A Look At 3 Trust Banks In Early 2013

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Note: A previous version of this article incorrectly stated the number of branch offices operated by Northern trust. The article has been corrected.

There are big national banks, the ones I characterize with over $1 trillion in assets. There are the large regional banks, with assets of over $50 billion. We have seen that the regional banks have nearly unanimously met or bettered Wall Street estimates this earnings season. We have seen the big banks have struggled. Today I am going to discuss the banking netherworld, those institutions that are considered banks, but don't do much in the way of commercial or retail banking. I will focus on a few of the country's largest “trust banks,” which earn the bulk of their revenues from commissions and fees taken in holding funds of other banks, universities, municipalities, etc. Major Wall Street banks such as JPMorgan Chase (JPM) have large trust departments, but I will focus on banks that make such custodial fee based activity the focus of their businesses.

Bank of New York Mellon (NYSE: BK) is the largest such trust bank in the country, with about $340 billion in assets. Technically it is the country's seventh largest commercial bank; though I usually omit it from rankings of banks by asset size since it only has four branches in this country, plus another 13 overseas.

In the fourth quarter of the year, Bank of New York Mellon earned $622 million, or $0.53 per share, a 26% jump from the fourth quarter of 2012, and precisely matching analysts' reduced estimates for the quarter. For all of 2012, earnings came to $2.4 billion, or $2.03 per share, compared with $2.5 billion, or $2.03 in 2011. What has been going right is its core custodial business. Over all of 2012, assets under management grew ten percent, or by $56 billion. Custodial assets grew by $1.5 trillion, or nine percent. Also, despite buying back $1.1 billion shares of its stock, this big bank's Basil III capital grew to 9.8%, and its Tier One Common Ratio grew to 15.1%. Trust focused banks always have higher capital levels than retail banks, as last year's Stress Test showed.

Trust banks inherently have relatively predictable earnings. Analysts see profit growth in the low double digits over the next five years, giving Bank of New York Mellon a PEG of 0.89. Combine that growth, value, and safety of a large trust bank virtually guaranteed to receive approval this March for more returns of capital to shareholders, and I believe this is a terrific situation for conservative investors.

State Street (NYSE: STT) is the country's second largest trust bank, with about $205 billion in assets. It too has a very limited branch network, with two branches in this country and another dozen overseas. Its fourth quarter earnings came to $534 million, or $1.11 per share, the third consecutive quarter of beating analysts' estimates, which were for $1.00 per share. The result was a 19.4% improvement from the fourth quarter of 2011, and was revenue driven, as top line growth was 7%. For all of 2012, earnings came to $1.9 billion, or $3.95 per share, a six percent improvement from 2011. Revenue improvement late in the year came largely as a courtesy of State Street's acquisition of Goldman Sachs' (GS) hedge fund business that closed in mid-October.

Pretty much all of State Street's businesses did well in the quarter, with the exception of foreign exchange. That revenue stream was down about 21% versus the fourth quarter of 2011 due to narrow trading ranges and lower volume. But foreign exchange is a relatively modest part of State Street's overall business.

Looking ahead, I like State Street very much. It has the highest capitalization levels of any large bank, with Tier One Common of 17.1% and Basil 3 of 10.8% at the close of 2012. It also has been buying back stock under a $1.8 billion plan, of which $360 million remained unused at the close of the year. More returns of capital and acquisitions are likely in 2013.  Conservative investors can hardly make a better choice.

Northern Trust (NASDAQ: NTRS) is a slightly smaller (about $100 billion in assets) trust bank with slightly more emphasis than its larger peers on retail, private banking. Northern Trust operates in 85 offices in 18 U.S. states and 12 international offices in North America, Europe and the Asia-Pacific region. With that higher concentration of traditional loan and mortgage type activities, Northern Trust's earnings have not been quite as consistent either and it has frequently recorded annual earnings representing a well over 1.00% return on assets, most recently though in 2009.

This Chicago based bank had an excellent 2012, with one caveat. Its foreign exchange trading, that put a lot of pressure on earnings in the third quarter of 2012, bottomed out even further in the fourth quarter. Management blames this on the lack of volatility in foreign currencies, but a 43% decline in foreign exchange revenue in the fourth quarter of 2012 established that this is not a blip. Despite the foreign exchange softness, other areas of the bank performed admirably, and earnings in the fourth quarter came to $168 million or $0.69 per share. A year ago earnings came to $0.53 per share. For all of 2012, earnings came to $687 million, or $2.81 per share. The quarter did disappoint analysts, who had expected earnings of about $0.75 per share.

The biggest driver of Northern Trust's is trust and service fees, and those grew 15% year over year, The other big producer of revenue for the bank is its net interest income, which was under pressure due to a smaller loan portfolio compared to a year ago, and a narrowing interest rate margin. That margin averaged 1.17%, down 11 basis points from the fourth quarter of 2012.

I believe 2013 will be a good year for Northern Trust. It is on target for a $200 annual expense reduction by the end of next year, part of a larger, $250 million combined revenue enhancement and expense cut plan known as “Driving Performance.” Despite some confidence that Northern Trust can increase earnings in the low double digit range, its stock price has gotten out of control for a bank with a price to earnings ratio of 18. I would be more interested in this equity if the stock price fell to a price to earnings ratio of 12 to 14, but for now, this is an overpriced stock.


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