State Street Shares Worth $80 Despite Short-Term Headwinds Across Its Operating Divisions

State Street‘s (NYSE:STT) shares have lost more than 5% of their value since the global custody banking giant reported its results late last week, as investors expressed their concern about the bank’s sub-par revenues for the period while industry headwinds and recent developments threaten to hurt profits in the near future. ^[1] While the ongoing trend of investors transferring cash from traditional investment options like mutual funds to low-cost ETFs is expected to have an overall negative impact on the industry as a whole, reports that the bank lost the mandate to service $1 trillion in BlackRock’s assets to rival JPMorgan only made things worse for State Street. ^[2]

While we have highlighted State Street’s diminishing market share in the rapidly growing ETF industry on several occasions in the past, the loss of BlackRock’s assets also means that JPMorgan will take the position of second largest custody bank in the world from State Street once the process of transferring assets is completed. This does not bode well for the bank, as nearly half its value comes from its core custody banking business, and a weaker position in the custody business may hurt growth prospects going forward.

That said, State Street remains an established player in the custody banking industry, and such a large-scale movement of assets is rare in the industry – something we believe is best categorized as a one-off event attributable to BlackRock’s decision to spread its assets across more custody bankers. More importantly, State Street is poised to see a sharp increase in revenues over subsequent quarters as the Fed continues to hike benchmark interest rates. This, coupled with State Street’s efforts to cut operating costs, should help ensure that profits grow over subsequent quarters. Keeping this in mind, we maintain a $80 price estimate for State Street’s stock, which is slightly ahead of the current market price

See our full analysis for State Street

The table above summarizes the factors that aided State Street’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. As shown in the table, the bank fared worse than it did in the previous quarter on nearly all revenue and cost fronts. But it should be noted that the third quarter is a seasonally strong period for custody banks, as fees from issuer services peak for the quarter. Also, trading and other revenues saw a one-time hit from increased amortization of its tax advantaged investments – masking the fact that increased volatility in the forex industry helped trading revenues increase in Q4 2016 compared to Q3 2016 as well as Q4 2015.

More importantly, the sharp increase in compensation expenses compared to both quarters is due to a one-time charge of $249 million linked to the bank’s employee benefit scheme. Factoring this in, compensation expenses fell sequentially and were slightly higher y-o-y primarily due to the bank’s acquisition of GE’s asset management arm. A key factor behind this is State Street’s focus on upgrading its technology platform to improve client offerings while also cutting costs as a part of its ongoing State Street Beacon program. The multi-year program achieved pre-tax savings of $175 million over full-year 2016, and will help the bank slash recurring costs by an additional ~$400 million over coming years. You can understand how this impacts State Street’s share price by making changes to the chart below.

State Street Should Be Able To Take Loss Of Assets To JPMorgan In Stride

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. While BlackRock’s decision to shift assets worth more than $1 trillion out of State Street to rival JPMorgan is bad news for the bank, this represents less than 3.5% of State Street’s $28.8 trillion in assets under custody and administration (AUC/A) at the end of 2016. Additionally, the bank won asset servicing mandates worth $1.4 trillion over full-year 2016 – so it is very likely that the bank will make up for the lost assets by the end of 2017.

Also, as State Street earns roughly $180 in annual fees for every million dollars in AUC/A, the lost assets translate to a reduction in total revenues of roughly $180 million. That’s just over 2% of its total fee revenues of $8.1 billion for full-year 2016 – hardly a cause for concern in the long run. We believe that the bank’s strong growth in the Asia Pacific region over recent quarters will be key to making up for the lost revenue over coming months.

Fortunes For State Street’s ETF Business Have Improved Over Recent Quarters

The ETF industry has seen rapid growth in recent years, and has grown to almost $4.5 trillion in size. 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 consolidating its position as the world’s second largest ETF provider at State Street’s expense. In fact, the market leader BlackRock and Vanguard have reported strong inflows in several quarters over recent years even as State Street witnessed net outflows. This resulted in State Street’s ETF assets stagnating over 2014-16 – in strong contrast to growth exceeding 15%annually for BlackRock. Things improved for State Street in Q4 2016, though, as its equity ETF offerings raked in $41 billion in net new assets for the quarter. Even fixed income ETFs witnessed net inflows, albeit a relatively modest $1 billion. The inflows in ETF assets helped counter outflows in State Street’s long-term institutional as well as cash management funds for the period, as detailed in the table below.

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1. Q4 2016 Press Release, State Street Press Releases, 25 Jan 2017 [↩]
2. J.P. Morgan to Become Custodian for $1 Trillion in BlackRock Assets, The Wall Street Journal, Jan 25 2017 [↩]