By Olivia Oran and Sudarshan Varadhan
(Reuters) - Morgan Stanley, which has struggled for years to improve its bond-trading business, may finally be turning the corner.
The Wall Street bank reported a lower second-quarter profit on Wednesday, but beat expectations by delivering relatively strong bond-trading revenue and cutting expenses.
Chief Executive James Gorman has faced tough questions from analysts about the state of its fixed income, currency and commodities trading unit since taking the helm of the bank in 2010. Morgan Stanley scaled back the business in an effort to make it more profitable, but its choppy revenue led some to wonder whether the bank was on the right course.
But so far this year, the business is hitting a revenue target Gorman laid out, and many analysts attributed Morgan Stanley's earnings beat to the bond trading unit. In discussing results, Gorman sounded triumphant, defending his decision to maintain the business on a smaller scale.
"(It's) the topic of the day, the year and the century, it would appear," he said when asked whether the results were sustainable. "Listen, my view was that there was a general over-reaction to the underperformance."
In both quarters this year, Morgan Stanley produced more than the $1 billion per quarter in revenue from fixed income, currency and commodities (FICC) trading that Gorman recently set out. As part of the restructuring effort, the bank has reduced headcount there by 25 percent, slashed risky assets and focused on transactions that require little capital under new regulations.
Gorman advised analysts to expect quarterly fluctuations, but said the target was achievable over the long term.
"At the time it almost sounded like an aspirational goal, but clearly they did well," said Oppenheimer analyst Chris Kotowski. "Maybe ... we are closing in on a sustainable and predictable level."
Morgan Stanley's shares rose 2 percent to close at $28.78.
Morgan Stanley is also in the midst of a cost-cutting program, targeting $1 billion by 2017. As part of this effort, the bank cut nonessential travel by half this year, Chief Financial Officer Jon Pruzan said. It is also closing data centers and shifting employees to lower-cost hubs.
Second-quarter operating expenses fell 8.4 percent to $6.43 billion. Compensation costs, its biggest expense, fell 8.9 percent to $4.02 billion.
Following the results, Evercore ISI analyst Glenn Schorr issued a report cheekily titled "Morgan Stanley Beats on FICC (not a typo) & Cost Control."
Although it exceeded expectations, Morgan Stanley is still falling short when it comes to a key measure of how well it's using shareholder money to produce profits.
Its return on equity of 8.3 percent during the second quarter is less than the 10 percent minimum that many investors expect, and less than Gorman's stated target of 9 to 11 percent by the end of 2017.
Overall, the Wall Street bank's net income attributable to common shareholders was $1.43 billion, or 75 cents per share, in the quarter ended June 30, compared with an adjusted $1.69 billion, or 79 cents per share, a year earlier.
Analysts on average had expected earnings of 59 cents per share, according to Thomson Reuters I/B/E/S.
After adopting a new accounting method, Morgan Stanley's earnings no longer reflect changes in the value of its own debt. Adjustments for the year-ago period make the figures comparable.
Equities sales and trading, typically a bright spot for the bank, fell 6 percent to $2.1 billion compared to the year before. Competitors including JPMorgan Chase & Co, Goldman Sachs Group Inc, Citigroup Inc and Bank of America Corp also reported strong bond trading and weak equity trading revenue.
Morgan Stanley's wealth management division, which the firm has sought to bulk up over the last few years as a more stable business than trading, saw net revenue fall 2 percent to $3.8 billion. Loans and lending commitments to wealth clients rose 5 percent over the prior quarter, to $61.3 billion.
Up to Tuesday's close, Morgan Stanley shares had fallen 11.4 percent since the start of the year.
Bank stocks have moved higher over the past week on better-than-expected earnings. The S&P 500 Financials Index is up 1 percent since the sector began reporting results on July 14 and up more than 10 percent from last month's lows reached after Britain voted to leave the European Union.
(Reporting By Olivia Oran in New York and Sudarshan Varadhan in Bengaluru; Writing by Lauren Tara LaCapra; Editing by Ted Kerr and Nick Zieminski)