State Street’s Biggest Concern In Q2 Was Slowing ETF Growth, Not Increasing Costs

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Investors were not happy with the Q2 results State Street (NYSE:STT) announced late last week, and they made their displeasure evident by sending the custody bank’s shares down 5% over trading on Friday, July 24. ((Q2 2015 Press Release, State Street Press Releases, Jul 24 2015)) Their biggest source of concern was the fact that State Street’s expense figure jumped to above $2.1 billion for the first time ever. The reason can be traced to the $250 million in additional legal reserves this quarter – up from $150 million in Q1 2015. With the total amount set aside by the bank to settle its long-drawn foreign exchange lawsuits reaching a much larger-than-expected $580 million in the last four quarters, the uncertainty surrounding the legal overhang irked investors. Operating expenses were also elevated in Q2 due to higher regulatory and compliance costs.

We do not think that either of these factors warrant the sell-off in State Street’s shares. The company’s management mentioned that the financial aspect of the settlement has been agreed upon by all concerned parties, and so the issue should be resolved soon. Moreover, higher regulatory and compliance costs stem from tighter regulatory requirements, and are not an issue specific to State Street. In fact, State Street has done quite well over the quarter to increase its revenues sequentially despite the notable reduction in net interest income. Record asset servicing fees for Q2 go a long way in demonstrating the strength of State Street’s custody banking services.

In our view, the only real weakness displayed by State Street was continued outflows in its exchange-traded fund (ETF) business. As we pointed out in an article earlier, State Street has been unable to keep up with rivals BlackRock and Vanguard, and is steadily losing market share in the rapidly growing industry (see BlackRock, Vanguard Post Big Gains From Record ETF Inflows While State Street Loses Its Way).

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We maintain an $80 price estimate for State Street’s stock, which is slightly ahead of the current market price.

See our full analysis for State Street

Fee Revenues Reach Another Record, Although Interest Income Nosedives

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 around $235 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 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 0.96% (operating basis).

Despite steady growth in interest-bearing assets over recent years, the falling NIM figure resulted in State Street reporting a net interest income of just $535 million in Q2 – the lowest since the economic downturn of 2008. Fortunately, State Street’s steadily growing asset base helped fee revenues reach a record $2.08 billion for the period. Fee revenues have been above the $2-billion mark for five consecutive quarters now, and this is unlikely to change in the future. The primary driver of growth was the record asset servicing fee figure of $1.32 billion, which in turn was a direct result of the bank’s assets under custody swelling to a record $28.65 trillion.

State Street Needs To Revamp Its ETF Offerings

The popularity of ETFs and other exchange traded products (ETPs) is evidenced by the fact that the industry has grown to $3 trillion in size from being a largely obscure investment option at the turn of the century. The reason for this growth is that ETFs provide investors a cheap and convenient way to put their money into fixed income, equity, currency, commodities and other investment markets. And with its popularity really only skyrocketing in the past few years, the industry has the potential to continue to grow considerably in the future.

But State Street has struggled to keep its competitors at bay over recent quarters, with Vanguard beating it to the position of the world’s second largest ETF provider. While BlackRock and Vanguard reported strong inflows in Q1 followed by nominal inflows in Q2, State Street ended up with net outflows for each of the two quarters. Notably, State Street’s fixed income and alternative ETFs saw marginal inflows over the first half of the year, as opposed to its equity ETFs, which lost $47 billion in investor cash over the period ($33 billion in the first quarter and $14 billion in the second quarter). The trend, which is in contrast to what is seen across the industry, indicate a need for State Street to improve its equity ETF offerings to remain competitive.

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