State Street Stays Neutral Despite Concerns of Rising Expenses

| About: State Street (STT)

We continue to maintain our long-term Neutral recommendation on State Street Corp. (NYSE:STT). Though we are concerned about rising expenses and the company’s risky investment portfolio exposure, the realignment of its investment portfolio, various restructuring programs, strong capital ratios along with well-off core servicing and investment management franchises will help it offset the financial weakness caused by the sluggish economic recovery, thereby providing buoyancy to growth in the near to mid term.

We view State Streetas a sound asset for yield-oriented investors. On March 18, 2011, following the release of the Federal Reserve’s much-awaited stress test results, the company got approval to hike its quarterly dividend to 18 cents per share for the first time since the second quarter of 2007. In the first quarter of 2008, the company had lowered its quarterly dividend to a penny, as it had taken TARP money from the government to stabilize its financials.

Furthermore, the company announced that it would buy back $675 million stock in 2011, marking its first share repurchase program since January 2008. This buyback program would replace the previous $1 billion program that still has nearly $13.25 million unutilized.

On March 23, 2011, Standard & Poor's (S&P) Ratings Services upgraded its outlook on State Street to ‘Stable’ from ‘Negative.’ The rating agency is impressed with State Street’s recent restructuring programs and sale of risky investment portfolios in its securities lending business. Furthermore, the rating agency expects the company to strengthen its capital levels despite the recent dividend hike and share repurchase announcements. The rating upgrade by S&P will boost investors’ confidence.

Given State Street’s significant non-U.S. exposure that got an added boost from the latest acquisitions, focus on activity managed accounts and market share in higher margin products, the company is poised to grow earnings at a faster rate than its peers over the long term. Management expects to double its non-US revenues from 2009 to the end of 2014. In 2010, the company’s non-U.S. revenue accounted for approximately 42% of its total revenue compared with 31% in 2009.

On the flip side, given the ongoing weakness in the mortgage market, we are significantly concerned about the sizable amount of mortgage-backed and asset-backed securities exposure in State Street’s investment portfolio, though it is diversified with respect to asset class.

The floating-rate asset-backed portfolio primarily consists of home-equity loans, credit cards, auto- and student loan-backed securities. Markets for all these segments have been hard hit since 2007, though they are now recovering at a slow pace. We expect impairment charges on these exposures to negatively impact the company’s financials in the near future.

The Dodd-Frank Law is expected to impact the manner in which the company markets its products and services, manages its operations, and interacts with regulators. This could materially affect the company’s operations, financial condition and liquidity over the near term. Various provisions in the Dodd-Frank Act are expected to hamper top-line growth in the near future.

State Street has a significant presence in Europe. There remain concerns about the ability of European countries, such as Greece, Ireland, Portugal, Spain and Italy, to finance their deficits and service growing debt burdens amidst difficult economic conditions. Hence, weakness in the Euro or the failure of a significant European financial institution can have an adverse impact on the company’s financials.

State Street currentlyretains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. Fifth Third Bancorp (NASDAQ:FITB), one of State Street’sclosest competitors, also retains a Zacks #3 Rank (short-term ‘Hold’ rating).