Raymond James Financial Inc (RJF) — Q4 2017 Earnings Call Transcript

Thank you, Darla. Good morning and thank you all for joining us on this call. We appreciate your time and interest in Raymond James Financial. After I read the following disclosure, I will turn the call over to Paul Reilly, our Chairman and 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, financial results, acquisitions, our ability to successfully recruit and integrate financial advisers, anticipated results of litigation and regulatory developments or general economic conditions. In addition, words such as believes, expects, plans and future conditional verbs such as will, could and would, as well as any other statement that necessarily depends on future events, are intended to identify forward-looking statements. Please note that forward-looking statements are subject to risk and there can be no assurance that actual results will not differ materially from those expressed in the forward-looking statements. We urge you to consider risks described in our most recent Form 10-K and subsequent forms 10-Q, which is available on our website. During today's call, we will also use certain non-GAAP financial measures to provide information pertinent to our management's view of ongoing business performance. A reconciliation of these non-GAAP 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, Chairman and CEO of Raymond James Financial. Paul?

Thanks, Paul, for that inspiring opening, and I appreciate everyone joining the call. With numerous releases in our industry today, including from major companies, I wanted to take a moment to reflect. If someone had told me last September that we would have Trump as President, the market up 25%, and deposit betas at an all-time low—and to top it off, the Cubs winning the World Series—I might have found that hard to believe. Looking back, it has truly been an exceptional year, thanks to the dedication of our advisers and associates, as well as favorable market conditions and interest rates. We achieved record net revenue of $6.3 billion, an 18% increase from the previous year; net income reached $636 million, up 20%; and adjusted net income was $768 million, an increase of 35%. Each of our core operating segments saw record net revenues and pretax income for the year. We finished with a 12.2% return on equity and an adjusted 14.5% return on equity, which is impressive considering our conservative approach to leverage and capital ratios. Importantly, we made significant investments in adviser technology, and we saw strong recruitment and ongoing positive momentum. We successfully integrated Alex. Brown, 3Macs, and Mummert, all while navigating DOL and regulatory changes. I want to express my gratitude to our associates for their hard work this year. I want to emphasize that our culture has significantly contributed to our recruiting and retention efforts. We’ve consistently reinforced our core values, which became evident during the hurricanes this year. For instance, during Hurricane Irma, we flew 175 associates, their families, and pets to Memphis and operated there for several days, ensuring service levels remained high while adapting our operations. To support our employees, we provided a $300 pretax bonus to assist with their evacuation and shelter needs. The firm also committed over $1 million in donations, with associates contributing more than $500,000 to the Friends of Raymond James to help those affected. In Canada, we contributed $100,000 for the flood relief in British Columbia and Quebec. This speaks volumes about our firm and underscores our commitment to associates rather than just the bottom line. Moving on to our fourth-quarter results, we saw record quarterly net revenues of $1.69 billion, representing a 16% increase from the previous year and a 4% increase from the prior quarter. Our record quarterly net income was $193.5 million, equating to a fully diluted share of $1.31, which is up 13% from last year’s fourth quarter and 5% from the preceding quarter. Adjusted quarterly net income was $217.3 million or $1.47 per diluted share, reflecting a 12% increase from last year's fourth quarter and a 17% improvement from the previous quarter. We achieved record quarterly net revenues and pretax income in the Private Client Group, Asset Management, and RJ Bank, and had a record success in capital markets when compared to the last year. Our quarterly return on equity stood at 14.1%, with a non-GAAP adjusted rate of 15.8%. It was indeed a stellar quarter. Looking ahead, we ended the quarter with record client assets under administration totaling $692.9 billion, financial assets under management at $96.4 billion, record loans at RJ Bank amounting to $17 billion, and a record advisor count of 7,346. In the Private Client Group, we reported record net revenue and free cash flow for the quarter, paired with strong recruitment and retention, maintaining substantial levels and a robust backlog, especially in fee-based accounts, supported by market growth and interest rates. We invested heavily in our technology, including enhancements to advisors’ desktops, adjustments for DOL compliance, and beta testing of our connected advisor initiative, which aims to digitally connect advisors and clients while improving onboarding efficiency. In the Capital Markets segment, net revenue increased by 3% sequentially but declined by 7% year-over-year from last year's record. However, quarterly pretax income rose 27% sequentially but fell 17% compared to a year-ago record. These results were primarily driven by M&A, reflecting the investments made over the last three years. Following our acquisition of Mummert & Company, we began to see the early advantages of those cross-border successes. While equity underwriting dipped this quarter, it rose 34% compared to last year. This segment continues to face challenges as institutional equity commissions are under persistent structural pressures, compounded by a low volatility environment. Fixed income results, both in commissions and trading profits, were similarly affected by the low volatility market and a flattening yield curve. Additionally, our tax credit funds faced hurdles due to the uncertain tax laws affecting developers and banks. In Asset Management, we recorded strong figures across the board. Financial assets under management reached $96.4 billion due to advisor growth, market appreciation, and increased use of fee-based accounts. We even saw a small positive net inflow into our Eagle Carillon Towers Group. We are still on track to complete the Scout and Reams acquisition this quarter, which is expected to add about $28 billion in assets under management. However, we anticipate that the fees associated with this business will be lower than in equity, moving forward. RJ Bank achieved record net revenue and pretax income for both the quarter and the year. Its net loans totaled $17 billion, marking a 12% increase year-over-year. Interestingly, the commercial and industrial portfolio saw a slight decline of 1%, which raises some concerns regarding pricing and the risk of new deals. Growth stemmed primarily from private client group special purpose loans and mortgages, as well as tax-exempt loans from our public finance sector. Net interest margins slightly decreased from 314 basis points to 311, but this was primarily due to excess cash and securities we have been investing in. The increase in cash balances alone affected the margin by 4 basis points. When reviewing the net interest earnings, we have an increase of $11 million quarter-over-quarter, representing 8% growth and 23% year-over-year. While many focus on the net interest margin, it's essential to recognize that this includes the impacts of cash and securities investments. In reality, our loan NIM has improved on a comparable basis. We will continue to invest using minimal capital to enhance our net interest earnings. Importantly, our total non-performing loans are down 49% year-over-year and 8% sequentially, while total credit-sized loans of $265 million decreased by 12% year-over-year and 2% sequentially. Overall, we are in good shape. Now, I’ll hand it over to Jeff for further details and insights into the outlook for these segments.

Thanks, Paul. I usually compare our actual results to the consensus model to identify areas where we fell short of market expectations. Most of our figures were close to forecast, with just a few exceptions to discuss today. In terms of commission fee revenues, we were slightly below expectations, primarily due to a decrease in institutional commissions, as detailed in the press release. The performance of PCG was nearly spot on, coming in about 1% under expectations, which isn't a significant miss. The standout area was investment banking, particularly strong M&A fees, which rose 34% from the previous quarter and 54% year-over-year. This uptick occurred later in the quarter, limiting our ability to provide commentary throughout. Aside from those two items, most other metrics were within $2 million to $3 million of expectations, with some even exceeding consensus. On the revenue side, net interest income was several million over expectations, while accountant service fees came in below forecasts. This variance is related to moving more client cash balances onto our balance sheet as we support the bank's growth. Overall, it's very close. On the expense side, we saw an increase in communication and information processing costs compared to the previous quarter, but year-to-date, they align closely with our guidance. Moving forward, we consciously chose to continue and complete our current initiatives, many of which aim to enhance the competitive position of the FA desktop and improve client onboarding. This includes upgrading our compliance systems and pursuing additional projects. As a result, our guidance for next year projects expenses in the high 80s per quarter, up from the high 70s last year. While we can manage this to some degree, if market conditions shift negatively, we might adjust accordingly. The plant fitting equipment line also rose compared to the last quarter, driven by one-off items, but reflects ongoing growth as we need to accommodate more staff and expand our branch footprint. Our headquarters saw a significant expansion of about 300,000 square feet last year, and we're preparing to utilize an additional 100,000 square feet. As a result, our guidance for next year will likely remain similar to this quarter's run rate, considering these one-offs. Regarding the bank loan loss provision, it's worth noting that we grew loans by about $376 million this quarter, primarily in lower-risk categories like mortgages. We also sold some loans under favorable market conditions, even those that were trending poorly, resulting in prices exceeding our reserves. Though this resulted in an actual loss, it allowed us to release some reserves that slightly exceeded the new provisions associated with loan growth, which was only about $2 million for the quarter due to the mix of loans. Other expenses were close to consensus, but I want to highlight the impact of hurricane-related costs, totaling around $2 million, which we did not adjust for. These involved payments to employees for repairs and evacuation, along with costs for deploying our personnel to alternative locations. Income taxes deserve mention, as we typically benefit when markets are performing well. We possess over $300 million in reserves; thus, when equity markets rise, we gain a tax advantage, and conversely, a drop leads to a higher tax rate. This will vary each quarter. Our bank is also required to invest in low-income housing tax credit projects, generating significant credits. An important change involves how we reflect the appreciation of equity awards in our tax provision rather than directly to equity. Current stock prices suggest a benefit of about $16 million annually, primarily influencing the December quarter, when most awards are granted, resulting in an abnormally low effective tax rate during that period. Looking at margins by business, I'm pleased to report that my previous estimates exceeded expectations. For PCG, I forecasted a 12% margin, and it reached 12.2% this quarter—though it averaged 11.4% for the year because of a challenging start. Capital markets achieved a 16.5% margin this quarter, up from 15%. We continued our goal of exceeding 30% in asset management, with a quarterly result of 37.1%. The firm's overall non-GAAP margin reached 18.7% this quarter, exceeding our projected 17% due to favorable equity markets and stable interest rates. The compensation ratio stood at 65.3% for the quarter, supported by a surge in M&A fees, and averaged 66.4% year-to-date, a figure we're content with. Our target remains below 67%, aiming for around 66.5% if current conditions persist. Although we aren't making 65.3% our new target based on a single quarter. The adjusted return on equity for the year was 14.5%, with an ongoing comfort level between 14% to 15%. The quarter's ROE was notably strong at 15.8%. Our capital ratios improved slightly, driven by low-risk asset growth, which outpaced risk weighting due to cash and SPLs added to our balance sheet. Paul already noted the bank's net interest income, which is critical. While we haven't spent much additional capital on expanding securities, cash growth at the bank—nearly $0.5 billion on average—has significantly contributed to net interest earnings. Guidance for net interest margin was set at 310 to 320 basis points, and while cash growth may affect margin slightly, we prioritize growing net interest earnings prudently. Currently, we maintain a spread in excess of 110 basis points on client cash balances, experiencing increased competition for deposits. Future predictions are uncertain, as spread compression may occur if competitors raise rates more aggressively. Although we haven’t seen significant changes yet, some modest spread compression seems likely throughout the year. Overall, I was surprised by the negative tone from last night's comments given the solid fundamentals across our primary segments. All except the fixed income division in capital markets are performing strongly. I wouldn't anticipate easily replicating this quarter's results due to exceptionally strong M&A activity, but many favorable factors remain for the short term. I'll now hand it back to Paul for more insights on the outlook.

I agree with Jeff. I believe we had an outstanding fourth quarter, and I stand by that because of the positive operations, growth, and fundamentals. I know expectations are high for us, and we share those high expectations. This is acceptable. As we enter 2018, we have several positive trends. In our Private Client Group, both advisor headcount and the recruiting pipeline are on the rise. We already have about $80 million in commitments for the upcoming year, most of which will materialize as we continue recruiting. The strength of our Private Client Group business comes from retaining our excellent advisors and attracting new ones. Our fee-based accounts billing will increase by 6% from last quarter to this quarter, which is a good sign. We do anticipate a decrease in advisory payouts. We previously informed you that we reduced our grids by 100 basis points, but some of that has been countered by a progressive grid in our employee division, and the upward market has slightly offset that reduction. In the independent division, we phased in some grid changes. We had to make the product-neutral grid comply with DOL regulations, so we adjusted it to half or less this year, assuming markets don't decline further. While we expect to see some gains, we won't capture all the benefits. On the positive side, we are in a stronger market, although the capital markets segment is facing challenges. The ECM is coming off a record for M&A, with a solid backlog, and we're setting ambitious goals for 2018 and remain optimistic about the M&A business, despite the past concerns about its recovery. In terms of challenges, tax credit funds, which is the largest syndicator of tax credits, is dealing with market uncertainties as buyers and sellers find it difficult to agree on pricing, creating a gap. Unless tax laws change, we may not see improvement, and if clarity doesn't come, the market might remain sluggish. Commissions in institutional equity and fixed income are under pressure, particularly due to low volatility in equity markets, which will also have an impact. It's ironic that we are nearing implementation with minimal guidance, and while I don't expect it to produce significant effects, it remains an essential part of our business. Our fixed income commissions and trading profits have performed relatively well against competitors, but the flat yield curve and low volatility are likely to keep them depressed. John Carson, who oversees fixed income public finance, once mentioned that very strong fixed income years for the firm can indicate that the equity markets are struggling, so there's a bit of offset here. They’ve managed well in a challenging environment, which is a headwind for that sector. Asset management's AUM has started 6% higher, indicating a positive beginning. We expect to finalize that deal this quarter, which will be slightly beneficial; however, it’s important to keep in mind that due to the nature of fixed income, it yields lower margins than the rest of our operations, potentially affecting overall margins. Nevertheless, it should still be somewhat positive, and we expect to see related intangibles starting next quarter. Our bank has seen impressive growth recently, although we've been cautious with C&I loan growth due to pricing and risk not aligning favorably. I remind everyone that while this quarter saw a downturn, this business has variable performance. When the metrics align with good credit opportunities, we'll provide loans, and I anticipate that Private Client Group-related loans will continue to grow following a strong quarter. We're poised to expand our agency-backed securities as they provide an attractive risk-adjusted return, enhancing liquidity and stable funding ratios, which are crucial for our rating agencies. This will increase net income but may compress NIM due to lower rate securities. I understand there might be confusion surrounding this aspect. I think there's a push for us to increase securities portfolio leverage in the bank now that we've made progress. We need to distinguish between loan NIM and the NIM generated through additional interest from securities investments. The first quarter shows promising trends, and as Jeff mentioned, we should also benefit from tax advantages in equities. If conditions hold, the first quarter of 2018 could be strong, but the significant uncertainty remains with the stock market—an unknown that could go either way. Some say it's overvalued, while others believe there's growth potential ahead; we can't definitively predict it at this moment. Jeff mentioned deposit beta decreased by 20 basis points; I feel tax may improve further. If we see another rate expansion, the pressure so far has been on higher rates, so it may stabilize for now, although I do think it has to adjust eventually. As we head into the next calendar year, it’s harder to provide clear insights due to market conditions. We've ramped up our technology investments, which are crucial for our business as they not only enhance efficiency over time but also enable us to support advisors in serving their clients effectively. These technological advancements, such as connected advisor tools, are vital for connecting next-generation advisors with smaller accounts to facilitate better interactions. These investments are key to attracting and retaining our advisors, and I believe they are essential to staying competitive. Even though we are taking on debt, I see it as a positive move. The investments made in recent years have significantly boosted our recruiting and retention efforts, and we are committed to leading in the areas we choose to compete. I believe we are well-positioned, reflected in our robust recruiting pipeline. We have good momentum and great talent. While our industry may face ongoing market uncertainties, especially with current equity highs and the question of deposit beta, our long-term focus is on continued investment for a stronger future. With that, I will turn it back to Darla for questions.

Hi, good morning. So I wanted to start up with a question on the AFS book, and may you guys have spent some time highlighting the opportunity there and the fact that it is accretive to NII regardless of the adapting NIM effect, so certainly appreciate that dynamic. But we did see the patient growth slow a little bit this quarter. And I'm sorry if I missed this. I jumped on a little late in the prepared remarks. So I'm just wondering if there is any change in terms of your strategy and long-term growth targets for the securities book. I think you have talked about $6 billion in the past, and I am wondering, given the case of capital build that we’ve seen, whether you would be inclined to actually grow beyond that target?

Steve, I believe that remains our goal, although it may take a bit longer to achieve than we initially expected. The growth rate has slowed down, as you may recall we experienced a significant decline in cash balances from the end of March to the end of June, about a $2.5 billion drop in client cash balances. This created challenges with some of our banking relationships, making it awkward to transfer such a large sum quickly from other banks to our own. We opted for a more measured approach and intentionally slowed the growth of our securities portfolio during that quarter. Additionally, the likelihood of another rate hike increased, which made us cautious about purchasing fixed-rate securities amid rising rates, with the next hike already priced in. As you can see, we managed to rectify the cash balances by the end of the quarter, with a substantial amount on the bank's balance sheet in the latter half of the quarter, though it started off very slowly. We are operating with very strict criteria regarding what we will purchase. In our core meeting yesterday, we identified a limited range of securities that meet our standards related to extension risk, yield, and being agency-backed, while also avoiding credit risk and adhering to duration considerations. Therefore, our approach to business may start off more cautiously. We’re not planning to invest the same fixed amount every week. The slow start was primarily due to the cash balances not recovering until later in the quarter.

So there has been no change in the strategy; it’s just a slight kind of delay this quarter, and we are still on course.

Got it. And as you think about the risk-reward potential from steepening more into the bank, there has been some speculation that where the said balance sheet online, you could in fact see term premium arise. If you do in fact see some steepening as a curve, and that will penetrate your fixed trading businesses certainly, but as we start to think about tire and deploy some of that excess cash, could we see you guys exceed that $6 billion target in an effort to drive some higher returns?

I think for now right now that’s our goal where we get closer, but no, these securities turn over too. So as rates rise, they will turn. We have made $400 million a year in runoff right now.

Yeah, they’ve amortized about 25% a year, so it’s pretty quick turnover. I actually think that steepening yield curve may actually help banks' loan spreads throughout it, but that remains to be seen.

Right. And just one last question from me on how we should be thinking about the pretax margin outlook for our 2018? You guys certainly gave some very helpful color thinking about the comp dynamics, some incremental non-comps as it relates to communication expenses. But just giving some of the tailwinds exiting the year, both in terms of the asset growth that we have seen as well as growth of the bank, what's the reasoning for expectations for margin expansion if we continue to have a relatively healthy market and maybe even some help in that’s having in the form of the rate hikes?

Hey guys, it’s not just the rate hikes through the spreads that make a difference to us. I mean, if we could repeat a 17%-plus margin for next year, I think on an expanded revenue base, we would be pretty content with that in light of the expense growth that we have talked about that we have planned.

Understood. That’s it from me, and congrats on a strong quarter.

Thank you.

Thanks, guys. I wanted to ask you about the outlook for the comp ratio. If we think about 2018, you've got a couple things growing on. You’ve got a full year benefit of the rate hikes that have happened. There is a PCG payout grid change that you talked about. You’ve got Scott coming on. And so all those things, I think, are tailwinds to the comp ratio. So I guess where am I missing as to why it shouldn’t be much better than the 66.5% that we’re talking about this morning?

So there is an awful lot of that mix. So right now, if you looked at our balances growing in the PCG segments, it’s been the independent segment which has a much higher payout. So if that continues, I mean, they both are doing well and they come and go, but that’s going to skew payouts up. If this quarter we’re held by really big M&A volume, which is lower than our average payout, so that brought them down. There is so much delta in the mix that it’s really hard to come out with any other number. And we do have increasing comps with compliance and other things we continue to grow overhead.

And we also had a full complement of all the compliance AML, risk management people that we have brought up for this year and we’re going to continue into that in terms of compliance of supervision staff.

In a strong market, our performance improves, but I did not anticipate a 25% market increase this year, and we’re not expecting it next year either. However, if it does occur, we will certainly benefit from it.

Good morning, guys. How are you?

Hi, Devin.

Maybe just one on the outlook for some of the fixed income businesses and a lot of moving parts in there between what’s going on with municipalities and taxes relative to yield curve. We saw a marginal uptick in kind of the yield curve kind of towards the end of the quarter. So I’m curious kind of that you’ve kind of put it all together if it feels like we kind of have a low bar year for the fixed income trading, underwriting tax credits kind of all in aggregate heading into fiscal ’18?

That’s correct. I think the question is certainly, yes, it is raised, caused some trading increases. But how long did they last? I think the curve is still flat; if they raise short-term rates while the tenure follows, I mean, there are just a lot of questions. I think that business has done really well with double-digit margins in a really tough environment. It’s down less than its competitors. It’s a great agency business, a big segment of the fixed income business as well as other financial institutions. And so, certainly, that has its own dynamics of their own securities buying. So I don’t see an enough moment in the market to say that’s going to really bounce back, on the other hand, when they’re down, equities usually stay constructive. If you had a really volatile fixed income market, I'm not sure the equity markets wouldn't give it back, so for us. So that's the challenge, Devin.

That's helpful. Following up on the outlook for fees from product manufacturers and sponsorship revenues, some firms are dropping manufacturers that aren't willing to pay for distribution. I'm interested in your current discussions with third-party manufacturers and what the broader outlook looks like, especially if you anticipate some firms being removed due to these circumstances.

So for our mutual fund partners, we've taken two steps. The first step is to make sure we review all compliance. So we've renegotiated across the platform to ensure that we are compliant with DOL, and I think we'll do that pretty much on a revenue-neutral basis. So as we close them at the end of the year, and what we hold on to Step 2 that we would strategically look next year at what we're doing with the overall platform. I know it’s coming from the jump right into it. We feel that wasn’t fair to our partners and it really didn’t give us adequate time for advisors to do their planning. So we are finishing up with the negotiations with the contracts to make sure we're compliant by year-end during the transition period. Even if it's delayed, we'll be in good shape. And which we expect the DOL to be delayed, but we will still be in compliance. And then step two, as we're looking to the overall who is paying their requirements and how we price it. That's going to be something we're looking at next year, and the focus of our executive committee and board offsite actually.

Got it, okay. Maybe there’s a last quick one here. Paul, this has been addressed, but in some of the conversation around that the tax tap on 401k contributions and hopefully that doesn't happen. But not sure how we should think about the considerations for Raymond James if that were to happen, and I believe in your administrator. But if we can think about what the implication of that could be just on the business?

Yeah. So my philosophical answer is it's not good policy that we need more savings. Even if that means to cluster or whatever, I think eliminating the 401k deduction is not good policy. From a firm standpoint, it’s not a big part of our business.

We're an advisor much more than an administrator.

So it doesn't have the impact that it does over the big firms that really do a lot of that.

Yeah, okay. Great, thanks a lot.