Low Interest Income, One-Time Expenses Drag Down BNY Mellon’s Q2 Results

At first glance, Bank of New York Mellon’s (NYSE:BK) results for the second quarter of the year look rather poor, with the net income figure being 16% lower than that for the previous quarter and a good 33% below the figure for the same period last year. ^[1] However, a more detailed look at the custody bank’s numbers reveal that it actually did fairly well over the period. This is because the bank incurred one-time charges of $161 million this quarter related to its investment management funds and severance, adjusting for which shows a 9% quarter-on-quarter improvement in pre-tax income. Also, adjusting the Q2 2013 results for the one-time equity investment gain of $109 million shows that the actual year-on-year decline is a little more than 11% – a difference that can be almost completely attributed to the much better foreign exchange and trading performance last year as well as to the notable decline in net interest revenues over the period.

There are other pieces of good news to be found in BNY Mellon’s Q2 results, including record asset servicing revenues of over $1 billion stemming from record levels of assets under custody and administration (AUC/A) and assets under management (AUM) of $28.5 trillion and $1.64 trillion, respectively. The  global custody bank also continues to focus on cutting expenses, as adjusted non-interest expenses of $2.64 billion in Q2 2014 were 2% lower than the figure for Q2 2013 and almost 4% below that of Q1 2014. This improvement can be traced back to a notable reduction in employee costs.

The better-than-expected operating margin improvements coupled with an uptick in fee-based revenues led us to revise our price estimate for BNY Mellon’s stock upwards from $35 to $38.

See our full analysis for BNY Mellon here

Low Interest Environment Continues To Eat Into Profits…

Our analysis of BNY Mellon shows that the bank draws 30% of its value from its asset servicing business and another 27% from its asset management business – something that is easily understood given that it is the world’s largest custody bank and also a key player in the global asset management business. However, as can be seen from the chart above, the next biggest source of value for the bank is the interest it earns on its interest-earning asset base of just over $300 billion. While the size of these assets have grown considerably over recent years, the prolonged low-interest rate environment has put considerable pressure on interest margins across banks. BNY Mellon has seen a particularly sharp revenue hit from shrinking net interest margin (NIM) figures.

The current economic conditions have squeezed BNY Mellon’s NIM figure from a high of almost 1.9% in early 2010 to its current all-time low figure of 0.98%. This disparity between the two figures is quite large, as the NIM has nearly halved in less than four years. To put things in perspective, if BNY Mellon’s NIM figure for Q2 was 1.9% instead of the 0.98% it reported, then its net interest revenues for the period would have been roughly $1.4 billion instead of the reported figure of $719 million. You can understand the impact of falling margins on BNY Mellon’s total share value by making changes to the chart below.

With the Fed’s tapering plan underway, we expect interest rates to improve over the second half of the year – allowing BNY Mellon to report its first quarter-on-quarter improvement in interest margins as early as Q3 2014.

Cost Management Mitigating The Effect

As we mentioned above, BNY Mellon reported adjusted non-interest expenses of $2.64 billion for the first quarter of 2014 – the lowest in the last seven quarters. A key factor behind this cost-cutting drive has been investor pressure on BNY Mellon to take a hard look at expenses in an environment not conducive to growing revenues. While severance payments resulted in a one-time increase in the bank’s non-interest expense for the quarter, the benefit on profitability showed almost immediately, as staff costs in Q2 2014 fell to the lowest level since Q3 2012. We expect BNY Mellon to report lower staff costs for the rest of the year as a direct result of these job cuts, with recurring margin benefits accruing in the future.

You can understand how sensitive BNY Mellon’s share price is to its non-interest expenses by making changes to the chart below.

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1. Second Quarter Earnings, BNY Mellon Financial Releases, July 19 2014 [↩]