State Street Posts Strong Q3 Results As Swelling Asset Base Brings In Record Servicing Fees

State Street (NYSE:STT) saw its shares jump 4.3% over trading on Friday, October 24, after the custody banking giant topped Q3 expectations on the back of a marked increase in fee-based revenues. ((Q3 2014 Press Release and Addendum, State Street Press Releases, Oct 24 2014)) The bank’s results mirrored the performance of its rival, Bank of New York Mellon (NYSE:BK), which reported its performance for the third quarter earlier last week (see Record Fee Revenues Help BNY Mellon Post Strong Q3 Results Despite Shrinking Interest Margins). However, the results were much better than what investors were looking for primarily because State Street had provided a weak outlook for the second half of the year in July. ((State Street Gives Disappointing Expense Outlook, The Wall Street Journal, July 22 2014)) State Street warned then that profit margins over the third and fourth quarters of the year were likely to be hit by falling net interest revenues, lower fee revenues and higher regulatory expenses – none of which adversely affected Q3 numbers. In fact, the bank’s adjusted operating margin figure (non-GAAP) of 32.4% was the best for any quarter since the economic downturn of 2008.

More importantly, State Street managed to increase its assets under custody and administration (AUC/A) for the quarter to a record $28.5 trillion despite falling security valuations and unfavorable foreign exchange movements – allowing it to edge past BNY Mellon’s $28.3-trillion figure to become the largest custody bank in terms of AUC/A.

We have increased our price estimate for State Street’s stock from $77 to $78, with the new estimate being roughly 10% ahead of the current market price.

See our full analysis for State Street

Swelling Fee Revenues Compensate For Shrinking Interest Margins

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 $220 billion – shown in the chart above as proprietary investments. The bank’s efforts to grow its custody banking business over recent years has countered the impact of a steady decline in net interest margin (NIM) figures over the period to a great extent. State Street’s NIM figure has fallen from a high of 2.2% in early 2010 to its current all-time low figure of 1.06% (operating basis).

On the other hand, State Street’s steadily growing asset base helped fee revenues remain above the $2 billion mark for a second consecutive quarter, with servicing fees increasing to a record $1.3 billion. Asset management fees and revenues from trading services were also up – seeing a notable improvement compared to the previous as well as the year-ago periods.

Cost-Cutting Efforts, Increasing Legal Provisions

State Street 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. While operating expenses of $1.89 billion for the quarter were slightly higher than what was seen in the previous quarter, employee-related expenses actually fell 3% sequentially. The reduction in compensation costs largely nullified the impact of a $53 million increase in legal provisions by the bank to cover its remaining forex-related lawsuits.

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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