|Shares Out. (in M):||1,164||P/E||10.8x||10.1x|
|Market Cap (in $M):||32,500||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
We are patient investors with a 3-5 year time horizon. We like companies that are less risky that the market perceives but that have plenty of upside for those patient enough to wait. We like Bank of New York Mellon.
andrew109 did a good job writing up BK in the summer of 2011. We believe that his thesis remains true though we are closer to “normalized” earnings than we were back then. In fact, as interest rates begin to rise we believe BK’s earning power will rise by approximately 40% yet the market seems to be giving the company little credit for this potential outcome. Before we get to the numbers, let’s break down the two important lines of business (or why this company shouldn’t be called a “bank”).
Investment Services (Custody):
The largest segment of BK’s earnings stream comes from Investment Services. This includes asset custody, securities lending, forex trading, clearing services, etc. As of 12/31/12 the company has $26.7 trillion in assets under custody (AUC). BK had $1.5T of new wins during 2012. The company currently has a pipeline of $800B of new custody assets that will come in over the next three quarters. These services are critical for large asset managers, and the industry is structured as an oligopoly with BK as the largest player.
Earnings in this segment have been impacted by lower securities lending revenues since the financial crisis, low foreign exchange volatility, and lower issuer services (handling depositary receipts, etc). The business of asset custody is more stable, but BK does not have room to raise price materially on approximately 80% of their asset base (very large clients that are too strategic to lose). The bank is currently raising prices on smaller customers by a reasonably large amount, though this will come through the income statement slowly as contracts are up for renewal. We believe that while there is no real pricing power on the big accounts, there are plenty of opportunities for BK to generate additional revenues from these customers over time (primarily through higher securities lending, more volatile forex, etc.).
Importantly, this is a business where scale matters immensely, so there are very high barriers to entry. There is also a deflationary element to costs in this business as it is highly technology driven. Given the scale advantages, there is plenty of opportunity for the American custody banks to take share in places like Europe where few banks have the custody scale to compete globally. BK also has a huge opportunity to build additional revenue streams through collateral management services which are becoming increasingly important as Dodd-Franks regulations become active.
Simply put, custody is a very solid business with recurring revenues, high barriers to entry, an oligopoly industry structure, and opportunity to grow with the growth of global market share and global financial assets.
BK is the 7th largest asset manager in the world with $1.4 trillion AUM. These assets are invested in relatively simple products that don’t rely on a group of stars to generate results. In 2012, asset management generated $3.5 billion in fees (not including net interest revenue) and $900M in EBIT (again, not including NIR).
This segment generated $56 billion in long-term flows during 2012 with only 33% of assets exposed to the equity markets. Not including money market funds, BK has generated positive asset flows in every quarter for the past two years. We think this is an excellent business with the scale and scope to compete around the globe for institutional asset management mandates.
Net Interest Revenue:
BK was considered the safest “bank” in the United States in 2012 (best CCAR capital ratios), so they have the enviable position of generating significant deposit flows. In 2010, BK deposits grew 9.5% to $143 billion while interest earning assets grew 9.1% to $270 billion. However, net interest margin shrank from 1.27% to 1.02%. Nearly a quarter of BK assets are held at either the Federal Reserve or other central banks. During this past year, the ECB stopped paying interest in deposits which dramatically hurt BK’s NIR. Aside from central bank deposits, BK has large amounts of assets on deposit with foreign banks and they own a significant amount of US Treasury obligations. This is important because unlike most every other bank, BK has very little credit risk.
The downside of this asset strategy is a very compressed net interest margin in the current rate environment. We think that an important element to “normalized” earnings is simply a return to NIM spreads that have historically held (though we’ll show later that simply returning to early 2011 levels boosts earnings quite nicely). It is important to note that despite an ever-falling NIM, BK has done well to take gains across their short term bond portfolios to maintain duration. There is such high demand for short term paper with yield that BK has worked down their portfolio taking gains and reinvesting in slightly longer paper to maintain a 2-year duration. So, NIM falls but gains partially offset the drop.
The goal of the company is to pay out 65% of their earnings in the form of dividends and share repurchases. During the past several quarters, they have bought stock with about 40% of their earnings and paid dividends that amounted to about 25% of their earnings. As a result the diluted share count fell 3.8% in 2012 (below we assume 1% annual declines over the next 3 years).
We look at future earnings by simply taking the current earnings run rate and adjusting for a more normal interest rate environment with very conservative assumptions. These are our 2015 estimates --
Current Run-Rate Earnings per Share (non-GAAP) $2.58
Normal NIR – take NIM back to 1.5% from 1.02%, 1% B/S growth, tax 0.58
Money market fee waivers (company not charging fees on money market funds) 0.16
Operational Excellence initiatives (we use $150M significantly below BK target) 0.09
Share repurchase (1% annual buybacks) 0.09
Total EPS $3.50
Given the very high returns on tangible capital, and the low risk inherent in this business model we think a 12-14x multiple of “normal” earnings would be appropriate. Thus, the valuation by early 2015 would be $42-$50 compared to a price today of $28.