Bank of New York Mellon – A Reasonable 3X Speculation?
Trading in early December at a little over $19, a solid case can be made for BK being worth $58 a share within four years, giving you – with dividends - a potential 35% compounded annual rate of return. So with this kind of potential, let’s take a look at the company.
History and Tradition Unmatched
Founded in 1784 by Alexander Hamilton, BK is the oldest banking business in America and is the “only U.S. financial firm with long term senior debt rated AAA at the bank level by Moody’s” (source: BNYMellon.com). BK has a very strong 14.0% tier 1 capital ratio and a 16.1% total capital ratio; Global Finance magazine in August 2011 ranked Bank of NY Mellon as the safest bank in the U.S.
Global Financial Services Company
Today it’s a worldwide financial services company operating in 36 countries. Unlike the typical customer-focused bank, BK’s focus is upon other financial institutions, corporations, government agencies, endowments, and very high net worth individuals. It’s important to understand this difference when comparing BK to other banks. As of September 30, 2011 BK’s huge asset management business – the 11th largest in the world - served $1.1 trillion plus an additional $161 billion in private client assets. In its other major business category, Investment Services, BK services $25.9 trillion in custody and administrative services, and processes within Treasury Services approximately $1.6 trillion daily in global payment transfers.
In 2011 BK is expected to report a profit of $2.645 billion on an asset base of $350 billion. Like so many banks, BK suffered during the 2008-2009 global financial crisis. For BK the worst time was 2009 when it reported a $978 million loss and had to set aside $332 million for possible loan losses, and the dividend was cut from $0.96 to $0.51, and cut again in 2010 to $0.36. Loans, however, make up a much smaller part of BK’s business than many other banks which reflects the nature of the institutional services they provide. In banking, return on (average) total assets is a key metric, and achieving 1% or more is seen as very good. The table below illustrates these two data points:
A Worldwide Leader in Wholesale Banking -- With Two Problems
Since the difficult times of 2008-2009 BK has regained its footing as one of the global leaders in wholesale banking yet its stock price is near its 2009 lows. Total assets are up strongly to an all-time high, loan loss provisions are back to normal, and earnings are up. However, in October 2011 the Justice Department filed a lawsuit against BK for alleged foreign currency price manipulations against clients, and claimed as much as $2 billion in illegal profits based on pricing of transactions. Discussions have been ongoing regarding a possible settlement but the uncertainty and legal costs will continue to hold the stock back until resolved.
Another negative is that BK suffered “a precipitous fall in Investment Management revenues, due to the European financial crisis and the U.S. market plunge in August” (S&P Stock Report, November 30, 2011). This segment represents 75% of BK’s NOI. This illustrates BK’s sensitivity to capital markets, in part because its fees are a percentage of assets under management. Finally, BK’s net interest spread is affected by the difference between short-term rates and the 5-10 year Treasury rates; when the spread is lower, banking profits decline and the opposite is also true. Thus, in the short run if central banks continue their downward pressure on rates, banking profits will be under pressure.
Stock Substantially Undervalued
It appears the market has failed to recognize BK's resurgence and is instead focused on two more temporary problems. BK is substantially undervalued at less than $20 a share. This reflects its own litigation problems, difficult market conditions for banks, and the global financial uncertainties. Nevertheless, at 31% below book value [$28] and 62% off its high stock price ($50.26; December 2007), coupled with a P/E of just 8.0 times 2012 estimated earnings, the stock looks like a strong though speculative buy.
“Speculative” is due more to the global financial uncertainties than to BK itself. BK should be able to reach well over $3 per share within 3-4 years, and historically BK’s P/E ratio has somewhat exceeded the market. At 16-18.0X and $3.25 per share (source: VLIS, November 2011), BK would trade at $52.80-58.50.
BK’s stock price dipped to the $17-$18 range in early 2009 from it’s five-year peak of approximately $50 -- in the euphoria of 2000 it briefly went over $60 -- and again touched the $17-$18 area this fall, but that price range appears to be a solid support level at the same time that it represents, in my opinion, excellent long term value. For protection one could purchase the Jan 2013 $15 puts for about $1.80 a share.
Income investors will also like BK’s dividend. The current run rate is $0.52 a share, which at a stock price of $19.29 provides a yield of 2.7%. However, the company is presently paying out just 22% of profits whereas over 40% is historically normal, so as earnings go up the dividend should rise faster to perhaps $1.00 or more with time, which would provide a 5% yield on current cost.
In summary, Bank of New York Mellon appears to be a very good opportunity to realize a 2-3X price gain within the next several years. In addition it pays a respectable dividend which should also rise over time. BK has a long, proud tradition and is one of the world’s leading wholesale banks with a strong global investment management, wealth management and issuer services business.
BK has a very strong capital base, and has the highest bond and safety ratings of any bank in the U.S. On the downside, the company is intricately connected to the global capital markets and economy, as recent events in Europe illustrate. BK – like almost any financial services stock in this environment – is somewhat speculative but we believe that at 31% below book value with a forward P/E of just 8.0, it is substantially undervalued and that the opportunity much outweighs the investment risk, provided an investor is committed to a holding period of several years or more.
Disclosure: I am long BK.