BNY Mellon’s Q3 Results Highlight Shifting Industry Preferences, And The Bank Can’t Do Much About It

Bank of New York Mellon (NYSE:BK) reported stronger-than-expected performance figures for the third quarter of the year recently, as the world’s largest custodian leveraged its global strength to grow its top line even as continued focus on cutting costs boosted profits. ^[1] Improvement in market valuation across asset classes coupled with new mandates received over the quarter helped the bank’s assets under custody and administration (AUC/A) swell to a record $30.5 trillion from $29.5 trillion at the end of Q2 2016. The bank’s investment management arm also gained from improved valuation, as total assets under management (AUM) crossed $1.7 trillion after hovering around $1.65 trillion for four quarters. While the improved asset base led to higher fee revenues for BNY Mellon, the bank also benefited from an uptick in its net interest margin figure.

But a concerning trend is observable in BNY Mellon’s investment management business over recent quarters – the bank has not reported net inflows into its funds for a single quarter since Q1 2015. We believe there are two key reasons for this: the bank’s business model that focuses almost entirely on institutional clients, and the ongoing trend among investors of shifting their cash into low-cost exchange-traded fund (ETF) offerings. And neither of these factors have a short-term solution, which means that the bank will likely see investment management revenues decline over coming quarters.

That said, as the largest custody bank, BNY Mellon’s cornerstone asset servicing business should help mitigate these problems to an extent. Also, the bank stands to gain handsomely from the imminent rate hike by the Fed. Because of this, we maintain our $45 price estimate for BNY Mellon’s stock, which is slightly ahead of the current market price.

See our full analysis for BNY Mellon here

Fees From Investment Services Reach Record High

The table above summarizes the factors that aided BNY Mellon’s pre-tax profit figure for Q3 2016 compared to the figures in Q3 2015 and Q2 2016. Notably, the bank’s investment services fees were responsible for an improvement in profits y-o-y as well as sequentially. Our analysis of BNY Mellon shows that the bank draws more than 45% of its value from its investment servicing business which includes asset servicing, issuer services, clearing services and treasury services units. The seasonal nature of revenues from the bank’s issuer services unit played an important role in the jump in revenues compared to Q2, as issuer services fees were $103 million higher this time around (a 44% jump q-on-q).

The other units reported revenues that were largely unchanged compared to the other two quarters, because of which total investment servicing fees rose to an unprecedented $1.89 billion. The core asset servicing business anchored results with fees of over $1 billion – 27% of total revenues for the quarter – thanks to the notable increase in the asset base to a record $30.5 trillion. After all, BNY Mellon is the world’s largest custody bank with a comfortable lead in the industry over its two biggest competitors, State Street and JPMorgan. It should be noted that gains from improving market valuation over the quarter would have been erased to some extent by negative forex changes. Accordingly, the large growth in total AUC/A would point to the bank winning sizable new mandates from clients in Q3.

Net Interest Margin Improves In Q3, More To Accompany Rate Hike

One of the biggest sources of value for BNY Mellon is the interest it earns on its interest-earning asset base of roughly $300 billion. The prolonged low-interest rate environment has put considerable pressure on interest margins across the banking industry – resulting in a decline in net interest margin (NIM) for BNY Mellon from almost 1.9% in 2010 to an all-time low of 0.91% by Q4 2014. Since early 2015, the NIM figure has remained almost constant at 0.98%, but there was a jump in this figure to 1.06% in Q3. The reason for this can be traced to a reduction in interest expenses this quarter from the bank’s presence in key global economies that currently have negative interest-rates. You can see how an increase in the margin figure impacts the bank’s share value by making changes to the chart below.

The negative interest rates did have an undesirable impact on BNY Mellon’s balance sheet though – its interest-earning assets declined to below $300 billion from roughly around $320 billion the last two years. However, the combined effect of higher NIM and smaller asset base was to increase net interest revenues, as summarized in the table below.

Things Not Looking Great On The Asset Management Front

While the outlook for BNY Mellon’s asset servicing fees and interest revenues are quite strong, the same cannot be said for its investment management business. BNY Mellon is one of the largest asset management firms in the U.S., but the bank has been steadily losing market share in the rapidly growing and changing industry over recent quarters. The impact of this on the bank’s revenues is evident from the fact that the bank’s average investment management revenues over the last 5 quarters was below $840 million – down from an average of ~$875 million over 2013-14.

The table below captures how BNY Mellon’s assets under management (AUM) changed year-on-year as well as quarter-on-quarter.

As can be clearly seen here, the increase in BNY Mellon’s asset base has been completely from an increase in market value. This is in sharp contrast to the overall asset management industry which has seen a steady inflow of assets over recent years. We attribute BNY Mellon’s under-performance to its reliance on active investment offerings, which are falling out of favor. Actively managed long-term fund assets make up more than 65% of BNY Mellon’s total AUM, but investors have been moving their cash to cheaper alternatives (especially ETFs) as active funds have performed no better than indexed funds or ETFs.

While BNY Mellon offers indexed funds, it has not ventured into the rapidly growing ETF industry yet. The move is very likely because BNY Mellon acts as a custodian for major ETF providers with its line-up of tools customized for the ETF industry, and it would not want to risk losing these clients by stepping in as a direct competitor. Moreover, the bank’s business model focuses almost entirely on institutional clients, with private clients accounting for less than 5% of its total AUM. So the bank will have to make some fundamental changes in the way it operates to tap into the growing retail investor market. These two problems present sizable headwinds to BNY Mellon’s investment management division at least in the near term. What remains to be seen is how BNY Mellon fixes this problem in the long run.

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1. Third Quarter Earnings, BNY Mellon Financial Releases, Oct 21 2016 [↩]