State Street’s Strong Q2 Results Accompanied By Higher Expense Outlook

There was a mix of good and bad news for investors when State Street (NYSE:STT) followed up a better-than-expected second quarter performance with an announcement that expenses are likely to grow faster than revenues for the second half of the year. ^[1] The bank reported strong revenues of $2.6 billion in Q2 2014 – a 5% improvement quarter-on-quarter – on the back of higher servicing and securities lending fees. A continued focus on cutting costs and an effective tax rate of under 17% for the period helped State Street report a net income figure which was 71% higher quarter-on-quarter and 7% higher year-on-year. Also, State Street’s assets under custody and administration (AUC/A) and assets under management (AUM) reached record levels of $28.4 trillion and $2.48 trillion, respectively, at the end of Q2 2014. Notably, this brings the bank within striking distance of larger rival BNY Mellon (NYSE:BK) for the title of the world’s largest custody bank, as the latter reported a marginally higher $28.5 trillion in AUC/A for the period.

However, State Street warned about a likely reduction in profit margins over the third and fourth quarters of the year. ^[2] Fee revenues are not expected to see a jump similar to the one seen this quarter for the rest of the year, and the continuing pressure on net interest margins will keep interest revenues depressed. At the same time, State Street expects higher regulatory expenses to eat into the bottom line.

We maintain a $77 price estimate for State Street’s stock, which is roughly 10% ahead of the current market price.

See our full analysis for State Street

Interest Margins Continue To Suffer

Our analysis of State Street shows that the bank draws almost half of its value from its asset servicing business. The next biggest source of value for the bank is the interest it earns on its interest-earning asset base of almost $240 billion – shown in the chart above as proprietary investments. 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. State Street, like its peer BNY Mellon (NYSE:BK), has seen a particularly sharp revenue hit from shrinking net interest margin (NIM) figures.

The current economic conditions have squeezed State Street’s NIM figure from a high of 2.2% in early 2010 to its current all-time low figure of 1.12% (operating basis). This disparity between the figure four years ago and today is quite large. To put things in perspective, if State Street’s NIM figure for Q1 was 2% instead of the 1.24% it witnessed, then its net interest revenues for the period would have been roughly $900 million instead of the reported figure of $561 million. You can understand the impact of falling margins on State Street’s total share value by making changes to the chart below.

Higher Fee Revenues More Than Make Up For The Shortfall

State Street’s steadily growing asset base helped fee revenues scale new heights to cross the $2 billion mark for the first time. Servicing fees are responsible for almost 62% of these revenues – hardly a surprise considering the bank is the second-largest custodian in the world with $28.4 trillion in AUC/A. The notable increase in the AUC/A portfolio, which has jumped 3% sequentially and a good 10% since last year, is the reason for the healthy improvement in fees. Another factor that played an important role is that the second quarter sees a seasonally higher demand for securities lending services – something that helped fees from these services increase 73% quarter-on-quarter to $147 million in Q2 2014.

Focus On Costs For The Next Two Quarters

State Street’s operating expenses of $1.82 billion for the quarter were 5% below the figure for the previous quarter, although the figure rose 3% year-on-year. The bank has been trying to reduce costs by exploring ways to improve operating efficiency for several quarters now as a part of its “Business Operations and Information Technology Transformation” program. The cost-cutting program aims to achieve around $600 million in annual pre-tax savings by next year, and has made some progress towards achieving its goal. But the bank expects headwinds in its efforts for the rest of the year, as higher litigation costs are likely to inflate expenses. This, coupled with a largely lack-luster revenue performance for the period, implies that operating margins for the bank will shrink over Q3 and Q4 2014.

The sensitivity of State Street’s stock to its operating margins can be better understood by making changes to the chart below.

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1. Q2 2014 Press Release, State Street Press Releases, July 22 2014 [↩]
2. State Street Gives Disappointing Expense Outlook, The Wall Street Journal, July 22 2014 [↩]