BNY Mellon Worth $55 As Custody Banking Business Is Booming

Bank of New York Mellon (NYSE:BK) stands out in the list of ten largest U.S. banks as the only one with a business model that relies completely on custody banking and investment management services. And we believe that this focused approach is the biggest source of value for the banking giant – something that has helped it grow over the years to become the largest custody bank in the world. Since the economic downturn, the global regulatory environment has adopted changes that are favorable for custody banking (in contrast to the restrictions imposed on investment banking activities), and BNY Mellon has done well to leverage the growing demand for these services. This has brought in billions in new mandates for the bank each quarter. Taken together with upbeat security valuations, this helped BNY Mellon’s total assets under custody and administration (AUC/A) swell to a record $32.2 trillion by the end of Q3 2017. Notably, this resulted in the bank reporting more than $4 billion in revenues for the first time in a quarter from continuing operations (higher figures for Q2 2013 and Q3 2014 were due to one-time gains).

That said, BNY Mellon continues to face its share of problems, most notably its much lower operating margins when compared to peers like State Street and BlackRock. Although the bank has made some headway over recent quarters to improve its profit margin figure, progress has been slow and there still appears to be considerable scope for improvement. At the same time, the bank’s investment management arm has been a clear under-performer in the industry due to the impact of secular trends. That said, we believe that investors are giving undue importance to these issues, and overlooking the growth opportunity that still exists for BNY Mellon in the global custody banking industry. In our opinion, BNY Mellon’s stock is worth $55 – a figure that 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. While investment services fees have grown in tandem with the bank’s asset base, BNY Mellon has also seen its net interest revenues improve over recent quarters thanks to the Fed’s ongoing rate hike process. The individual impact of changes in net interest margin (NIM) and the bank’s interest-earning assets is summarized in the table below.

While BNY Mellon’s custody banking business has been growing steadily, the bank has been losing market share in the rapidly growing and changing asset management industry. There are two key reasons for this: the bank’s business model, which focuses almost entirely on institutional clients (even as the retail investment segment has seen sharp growth), and the ongoing trend among investors of shifting their cash into low-cost exchange-traded fund (ETF) offerings. The table below highlights this, as BNY Mellon’s long-term inflows have been negligible.

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 primarily to its reliance on active investment offerings, which are falling out of favor. Also, BNY has not ventured into the rapidly growing ETF industry yet – possibly to avoid being seen as a competitor by major ETF providers which are clients of its custody banking arm. In view of these factors, we believe that the best way forward for BNY Mellon is to reduce its focus on its long-term fund offerings, and to focus almost entirely on its core custody banking business.

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