After shunning financials for some time, what attracts you to Bank of New York Mellon [BK]?
DO: This is a good example of the type of situation that attracts us. As the financial crisis unfolded and all financial stocks got hit hard, we focused in the sector on feegenerative businesses, as opposed to the highly leveraged banks and investment banks. Bank of New York makes the majority of its money through asset and custody services like holding funds in trust for debt issuers, securities lending, clearing government securities and calculating net asset values for mutual funds. These are highly consolidated markets and Bank of New York is oftentimes the clear number one, benefiting from regulatory barriers to entry, scale advantages and reputational advantages. The result is high – 35%-plus – operating margins. The company is also a leading global provider of investment management products, in everything from mutual funds at subsidiaries like Dreyfus to an extensive private-banking operation.
In addition, because they hold so many assets in trust or in transit, they have a significant amount of float to invest. As you might expect, these last two areas have been hurt by the crisis, but the servicing businesses – which makes money on the volume of capital-markets activity as well as the level at which markets trade – has done very well.
It’s also been a positive from a market-share perspective that the major servicing competitor, State Street, has had far more problems with excess leverage and toxic assets.
Overall, Bank of New York earned as much in 2008 as it did in 2007, around $3.50 per share.
Is it difficult to estimate a normal level of earnings here?
DO: To be conservative, we actually use $3 per share as the level of normal earnings power. We don’t expect the volatility and asset churn the company benefited from last year to be the norm.
But at the current share price [of just under $28], the shares trade at only 8x trailing earnings and just over 9x what we consider normal earnings. That’s extremely cheap for an oligopolistic, high-barrier-to-entry, high-return business that is taking market share. We believe that kind of business could eventually be worth a minimum of 15x earnings, and 20x is not out of the question.
The key for us in financial services today is to get comfortable with the sustainability of earnings going forward. We have that comfort with Bank of New York and are thrilled to buy something of this quality when it’s cheap based on earnings at the bottom of the market.
To us, it’s one of those proverbial babies being thrown out with the bathwater. If capital markets came back strongly, which we’re not counting on, it could earn $4 per share.
Any company with such a giant asset base can’t be without potential risk in this environment.
DO: It certainly isn’t without risk, but the company’s pre-loss-provision operating profit – adjusted for merger expenses and amortization – was around $6 billion in 2008. The lower quality portion of the securities portfolio, which they’ve already written down by almost 40%, is now worth something like $15 billion. That level of cash flow relative to the total value of the questionable securities is huge, which should allow them to relatively easily absorb any further writedowns.
Given that they’ve been conservative in their markdowns to date, there’s actually a chance the portfolio ends up being written back up over time.