Bank Of New York Mellon: Buying At Buffett Prices
- BK continues to build its payment solutions and seeks to be a leading cryptocurrency custodian.
- Low funding costs, rate sensitivity may drive earnings, and returns on tangible equity are exceptional.
- Warren Buffett increased its BK stake by 52% in 2017 at 1.3x book value, shares now sell for only 1x book value.
- With a buyback program and shares selling for <10x earnings, double digit total returns look achievable.
The Bank of New York Mellon (NYSE:BK) is the largest custodian bank with $46.7 trillion in total assets and AUM of $2.4 trillion. The company also clears about $10 trillion of securities and processes over $2 trillion in payments per day. Finally, it manages $5 trillion in collateral worldwide, the largest operator in the space. BK operates three primary business lines, including securities services, market and wealth services, and investment and wealth management with the various segments detailed below:
For a more detailed breakdown of the products and services as well as the revenue types derived from each segment, you can view page 194 in the company's 2021 annual report financial section. Overall, the company is well-diversified, continues to transform its businesses with technology (e.g. 2021 expense growth will be 5.5%, along with continued investments in 2023 and 2024), as well as entrance into new business ventures.
According to the company's 2021 annual report, management continues to steadily expand its other business lines, including bill-pay solutions. According to their whitepaper, Innovation in Payments: Multiple Paths, One Destination, they believe that financial services firms should invest in a suite payment solutions:
Real-time payments, SWIFT gpi, SWIFT’s transaction manager, artificial intelligence, blockchain and digital currencies —to name just a few —are each providing banks with opportunities to make domestic and cross-border transactions faster, more frictionless, efficient, transparent and cost-effective.
In 2021, BK formed an enterprise Digital Asset unit to accelerate technology advancements in custody, administration, execution across asset classes, including cryptocurrencies. Currently, the cryptocurrency market has ballooned into a $2 trillion industry, and the financial services industry for the most part believes that cryptocurrency is here to stay and even more so blockchain technologies will shape the future. Ex-CEO of Goldman Sachs, Llyod Blankfein, gave a fair response regarding the crypto marketplace back in January when interviewing with CNBC:
"It’s lost a lot of value, but at a point where it’s trillions of dollars of value contributing to it and the whole ecosystem growing around it."
My sense is that cryptocurrency will become further entrenched in the global financial system and valuations will continue growing over the long term. BK made a direct investment in early 2021 in the cryptocurrency compliance software, Chainanalysis. Chainanalysis is reportedly growing revenue by more than 100% and recently completed a funding round that led to an $8 billion valuation. BK now using Chainanalysis software plans to launch its custody platform, further building upon its leading custody position globally.
In other words, BK has already capitalized on direct investments in the crypto industry and will likely develop itself as one of the top crypto custodians, if not the market leader in the industry, given its well-developed infrastructure and room for revenue synergies across investment asset classes.
Key Earnings Factors
BK maintains exceptionally low funding costs as all four major bond rating agencies have provided credit ratings between "A" and "AA" for the parent company and its subsidiaries.
With a strong capital structure, the company's funding costs remain very low, and issued senior notes throughout 2021 at 0.5% and 2% coupons with varying maturity dates.
BK is interest rate sensitive and therefore generates a considerable amount of its earnings through net interest margin and net interest revenue. Net interest margin showed moderate compression in 2021, along with net interest revenue. However, with the Federal Reserve expected to raise interest rates over the course of 2022 and 2023, that alone could expand earnings by 10% or more. According to CME Group's FedWatch Tool, the Federal Funds Rate is projected to reach 1.5% by mid-2023. Even if the Fed takes longer than expected to hit that target, the more important factor is to consider that we will be directionally lifting off the zero lower bound. More on this later.
Regarding returns on tangible equity, BK is first-class by generating consistent 20+%, which runs above other banking and asset management industry operators. Why? It's mostly due to the company's significant barriers to entry, and the primary forms of competition come from the likes of State Street (STT) and Black Rock (BLK), among others.
Buy Like Buffett
In mid-2017, Warren Buffett increased his stake in BK by approximately 52% at an average purchase price of $47.79 per share. At the time, the company's price to book value was around 1.3x. According to Berkshire Hathaway's 2021 shareholder letter, BK still remains a top 15 holding and total ownership floats around 8.3%.
The share price has increased slightly since then to $50/share, however, BK has cumulatively generated more than four years worth of net earnings. Additionally, management has aggressively repurchased outstanding shares, which effectively dropped the share count from 1+ billion to 800 million, or 23% since Buffett's purchase price.
Yes, net income has come down by approximately 10% due to lower interest rates, however, investors can now buy into BK at a price to book value of 1x, which is 30% discount to the levels Buffett acquired shares back in 2017.
In effect, I think investors are essentially buying at an attractive valuation as the earnings erosion is more than fully offset by the pricing discount. Also remember that earnings power and EPS is expected to be rejuvenated by rate sensitivity, new business ventures, and share repurchases:
Putting things together, the stock trading for $50/per share against an EPS estimate of $5.71 gives us a forward P/E ratio of 8.8x. Also, management plans to continue executing its buyback program, which by definition should deliver at least 10% earnings accretion to shareholders.
Currently, the dividend comes out to $1.36 annualized, or a yield of 2.7%. But remember that BK has been consistently raising its dividend every year. In the last 10 years, the dividend growth rate was 6.2% and 15.8% in the last five years. With earnings tailwinds behind the company, if we assume that the dividend is raised again, investors could be looking at a forward dividend yield of 3+% within the next year.
That's a ton of capital being returned to shareholders.
Headwinds & Risks
Like an investment, there are a number of risk associated with investing in BK shares but not limited to the following:
- Management acknowledged that elevated investment spend will limit any operating leverage to boost earnings.
- Competition remains aggressive, which could limit growth in service fees.
- Low interest income and money market waivers could persist if the Fed does not raise base interest rates.
- The broader economy could falter, i.e. risk of a recession and/or high oil prices.
- Geopolitical events, e.g. Russia and Ukraine, could lead to incremental asset price volatility.
The Bank of New York Mellon is an exceptional business. The recent 22% share price decline in the last few weeks presents prospective investors with the opportunity to buy at Buffett-like valuation. BK will likely be the recipient of several earnings tailwinds that should help it achieve earnings growth over the next few years. Overall, BK looks like a good buy at today's prices and I'll likely be adding shares to my portfolio soon. What do you think? Let me know in the comments section below. As always, thank you for reading.
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This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in BK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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