Why State Street’s Stock Is Worth $75 Despite Its Dwindling ETF Fortunes

State Street (NYSE:STT) saw its shares plummet 7% over trading last week after the global custody banking giant failed to meet investor expectations for its Q4 results due to a year-on-year reduction across its key revenue streams. ((Q4 2015 Press Release, State Street Press Releases, 27 Jan 2016)) While the last quarter of the year was a poor period for the banking sector as a whole, investors were not happy with the fact that State Street fared worse than its primary competitors in the custody banking and asset management industries – Bank of New York Mellon (NYSE:BK) and BlackRock (NYSE:BLK), respectively. BNY Mellon managed to improve revenues year-on-year compared to the 3.3% decline for State Street, while asset management giant BlackRock reported strong inflows of $54 billion for the quarter – in sharp contrast to the $19 billion in outflows for State Street.

The increasing pressure on State Street’s top line figure is definitely a cause for concern. But it must be noted that an important factor behind this trend is the strengthening U.S. dollar – something that had a sizable negative impact on revenues for the geographically diversified custody bank. Also, the fact that State Street’s wealth management operations have lagged behind other players in the industry – especially in the ETF segment – does not warrant such a strong reaction from investors, as these operations are a very small part of the bank’s business model (~11% of total value).

All things considered, State Street remains a key player in the custody banking industry and will see notable improvements in revenue over subsequent quarters as the Fed’s decision to hike benchmark interest rates eases the pressure on its net interest margins. Also, the bank’s decision to pursue a deal to acquire GE’s asset management business should give its unit a shot in the arm. ^[1] State Street’s continuing efforts to cut operating costs should also help ensure that profits do not decline in the short term. Keeping all these factors in view, we maintain our $75 price estimate for State Street’s stock, which is roughly 35% ahead of the current market price

See our full analysis for State Street

Custody Banking Remains Strong, Will Drive Future Growth 

Our analysis of State Street shows that the bank draws almost half of its value from its investment servicing business, which provides custody and administration services to financial institutions around the globe. With State Street securing $300 billion in additional mandates over the last quarter, and with equity valuations improving considerably since the dismal Q3 2015, there was an increase in the size of assets under custody and administration (AUC/A) from under $27.3 trillion in the previous quarter to over $27.5 trillion now. While AUC/A in North America gained 1.5% q-on-q, the figure for the EMEA region fell 1.2% as a result of a stronger dollar. This weighed on servicing fees, which fell 2% compared to Q3 2015 as well as Q4 2014.

The fourth quarter of the year is usually the weakest period for the seasonal custody banking industry. Although exchange rate fluctuations are likely to remain a concern in the near future, the steady increase in custody and administration mandates will be the primary driver of growth in State Street’s profits in the future.

Cost Cutting Initiative Should Have A Sizable Impact On Profits

After a poor showing in Q3 2015, State Street detailed plans to reduce its headcount by 600 by the end of 2016 in a bid to reduce annual recurring costs by roughly $50 million. In Q4, the bank announced additional cost cutting measures as a part of the more elaborate State Street Beacon program. The multi-year program includes the previously-announced headcount reduction and additional investments in technology with an overall goal to improve operating efficiency. The new plan will save roughly $550 million in operating costs over the next five years and will itself cost between $300-400 million to implement. In the long run, annualized cost savings should be north of $100 million – representing a little more than 1% of State Street’s annual expenses of $8 billion for 2015.

You can understand how sensitive State Street’s share price is to its non-interest expenses by making changes to the chart below.

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1. State Street nears deal for GE’s asset management arm, Reuters, Feb 4 2016 [↩]