Bank of New York Mellon (BK) has quietly assumed the role on of the nation's largest asset custodians, with $250 billion in assets held at the boutique bank. With interest rates at practically zero, the smallest uptick in rates will have exponentially positive implications on the company's net income.
Over the past 10 years, Bank of New York (aka BoNY) has been quite disciplined in retaining profits and reinvesting capital into additional growth. Based on the company's current discounted cash flow model, this banking stock is one of the many banking stocks that are artificially underpriced due to market inefficiencies. In 2001, the company had total stockholder equity of $6.32 billion.
By 2010, that number had mushroomed to $32.35 billion and continues to increase, especially after the collapse of the nation's top investment banks in 2008 and 2009. BoNY proved to be one of the most solid and fundamentally sound multi-national banks and as a result, saw a huge influx of assets in 2010 after watching $27 billion leave the banks vaults as clients withdrew funds en masse during the crisis. However, the bounce back to over $215 billion in total assets is a new high water mark, over $6 billion above pre-crisis levels. This is an enormously positive sign and institutional validation of the bank. One of the reasons the price continues to remain in the $20's is because of a distorted return on invested capital (ROIC).
This figure represents total free cash flow, which as Warren Buffett said "is the lifeblood of any company", divided by total invested capital. BoNY is a custodial bank. As such, their total invested capital will increase if the bank is growing at a healthy rate. With total invested capital in the denominator, the ROIC is consistently destined to head lower as the denominator gets bigger.
The figure to focus on to see the true value of this company is free cash flow. This figure has been negative only once in the past 10 years, in 2005. In 2010, the company generated $3.82 billion in free cash flow. This was the 3rd highest in the company's history. In 2009, when the rest of Wall Street was burning up, BoNY was able to generate an extra $570 million in free cash, for a total of $3.46 billion, which followed a so called "dismal" 2008 at $2.91 billion. Wall Street punished the stock that year, along with all banks of course, but BoNY was hit harder than others because total free cash flow dropped by $1 billion. This meant institutional cash withdrawals were huge that year. Now that the trend has reversed and in fact in flows of new capital are coming in at a growing rate, the cash flow the company should ultimately end up reporting for all of 2011 should be a record breaking number.
Our internal models suggest free cash flow for all of 2011 should come in somewhere between $4.2 billion and $4.5 billion. Mainly because of the massive influx of institutional capital, however, with rates as low as they are, that stubborn ROIC will continue to show red. However, eventually, perhaps after election year has passed, interest rates in the US will have to increase enough to offset possible labor shortages in the pipeline that could result in supply side inflationary pressures unless productivity rises to offset those pressures.
Either way, with BoNY's massively expanding capital base, the total amount of liquid cash on their books, it's likely that BoNY will make a major acquisition to double total assets under management in one big gulp. The company will be prepared for even a marginal rise in rates as the results on net income will be profound. At current prices, we believe Bank of New York Mellon is undervalued to the tune of approximately $25 per share. Call us bold for making that prediction, but in this business of professional investing, no guts no glory. Be that as it may, we're not cowboys shooting from the hip.
We strictly adhere to our internal proprietary analytics and depend on what they tell us. Occasionally the model will spit out a trade that low risk/high return and high probability that we feel comfortable sharing it with our readers.
Disclosure: I am long BK.