State Street Corporation (NYSE:STT) has a major catalyst at hand: activist investor Nelson Peltz. The Billionaire is pushing for shareholder-friendly changes that will dramatically raise upside while de-risking the business as a whole. As I have pointed out earlier here, having an activist on board is beneficial to long-term, not just short-term, value. BNY Mellon (NYSE:BK) may have a dividend yield that is 90 basis points higher, but it has underperformed its competitor over the last 1 month, 3 month, 6 month, 1 year, 5 year and 10 year periods.
From a multiples perspective, BNY Mellon is the cheaper of the two. It trades at a respective 8.9x and 8.1x past and forward earnings while State Street trades at a respective 12.6x and 9.9x past and forward earnings. Analysts currently rate the former around a "hold" and the latter a "buy".
At the third quarter earnings call, BNY Mellon's CEO, Gerald Hassell, noted positive developments amidst a challenging environment:
"The headline for our quarter is solid fee and net interest revenue growth and 200 basis points of positive operating leverage. Sequentially, we certainly faced difficult market conditions, which have resulted in lower revenues. But we were able to manage expenses down despite higher litigation, legal and severance costs. The result was earnings per share for the quarter of $0.53 or $651 million. That's an improvement of 4% year-over-year. Revenue was up 8% year-over-year, the fact that we achieved the growth notwithstanding the macro environment, low interest rates, the continued aversion to riskier assets and the lack of structured debt issuance reflects the strength of our business model.
Fees were up 9%, as we benefited from new business, net long-term asset flows and increased foreign exchange revenues. In addition, DR has had a particularly strong quarter as certain corporate actions for some clients moved up to the third quarter versus the fourth quarter".
The bank is aiming for increased fees and cost saving initiatives to boost gross margins. While customer declines will result from the efficiency efforts, greater overall profit can be anticipated. Business Operations, Corporate Services, and Technology will all be streamlined to reduce costs. The firm may have upwards of $260M worth of savings in 2012 and much more in the following years. The Tier 1 Common Equity (Basel III) could possibly hit 10.5% by the end of 2014 according to analysts.
Consensus estimates for BNY Mellon's EPS are that it will decline by 5.3% to $2.16 in 2011 and then accelerate to 8.3% and 12.4% in the following two years. Assuming a multiple of 10x and a conservative 2012 EPS of $2.28, the rough intrinsic value of the stock is $22.80, implying 19.2% upside. If the multiple were to decline to 8x and 2012 EPS turns out to be 4.7% below the consensus at $2.23, the stock would fall by 6.7%. Accordingly, the firm has greater reward than risk, but not enough that I would consider it a value play for right now.
State Street is taking similar measures to reduce costs. Cost savings is 400 basis point larger than BNY Mellon's as a percent of 3Q11 annualized opex. Furthermore, I am attracted to the firm's exposure in core custody and services/products - such as outsourcing, alternatives, ETFs, etc. - which have strong growth potential. The firm is trading at its historical low and the core business has been "stress-tested" positively by market performance. 2%-owner Peltz of Trian is pushing for the firm to (1) focus on capital allocation policy instead of dilutive M&A, (2) explore splitting investment management from high-growth investment services, (3) enact changes to corporate governance (i.e. possibly split role of Chairman and CEO), among other things. All three would be highly beneficial to long-term value.
Consensus estimates for State Street's EPS are that it will grow by 10% to $3.74 in 2011 and then by 7.8% and 13.6% in the following two years. Assuming a multiple of 12x and a conservative 2012 EPS of $3.97, the rough intrinsic value of the stock is $47.64, implying 19% upside. If the multiple were to decline to 10x and 2012 EPS turns out to be 3% below the consensus at $3.91, the stock would fall by only 2.3%.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in STT over the next 72 hours.