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Morningstar | Bank of New York Mellon: Expense Management Helps Offset Some of the Revenue Headwinds

Wide-moat Bank of New York Mellon reported second-quarter results that highlight the revenue challenges for the custody banks. Revenue was down 5% driven by a 12% decline in net interest revenue and a 3% decline in fee revenue. On the positive side, expense control was good with expenses declining 4% as declines in staff expenses more than offset increases in software and equipment expenses. Pretax income and net income both dipped 8% though earnings per share was only down 2% due to share repurchases. Return on equity was 10.4% and the return on tangible equity finished at 21.2%, up modestly from first-quarter 2019 but down from the year-ago period. After adjusting our model, we maintain our fair value estimate of $48 as lower net interest income is offset by lower expenses.

Net interest income was down 12% as interest-earning assets decreased 2% and the firm’s NIM declined to 1.12% from 1.26% in second-quarter 2018 and 1.20% in first-quarter 2019. Deposits were up 1% but non-interest-bearing deposits declined 18%. Interest income has been negatively impacted by flattening yield curve that hurts reinvestment yields. Net interest income declined 5% sequentially, and management would expect a similar decline in third-quarter 2019 given the yield curve and deposit competition. Management's preliminary expectations are for similar levels of interest-bearing deposits and a continued decline of non-interest-bearing deposits.

Non-interest income was down 3% with investment management and performance fees declining due to lower performance fees, AUM outflows, and the unfavorable impact of a stronger U.S. dollar. Asset servicing fee revenue was down 1% due to lower securities lending revenue. Excluding securities lending, asset servicing fee revenue was flat though AUC/A was up 6%. Clearing services fee revenue, which is primarily Pershing, was up 2%. Issuer services revenue, which can be lumpy, increased 3% as the ADR and corporate trust business performed well.

Expense management did help offset some of the revenue headwinds. Staff compensation expenses were down 5% year over year and the firm’s full-time employee count of 49,100 was down 1% sequentially and 6% from the year-ago period. Net occupancy expenses also declined as the firm consolidates its real estate footprint. On a segment basis, the Investment Services pretax margin was 35%, down from 37% year over year but not a surprise given the declines in what we believe are highly incremental revenue lines--net interest income, securities lending revenue, and foreign exchange trading revenue. Investment Management’s pretax margin decreased to 29% from 31% as a 10% decline in revenue overshadowed a 6% decline in expenses.