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Morningstar | OK Quarterly Results and a New Acquisition All Part of 2Q Earnings for State Street

Wide-moat-rated State Street reported OK second-quarter results and announced the acquisition of Charles River Development, which it expects to complete by the end of 2018. There were a number of moving parts, and after updating our models, we are dropping our fair value estimate to $100 from $107. We note that this updated estimate only gives State Street credit for half of the revenue synergies it expects from the CRD acquisition and assumes fairly conservative noninterest income CAGR of 5% through 2022 (closer to 4% without the acquisition) and modest operating leverage averaging 50 basis points per year. We have the firm meeting its long-term goal of a 15% return on equity by 2022, and this guidance from management was before tax reform, which implies that our 15% estimate would have been in the midrange of management’s goal, not the high end. We believe many of the strategic aspects of the acquisition make sense, and even though it will take several years to be accretive to EPS, in the long run it will likely be worth it.

State Street continued to grow assets under custody and administration, up 1.8% quarter over quarter and 9.1% year over year. Growth in assets under management did slow down, however, roughly flat quarter over quarter as alternative investment exchange-traded funds saw decent declines in AUM during the quarter. While AUM growth has been mediocre for the last two quarters, levels are still up year over year. Servicing fees were down quarter over quarter, but we are working through the BlackRock realignment, and the tailwind of new client onboardings should begin to ease the pressure over the second half of the year. We also found out that one of the new client wins for State Street was Vanguard, and given Vanguard’s reputation as a tough bargainer, we believe it was likely State Street’s improved capabilities over the last several years that allowed it to offer the best overall deal. Expenses were up moderately, roughly matching the overall fee income growth year over year, and we wouldn’t be surprised if the firm edged out some slight fee operating leverage for the year. Net interest income continued to grow, up over 2% quarter over quarter, and we would expect more NIM expansion as rates continue to rise. The return on equity continues to trend in the right direction, up to 14.7% in the quarter from 12.8% last quarter, and we believe a consistent 15% is well within the firm’s grasp.

State Street announced that it is acquiring Charles River Development, a provider of front-office services for investment managers. The majority of Charles River Development revenue comes from software solutions to asset managers in the Americas. The firm generated $311 million in revenue in 2017, and earns between 40% and 50% EBIT margins. Overall we like the strategic fit, and understand the appeal that a one-stop shop for back-, middle-, and front-end services would offer. We do believe there is room to both cross-sell State Street/CRD products to new customers, and to integrate the offerings to offer more streamlined product packages. We also note that firms like BlackRock have used front-end software packages (Aladdin) to help encourage flows to their ETF business, and this may also be part of the strategy for State Street. Overall, in the long run it makes sense for the providers with the most scale, with the greatest access to data, and with the most products across which they can cross-subsidize revenue, to provide integrated platforms like the one State Street is attempting to build. And we point out, State Street is one of the largest custodians in the world, with some of the best access to global data due to the nature of their operations, and with a large existing ETF operation and more which they can combine and then cross-subsidize revenues and growth. We are only giving State Street credit for 50% of their projected revenue synergies, which may be conservative.

State Street was approved for $1.2 billion in stock repurchases over the next four quarters, but to finance the acquisition, the bank is suspending $950 million of those repurchases. The bank is also issuing common and preferred shares. The quarterly dividend, however, was increased to $0.47 per share, even as buybacks are largely put on hold.

For a more in-depth take on capital returns in the banking industry and the effects of changing stress-test regulations, please see our July 8 special report "New Regulatory Proposals Will Change Stress-Test Landscape."