Why BNY Mellon’s Shares Are Worth $59 Despite Lukewarm Q3 Performance

Bank of New York Mellon (NYSE:BK) reported an earnings beat for the third quarter of the year late last week despite reporting weak revenue growth and incurring millions in one-time charges, thanks to a much lower-than-expected tax expense for the quarter. While the third quarter was an overall forgettable period for the custody banking giant, a key factor behind its poor top line growth was the strengthening of the U.S. Dollar over the quarter, as this had an unfavorable impact on BNY Mellon’s geographically diversified business.

The subpar performance, however, does not take away from the strength of BNY Mellon’s business model, which stands out among the largest U.S. banks due to its complete focus on custody banking and investment management services. The stricter regulatory environment globally since the recession has boosted demand for custody banking services over recent years, and BNY Mellon has done well to leverage its strength as the market leader to grow its base of custody assets. Notably, the bank reported total assets under custody/administration (AUC/A) worth a record $34.5 trillion at the end of Q3 2018, and the only reason this did not translate into sequentially higher revenues was the negative FX impact.

As we detail in our interactive valuation dashboard for BNY Mellon, the bank’s shares are worth $59 even after taking into account the weaker-than-expected Q3 performance. While this price estimate is about 25% ahead of the current market price, a bulk of this difference can be attributed to the selloff in bank shares over recent weeks from the growing fear of a trade war and from the ongoing political turmoil in Europe.

See our full analysis for BNY Mellon here

BNY Mellon’s Value Is Minimally Affected By Investment Management Headwinds

BNY Mellon’s business model primarily depends on its custody banking services business (including FX trading operations), which we estimate accounts for nearly 77% of the banking giant’s total value. The investment management unit, in contrast, is responsible for less than 23% of the total value.

Notably, BNY Mellon’s investment management unit has been an underperformer in the industry for years now, as it only works with institutional clients (missing out on the huge retail investor base), and also because it has chosen to hold off on entering the rapidly-growing ETF space to avoid competing with large asset managers that are customers of its custody banking business. Because of this, the headwinds in the investment management industry are likely to hurt BNY Mellon more than peers State Street and BlackRock. But the smaller contribution from this business also means that the impact on the overall value is considerably lower than that for its peers. To put things in perspective, a 10% reduction in asset management revenues for BNY Mellon translates into a reduction in total revenues of roughly 2.5%. This is understood better from the chart below that captures the relative size of BNY Mellon’s various revenue streams.

BNY Mellon Has Also Made Some Headway On The Cost Front

An important cause for concern for BNY Mellon investors over the years has been the bank’s lower operating margins compared to its peers. The bank has addressed this over recent quarters, and the impact of its decision to streamline operations (notably by shuttering some of its boutique investment management units) is visible on its bottom line. Taking into account one-time costs for Q3 and elevated technology-related spends over recent months across the industry, BNY Mellon reported lower operating expenses for the quarter compared to the prior year period across most of its reported expense heads.

The overall improved profit margins should therefore have a positive impact on the EPS figure for the year, as detailed in the charts below. It should be noted that the net margin for 2017 was unusually high because of one-time gains from the changes in the U.S. tax code.

As detailed in the chart above, we now expect BNY Mellon to report EPS of $3.93 for full-year 2018, as opposed to the figure of $4.00 prior to the reported Q3 results. Using this estimate, and a P/E multiple of 15x (which we believe is appropriate for the custody banking giant), this works out to a target price of $59 for BNY Mellon’s shares – marginally lower than our initial estimate of $60, but still a good 25% ahead of the current market price.

You can find additional info in our interactive dashboard for BNY Mellon

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