State Street’s Core Operating Strengths Justify $78 Price

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State Street’s (NYSE:STT) shares took a beating on Friday after the custody bank reported worse-than-expected figures for the last quarter, with their value sinking 4.5% over trading that day. ((State Street Reports Fourth-Quarter 2013 GAAP-Basis EPS of $1.22 on Revenue of $2.46 Billion; Full-Year 2013 GAAP-Basis EPS of $4.62 on Revenue of $9.88 Billion, State Street Press Releases, Jan 24 2014)) Incidentally, shares of State Street’s larger competitor Bank of New York Mellon (NYSE:BK) met the same fate a week earlier – meaning the market’s expectations from custody banks for Q4 were likely inflated due to similar factors.

The factors in question are those which have been plaguing the banking industry for quite some time now – record low interest rates and litigation-related expenses. In State Street’s case, the latter had a bigger role to play as litigation provisions of $45 million increased its “other expenses” to $337 million for Q4 – 21% higher than the figure for the same period last year and 32% more than that for Q3 2013.

But looking beyond this, there were some promising developments for State Street which will drive profitability in the near future. Firstly, the bank’s asset base saw considerable growth over the period. Also, the bank’s expenses continue to tell a good story on an operating basis.

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While litigation expenses are going to remain a concern over coming quarters, they do not impact our long-term view of State Street. We maintain a $78 price estimate for State Street’s stock, which is about 10% ahead of the current market price.

See our full analysis for State Street

State Street Leaves Asset-Growth Woes In The Past

State Street raised concerns among investors at the end of Q3 2013 because growth in its asset base had been notably lower than those of its biggest competitors for that period. Intense competition in the custody banking and asset management industry has resulted in a reduction in fee revenues as a percentage of assets for most market players over recent years. So, the only option they have to improve revenues is to resort to steady asset growth.

Those concerns were largely assuaged this time around, with State Street’s assets under custody / administration (AUC/A) jumping to a record $27.4 trillion at the end of the year – a good 5.5% higher than the figure at the end of Q3 2013. In fact, State Street’s custody assets are now within striking distance to the $27.6 trillion AUC/A figure for the world’s largest custody bank, BNY Mellon.

State Street also reported record assets under management (AUM) figures of $2.3 trillion at the end of the period. The strong asset growth reflected on the income statement too, as the bank’s servicing fees as well as management fees for the last quarter were record figures of $1.23 billion and $290 million, respectively.

Overall Progress On Cost-Cutting Front Looking Good

State Street’s operating expenses of $1.76 billion for the quarter were 3% above the figure for the same quarter last year and 4% above that for the previous quarter. A bulk of this change can be attributed to higher incentive-based compensation for the period, which saw strong inflows and considerable market appreciations of assets – something we have already pointed out above.

The bank has been trying to reduce costs for several quarters now and exploring ways to improve operating efficiency. Cost improvements continue to be seen in the bank’s IT expenses, and the decision by State Street’s top management to keep working on costs over coming quarters is good news as the bank’s stock value is quite sensitive to its operating margins – something that can be seen by making changes to the chart below.

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