State Street Reports Lukewarm Q1 Results On Higher Employee-Related Expenses

State Street’s (NYSE:STT) shares slid 3% on Friday, April 25, after the custody bank reported Q1 performance figures that were slightly below expectations. ((Q1 2014 Press Release and Addendum, State Street Press Releases, Apr 25 2014)) The bank beat revenue estimates for the period despite a drastic reduction in net interest revenues thanks to the appreciation in equity market valuation of securities under its custody – allowing it to report record servicing fees of $1.24 billion. But the improvement did not propagate to the bottom line due to $72 million in one-time severance costs that State Street incurred as a part of its larger cost-cutting plan. The corresponding job reductions are expected to cut annual expenses by roughly $40 million starting next year.

We believe that the continued reduction in net interest margins for State Street does not outweigh the benefits its business model enjoys from a strong position in both the custody banking and asset management industries – more so because shrinking interest margins are an industry-wide phenomenon. Also, in view of the bank’s position as the country’s best capitalized bank holding company as demonstrated by the Fed’s stress tests for this year as well as its continued efforts to cut costs and to return cash to investors, we maintain our $77 price estimate for State Street’s stock, which is about 20% ahead of the current market price.

See our full analysis for State Street

Falling Interest Margins Clearly Dragging Down Revenue Figures

Our analysis of State Street shows that the bank draws 45% of its value from its asset servicing business. The next biggest source of value for the bank is the interest it earns on its interest-earning asset base of about $190 billion – shown in the chart above as proprietary investments. While the size of these assets have grown considerably over recent years, the prolonged low-interest rate environment has put considerable pressure on interest margins across banks. State Street, like its peer BNY Mellon (NYSE:BK), has seen a particularly sharp revenue hit from shrinking net interest margin (NIM) figures.

The current economic conditions have squeezed State Street’s NIM figure from a high of 2.2% in early 2010 to its current all-time low figure of 1.24%. This disparity between the figure four years ago and today is quite large. To put things in perspective, if State Street’s NIM figure for Q1 was 2% instead of the 1.24% it witnessed, then its net interest revenues for the period would have been roughly $950 million instead of the reported figure of $555 million.

While we expect margins to pick up this year, you can estimate the impact of falling margins on State Street’s total share value by making changes to the chart below.

State Street Continues To Give BNY Mellon A Run For Its Money

State Street raised concerns among investors in mid-2013 because growth in its asset base had been notably lower than those of its biggest competitors for that period. Intense competition in the custody banking and asset management industry has resulted in a reduction in fee revenues as a percentage of assets for most market players over recent years. Therefore the only option they have to improve revenues is to resort to steady asset growth.

Those concerns have all but vanished, with State Street’s assets under custody/administration (AUC/A) reaching a record $27.5 trillion at the end of Q1 – a good 8.1% higher than the figure at the end of Q1 2013. The custody bank remains the strongest adversary to BNY Mellon which reported a $27.9-trillion AUC/A figure for the same period.

High Q1 Costs A One-Time Anomaly In Long-Term Plan

State Street’s operating expenses of $1.92 billion for the quarter were 6% above the figure for the same quarter last year and 9% above that for the previous quarter. While first quarter expenses are seasonally higher due to bonus payments to employees, the figure took a hit from $72 million in pre-tax severance costs. Adjusting for this one-time hit, operating expenses showed a nominal 2% increase year-on-year – not something to worry about given the much better performance by State Street’s asset servicing unit between the two period.

The bank has been trying to reduce costs for several quarters now and exploring ways to improve operating efficiency. The decision by State Street’s top management to keep working on costs over coming quarters is good news as the bank’s stock value is quite sensitive to its operating margins – something that can be seen by making changes to the chart below.

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