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Summary

  • Custodian or Trust banks operate in a highly profitable oligopoly.
  • Their business model lends itself to a wide moat, because of high customer switching costs, high fixed cost in systems and technology and cost advantages due to scale.
  • The custodian banks appears to be significantly undervalued and should appreciate as their Price to Tangible Book Value ratio expands back to pre-financial crisis level.

An area of financial services, which operates as an oligopoly, are custodian banks also known as trust banks. There companies provide back office services to other banks, mutual funds, corporations, pension funds etc. by holding their assets in trust. A custodian bank is a specialized financial institution responsible for safeguarding a client firm's or individual's financial assets. The role of a custodian bank would be to:

  • hold in safekeeping assets/securities such as stocks, bonds, commodities such as precious metals and currency (CASH), domestic and foreign
  • arrange settlement of any purchases and sales and deliveries in/out of such securities and currency
  • collect information on and income from such assets (dividends in the case of stocks/equities and coupons (interest payments) in the case of bonds) and administer related tax withholding documents and foreign tax reclamation
  • Administer voluntary and involuntary corporate actions on securities held such as stock dividends, stock splits, business combinations (mergers), tender offers, bond calls, etc.
  • provide information on the securities and their issuers such as annual general meetings and related proxies

Three of the biggest custodians are:

  • Bank of New-York Mellon (NYSE:BK)
  • State Street Corporation (NYSE:STT)
  • Northern Trust (NASDAQ:NTRS)

JPMorgan Chase (NYSE:JPM) also has a large custodian business (second only to BK) but given its size and diversity of its other operations custody is a small part of its overall business and will not be discussed further in this article. As an aside, I think JPM, remains significantly undervalued and must be considered on its own merit.

The custodian banks operate like an oligopoly because of the inherent stickiness of their business - when a financial institution (i.e., a company or a mutual fund) entrusts its assets to a custodian its operations tend to get intertwined with that of the custodian's. This makes it very tough for the clients to move from one custodian to another. Custodians also maintain high fixed costs in technology, which makes it difficult for new competitors to come into the market. Further incremental cost or marginal cost of serving one more customer is very low therefore they have a scale advantage. All these factors tend to make them a wide moat business. Custodians further embed themselves with their clients by up-selling them a whole lot of other related services like:

  • maintain currency/cash bank accounts, effect deposits and withdrawals and manage other cash transactions
  • perform foreign exchange transactions
  • additional services for particular clients such as mutual funds; examples include fund accounting, administration, legal, compliance and tax support services

Custodians operate boring and dull businesses. But therein lies their appeal. The custodians are in the business of reliability and reassurance - not excitement. If you are looking for excitement move on to the Go-Pros and Twitters of this world.

Key Statistics

Symbol

BK

NTRS

STT

Company

Bank of New York Mellon Corp.

Northern Trust Corp.

State Street Corp.

Market Cap (in millions)

41315.711

15241.205

28760.769

Share Price

36.23

64.45

66.82

Yield

1.71

1.96

1.62

Payout Ratio

0.27

0.41

0.31

Share Buyback Rate

1.7

0.3

2.9

ROE

5.63

9.6

10.48

ROI

2.96

4.05

5.85

ROA

0.56

0.8

0.88

P/E

14.3

20.6

15

P/B

1.13

1.92

1.44

P/S

2.71

3.89

3.02

Price/Tangible Book Value

2.95

2.06

2.46

Earnings Per Share

2.54

3.125

4.443

Return of Tangible Equity

20.68%

9.99%

16.36%

While all three of the trust banks are somewhat similar, they operate diverse business models. BK derives a big chunk of its revenues from investment management apart from its custody business. NTRS has a large private banking business catering to wealthy families and trusts while STT is in large part a pure play custody bank. BK's growth has been fueled by mergers and acquisitions. Its last merger between Bank of New York and Mellon bank in 2007 was very ill timed and resulted in significant dilution of shareholders and large amount of "good will" on its balance sheet.

(see: BNY Mellon Isn't the Underdog It Seems )

The following chart shows Price to Tangible Book ratio (P/TB) for the three custodians for the last 10 years:

As you can see the custodians traded at much higher P/TB ratios prior to the financial crisis. If we were to assume that in the next five years they would eventually achieve comparable level of P/TB expansion, we are looking at 100% or more price appreciation from this expansion alone not even counting organic growth, which is around 5% per annum for the industry.

So which custodian is the most undervalued of all. Frankly I would buy all three of this profitable oligopoly but looking at the above chart BK and STT appear to have more potential than NTRS. They are all paying decent dividend and are buying back shares.

Source: Mirror, Mirror On The Wall, Who Is The Best Custodian Of All?