Despite Expected Headwinds, State Street’s Still Worth $80

When State Street (NYSE:STT) released its results for the fourth quarter of the year on Friday, January 23, investors took little note of the fact that the custody banking giant had comfortably beat their revenue as well as earnings expectations for the period. ^[1] Instead, the focus was on the weak outlook for 2015 that State Street’s management presented. The prolonged low-interest rate environment has put pressure on the bank’s top line figure for several quarters now, and the situation is not expected to improve over 2015 with State Street likely to report lower net interest income for the year. Moreover, the bank will also end up incurring higher costs to comply with capital requirement standards – negatively impacting operating margins.

To add to State Street’s woes, reports released the same day showed that the bank slipped to the third position in the U.S. exchange-traded fund (ETF) industry, with Vanguard edging past it to capture the #2 spot after industry leader BlackRock (NYSE:BLK). ^[2] As the primary reason for this is the steady outflow of assets from some of State Street’s largest ETF offerings – including the SPDR S&P 500 ETF, which is the world’s largest ETF – investors viewed this as a sign of the bank losing ground to competitors in the rapidly growing industry. In response, investors promptly led State Street’s shares 6.1% lower over trading that day.

While we acknowledge the downside risk presented by shrinking interest margins as well as operating margins, we believe that investors over-reacted to the negative news. We maintain our price estimate of $80 for State Street’s stock, which is roughly 10% ahead of the current market price.

See our full analysis for State Street

Interest Margins Should Reverse Declining Trend By End Of 2015

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 $230 billion – shown in the chart above as proprietary investments. While the interest-bearing assets have grown considerably over recent years, the prolonged low-interest rate environment has put considerable pressure on interest margins across banks. State Street, along with its larger competitor BNY Mellon, has seen a particularly sharp revenue hit from shrinking net interest margin (NIM) figures as custody banks are more sensitive to interest rate fluctuations compared to their commercial banking peers.

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 1.04% (operating basis). We expect margins to pick up later this year once the Fed raises benchmark interest rates. You can estimate the impact of changes in interest margins on State Street’s total share value by making changes to the chart below.

ETFs Represent A Small Part Of State Street’s Business Model

ETFs have steadily grown over the last decade to become one of the most popular investment options for institutional as well as retail investors – primarily thanks to their flexibility and transparency. Over the years, State Street has emerged as one of the largest providers of ETFs in the world, and it remains a formidable player in the industry despite being unable to capitalize on the ETF growth story to the same extent as some of its peers. While slower growth in ETF assets for State Street undoubtedly points to a reduction in overall value for the bank, the impact is not particularly sizable. This is because State Street’s primary source of value is its custody banking business, with ETFs accounting for less than 5% of its total value.

You can see in the chart below how State Street’s stock is impacted by the assets under management for its ETFs. Assuming that these assets remain at the current level for the rest of the future – a very pessimistic outlook – the reduction in share value is still less than 2%.

Increased Regulatory Costs Should Be Countered By Cost-Cutting

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 the end of this year, and has made some progress towards achieving its goal. While operating expenses of almost $2 billion for the quarter were higher than the $1.85 billion figure for the year-ago period, the figure for this quarter also saw a one-time legal charge of roughly $100 million. We expect State Street’s strict expense management focus to help alleviate some of the negative impact on its bottom line from increased regulatory costs.

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. State Street Reports Fourth-Quarter 2014 GAAP-Basis EPS of $1.24 on Revenue of $2.6 Billion; Full-Year 2014 GAAP-Basis EPS of $4.69 on Revenue of $10.3 Billion, State Street Press Releases, Jan 23 2015 [↩]
2. Vanguard Rises To No. 2 ETF Firm By Assets, ETF.com, Jan 23 2015 [↩]