Why The Pessimism Surrounding State Street’s Acquisition Of Charles River Is Overblown

Investors weren’t happy when State Street (NYSE:STT) announced its decision to acquire Charles River Development late last month, and they expressed their displeasure by sending the custody banking giant’s shares down nearly 10% within hours of the announcement. The bank’s shares have largely then flat since then, indicating that investor opinion about the acquisition hasn’t changed. While the lower share price is partially justified given that State Street is funding the all-cash acquisition primarily through a stock issuance, the key concern investors have is that the $2.6 billion price for Charles River is too steep. But as we detail in our interactive dashboard for the impact of the Charles River acquisition on State Street, the deal neither adds nor erodes significant shareholder value.

Accordingly, we maintain our price estimate of $110 for State Street’s stock, which is about 25% ahead of the current market price.

See our full analysis of State Street

The complete impact of the acquisition on State Street can be gauged by understanding how the deal specifically affects the bank’s key operating metrics, including:

• Assets under Custody/Administration (AUC/A): State Street is the second largest custody bank in the world, with total AUC/A of roughly $33 trillion. Under our pre-acquisition scenario, we expected the AUC/A to cross $33.4 trillion by the end of 2018. However, assuming State Street closes the deal by the end of this year, this figure could increase substantially. Charles River currently has around $25 trillion in total AUC/A. However, roughly half these assets are already included in State Street’s total AUC/A figure. This implies that State Street’s asset base will swell by about $12.5 trillion at deal closure – pushing the total figure to almost $46 trillion.
• Fees as % of AUC/A: Notably, the roughly 38% increase in asset base will not translate into a proportional increase in revenues, as fees for Charles River’s front-office custody services are substantially lower than the core book-keeping and other back-end custody services offered by State Street. Charles River reported $311.2 million in revenues over 2017, and assuming its revenues for 2018 are slightly higher, the acquisition will boost State Street’s pro-forma 2018 asset servicing revenues to around $6 billion from our pre-acquisition estimate of $5.6 billion. Using this with the estimate for AUC/A above, this works out to an overall fee as % of AUC/A of 0.013% (down from 0.017% for the pre-acquisition scenario). The chart below details the change in our forecast for State Street’s asset servicing fees before and after the proposed acquisition of Charles River. (The grey bars/lines in all charts represent the pre-acquisition scenario, whereas the blue bars/lines represent the post-acquisition scenario.)

• Income Margin: Charles River’s reported operating income for 2017 was $118 million. Taken together with revenues of $311 million for the year, this works out to an operating margin of 38%. Assuming a tax rate of 27% (due to its sizable presence outside the U.S.), this implies an income margin of 0.38 x (1 – 0.27) = 0.28, i.e. 28%. This is much better than the 22.7% in income margin we currently forecast for State Street. After the acquisition, the pro-forma income margin for the company should increase slightly to 22%. Moreover, revenue and cost synergies should help the income margin improve at a faster rate over coming years. Combined with higher revenues after the acquisition, this should have a positive impact on State Street’s net income figure going forward.
• Shares Outstanding: The net income gains will not translate to higher EPS for State Street investors, though, as the bank recently issued 13.2 million shares to cover the acquisition costs. As we detail in the chart below, the resulting increase in shares outstanding cancels out any gains from the acquisition almost exactly.

The charts below capture our forecasts for State Street’s EPS under the pre-acquisition as well as post-acquisition scenarios. The small increase in EPS for 2018 can be attributed to the fact that the increase in share count will have only a small impact on the average share count for 2018, with the full impact being realized from 2019 onwards. Notably, the share price estimate for 2019-20 remains unchanged – indicating that the $2.6 billion acquisition should be largely neutral for State Street.

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