Raymond James Financial Inc (RJF) — Q3 2018 Earnings Call Transcript

Thank you, Rae, and thank all of you for joining us on the call this morning. 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 Chairman and Chief Executive Officer; and Jeff Julien, our Chief Financial Officer. Following their 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 advisors, anticipated results of litigation and regulatory developments or general economic conditions. In addition, words such as believes, expects, plans and future conditional verbs 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 risks 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 the risks described in our most recent Form 10-K and subsequent Form 10-Q which are available on our Web site. During today's call, we will use certain non-GAAP financial measures to provide information pertinent to our management's view of ongoing business performance. A reconciliation of these 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. Good morning, everyone. I’m actually calling you from Orlando, Florida, where we have our Private Client Group employee division’s summer development conference, which is a conference full of educational and communicational opportunities for our advisors. Unique to Raymond James’ culture, we actually have slightly more children under 18 than advisors attending. It’s a family-oriented event. This really highlights the difference in the Raymond James culture, and we believe it is part of the reason you see such low turnover statistics in our Private Client Group because of our culture. This morning, I’m going to give some highlights over the results and I’m going to turn it over to Jeff Julien, who will go over some of the details especially in the expense items which I know you’re going to have questions about, and then I’ll close with a little bit about the outlook for next quarter before we turn it over to you for questions. Looking at the results, the revenue drivers were all very strong, and we did have certain elevated expense items that we believe were higher this quarter than they will be going forward. I hope some of them were temporarily elevated, but we’ll get into that in a little bit. First, I want to start with our revenue metrics, which I believe were very strong, $1.84 billion, up 13% over last year’s quarter and up 1% sequentially. In fact, we have quarterly net revenue records in three of our four business segments, including the Private Client Group, the Bank, and Asset Management. Capital Markets in the ECM side had very strong numbers which we’ll discuss in the segment, but it was really held back by a tough fixed income market environment where the fixed income division is struggling. At the end of the third quarter, we ended with record assets under administration of $754.3 billion, up 14% over last year’s quarter, and up 3% sequentially even more than the market relative to that quarter. We had assets under management of $135.5 billion, up 49%, but of course that included the Scout and Reams acquisition versus a year ago quarter but up 2% sequentially, again good numbers given the market. We had a record number of FAs of 7,719, up 115 in this quarter alone. We’re on a record recruiting pace this year and record net loans at the Bank of $19 billion and also an interest rate hike in June which should carry through in the next quarter. I’m very pleased overall with our revenue and asset growth and positioning going forward. The sequential decline in our income I’m sure was a bit disappointing but let me touch on some of the reasons, and Jeff will get into more detail so you’ll have perspective. Our quarterly net income of $232.3 million was up 27% over a year ago quarter and down 4% sequentially where we earned $1.55 per fully diluted share, up 25% over a year ago quarter and down 5% sequentially. The sequential decline was almost entirely due to two areas this quarter; one was business development and the other was other expenses. I would call the business development line mainly good kind of expenses. Part of it is the timing of our conferences and recognition events where we’re going to give more guidance on that because they are unpredictable and they were elevated last quarter due to two significant events. Additionally, significant recruiting and onboarding expenses amounted to about 115 advisors plus a new correspondent, all of which should be great investments going forward. These expenses are lumpy as to timing and are really investments for the long term. Other expenses were less positive but mainly driven by legal and regulatory expenses. They were lumpy and we hope they are not recurring. We believe that the annual run rate will be a better number than this quarter. They happened to be a number of things that accumulated this quarter. We also had some ongoing consulting and audit fees. Since these fees are unpredictable, we believe going forward that the year-to-date run rate is more accurate than the quarterly run rate. But Jeff will get into those in detail. Before I turn it to Jeff, I’ll briefly touch on our segments. The Private Client Group numbers were driven by record recruiting and retention. Our retention continues to be our strategic advantage, keeping our great existing advisors. We’re on track for a record recruiting year across all of our affiliation options. Growth in fee-based assets was up 24% over last year’s quarter and 6% sequentially. Fee-based assets today account for about 48% of all our Private Client Group assets and about 16% of the total securities commissions in the segment. The rise in short-term interest rates in June should help going forward as long as we can maintain cash balances that Jeff will talk about in a little bit. In the Capital Markets segment, the equity capital markets had a strong quarter, with investment banking revenues of $115 million driven by a strong record of M&A. Sometimes when you come off a good quarter like we did this year, you might worry about the backlog, but it remains very strong. Our first month of July was good as well. However, institutional fixed income commissions and trading profits continue to be challenged. As long as there’s low volatility in interest rates in this flattening yield curve, they should continue to be challenging, although we are doing well compared to competitors. In the Asset Management Group, they had both record quarterly net revenues and record quarterly pre-tax income. They ended the quarter with record assets under management of $135.5 billion and that was driven by great Private Client Group recruiting as recruits often move some of their clients’ money into those accounts. There is an increased use of fee-based assets as an industry trend and certainly with us, accompanied by market appreciation. Carillon Towers Advisors also managed a reasonable positive inflow for the year, especially given a challenging active management environment. Lastly, the Bank had a record quarterly net revenue and a record quarterly pre-tax income, with record loans of $19 billion, up 14% over last year’s quarter and 5% sequentially. The loan growth was broad-based, but we had particularly good results in Private Client Group-related loans, including our securities-based loans and mortgages, which continue to grow. So if you look at it, I think our revenue and business drivers are in good shape for the quarter. I’m going to go ahead and turn it over to Jeff to address some of these items before I talk about the outlook for next quarter. Jeff?

Thanks, Paul. My personal big picture view of this quarter is that, with the exception of the two line items mentioned in the release and in Paul’s comments, results were very much in line with consensus expectations and certainly in line with somewhat aggressive expectations that you all might have had in terms of asset levels and revenue levels, etc. So a lot of good things, and to that we’ll talk about in more detail here. Again, most of the revenue and expense line items were close, with the exception of business development and other expenses that were within single-digit millions of the consensus model, so not many significant variances to talk about. But on the securities commissions and fees line, we continue to see trends toward increased fee-based assets and fewer and fewer transactional commissions; that trend continued this quarter. And as you can see in the press release, fee-based assets in PCG were up 6% over the preceding quarter, which bodes well for the billings that occurred on July 1 and will be recognized throughout the fiscal fourth quarter. Equity capital markets commissions rebounded sequentially, riding the better underwriting activity that occurred during the quarter. Fixed income commissions, both commissions and trading profits, continued to be weak, and we really don’t see that changing in the short term. On the investment banking line, I mentioned the better underwriting sequentially, and the M&A fees for the quarter of $84.7 million were a record M&A quarter for the firm. There was a lot of activity happening late in the quarter. I should point out that tax credit funds had an exceptionally low revenue quarter. This business is lumpy depending on the timing of closings, but given their activity levels, we expect to rebound to at least more normal levels in the fourth quarter as well. On the overall investment banking line, we had talked about hoping to match last year’s revenue number on that line, which was just under $400 million. Now we’re trending at about right now $95 million a quarter, so we think that’s still within reach if we have a good close to the fiscal year. Let me talk about net interest for a second. We’ve passed a little more than half of the June increase in rates, so we do have some modest upside in spreads for Q4. But with respect to the March increase, we also passed through a little bit more than half. We did benefit a little bit from widening spreads. Offsetting that, of course, are client cash balances which are not growing and we put that metric in the press release as well. One dynamic we’ve been observing is that, as the Bank continues to grow, more of the client sweep cash has been directed to our Bank rather than outside banks. So we see a shift in geography here on the revenues away from account and service fees, which are the fees we get from the independent banks in the sweep program, and more toward the interest earnings side generated in our own Bank. So that shift you’ll see continuing to happen. So far, the increased spread is more than offsetting that shift, and we continue to see increases in both line items. But at some point, we may see a leveling off of the account and service fee line item with respect to the Bank sweep. The Bank’s NIM for the quarter of 330 basis points is up nicely from the 321 last quarter; most of that is due to the higher spreads and the balance related to having less free cash on average on the Bank’s balance sheet over the course of the quarter, which we actually have the net interest margin calculations also in the press release for you to see. A lot of factors go into the net interest margin that didn’t come into play this time. There’s acceleration of fees depending on the amount of payoff activity and there are other elements as well. At this point, I think that I’ve talked with Steve Raney who is here with us for those of you who have detailed bank questions, and I think at least for the short term, we anticipate a similar net interest margin for the fourth quarter. Longer term, I’m continuing to caution that at some point, spreads are going to contract a little bit. For our modeling purposes, we would probably project something closer to the 320 long term for the spread at the Bank. The comp ratio came in at 65.7%, which was well below our 66.5% target and interestingly, exactly as the consensus model predicted at 65.7%. Comp certainly continues to be well controlled. Communications and info processing were guided toward the $90 million per quarter type number. It was $91 this quarter–it’s averaging $91, I’m sorry, this quarter this year-to-date. So we’re just slightly above guidance. It should be somewhat close to that for the year, and then we’ll look at next year, maybe have some color by the time we do this call next quarter. Business development is one of those line items we need to spend some time on. The costs in this line item used to be more evenly spread over the course of the fiscal year; but now, due to the timing in the calendar, it’s becoming a much lumpier item. The biggest costs in here are conferences, recognition events and trips, advertising, which isn’t consistent. You don’t run flights of ads every quarter; we certainly don’t produce new ads every quarter. The level of recruiting activity has been somewhat consistent, but even within recruiting, there are costs that aren’t always the same. Sometimes they come from headhunters, sometimes they don’t, etc. This has become something that’s unfortunately lumpier than it has been in the past and much more difficult for us to provide guidance. Based on the way that our events are currently scheduled for the next year or two, which generally are booked, it looks like in terms of conferences and recognition events, that the June quarter will be the highest in that category for the next couple of years, followed by the September quarter. The December and March quarters have much fewer such costs, so we’re seeing the peak here in the June quarter that we just released. The September quarter will be down from that in terms of costs. The Bank’s loan loss provision showed $837 million of loan growth, but over half of that was in residential mortgages and securities-based loans, which have fairly low levels of reserves against them, so the provision for the quarter at $5.2 million looks low relative to the allowance as a percentage of loans. Coupled with that, the Bank has continued to see improved credit metrics. The other expense, which is another line item that is significantly out of control this quarter, was primarily, as Paul mentioned, driven by legal and regulatory reserves in the PCG. For the year-to-date, it averaged $72 million a quarter and it was higher than that this quarter. We believe something in that range would be closer to expectations for the near term; but it’s hard to predict some of the legal items that go into that particular line item. The tax rate was right at 27%, so that worked out correctly. This quarter, it was at the low end of the guidance of 27% to 28%, but that’s also what you all had predicted. This was helped by about $8 million in COLI gains to some extent this quarter. Going into next quarter, we think it will be in the 27% to 27.5% range again; but bear in mind for those of you modeling 2019 and beyond, we think it will be in the 24% to 25% range as we get the last 3.5 percentage points benefit from the tax rate decrease that happened effective January 1 for most companies. Let me talk about comparisons to the revised targets that we went through at the recent Analyst Investor Day. Most of them or several of them are doing well, with one glaring exception that flowed through to the overall firm results. I’ll start with the ones that came in okay. The Capital Markets margin, we guided down toward 10 from the previous 15, and it actually came in at 9. I think 10’s probably still achievable with some better tax credit fund activity and continued good M&A activity in the equity capital markets; however, it’s going to be dragged down in the near term by the fixed income division. Asset Management's margin had a target of 33% but came in at 35%, so that one is running on track. The Bank's net NIM, we had guidance of 310 to 320, it came in at 330, which we think is probably right for the near term but again, longer term, we would head back toward 320. The comp ratio came in at 65.7%, and it's at 66.2% for the year-to-date, which was better than our 66.5% target. However, the outlier is the Private Client Group margin, which is where all the costs hit–business development costs and legal and regulatory accruals, all hit in the Private Client Group. Their margin for the quarter came in at 10.3%, putting them at 11.8% for the year-to-date versus our target of 12.5% or better in that particular segment. This dragged down the overall firm margin. We have an 18% target and came in at 17.3% for the quarter because of those costs, hitting 17.9% for the year-to-date. The firm ROE, which we have a target of 16% to 17% given the current environment, came in at 15.4% for the quarter. We’re at 16% for the year-to-date. Some misses were all related to those two expense items, while many things met or exceeded expectations. That’s kind of the quick rundown. I’m going to turn it back to Paul to give you the outlook for the fourth quarter beyond that.

Thanks, Jeff. From a high-level view going into next quarter by segment, first, the Private Client Group is entering the fiscal quarter with assets up 6% sequentially. Remember, in that group we bill quarterly in advance, so that should give a good tailwind for revenue for the Private Client Group. Retention and recruiting both tend to be very strong, so I think we’re in good shape there. Even with two firms entering protocol, we’re on record recruiting pace. We will see a bit of a shift in geography as more cash balances will go from the Private Client Group sweep program to the Bank. Some of those earnings may shift from the Private Client Group to the Bank, but that should be neutral to the firm if we maintain cash balances. The June rate hike will help a bit, and expenses should return to those annual averages. So I think with those numbers, we’ll return more to what you would expect next quarter. Capital Markets, even coming off that record M&A; the pipeline looks very robust, and I think the equity capital markets will continue to perform. Fixed income will remain under pressure due to lack of volatility and the flattening curve, so you’ll have a tale of two cities in that segment. The Asset Management Group starts up 2% sequentially, which should help billing over the quarter if the market holds. We also believe they should continue to grow as recruiting has been robust, and as those advisors bring their clients over and put some of their assets in that segment, we believe that will drive good growth. Raymond James Bank’s outlook looks promising. We’re starting with record loans and some tailwinds from the last rate hike. But again, for all these segments, things can be volatile. Markets can change, and things can shift, but given what we know today, we’re at a very, very good starting point. The last thing I’ll comment on is really our capital. We are aware of the growing capital levels. Our Board did authorize an increase to $250 million of our securities repurchase. Our target is to use $200 million for anti-dilution throughout the year. We think it’s good timing and will leave a little room for opportunistic repurchases should that happen. Most of our capital continues to be invested in recruiting and infrastructure, which have had very good returns. As always, we’re evaluating a number of opportunities for firms to join us. But we’re very disciplined, making sure there’s a cultural fit, a strategic reason, and they generate good returns for the firm. We cannot predict the timing of anything that may happen regarding our corporate development because it depends on agreements between both parties. So with that, I’m going to turn it over to Rae, our operator, for questions and answers. Rae?

Hi. Thanks. Good morning.

Hi, Ann.

My first one is on recruitment for you guys. Obviously, very strong recruitment in the quarter and it’s been strong year-to-date as well. I guess I was hoping to dig into some of what’s driving that acceleration. Is there any impact to the contrary from the withdrawal of some firms from the broker protocol? Has that had some opposite effect and helped you guys? Specifically, if we look at the employee channel, that recruitment accelerated in the quarter, so anything there?

I think first of all, the recruiting trends have been very good for a number of years and they continue to increase. Our platform both in our attitude towards advisors and their clients is unique, especially from the larger firms. We offer a platform that’s large enough to provide technology and services while maintaining more of a family feel, which is evident here with my 650 kids at our conference, a scenario you won’t find elsewhere. This resonates well with many advisors. Some advisors feel like they’re competing with their firms, which has encouraged them to explore other opportunities. On the protocol, we saw a slowdown from a couple of those firms, but the volume of discussions remains very high. So far, we’ve done well with temporary restraining orders in cases where firms filed against advisors, winning those. If advisors proceed properly and honor their agreements, transitions are happening. Overall, we’re experiencing a favorable market environment as many regional firms are doing well, but we are excelling due to our platform’s positioning.

Thanks, Paul. Just one clarification on recruitment and that impact on expenses this quarter. Was there anything specific to perhaps the greater recruitment in employees that drove onboarding expenses? I'm curious because you are consistently bringing new advisors on. So what was special about this quarter?

This was a very large quarter for recruitment. In June alone, our projected recruits were over 40% for the employee group. June has traditionally been our largest quarter after bonuses are paid, prompting people to plan their transitions. We incurred significant ACATs as part of transition assessments, and we also signed on a major correspondent firm which had substantial costs associated with it. This combined with our recruitment drove a spike in expenses this quarter.

That's very helpful. Last question for me on legal and regulatory. What specifically drove the increase in reserves for this quarter?

There were numerous cases and issues that we go through all year. This quarter, we had a significant number of legal items impacting our reserves, which resulted in an elevated expense. The accumulation of these events was purely coincidental and not indicative of our standard costs. We believe the year-to-date average would be a more accurate reflection of our operating pace.

Okay, I appreciate it. Thank you.

Thank you.

Thanks. I just wanted to follow up on that last question. Is it possible to quantify what the legal and regulatory items were in the June quarter?

We don’t comment on specific legal and regulatory matters.

In total, we had reserves of about $14 million that were above what we would consider a normal run rate. This figure effectively drove that line item significantly higher this quarter compared to the March quarter.

So I guess the $14 million reflects the elevated number for March relative to our typical run rate.

Got it, okay. That makes sense. If you think about the quarterly run rate being around $72 million, how does that translate for year-over-year growth vs. last year? Are there other expenses within that bucket that are elevated? What might those be?

There are many professional fees and consulting fees, including our audit costs. I don’t have the complete list at the moment as I’m currently at the conference with Paul in Orlando.

A significant driver of those increases has been due to developing our supervision and compliance systems, which have brought in consultants. We're incurring elevated professional fees driving some of that.

Okay.

The growth we see is somewhat correlated to general business development costs due to our growth; the other tends to be overhead costs increasing as the company expands.

Advisors tend to come over bringing a good portion of their book in the first quarter, maybe half, and then the remainder over the year. There’s definitely a lag effect. Each advisor differs in their ramp-up timing, leading to differences in the accounts transfer speeds. After the first year, they usually grow past where they were with some being new gross and others transitioning from their previous book, resulting in this lag effect.

Very good. Thank you.

Hi. Good morning.

Hi, Jim.

Maybe just a question on business development expenses. You indicated you had a large correspondent firm and also elevated recruiting along with conferences and advertising. Can you provide some sense of the breakdown—how much stemmed from the correspondent firm versus conferences?

It's tough to provide a clear picture for this line item. We’ve kept close to it. The June quarter will always be the highest due to the concentration of events. If I had to estimate, it’d probably be in the $50 million range next quarter, with the December and March quarters substantially lower due to fewer events.

There are many moving parts. This quarter alone, events cost over $8 million, in addition to around $1 million from travel and attending conferences. We could have done a better job of communicating the timing of these events throughout the year; they have become lumpier recently. The increase in recruitment costs stemmed from that $3 million fee associated with the transition for a very large correspondent firm.

Right, that’s helpful. Just a follow-up regarding net interest margin, Jeff. It seems you anticipate it could hold up next quarter but also foresee potential contraction in spreads. Could you help us understand how you view the duration of your balance sheet? It seems quite short, meaning the flattening curve shouldn’t impact you too much.

Yes, it is extremely short. Even the securities portfolio, which is where we take some duration risk, is pulled into the two to two and a half year range on recent purchases. As you noted, we haven’t been growing it aggressively in light of rising rates. Our approach to risk exposure keeps us shielded from significant impacts from rate changes.

Long-term deposit beta forecasts vary widely, from zero to 125. Everyone seems to have different views; our view is that competition will increase for cash. However, we haven’t witnessed that level of contraction yet.

Jim, this is Steve Raney. Around $15 billion of our loans are LIBOR-based floating rate loans. As noted, we maintain a very short balance sheet.

The longest loans are residential, typically structured as three to five-year adjustable rate mortgages, and we hedge portions of our tax-exempt portfolio, which may extend up to ten years.

All right, that's helpful commentary. Thank you.

Great. Good morning, guys. How are you?

Good, Devin.

Good. Just following up on some of the commentary about recruiting and the strength you're seeing, could we get some detail on what's happening in the Northeast and West? I know you’re focusing on those areas. Any anecdotes on market share trends or how much of the recent headcount growth is stemming from these regions?

We are seeing increased penetration in both the Northeast and West. We’d like to see even more traction because there’s a lot of market share opportunity. It’s fairly broad-based geographically, but there is an increase in the Northeast and West. Alex. Brown has gained traction in recruitment, and we’re seeing much higher numbers of recruits in that channel.

Okay, great. Thanks, Paul. On customer cash balances, I know there are a lot of moving parts that contribute to declines—money moving to the markets and yield behavior. Have you looked at other rate-tightening cycles to better gauge customer responses, or do you have any views as to when we might see stabilization?

It’s hard to answer as we’re in a unique cycle. In the past, client cash rates were linked to money market rates, but increasing regulatory costs have made them less attractive. Our current cash balances are being affected, even as our recruiting brings in new balances. How this shifts in the future is uncertain.

We've tracked client cash balances over the years. Before this year, we had only one other year when cash balances ended lower than they started. What’s different is the deposit beta. We've never seen spreads of this magnitude, and we expect eventual stabilization at a higher level than past averages.

Thanks, Jeff. One quick last question. I think I heard Steve Raney mentioned an uptick in C&I and CRE balances. Is this idiosyncratic timing or are you seeing signs of less competition for these new loans?

Good morning, Devin. The growth in C&I and commercial real estate is somewhat lumpier but has been very solid. While the pipeline for new deals is currently lighter, we will be opportunistic as conditions allow. I expect high-single digits loan growth for C&I and CRE over the next 12 months.

As mentioned, you're looking at net growth; the payoffs fluctuate significantly as well.

Got it. Thanks, Steve. I appreciate it.

With that, if there are no other questions—

Hi. Thanks. Sorry to come in right at the end. I just had one follow-up regarding your commentary on M&A. I guess I’m curious as to your perspective on the current landscape. If we compare where we are now to a year ago, equity markets have run up but they are somewhat more volatile. DOL seems to be a lesser issue now. There are still significant pools of private equity capital out there. How do you view the landscape now? Does it feel more constructive or less? Have the motivations for potential sellers changed?

I believe the overall M&A market remains constructive; there’s plenty of equity, especially in private equity funds. Many firms have opted for private equity instead of going public, leading to increased valuations. The private equity landscape is still quite strong, and most private equity firms aim to exit at the optimal time, creating many opportunities. The current environment appears favorable towards M&A activities.

How does that relate to your perspective on acquiring for yourself?

Our view has always been the same; we’re looking for strategic opportunities. However, cultural fit is fundamental, or we won’t pursue any firm, regardless of the market condition. Additionally, we’ll assess pricing. There are firms with whom we've been in discussions for many years, waiting for them to be ready. Conversely, we’ve also acted on some opportunities fairly quickly, like with Alex. Brown and Morgan Keegan. We are active and have a corporate development function, so we are always evaluating opportunities without letting market cycles dictate our decision-making.

Our strategic focus areas have not changed from previously stated criteria, looking for Private Client Group, Asset Management, and market niches that align with our core values.

Okay. That’s it for me. Thanks for taking all the questions.

Sure.

No problem. Any other questions, Rae?

Great. I want to thank you all for the call. I wish we could provide guidance when numbers fluctuate, but we lack control. However, all revenue drivers are in great shape. I believe we’ve addressed the unusual claims and expenses this quarter, and we look forward to next quarter. Thank you for your time. Thank you, Rae.