State Street's Blue Chip Turnaround, Part 3

| About: State Street (STT)

This is the third part of a three part series on State Street Corporation (NYSE:STT). The three parts are broken down as: 1) Recommendation and Overview, 2) Valuation Analysis, and 3) Risks and Outlook.

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Risks to Achieving $54.63 Common Stock Fair Value Target Price

Source: Saibus Research forecasts.

Financial Health

State Street has a strong balance sheet. It has over $201 billion of cash and other investment security assets, which represents 93% of its balance sheet assets. It has a solid stockholder equity capital base ($19.4 billion). It has generated about 10% annualized return on equity YTD and restored its dividend to $.72/share annualized in 2011 and $.96 in 2012, which is equal to what it was before the crisis hit.

We are also pleased that it generated over $1.8 Billion in adjusted free cash flows (Net Income plus Depreciation and Equity Compensation minus Deferred Tax Benefits, Net Capital Expenditures and Cash paid for Acquisitions), which was 90% of its Net Income, which shows that it is able to convert net income to free cash flows which it can use to benefit shareholders and reinvest in its business to generate incremental returns.

Also, it returned nearly $950 million in cash to shareholders in the form of dividends and share repurchases, which shows a prudent balance between building capital for future use and providing an immediate reward to shareholders. We are also pleased by its profit margins which were nearly 20% in 2011, despite the fact that it was facing a weaker interest rate environment. STT announced a significantly higher dividend increase and share repurchase program versus Bank of New York Mellon (NYSE:BK) and Northern Trust (NASDAQ:NTRS), who also offered plans to return capital to shareholders.

Banking and Asset Management Industry Outlook

We expect the banking and diversified financial services industries to continue to consolidate, as weaker banks and non-bank institutions either get seized by the government or sell out to stronger banks. Overall credit losses are expected to have reached its zenith in Q2 2010 and to decline for the rest of the year and in 2011, which will strongly lift bank earnings. However we are concerned that the European debt crisis will serve as an economic headwind as well as potentially impact balance sheets of banks and other financial institutions.

However the banking industry has been facing declines in loans and total assets as banks attempted to mitigate the damage from the recession and credit crunch by letting its loan and security portfolios runoff while reducing the amount of new credit it extended in order to improve its capital ratios as well as to build its loan loss reserves. We expect loan and total asset balances for the industry to remain either stagnant or declining in 2011 and into future years, until there is more certainty with regards to an economic pickup and also greater regulatory clarity. We feel that banks that derive a large proportion of its revenues from asset management, administration, and other fee-based businesses other than those impacted by Dodd-Frank will outperform its peers in the industry.

We are noticing a bifurcation of the asset management between boutique firms that can add value through active management and large quantitative-style low-cost index driven passive managers. We are seeing consolidation of the "middle class" of asset managers globally and the remaining firms are typically pure play firms, who have the advantage of no longer being trapped under the bureaucracy of a commercial bank, brokerage or insurance institution.

State Street is the second largest ETF provider with nearly $247 Billion in ETF assets under management and distribution and the second largest passive index manager with $1.33 Trillion index assets under management and we believe that it can either acquire other passive managers or small, innovative asset management boutiques through its State Street Global Alliance joint venture with APG, a Dutch Pension Fund. This joint venture currently has a majority interest in five managers who oversee nearly $19B in assets under management and are involved in private equity (Shott Capital), real estate (Tuckerman), healthcare sector specialties (Sectoral), emerging markets (Rexiter) and absolute return multi-asset class strategies (SSARIS).

We have noticed the demand for Global Assets Growing Faster than US Assets. With more than 50% of the global market capitalization represented by non-U.S. companies, U.S. investors are increasingly looking to diversify its assets through non-U.S. investments. We believe U.S. investors are under-allocated in global equities relative to global benchmarks, particularly in the defined contribution channel, with only 7% of defined contribution assets invested in non-U.S. equities. In response to increased demand, Cerulli Associates indicates that 65% of managers are allocating over 30% of new products to international strategies and 47% are allocating over 70% of new products to international strategies. According to the Investment Company Institute, flows to foreign stock funds increased more than 210% in 2010 relative to 2009.

Demand by U.S. investors for life cycle funds has been driven by investors' desire to diversify its investments across various asset classes as well as to automatically shift to less risky asset classes as these investors near or enter retirement. Cerulli Associates estimates assets in life cycle funds will increase by 40% per year from 2009 through 2015. As part of the Pension Protection Act of 2006, target-date funds have become a default option of 401(k) plans that have an automatic enrollment feature subject to safe harbor protections for plan sponsors.

A study by Hewitt Associates and Financial Engines found that participants that receive help in the form of professionally-managed target-date funds, managed accounts or online advice achieve better returns than participants that do not receive help. As a result of the Pension Protection Act of 2006 and subsequent U.S. Department of Labor guidelines, plan sponsors are now actively seeking automatic retirement savings solutions for its employees. Under the Pension Protection Act of 2006, employers who automatically enroll its employees in what are known as Qualified Default Investment Alternatives, or QDIAs, are safeguarded from fiduciary and legal risk if it adheres to certain regulatory guidelines.

Increased Risk Management Interest based on a reaction to 2008 and 2009 crisis. Following the credit crisis and global bear market that began in 2008 and early 2009, investors and financial advisors have become increasingly interested in absolute return strategies, or strategies that seek positive returns over full market cycles. A 2010 survey of financial advisors and brokers by Putnam Investments states that 59% of advisors were likely to recommend absolute return strategies to its clients. The study states that advisors generally see the benefits of absolute return strategies as minimizing portfolio volatility and serving as an asset class diversification strategy.

We believe our active and unconstrained investment approach within our blended asset class portfolios is well suited to meet the demand for absolute return strategies using traditional asset classes and is likely to be less expensive than alternative investment-based strategies with similar absolute return goals. Industry consultant Casey, Quirk & Associates predicts that over the next 10 years, managers will increasingly be paid for investment solutions as opposed to investment products, and Pensions and Investments notes that top money management firms are starting to strengthen its solutions units in an effort to provide highly customized investment solutions for its clients, with a goal of forming strategic partnerships, and, as a result, stronger relationships with clients.

Overall, we feel the industries are fairly valued, however we would use declines in the market to add to positions in high quality banks and asset managers like State Street and gains in the market to sell weaker banks and asset managers.

Disclosure: I am long STT. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report.

Disclaimer: Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.