Description
State Street (STT) is a US based financial company, operating two businesses: a custody bank and an asset manager. On a combined basis, STT should earn $3.75-$3.90 in 2012 and pay a dividend of $.96. STT’s earnings are currently depressed and the company trades at 10x 2012 earnings after backing out $6.2 per share in excess capital. Were STT to trade at 12.5x earnings potential of $4.40 per share, the company would be worth 36% more than the current stock price.
STT also plans to buy back $1.8bn of stock (8% of mk cap) through March 2013. Assuming 10% Basel III T1C ratio, STT has $3bn of excess capital, $6.20 per share 14% of mk cap. Recently, Nelson Pelt’s Trian Group has taken a stake in STT and agitated for cost cuts and splitting off the company’s asset management business.
STT operates the world’s 2nd largest custody business with $21T in AUC (BK is #1, JPM is #3 and Citi is #4). ). Custodians provide clients with a single, efficient, cost-effective interface for their market investment activities. Global custodians are able to pass economies of scale on to clients by aggregating activity data and disseminating it in a consolidated form (report) tailored to the client’s specific needs. By consolidating and synthesizing the client’s activities, the global custodians reduce back office costs and facilitate the client’s ability to manage their business and risks. Combining the custody function with an international commercial bank, Trust Banks provide a single, convenient, cost effective means of currency transactions, cash management, securities lending and other activities. Clients include public and corporate retirement funds, foundations, endowments, and global financial institutions (banks, broker dealers, investment manages, insurance companies and mutual funds). STT is particularly strong with mutual funds. Revenues in this business are driven by the amount of assets under custody or administration (“AUC/A”). AUC/A drives the business in part because STT charges a basis point fee based on the level of AUC/A, but also because the amount of assets leads to scale advantages and the ability/opportunity to provide ancillary services. Pricing can be piece meal, but more generally, pricing is done on a relationship basis in which core custody/administration is heavily discounted (nearly given away for large/active accounts) so that the Custody Bank can garner more AUC/A from which they can earn ancillary fees/products.
Particularly high profit ancillary products include: securities lending, FX, and deposit sweep. Securities lending involves STT splitting the earnings on client assets out on loan. FX revenues are generated by STT when they execute fx trades for clients to enable those clients to invest in foreign denominated securities or receive payments on foreign denominated securities. Deposit sweep arises from three sources of client activity: Frictional Cash, Buffer Cash and Safe Haven Cash.
The Custody business is sometimes confused for an asset light asset management type business – in reality, the economics look a lot more like a very good bank with STT earning an average of 20% ROTE in the custody business from 1999-2006 (excluding the financial crisis and subsequent period). In the past few years the custody business has been pressured because capital markets type revenues (securities lending and FX) have failed to meet expectations and NIM has been pressured by low rates.
The business has performed poorly because the custodian banks priced basic custody service as a give away to large accounts because they expected to make it up in securities lending and FX. Securities lending has been pressured by lower rates and risk reduction following 2008/09. FX has been pressured due to litigation surrounding standing instructions. These pressures have lead to STT earning a ROTE of 14% in 2011. In response the industry has begun a cost cutting initiative (Both STT and BK) and discussed pricing discipline. In the event the industry can get its act together (and ROE’s back to 20%), and STT were to be capitalized at 10% Basel III T1C, the custody business would earn approximately $3.90 per share. ($9.4bn of tangible capital earnings 20% over 485mm shares)
STT operates an asset management business with $2.1T in AUM, primarily in passive strategies. The company has a leading ETF franchise under the SPDR brand. This business has been very successful, growing AUM 11% annually over the past decade despite relatively flat equity markets. The business had $1,217mm in revenue in 2011 and assuming a 30% margin (consistent with BLK, BEN and other leading asset managers), should generate $.50 cents a share of earnings.
Catalyst
cost cuts, peltz successful, rates rise