State Street Shares Fall Despite A Strong Q1 Performance

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State Street (NYSE:STT) reported better-than-expected performance figures for the first quarter of the year on Friday, April 24, on the back of record fee-based revenues. ((Q1 2015 Press Release, State Street Press Releases, Apr 24 2015)) The custody banking giant’s results were aided by an exceptionally strong showing by its securities trading unit – a direct result of the increased global activity from the Swiss central bank’s unexpected decision to remove the cap on the Swiss franc. This, coupled with notable year-on-year gains in servicing and management fees, helped State Street mitigate the impact of declining interest margins on its top line – allowing it to report quarterly revenues that were above $2.6 billion for only the second time since the economic downturn. Moreover, State Street managed to increase its assets under custody and administration (AUC/A) for the quarter to a record $28.5 trillion thanks to improved market valuations and fresh mandates it received in Q1. The size of the bank’s assets under management (AUM), however, shrunk marginally due to negative foreign exchange movements.

Despite the string of good news State Street had to offer, the bank’s shares lost 2.3% of their value over trading on Friday. This can be attributed to a few specific factors that did not go State Street’s way. The biggest factor remains the rapid decline in State Street’s net interest margin (NIM) figure, which fell to a record low of 1.06% in Q1 2015. Another important factor is the worse-than-expected operating margin for the quarter, which was hurt by a one-time legal provision of $150 million. State Street has set aside $330 million over the last three quarters for its long-drawn foreign exchange lawsuit, and the top management recently admitted that the final settlement figure could be much higher. [1] Investors were clearly not happy about the bank’s legal overhang.

All things considered, State Street remains one of the largest players in the custody banking and asset management industries, and the issues pertaining to its shrinking interest margins and legal burden are unlikely to affect its value in the long run. This is why we stick to our $81 price estimate for State Street’s stock, which is roughly 10% ahead of the current market price.

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See our full analysis for State Street

Record Fee Revenues Balance Lower Interest Revenues For Now

Our analysis of State Street shows that the bank draws almost half of its value from its investment 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. 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 1.01% (operating basis).

Despite a steady growth in interest-bearing assets over recent years, the falling net NIM figure resulted in State Street reporting a net interest income of just $546 million in Q1 – the lowest since the economic downturn of 2008. Thankfully, State Street’s steadily growing asset base helped fee revenues reach a record $2.06 billion for the period. Fee revenues have now been above the $2-billion mark for four consecutive quarter. Although servicing fees fell slightly from the $1.3-billion level seen in each of the last two quarters to $1.27 billion, trading operations roped in $324 million this time around – the highest since Q3 2011.

Cost-Cutting Efforts, Increasing Legal Provisions

State Street has been trying to reduce costs by exploring ways to improve its 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 2015, and has made some progress towards achieving its goal. While the first quarter of the year normally sees higher employee-related costs due to bonus payouts, the bank did well to report a 6% reduction in compensation expenses year-on-year. The reduction in these costs was unable to negate the impact of a $150 million increase in legal provisions by the bank to cover its remaining forex-related lawsuits, though. 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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Notes:
  1. State Street Earnings Beat Expectations, The Wall Street Journal, Apr 24 2015 []