We can understand why Berkshire Hathaway (BRK.B) has taken a 19.6M share position in The Bank of New York Mellon Corporation (BK). The Bank of New York used to be a traditional deposit gathering and loan making institution before it sold its consumer and commercial banking operations to JPMorgan Chase (JPM) in 2006 in exchange for JPM's corporate trust business and a cash payment of $150M plus up to $50M of contingent consideration. The Bank of New York sold its traditional banking operations in order to focus on its asset management and servicing activities and it bulked up its asset management capabilities in 2007 with its acquisition of Mellon Financial, which formed BNY Mellon. We like BNY Mellon because it is one of three "trust banks" dedicated to asset management and asset servicing. We like the business because it provides a steady, annuity-like fee stream and BNY Mellon has massive scale in asset management and servicing. Although we agree with Warren Buffett and Berkshire Hathaway that BNY Mellon is a great trust bank, we like State Street Corporation (STT) better!
Source: Our August Report on State Street Corporation
Notable Items that Investors Have Been Focused on With State Street Corporation
While it was impressive that State Street beat the consensus adjusted EPS estimates by $.11 in the most recent quarter, we found that it was more impressive that its full year adjusted EPS of $3.95 exceeded the $3.94 EPS we projected in June 2012. Furthermore, its reported EPS of $1 met the $1 adjusted EPS consensus estimates that analysts were targeting in Q4 2012. We were also impressed that its adjusted EPS exceeded Q4 2011 levels despite its foreign exchange trading woes resulting in a 21% decline in foreign exchange trading revenues. STT's competitors The Bank of New York Mellon and Northern Trust (NTRS) saw its foreign exchange revenues decline by 39% and 43%, respectively, so it's not like STT is alone in that boat. Although State Street's year-over-year operating expense growth of 4% during the quarter was well ahead of BNY Mellon (0%) and Northern Trust (-4%), State Street's revenue growth of 6% exceeded BNY Mellon (2.2%) and Northern Trust (1.5%).
State Street's Intractably Recurring "Non-Recurring Charges"
With regards to the intractably recurring "non-recurring charges," State Street incurred $11M for litigation exposure and $139M in restructuring costs associated with the acquisition of Goldman Sachs Administration Services (GS) and severance costs associated with the recent layoffs of 630 employees. State Street also harvested $52M in discount accretion related to its former conduit securities, down from $61M in Q4 2011. BNY Mellon also had its share of "non-recurring charges" as well ($46M in Q4 2012, $559M in 2012).
State Street Global Services
State Street Global Services is State Street's bread-and-butter asset servicing business and it reports revenues that increased by 8.8% due to a stronger equity market, net new business and the October acquisition of Goldman Sachs' alternative asset servicing business. It was awarded $649B in new asset servicing mandates during the quarter and it installed $143B of these mandates in Q4 2012. The acquisition of Goldman Sachs Administration services contributed $11M in pre-tax operating income during the quarter and enabled State Street Global Services to win 92 new alternative asset servicing mandates. 14% of SSGS's new mandates came from outside of the US and SSGA has $506 billion in new asset servicing mandates that are expected to be installed during Q1 2013. SSGS saw its assets under custody and administration increase by 4% in the linked quarter and by 11.74% year-over-year, which was above its peer group average. SSGS's AUC growth in the linked quarter significantly exceeded that of Bank of New York Mellon and JPMorgan Chase, slightly exceeded that of Northern Trust and was slightly below Citigroup's (C) AUC growth.
State Street Global Advisors
State Street Global Advisors reported encouraging results. Investment management fee revenues grew by 3.6% in the linked quarter and by 28.7% on a year-over-year basis. The firm won $24B in net new mandates, which represented 1.16% in organic growth during the quarter. $13B of the net inflows went to SSgA's ETF product line, mainly in its SPDR S&P 500 (SPY), SPDR Gold Trust (GLD) and the high-yield fixed income fund. Over the last 21 months, SSgA has introduced 54 new ETF strategies. SSgA saw its assets under management increase by 1.16% in the linked quarter and by 13% year-over-year, which exceeded that of its peer group of Bank of New York Mellon, JPMorgan Chase, and Northern Trust. Citigroup is not included as an asset management peer since it sold its Smith Barney Asset Management business to Legg Mason (LM). We don't think State Street should spin-off SSgA and MutualFundWire.com agreed with us.
Sources: MRQ Reports for State Street, BNY Mellon, Northern Trust and J.P. Morgan Chase
State Street Corporation's Capital Position
State Street's capital ratios are among the highest in the financial services industry and we can't stress enough how State Street's dividend increase and share repurchase program was greater than what Northern Trust and BNY Mellon offered to shareholders after all three trust banks passed the Federal Reserve's CCAR stress tests. State Street restored its dividends per share back to the pre-crisis peak of $.96, which was last achieved in 2008. State Street's share repurchase program of $1.8B exceeded the combined $1.34B that BNY Mellon ($1.1B) and Northern Trust ($0.24B) offered in March. We believe that investors will give this program greater credibility because State Street has repurchased $1.44B of the $1.8B authorized, which exceeded the $1.3B spent by BNY Mellon ($1.14B) and Northern Trust ($163M) have spent so far. STT's estimated pro forma tier 1 common ratio under the recent U.S. Basel III Notices of Proposed Rulemaking was 11.9% as of Q3 2012, an increase of 60bp from Q3 2012 and 90bp from Q2 2012.
STT's tangible common equity was 7.2% during the quarter, which was comparable to the 7.2% TCE ratio for Northern Trust and both were significantly higher than BNY Mellon's 4.04%. State Street's ROE of 9.3% was slightly higher than Northern Trust's 8.8% and was much higher than BNY Mellon's 7.1%. State Street had a higher net interest margin than its trust bank peers in both Q4 2011 and Q4 2012 and this helped it grow its FY 2012 net interest income by 8.8% year-over-year while Northern Trust saw its net interest income decline by 2% and BNY Mellon saw its net interest income decline by 37bp due to a 15bp NIM compression.
Sources: MRQ Reports for State Street, BNY Mellon and Northern Trust
While we have always liked Bank of New York Mellon, we are sticking with our position in State Street. We'd probably sell State Street for BNY Mellon if it was to acquire Wisdomtree or if an activist investor took a stake in BNY Mellon. After flirting with the idea of switching State Street for BNY Mellon this year, we're maintaining our position because its management has been emphasizing dividends and share repurchases instead of acquisitions recently. Although Nelson Peltz has not engaged in much direct activism since his October 2011 White Paper, we believe that State Street's CEO Jay Hooley saw Mark Fetting at Legg Mason get bounced two months before Peltz's standstill agreement expired and Hooley had no intention of going out that way. We believe that Nelson Peltz's presence as a large State Street stockholder has made a positive impact for State Street shareholders. Berkshire likes BNY Mellon because of its asset management and servicing scale, annuity-like stream of fee-based revenues, strong capital position and minimal credit risk exposure and that's why we like State Street Corporation. We have shown that State Street offers better risk-adjusted return prospects to investors versus BNY Mellon and Northern Trust and here are the reasons why we believe that State Street has outperformed its two trust banking peers since Nelson Peltz released his October 2011 White Paper:
- State Street announced a larger share buyback than its two peers combined in March 2012 when all three passed the Federal Reserve CCAR Stress Tests
- State Street's only acquisition in 2012 was Goldman Sachs' alternative asset management business
- State Street's acquisition of GSAS was at a 53% lower price per assets served than SS&C's acquisition of GlobeOp
- State Street has improved its executive communication to the investment community
- State Street has officially sworn off acquisitions for the near term
- State Street is on track to complete its $1.8B share repurchase program
- State Street is looking for a more assertive capital return program in 2013
- State Street's H2 2012 performance has been better than its peers.
Sources: Morningstar Direct
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.