State Street: An Overlooked Safe Play in Banking
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Recently, both State Street Financial (NYSE: STT) and Bank of New York Mellon (NYSE: BK) gave investors' reports. I believe that trust banks are among the most overlooked companies in the financial sector. Because they are fee based, and not loan based, their income streams are far more stable than traditional commercial banks. Trust banks get the overwhelming amount of their revenues from flat percentage fees on money they hold in trust for other banks, governments, non-profits, and similar institutional clients, and also from commissions on assets they actively manage on behalf of those institutions. While they sometimes have a small loan portfolio, loan losses are rare, and reserve levels are usually near zero.
Bank of New York Mellon is by most measures the largest trust bank in the country. It is not quite a “pure” trust bank either, and generally holds between 10% and 15% of its assets as loans. It has four domestic branches, along with another 13 overseas. As of March 31, 2012, 38% of the bank's assets were outside the United States. It had an unspectacular first quarter, with revenue exactly even with the first quarter of 2011. Custodial assets rose four percent from the year earlier to $26.6 trillion. Assets under management rose 6% from a year ago, to $1.3 trillion. Profits in the first quarter came to $619 million, or $0.52 per share. In the first quarter of 2011, earnings were $625 million, or $0.50 per share. Bank of New York has been buying back stock, which is what lifted the per-share numbers in the recent quarter. In March, the bank's board authorized up to $1.16 billion for additional purchases.
Over the past 12 to 18 months, Bank of New York has faced massive litigation and penalties for its foreign exchange trading on behalf of institutional clients. And despite some partial settlements, other suits are still percolating within the system. The exposure of the sum of civil suits that may be filed is not known, but could surely be worth several hundred million dollars.
Despite this, I like Bank of New York a lot for long-term investors. It is growing, slowly but surely. Its earnings are healthy and predictable. The loan loss provision was all of $1 million last year. The bank's capitalization was the second strongest among all banks measured on the Federal Reserve's “stress test” in the first quarter, and it is returning cash to shareholders through a share buyback program and 2.5% yield. Its 5-year PEG of 0.82 is cheaper than direct competitor State Street's 1.18. The next six to twelve months might be a bit rocky due to foreign exchange litigation, but beyond that Bank of New York Mellon is a winner for most growth and income investors.
With a little over $188 billion in assets, State Street ranks as the eighth largest domestically owned bank. But is has only two branch offices, and does not offer checking accounts. It is a true trust bank. More important than its own size is the amount of money it is either custodian or investment advisor over. Since December 31, 2011, it added $1.4 trillion in new accounts to its custodial division, and $39 billion in new, long term assets to be managed. That gave it custodial assets of $23.2 trillion and assets under management of $1.99 trillion. Revenues in the first quarter of 2012 rose to $2.42 billion, up 3% from a year ago, and 5% from the sequentially linked quarter. But expenses exploded in the first quarter to $1.8 billion, up $115 million, or 7%, from the first quarter of last year. Because of that rise, earnings came to $427 million or $0.85 per share, off 9% from the year ago, but up 12% from the fourth quarter of 2011.
But the story of State Street is about safety and integrity. The institution is able to base its business solely upon the perception that it will not engage in anything but ethical and fair treatment in its transactions, such as setting prices for mutual funds. Its capitalization levels are without parallel in the banking world, with Tier 1 capital standing at 20.6% at the end of the first quarter. Even under Basal III standards, State Street's 14.4% Tier 1 capital is the highest of any large American bank. That same reality of financial strength was surely a role in State Street winning a chunk of Emory University's sizable endowment to manage. So too, State Street has been scooping up hedge funds as pressure is brought to bear on commercial banks' ownership of such funds in the wake of a string of financial scandals. Recently, there have been rumors that it will acquire Goldman Sachs (GS) book hedge fund administration business.
I believe State Street will benefit from the European banking instability. As banks look to offload assets in order to shore up their capital ratios, no bank will be in a better position to acquire assets than State Street. The other side of the coin is that the trust bank's expenses have ballooned, and must be brought under control. One specific initiative to use more “cloud” based computing could save the company as much as $600 million per year. The bank also plans to save nearly $100 million per year with reduced employee compensation costs. It actually is not hiring current graduates.
Analysts expect earnings advances averaging about 10% per year going forward, which I think is fair. In the near term they are looking for State Street to earn $0.98 in this second quarter of this year. The bank has become quite generous with shareholders as well, with a 2.2% dividend yield and a $1.8 billion share buyback plan. I believe this is an excellent choice for the risk adverse investor.
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