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Morningstar | Cost Cuts Can't Save State Street From Fee Pressures; Revenue and Net Income Drop Sharply in 1Q

The difficulties continued for wide-moat State Street in first-quarter 2019, as it has for the entire industry. Adjusted earnings per share were down 23% as total revenue was down 4% and expenses were up 1%, leading to a decline in net income of 23%. These results were similar to what we saw BNY Mellon report last week. State Street was able to cushion its net interest margin a bit more, down only 1 basis point compared with fourth-quarter 2018, and the bank did see slightly lower overall deposit outflows. This helped cushion the bank’s net interest income a bit more, but otherwise the positives were difficult to find. The return on tangible common equity was 15% for the quarter, the worst result since the second quarter of 2016. The bank was able to control expenses, which were up only 1% even after accounting for the addition of Charles River Development. However, fee pressures and growth pressures are outweighing any cost savings.

Given all of the fee pressures, management’s reluctance to offer any indication of when these may ease and when fee growth may resume, and a more difficult overall market and global growth outlook, we have lost confidence in the bank’s ability to consistently increase fees over the next several years. We have now dropped our overall outlook for fee growth to only a 0.5% CAGR for State Street over the next five years. This does bake in some declines in equity markets in the middle years of our forecasts. We have also had to adjust our net interest income growth numbers, as a shrinking balance sheet combined with the end of NIM expansion has put a stop to NII growth as well. After adjusting our model with these updates, we are decreasing our fair value estimate to $73 per share from $82.

With the recovery in overall market levels during the quarter, assets under management rebounded, up 3% year over year and 12% compared with fourth-quarter 2018. Active equity AUM was down year over year, but stronger performances within passive equity helped drive AUM higher. Much of this growth also appears to be coming from the Asia/Pacific region, as growth in EMEA was negative and in North America growth was positive but muted. Assets under custody and administration were down 2% year over year, or a little less than $1 trillion, which was affected by a higher profile client departure back in the second quarter of 2018. Absent this, there would have been slight growth.

Even with AUM up year over, management fees were still down 11%, as the shift to lower cost products continues in earnest for the industry. Servicing fees were down 12%, foreign exchange service fees were down 8%, and securities finance fees were down 16%. Overall, this led to fee revenue declining roughly 6% year over year. Management does expect some rebound in securities finance-related fees, as some of the dip was seasonal. Even so, we would have expected some of those season factors to have been present last year as well, suggesting there may be more to the slowdown than just seasonality. Many of the other fee items are also not rebounding in line with market levels. Overall, we think fee compression will be a consistent theme going forward.

The Charles River Development integration does seem to be going well, and management said it expects a number of new business announcements throughout 2019. State Street also hinted that CRD could be used as its own front to back end solution, or could also be integrated with other platforms, such as Aladdin. State Street may be a step ahead of BNY Mellon here, as BNY Mellon only just announced a partnership with Aladdin recently. These newer front-to-back-end integration initiatives may be a bright spot for the trust banks over the medium term, amid a rather bleak backdrop, but if many platforms are all interoperable, pricing pressure may creep into this segment over time as well.