State Street’s Q3 Results Were Underwhelming, But The Selloff Looks Overdone

by Trefis Team
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State Street (NYSE:STT) saw its shares tank nearly 10% within hours of its weaker-than-expected results announcement on Friday, October 19, before a marginal recovery limited the final decline in share price for the day to 8.5%. Notably, this was reminiscent of a similar drop in the custody bank’s stock this July, after it announced plans to acquire Charles River Development alongside its Q2 results. There were different reasons behind the two selloffs, though, with investors reacting in July to the fact that the all-cash acquisition was at a valuation perceived to be too high, while the key investor concern this time around is that State Street’s profits are likely to take a hit going forward. But the two selloffs were similar in one respect – they were both largely unjustified.

While investors were understandably disappointed by the fact that State Street missed revenue as well EPS estimates for this quarter, we believe the markets overreacted to the negative impact slowing fees and increased short-term costs can potentially have on the bank’s value. As we have detailed in our interactive valuation dashboard for State Street, the expected earnings headwinds do not warrant such a sharp reduction in share price for the custody bank. In fact, we believe that the fair value for State Street’s stock is around $99, which is now about 35% ahead of the current market price.

See our full analysis of State Street

Understanding The Key Factors Behind The Sell-Off

We believe that there were three key factors that led to the sell-off in State Street’s shares:

  1. A revenue and earnings miss for Q3
  2. Expected pressure on investment management fees for the foreseeable future from industry headwinds
  3. An increase in operating costs in the near term from ongoing technology investments

The Revenue And Earnings Miss

State Street reported revenues of $2.95 billion for Q3 2018 – slightly lower than the $3.02 billion consensus figure for the quarter. Taken together with higher-than-expected costs for the period, this translated into an EPS figure of $1.87 for the quarter, slightly lower than the expected figure of $1.89.

Now, the revenue miss likely wasn’t a big issue for investors, as two of State Street’s peers – BlackRock and Bank of New York Mellon – also missed Q3 revenue estimates. However, unlike its peers – who still managed to report strong earnings thanks to cost saving measures – State Street also missed on EPS. We attribute this to the fact that State Street has been investing millions over recent quarters as a part of its Beacon program to transform and upgrade its technology infrastructure, and the earnings miss in itself is not really a major cause for concern.

Expected Pressure on Investment Management Fees

The investment management industry as a whole has seen some headwinds over recent years, with institutional and retail investors shifting their cash to low-cost passive funds and ETFs from actively-managed funds, that generate much more revenue for the investment managers. At the same time, increasing competition in the industry has led to a price war, especially in the rapidly growing ETF industry. To add to this, Fidelity waived all fees on some of its passive funds this quarter – a move that is likely to further add to the fee pressure as other incumbents follow suit.

The combination of slower expected growth in total assets under management and a sharper reduction in fees per dollar managed will have a notable impact on State Street’s investment management fees over coming years, as detailed in the chart below (grey bars/lines represent the base case scenario, and blue bars/lines represent the updated post-Q3 scenario).

However, it should be noted that investment management is a much smaller part of State Street’s business model compared to its custody banking business (and other allied services). To put things in perspective, the investment management arm was responsible for just over 15% of State Street’s total revenues in 2017. And with the bank’s acquisition of Charles River, the proportion is only going to be smaller going forward. This reinforces our view that slower revenue growth for this division over coming years has limited impact on State Street’s share value.

Increase in Operating Costs

As we pointed out above, State Street has set aside millions to transform its operations as well as technology backbone as a part of Project Beacon. While these costs have weighed on results over several quarters now, the bank has begun to realize gains from the investment, with total recurring cost savings now expected to be $200 million for 2018 from the original estimate of $150 million. Additionally, State Street expects the investment to help it differentiate its services in the the custody banking space – which, taken together with the end-to-end custody services it can offer after the successful integration of Charles River, can drive faster growth in its cornerstone custody banking business.

Even if we assume that State Street isn’t able to realize any cost savings (which would be the worst case scenario) in the coming years, and its net margin is lower than what we forecast in our base case, the effective reduction in earnings over the coming years is still nowhere as drastic as suggested by the recent sell-off. In fact, as we capture in the charts below, State Street’s EPS – despite the headwinds detailed above – will grow steadily over the coming years. Based on the forecast of EPS below and using our P/E ratio of 15.5, we estimate that the fair value for State Street’s shares is over 30% ahead of the market price.

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