State Street Global Advisors: Mend It, Don't End It

| About: State Street (STT)

There have been calls for State Street Corporation (STT) to spin-off State Street Global Advisors (SSgA) to shareholders or sell it. The rationale was that a spin-off would create two pure-play businesses with significant scale in each of the industry segments (asset servicing for "legacy State Street" and asset management for legacy "SSGA"). We disagree with the need to spin-off SSgA but believe that State Street can certainly improve its operating and financial performance.

State Street Global Advisors was founded in 1978 as the investment management division of State Street Bank and Trust. The firm was a pioneer in the development of domestic and international index funds. In 1990, it was reorganized as a separately incorporated subsidiary of State Street. Client AUM has increased from $38.4B in 1988 to $1.858T in 2011, a compounded annual growth rate of 18.37% over 23 years. SSgA has only made two notable acquisitions during this time period, in 2001 it acquired the passive asset management business of Gartmore, which added £18B in client AUM, and in 2011 it acquired $23B in AUM from the Bank of Ireland Asset Management acquisition.

SSgA was a pioneer in the Exchange-Traded Fund Business and created the Standard & Poor's Depository Receipts (SPDRs) S&P 500 (SPY) ETF in 1993, followed by the SPDR S&P MidCap 400 (MDY) ETF and the SPDR Dow Jones Industrial Average (DIA) ETF in 1998. In 2004, it became the marketing agent for the SPDR Gold Trust (GLD) ETF. These four funds account for over 60% of the $300B Assets under Management held by the SPDRs family of ETFs. The SPY and GLD are the two largest individual ETFs that are on the market. Despite offering the two biggest ETFs in the market, SSgA's SPDRs brand is a distant second in ETF AUMs at $300B as of March 2012, behind BlackRock's iShares family (BLK), which had $572B in AUM as of December 31, 2011. SSgA was able to avoid cutting the annual fees on GLD in response to a fee cut from a competitor last year and was still able to increase AUM in the product from $40B to over $60B.

Scott Powers has been President and CEO of SSgA since 2008. He joined SSgA from Old Mutual US, where he served as CEO. He replaced William Hunt, who resigned in disgrace due to client losses from fixed income products managed by SSgA. Prior to the financial crisis, SSgA had five straight years of positive organic growth from net client deposit inflows into SSgA mutual funds, ETFs and institutional separate accounts. Because of the backlash from the client losses, SSgA has seen net client withdrawal outflows from its products in three out of the last four years, though the $261B inflow of client funds under management more than offset the $257B total outflow of client funds under management in 2008, 2010 and 2011. This is disappointing because other ETF managers, most notably Wisdomtree (WETF), Invesco Powershares (IVZ) and Vanguard are seeing strong organic growth through net client fund inflows. Nearly half of the net outflows from 2008, 2010 and 2011 came from a sale of approximately $125 billion of U.S. government securities associated with the U.S. Treasury's winding down of its portfolio of agency-guaranteed mortgage-backed securities. Future sales of the remaining portfolio are approximately $47 billion, which are anticipated to occur in 2012. One bright spot was the SPDR Barclays Capital High Yield Bond ETF (JNK), which has grown AUM from $5B to $12B in the last 18 months. SSgA estimates that 75-80% of net new business comes from existing clients.

At the UBS Asset Gathering Conference on March 23, 2012, Powers mentioned that SSgA has relationships with 23 Sovereign Wealth Funds and 24 Worldwide Central Banks. $185B of the firm's nearly $2T in Client AUM as of March 2012 was in defined contribution assets, which we expect will grow faster than traditional defined benefit pension assets in the future, as employers seek simplified retirement solutions to offer employees. We also think SSgA should target a broader client base than merely large $750M and above Defined Contribution plans. We like that Powers is an active CEO, having visited over 200 corporate clients last year. Powers also noticed that SSgA's investment teams had an overly inward focus and he had worked to bring the team together to have the ability to go across asset classes, that has expertise in tactical asset allocation and risk budgeting and risk management and portfolio construction, and has a strong fiduciary bias, to be able to bring all of the intellectual capital of the firm and all those skill sets to bear on the clients in a very customized way.

We agree with Peltz that SSgA's margins are below its peers and in need of improvement. Last year, SSgA generated a 26% Operating Margin. While this may be above average relative to other industries, this is terribly below average relative to other asset managers (Page 27). Moreover, the 2011 Operating Margin of 26% was less than the adjusted recurring operating margin of 34.5% in 2010 and 33% in 2009. We felt that the increase in asset management fees of 10.6% in 2011 versus 2010 and 8.2% in 2010 versus 2009 was positive going forward for the company. Unfortunately, securities finance revenue collapsed from 2009 levels, which served as a headwind towards total division revenue growth.

During the quarter, SSgA introduced four new ETFs in the US and six new ETFs in Ireland. These Funds have a total of nearly $238M in AUM. SSgA also seeks to expand its presence in Europe despite the debt crisis because although the firm is number two in North America, number two globally and number one in Asia-Pacific, SSgA only had about $2B in ETF AUM in Europe.

Source: Morningstar

Based on what we see with regards to SSgA, State Street should mend it, not end it. SSgA is the world's second largest asset manager and is a pioneer in the hottest asset management segment (Exchange Traded Funds). Already this year, SSgA has seen net ETF inflows of $8.5B YTD, which easily exceeds the outflows incurred in 2010 & 2011. We believe that a spin-off or sale of SSgA could pose strategic risk, especially since three-quarters of the company's top 100 investment servicing clients use SSgA to manage a portion of their assets. State Street could also benefit from a more dynamic management discussion, reporting and analysis of the SSgA business. They should take some cues from how J.P. Morgan Chase (NYSE:JPM) reports asset management operations.

Disclosure: I am long STT.

Additional disclosure: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.

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