide definitive answers. Nonetheless, I am confident our team is managing this situation effectively. Looking at this quarter as we progress into the next, we face some headwinds with trading profits. We’ve seen solid trading profits, but replicating last quarter's performance will be challenging. There were typical private equity gains this quarter that are not anticipated next quarter. Additionally, the interest expenses associated with bonds represent a new cost that we haven’t encountered this quarter or traditionally. However, we do have favorable aspects such as record assets under administration, record assets under management, and record loan levels, which should positively influence revenue in the upcoming quarter. We expect an increase in Equity Capital Markets, although that will depend on market conditions. We hope that legal and regulatory expenses do not continue at the elevated levels we have seen over the past two quarters. Before I conclude, I want to express my gratitude to our associates. We have been busy with many initiatives, including a successful integration of Mantas, completed in record time according to our vendor. We have been working hard on the Alex Brown acquisition and feel we are on track. Additionally, we have put considerable effort into the DOL situation. I want to extend a special thank you to our advisors for their dedication in guiding their clients through these turbulent times. With that, I believe Jeff has one final comment before we open the floor for questions. Jeff?

Yes. On the acquisition expenses when I guided up now to the high $30 millions, that's really just for the Deutsche Bank Alex Brown transaction. The 3Macs transaction in Canada will also have some acquisition-related costs. A lot of that's contract termination and severance and things like that. But that total for that transaction is estimated to be a little less than $10 million and that will hit some in the September quarter and some in the December quarter. We're hopeful, because we're not big proponents of non-GAAP presentations, we're hopeful that we can get all of these costs either incurred or accrued by the end of the calendar year. They may slip into March a little bit, but hopefully we can get most of them done by the end of the calendar year so we don't have to continue with that presentation going forward from that point.

So just firstly on litigation expenses, I guess a couple quarters now of these outsized litigation costs. I don't know, just longer term should we think of issues here as maybe driving structural higher expenses for the firm? Are there any parts of your business model that maybe need to be modified or changed in some way to satisfy regulators? Specifically on AML, I mean, best you know are we done here? Or are you having discussions with other states?

No. So first, these two weren’t totally unrelated. One of the AML issues was related to the case and it was a specific case and a specific issue in the State of Vermont with a specific group of investors. We don't think those are happening all over. Now, you ask if they're structural? I think there is, in our industry, structural regulatory expenses and certainly a more aggressive stance by regulators. Fines are up in the industry. However, certainly not at this level. I think hopefully they’re unusual levels. There will be some fines. The 50 people in headcount and AML additions is just one example of the increasing regulatory costs, but those are in the numbers today. There is a structural elevated cost in regulatory.

For us they show up largely in compensation expense and systems. The only thing that's showing up in this other expense, really, are external litigations and fines and things like that. The structural element that's going to be ongoing is embedded in the comp and systems lines.

And then just on mutual funds, I believe in the release you spoke to a pickup in mutual funds service fees in the quarter. Can you give some more color around this, just because there seems to be more of a trend to what passes generally industry-wide? Was the quarter rise more about higher asset levels or do you see just a greater uptick on your mutual fund products?

I think it's just asset-based, both through recruiting and growth. A rise in the level of assets has caused the growth in that number for the quarter.

And then just some quick modeling questions, I don't know if you could give us like the total client cash balances. How much of that were in the deposit sweep programs? What kind of rates are you getting on that third-party sweep?

Not really much change from where it's been, Christian. It's still hovering around $38 billion. I think probably $32 billion of that is in the bank sweep program, but $13 billion of that $32 billion is going to our own Bank. Again, these numbers are not much different than they were a quarter ago. Post the Deutsche Bank Alex Brown transaction we will have different numbers, as there's somewhere between $5 billion and $6 billion of cash balances that will be coming onto our books in that transaction, and the spreads really haven't changed much either, by the way.

Maybe just a follow-up here on kind of thinking about the DOL. I mean, you mentioned Paul talking to fund families or starting to. I'm just curious if the negotiations around things like revenue share have already started? First question, then client focus has always been a big deal for Raymond James and you guys already aren't selling many products that are viewed as more lucrative by the industry. So I'm curious if you see any changes or expecting any changes to the types or even the number of products that you're selling in a post-DOL world?

Yes, Devin. I mean, it's too early to answer that. My contention has always been that you have fund families that want us to work with them. We've got to make sure clients are charged appropriately. Over time, there'd be some equitable redistribution that could impact clients because it's regulatory. We certainly don't want them to carry the burden. Some of the broker-dealers may impact advisors and the fund family. I would say we don't have an ask, so I don't think there's negotiation. I do think there's a willingness and an understanding that they will contribute to this. I don't think there's resistance to it. It's just how and how you structure it. How you keep it level for the firm, the client, the advisor, to meet kind of the DOL requirements? It's complex. I don't see resistance. But I can't say we all have an ask yet. We got to know what we're going to do before we have a solid ask.

And then in Private Client, I mean, it just seems a persistent theme here is subdued client engagement. Historically that doesn't correspond with record high markets. Maybe not seeing quite as much in your results because of the recruiting strength, but I'm just curious what you guys think is different this time and what may change the skepticism. I know macro uncertainty is high. I'm just curious if you kind of feel like there's just more of a lasting impairment, just with the financial crisis still relatively fresh?

Part of it, there are a number of elements to it. First, certainly equity syndicate being down is an impact. You almost have to move that as a separate piece. There’s also movement to fee-based accounts, so that certainly takes it out. We're digging into that number too and trying to figure out if this is systemic or market-oriented. I think most individual clients have been afraid of the market. With all this volatility, it's hard to blame them. We teach long-term investment anyway. Whether you could say there's a structural change or this is a market one, I don’t know if it’s been a long enough run. We're certainly looking very hard at that right now like everyone else in the industry.

Last quick one here just on the bank for Steve. I'm not sure if I missed this, but the NIM outlook just with the flattening of the curve here? And then provision. Understood the commentary, you still seemed a little bit light. I don't know if you can kind of hash out some of the moving parts. I know last quarter you highlighted the qualified reserves were maybe a little bit high, especially with some interest rate-related companies. Not sure if that played any part as well. Thank you.

Yes, we would expect, at least over the last couple of quarters as we sit here today, for the spreads in our loan portfolio to be pretty stable. Paul alluded to earlier, part of the contribution to the reduced provision expense relative to the gross loan increases was the loan mix and the fact that we really grew our private client banking assets, securities-based lending, and mortgage loan assets more rapidly than our corporate loans. We also net/net, you may have seen we had a reduced level of criticized loans in the quarter which reduced reserves on those specific loans that were either payoffs or, in one case, we did have one upgrade of a loan from criticized status. The bulk of it was just paydowns in criticized loans that contributed to that reduction in that asset category.

And of course, in any given quarter, we could have credit issues in either direction and we could have qualitative reserve impacts. Those are hard to predict, obviously going forward. But on the growth side, I think Steve's comments are correct.

Thank you, Raquel. We appreciate everyone joining the call. I'm very proud of our results. Growing assets and revenue in this kind of market is a strong indicator of long-term success. We certainly faced some unusual expenses and the environment—between technology and regulatory factors—has been quite challenging from a cost perspective. However, we are effectively managing it. With the acquisitions set to come on board this year, I am confident in our positioning and believe we will perform well, regardless of the market conditions. I'm proud of the team. We recognize the need to earn our success each quarter, and I appreciate your participation in the call this morning. Thank you.