After seeing State Street Corporation's (STT) Q1 Earnings Release and that the company missed expectations due to expense growth significantly exceeding revenue growth on a year-over-year basis, we were reminded of Peltz's White Paper Presentation discussing STT's poor management of compensation expenses. While we were certainly disappointed in the overall results, we saw a number of bright spots to take away from today's events:
- After the conference call concluded, State Street announced that SSgA had won a sub-advisory mandate from Upromise Investments, Inc. to manage the direct-sold 529 College Savings Plan administered by the State of Nevada. This mandate includes new portfolio options managed by SSgA's Investment Solutions Group, specializes in managing and advising investors on asset allocation, risk management, portfolio construction and plan implementation. This mandate offered college target date portfolios, risk-based portfolios, individual SPDR ETFs and was previously managed by Vanguard. This new mandate includes portfolios invested in 15 Individual ETF, including the SPDR S&P500 ETF Trust (SPY), the SPDR Barclays Capital High Yield Bond ETF (JNK) and the SPDR S&P Midcap 400 ETF Trust (MDY).
- In the linked quarter, State Street grew assets under management by 7.3% and assets under custody by 6.4%. SSgA saw net new business of $10B, an organic growth rate of 0.5%, which we are content with because this quarter included the impact of a planned $31B withdrawal by the U.S. Treasury. The Treasury only has $16B remaining for this mandate. Excluding this non-recurring withdrawal, SSgA would have generated an organic quarterly AUM growth rate of ~2.2%, including over $8.5B in new ETF Fund Flows (pdf). SSGA has been awarded new business from several U.S. public plans including Michigan, Nevada, Oklahoma, Indiana, and Missouri. We are pleased that STT's linked quarter results in the asset servicing and asset management segments were comparable to Northern Trust (NTRS), J.P. Morgan Chase (JPM) and Citigroup (C), which have already reported Q1 EPS.
Source: company press releases and conference calls
- STT generated $233B in net asset servicing mandates and we have specifically mentioned 5 of the most notable contracts in a previous article. Two-thirds of the asset servicing mandates were in the U.S. Among STT's larger investment servicing mandates was the Q Super Australian superannuation fund with over 500 new members and A$32B in assets to be serviced. This mandate will provide a broad range of custody administration and accounting services and builds on STT's previous wins with Sun Super and Rest Industry Super in 2011. With these mandates, STT now serves three out of the top 10 Australian superannuation funds.
- The biggest mandate won in the quarter was an $80B servicing and securities finance mandate from the State of Washington. Regarding the timing of installations during the first quarter STT installed $205B, of this $90B was awarded in the first quarter, and $115B was awarded in 2011. Of the total business awarded in the first quarter, about $143B remains to be installed.
- In the alternative asset servicing area, demand remains very strong. This quarter STT added 42 new mandates in the alternative services business and alternative assets under administration increased from $816B as of December 31st, 2011 to $895B as of March 31st, 2012.
- Since the capital ratios are among the highest in the financial services industry, STT was able to increase its common stock dividend again this year back to its pre-crisis high of $.24/share quarterly and also increase its common stock purchase program. The Federal Reserve allowed STT to repurchase up to $1.8B in stock, which represents over 8% of STT's current market capitalization. STT's dividend and share repurchase programs exceeds the dividend and repurchase programs of Northern Trust , Citigroup and Bank of New York Mellon (BK) and was comparable to J.P. Morgan Chase's dividend and share repurchase programs.
Source: company press releases and conference calls
- We wish management would stop making references to acquisitions. When management makes significant progress toward repurchasing stock under its $1.8B authorization issued last month, then we will be more receptive to acquisition talk. Management did say that the plan was to repurchase about $1.35B for the last three quarters and the remaining $450M would be in Q1 2013. We were surprised that Mike Mayo, a well-known bank analyst asked STT if the repurchase plan would be "front-loaded" because as much as we would certainly prefer STT acquire it all in March 2012, we were expecting STT to acquire it periodically over the next 12 months.
- We also think his question about the difference in growth from servicing fees and assets under custody and administration was kind of simplistic. While it was disappointing to see servicing fees (2%) grow slower than assets under custody and administration (6.4%), we can tell that custody volume growth at the end of the period versus the beginning does not always translate into revenue growth. Unless all the growth takes place at the beginning of the quarter, the benefit will be muted. We expect that the benefit to servicing fees will accrue in Q2 results. We also noticed he asked that same question at the Northern Trust conference call .
- Net interest income grew by 3% linked quarter and 8% year-over-year, far ahead of our projections earlier this year.
Here are some of the areas we wish to see improvements on:
- State Street incurred $15M in litigation settlement costs, including $5M from the Commonwealth of Massachusetts for its part in a failed CDO.
- On a year-over-year basis, operating expenses (7%) grew faster than revenue (3%). The only expense items that grew slower than revenue were information technology and transaction processing. It can be noted that on a linked-quarter basis, the only operating expense that showed significant growth was compensation, which was due to the seasonal timing of employee stock awards.
- State Street says it is targeting compensation as a percentage of revenue of 39.2% for 2012. This represents about 1% less than what was achieved in 2011. This will require stronger revenue growth plus prudent staff management during the rest of the year in order to try to reach that goal. We have noticed that the first quarter has a higher proportion of compensation to revenue due to the timing of employee stock awards and other benefit payments.
- On a year-over-year basis, compensation had increased by 9%, which was a shock given State Street's efforts to right-size the staffing levels of the business through its IT-organizational transformation initiative. This was the biggest factor why STT's EPS declined by 9% year over year. We will continue to monitor this situation.
- We were disappointed that State Street saw a decline in trading revenue of 7% year over year. We believe that lower volatility and headwinds from the litigation State Street is facing with regards to its FX trading operations have more than offset higher transaction volumes in this segment. We also noted that Bank of New York Mellon had been facing the same litigation issues that State Street faced and that 5 out of the 9 charges that BNY Mellon faced were dismissed, with the remaining charges remanded to state courts.
- Despite the fact that STT's stock has increased by 1.99% after it released EPS, compared to 1.54% for Northern Trust, 2.19% for Bank of New York Mellon, which reported on Wednesday and 1.55% for the S&P 500, we are disappointed that State Street missed consensus EPS estimates by $.03. Not only did we expect STT to meet consensus EPS estimates, we expected STT to beat consensus EPS estimates. We noted that STT exceeded consensus revenue expectations by $80M.
We still maintain our buy rating on State Street Corporation. We believe that the recent bout of capital markets volatility coupled with improved capital market asset prices in Q1 2012 carrying over to Q2 2012 will serve to increase STT's fees from average assets under custody, administration and management, as well as trading. Also we believe that the new asset servicing and management mandates won in Q1 will serve as another revenue tailwind for STT's fee-based revenue. Finally, we are highly confident that STT's net interest income will exceed our expectations, as we set a low projection with regards to STT's net interest income and growth in net interest income.
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.