Gains From Interest Rate Improvements Outweigh Weak Asset Management Outlook For BNY Mellon

Investors were not thrilled with Bank of New York Mellon’s (NYSE:BK) fourth quarter results late last week, as the custody banking giant reported underwhelming revenue and earnings figures for the period – in contrast to the trend of strong earnings beats by the largest U.S. banks over recent weeks. ^[1] However, it would not be fair to view BNY Mellon’s results in the same light as other banks, given that its business model hinges on custody banking and asset management operations as opposed to the retail banking / investment banking focus of other larger banks. While the bank’s fee income for the quarter was unusually low (even after considering the fact that the fourth quarter is seasonally the slowest period for the custody banking industry), and the overall poor performance of its investment management arm represents a downside to the bank’s value, there were some clear trends that we believe will be key to the bank’s profitability over coming years.

The single biggest factor to bear in mind is the sensitivity of BNY Mellon’s profits to changes in interest rates. Record loan balances coupled with the Fed’s rate hike in December helped the bank report its highest quarterly net interest income figure in its history. With the Fed expected to hike rates three times each year over 2017-19, we believe that BNY Mellon is well placed to report a significant jump in interest revenues over coming years. Also, the bank seems to have made some progress on cutting costs over recent quarters, as evidenced by the fact that compensation costs fell to below $1.4 billion for the first time since late 2011 despite the 1.6% increase in headcount y-o-y.Given the strength of BNY Mellon’s cornerstone asset servicing business, the strong outlook for interest rates, and the notable improvement in profit margins for Q4, we have revised our price estimate for BNY Mellon’s stock upwards from $45 to $49. The new target price is roughly 10% ahead of the current market price.

See our full analysis for BNY Mellon here

The table above summarizes the factors that aided BNY Mellon’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. The two factors that worked in the bank’s favor in Q4 were an increase in net interest revenues and a reduction in compensation expenses. The sequential reduction in investment services fee was due to seasonally-inflated issuer services fees, which were $337 million in Q3 2016 and $211 million in Q4 2016 (up from $199 million in Q4 2015). “All other revenues” were lower in Q4 2016 due to a combination of lower investment management fees, lower trading revenues as well as lower one-time fees.

Notably, the bank’s compensation expenses fell from $1.48 billion in Q4 2015 and $1.47 billion in Q3 2016 to below $1.4 billion in Q4 2016 – a reduction of ~5% compared to both quarters. It should be noted that BNY Mellon has been under considerable pressure from some of its biggest investors since early 2015 to cut costs and improve its returns. One of the investors – Marcato Capital Management – estimated in April 2015 that the bank had roughly 10,000 more employees than it needs (representing 20% of the total headcount) based on comparisons made with several competitors. ((Presentation, Marcato, Apr 7 2015)) Although the bank has not seen much change in headcount since then, there has been a clear reduction in compensation and other operating expenses – something that has helped boost profits.

Rate Hike Boosts Top Line, Expect More In Subsequent Quarters

One of the biggest sources of value for BNY Mellon is the interest it earns on its interest-earning asset base of ~$290 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 hovered around 1%, before increasing to 1.06% in Q3 and then jumping to 1.17% in Q4 2016. The most recent jump is because custody banks can realize gains from the Fed’s interest rate hike almost immediately, as opposed to the delayed gains for retail and investment banks. You can see how an increase in the margin figure impacts the bank’s share value by making changes to the chart below.

While BNY Mellon’s net interest margin figure increased considerably, the bank reported a sizable reduction in interest-earning assets for the quarter – something that can be attributed to negative forex movements as well as to the fact that improving interest rates give banks and large institutions (which park their liquid assets with custody banks) a reason to move some of these assets to higher-yielding investment options. The combined effect of higher NIM and smaller asset base was to increase net interest revenues, as summarized in the table below.

Decline In Investment Management Fees Unlikely To Turn Around

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. A concerning trend that has been observable in BNY Mellon’s investment management business over recent quarters is that 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. 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 4 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. And with the DoJ’s fiduciary rule governing retirement savings expected to come into force in a few months, the exodus from traditional mutual fund products to similar, but cheaper ETFs will only be more pronounced.

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. The only quick solution the bank can explore is the acquisition of one of the smaller but rapidly-growing players in the ETF industry.

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1. Fourth Quarter Earnings, BNY Mellon Financial Releases, Jan 19 2017 [↩]