State Street Announces Job Cuts After Poor ETF Growth, Swelling Expenses Hurt Q3 Results

Late last week, State Street (NYSE:STT) announced performance figures for the third quarter that were well below expectations, as a reduction in fee-based revenues coupled with higher operating costs dragged down the bottom line. ^[1] Investor expectations for State Street were raised over recent weeks, as the bank’s primary competitors in the custody banking and asset management industries – Bank of New York Mellon (NYSE:BK) and BlackRock (NYSE:BLK), respectively – reported strong operating results for the period. While BNY Mellon posted record revenues for its asset servicing division, State Street generated lower fees from these operations compared to a year ago. At the same time, the fact that State Street witnessed net outflows of $29 billion for a quarter when its larger rival BlackRock enjoyed net inflows of $50 billion highlights another weak showing from the bank’s asset management arm.

State Street tried to make up for the poor operating performance by detailing plans to reduce its headcount by 600 by the end of 2016 – a move that is expected to reduce annual recurring costs by roughly $50 million. This announcement did not appease most investors, though, as the bank’s shares dropped by around 3% over trading on Friday, October 23.

While State Street’s decision to work on cutting costs should add value in the long run, we believe that the bank’s declining strength in the asset management industry – especially in the rapidly growing exchange-traded fund (ETF) category – is a cause for concern. This is why we have reduced our price estimate for State Street’s stock from $80 to $77. The new target is roughly 15% ahead of the current market price

See our full analysis for State Street

Fee Revenues Disappoint, Interest Rate Pressure Hits Interest Income

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 $225 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. But a reduction in the size of total interest-earning assets exacerbated the impact of a falling NIM figure on State Street’s top line, as bank reported net interest income of just $513 million in Q3 – the lowest since the economic downturn of 2008. State Street’s NIM figure slipped another basis point (0.01% point) over the quarter to reach an all-time low figure of 0.95% (operating basis).

Sharp reductions in market valuation across asset classes resulted in a reduction in the size of assets under custody and administration (AUC/A) from the record $28.65 trillion in Q2 2015 to under $27.3 trillion this time around. The bank’s asset management arm also saw a reduction in total assets under management (AUM) due to net outflows and lower valuations to end the period at $2.2 trillion – marking a decline for the third consecutive quarter from the record high of $2.45 trillion reported in Q4 2014. As a result, State Street reported a reduction in asset servicing as well as asset management fees compared to Q2 2015 and Q3 2014.

Although total fee income crossed the $2.1 billion mark for the first time this quarter, adjusting this figure for the one-time gain of $83 million from the sale of commercial real estate shows that these revenues fell 3% sequentially. Only State Street’s trading and foreign exchange unit reported an improvement in revenues year-on-year as well as quarter-on-quarter, although the gains were not sizable.

State Street’s ETF Offerings Continue To Fall Out Of Favor

The popularity of ETFs and other exchange traded products (ETPs) is evidenced by the fact that the industry has grown to almost $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. We have pointed out the steady decline in market share for State Street on numerous occasions in the past, and with outflows continuing in Q3 2015, the gap between State Street and Vanguard has widened considerably. While BlackRock had $742 billion in assets under management across its ETF offerings at the end of Q3 2015, the figure for Vanguard was $445 billion compared to less than $390 billion for State Street. ^[2]

Notably, BlackRock and Vanguard reported strong inflows in Q1 followed by nominal inflows in Q2 and Q3, while State Street ended up with net outflows for each of the three quarters. The trend indicates that retail and institutional clients may be switching from State Street’s ETFs and moving their cash to competitors’ offerings instead – something that does not bode well for the bank’s long term value.

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1. Q3 2015 Press Release, State Street Press Releases, 23 Oct 2015 [↩]
2. Painful Quarter Doesn’t Stop ETF Inflows, ETF.com, Oct 1 2015 [↩]