Improved Fees Help BNY Mellon’s Q2 Results, But Is It Doing Enough On The Cost Front?

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Bank of New York Mellon

Bank of New York Mellon (NYSE:BK) comfortably beat investor expectations with its Q2 2015 results earlier this week, as the banking giant reported one of its best operating performances in recent years by churning out higher fee revenues from asset servicing, clearing and foreign exchange trading activities. [1] Incidentally, this was the first time since the economic downturn of 2008 that BNY Mellon’s total fee-based revenues (as adjusted for one-time gains) crossed the $3 billion mark. Also, an improvement in the net interest margin figure for the second consecutive quarter helped net interest revenues reach $779 million in Q2 – the second highest level in the bank’s history after the marginally higher $780 million figure in Q4 2011.

BNY Mellon also did well to increase the size of assets under custody and administration (AUC/A) to a record $28.6 trillion in Q2 2015 compared to a figure of $28.5 trillion in Q1 2015 as well as Q2 2014 despite the negative effect of unfavorable foreign exchange movements. However, the bank’s investment management arm saw a reduction in total assets under management (AUM) despite net inflows to end the period at $1.72 trillion – below the record $1.74 trillion reported at the end of Q1.

BNY Mellon appears to have excelled in terms of costs, too, as the total non-interest expenses for the quarter (adjusted for charges related to amortization, restructuring and litigation) were the lowest in three years. But it must be noted that expenses benefited from exchange rate movements, and things would not have been so good in constant dollar terms. This leads us to question the extent to which the bank is implementing cost cutting measures.

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We maintain a $46 price estimate for BNY Mellon’s stock, which is slightly ahead of the current market price.

See our full analysis for BNY Mellon here

Good News On The Interest Front, Things Should Improve Early Next Year

Our analysis of BNY Mellon shows that the bank draws 44% of its value from its investment servicing business (which includes asset servicing as well as issuer, clearing and treasury services) 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 around $320 billion. While the size of these assets has 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 between 2010 and 2014 – as the NIM fell from almost 1.9% to an all-time low of 0.91% over this period. The importance of a healthy NIM figure for BNY Mellon’s value can be easily understood from the fact that a 1 basis point (0.01%) increase or decrease in the NIM figure can raise or lower the bank’s total revenues by roughly $32 million. This is just under 1% of the bank’s total average quarterly revenues of $3.9 billion over recent years.

Fortunately, the interest margin has seen an improvement over the last two quarters after witnessing a decline for five consecutive quarters. The NIM figure for Q2 2015 was 1%, and coupled with a sequential 3.4% jump in average interest-earning assets, this helped net interest revenues jump 7% quarter-on-quarter. Although the NIM figure can potentially fall again over the next couple of quarters, there will be a notable increase once the Federal Reserve hikes benchmark interest rates. With the rate hike likely to come in the last quarter of 2015, BNY Mellon is poised to realize considerable gains on its large interest-earning asset base early next year.

Not Making Much Headway In Slashing Costs

BNY Mellon has been under considerable pressure from some of its biggest investors since early this year to cut costs and improve its returns. In April, one of the investors – Marcato Capital Management – called for major changes to the top management team based on claims that the bank has been performing below par over recent years. [2] Marcato estimated that the bank has roughly 10,000 more employees than it needs (representing 20% of the total headcount) based on comparisons made with several competitors.

Notably, BNY Mellon reported a notable year-on-year reduction in non-interest expense figures for Q1 as well as Q2, with adjusted non-interest expense figure of $2.6 billion for Q2 2015 being the lowest in three years. But the primary reason for this has been the increasing strength of the dollar, and not an improvement in operating efficiency at the ground level. In fact, BNY Mellon’s employee count has increased from 50,300 at the end of 2014 to 50,700 at the end of Q2 2015. This will undoubtedly elevate employee-related costs for the last two quarters of 2015 on a year-on-year basis, and may have a negative impact on operating margins for the year. 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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Notes:
  1. Second Quarter Earnings, BNY Mellon Financial Releases, July 21 2015 []
  2. Presentation, Marcato, Apr 7 2015 []