Business context and reporting period
The Bank of New York Mellon Corporation (BNY Mellon) filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2010. The company provides asset and wealth management, asset servicing, issuer, clearing, and treasury services. At quarter-end, it reported $24.4 trillion in assets under custody and administration (AUC), $1.14 trillion in assets under management (AUM), and serviced $12.0 trillion in outstanding debt.
Results are presented on a continuing-operations basis unless noted. Comparisons with 2009 are materially affected by the prior-year investment-securities restructuring loss.
Financial results and key metrics
- Third-quarter earnings: Net income applicable to common shareholders was $622 million, or $0.51 per diluted share; continuing-operations income applicable to common shareholders was $625 million. Second-quarter 2010 figures were $658 million and $0.54 per share, respectively. Third-quarter 2009 reported a $2.458 billion net loss, largely reflecting securities losses.
- Revenue: Third-quarter total revenue was $3.423 billion, including $2.668 billion of fee and other revenue, $718 million of net interest revenue, and $37 million from consolidated asset management funds. Fee revenue increased 2% year over year and 5% sequentially. Nine-month total revenue was $10.124 billion.
- Profitability and margins: Third-quarter pretax income was $834 million versus a $3.965 billion loss in 3Q09; the prior-year loss included $4.833 billion of net securities losses. Reported pretax operating margin was 24%; management’s adjusted non-GAAP margin was 30%. Annualized return on common equity was 7.7% and return on average assets was 1.03%.
- Expenses and credit: Noninterest expense was $2.611 billion, up 13% year over year and sequentially, driven principally by acquisitions, compensation, software, litigation and integration costs. Provision for credit losses was a $22 million credit, versus a $147 million charge in 3Q09. The allowance for credit losses was $608 million; nonperforming assets were $401 million, or 1.1% of loans and other assets.
- Interest income: Net interest revenue was broadly unchanged year over year, but the FTE net interest margin declined to 1.67% from 1.85% a year earlier and 1.74% in 2Q10, as lower spreads and the low-rate environment outweighed asset growth.
- Cash flow: For the first nine months, operating cash flow was $2.889 billion, investing cash flow was negative $16.251 billion, and financing cash flow was positive $13.292 billion. Acquisitions and investment purchases were major investing uses; deposits and other borrowings contributed to financing inflows.
- Balance sheet and liquidity: Total assets were $254.2 billion, including $14.6 billion of consolidated asset-management fund assets; total deposits were $149.0 billion. The company reported $84.5 billion of available funds and liquid assets equal to 33% of total assets. Its liquidity measures exceeded internal minimum guidelines, and the parent met its target of funding obligations for 18 months without subsidiary dividends or new debt.
- Debt and capital: Long-term debt was $16.720 billion. The Tier 1 capital ratio was 12.2%, down from 13.5% at June 30, primarily reflecting acquisitions; total capital ratio was 15.8% and Tier 1 common ratio was 10.7%. The company stated it and its bank subsidiaries were well-capitalized. Common equity to total assets was 12.7%.
- Dividends and shares: The quarterly common dividend was $0.09 per share. A forward equity sale settled in September, raising approximately $677 million and adding 25.9 million shares.
- Business volumes: AUC rose to $24.4 trillion, primarily from acquisitions, higher market values and new business. AUM rose 18% year over year to $1.14 trillion. Securities servicing fees increased 20% year over year, while foreign exchange and other trading revenue fell 41% to $146 million.
Material changes versus comparable periods
- Compared with 3Q09, reported earnings and revenue rebounded sharply because 3Q09 included the $4.833 billion securities loss. Excluding that distorted comparison, fee revenue rose 2% year over year, while expenses increased 13%.
- Compared with 2Q10, common-shareholder net income declined to $622 million from $658 million. Fees rose, but reported expense increased $295 million; foreign exchange and other trading revenue fell from $220 million to $146 million.
- GIS and BAS acquisitions expanded servicing operations and helped raise AUC; the company also acquired I(3) Advisors. GIS was acquired for $2.3 billion in cash, BAS for approximately $330 million, and I(3) Advisors for approximately $21 million. Acquisition-related costs and integration expenses increased expenses, while acquisition impacts reduced the Tier 1 capital ratio.
- Adoption of consolidation guidance added approximately $14.4 billion to reported assets. This accounting change increased balance-sheet totals but, according to the filing, did not change the underlying economic risk of the affected funds.
- Credit indicators improved: criticized assets declined 52% year over year, and nonperforming assets fell from $550 million at year-end 2009 to $401 million.
Outlook, risks, contingencies and unusual items
- Management outlook: The acquisitions were expected to be accretive to 2010 earnings. Approximately $4.5 billion in deposits associated with GIS were expected to transition to BNY Mellon by the end of 2011; until then, the company expected economic-value payments. Management expected a fourth-quarter 2010 effective tax rate of approximately 28%–30%.
- Operating pressures: Management cited low interest rates and narrowing spreads, lower foreign-exchange volatility, securities-lending spread pressure, weak global debt issuance, money-market fee waivers and reduced exchange trading volumes. Litigation costs for the remainder of 2010 were expected to exceed historic trend levels.
- Credit and securities risks: The company identified uncertainty in residential mortgage and commercial real estate valuations and credit quality. Certain Alt-A, prime, subprime and other mortgage-related securities remained exposed to defaults and loss severities; $10.1 billion of securities were in a higher-risk watch list. Management stated that its impairment estimates depend on assumptions and market conditions.
- Contingencies: Maximum potential exposure under client support agreements was approximately $111 million after reserves. Off-balance-sheet exposures included $29.5 billion of lending commitments, $9.5 billion of standby letters of credit and $279.7 billion of securities-lending indemnifications, generally supported by collateral. A downgrade below investment grade could require an additional $1.042 billion of collateral; derivative close-out exposure varied by downgrade trigger.
- Legal and tax matters: BNY Mellon disclosed numerous litigation and regulatory matters, including securities-lending disputes, Madoff-related claims, auction-rate securities investigations, foreign-exchange inquiries and proceedings involving Pershing in Germany. Management said outcomes were uncertain and could materially affect net income in a period, though it did not expect the matters, after reserves and insurance, to materially affect consolidated financial position or liquidity. A disputed tax transaction had estimated exposure of approximately $900 million including interest; a final decision was not expected before late 2011.
- Regulation: The Dodd-Frank Act and Basel III implementation could change capital, liquidity, assessments and other requirements. The company said the eventual impact was uncertain and subject to rulemaking. It expected its effective tax rate could rise in 2011 from a federal tax-law change affecting foreign tax credits if mitigation efforts were unsuccessful.
- Other unusual items: The company recorded a $15 million third-quarter charge related to client fund support agreements and $56 million of merger and integration expenses. A $2.9 billion decline in investing cash flow versus the prior-year source of cash reflects substantially different securities, deposit and acquisition activity.
Important facts for investors to verify
- Reconcile GAAP revenue, earnings and margins with management’s non-GAAP adjustments, especially the unusually large 3Q09 securities loss.
- Track acquisition integration, realized cost synergies, GIS deposit migration and whether the acquisitions deliver the expected earnings contribution.
- Assess capital after acquisitions: Tier 1 fell to 12.2%, while tangible common equity to tangible assets was 5.3% and tangible book value per share was $8.59.
- Review credit-quality trends, mortgage delinquencies, criticized assets, allowance assumptions and the securities watch list, including the sensitivity of impairment estimates.
- Monitor whether low rates, narrowing spreads, fee waivers, trading volumes and securities-lending conditions continue to pressure revenue and margins.
- Follow litigation, the approximately $900 million disputed tax exposure, support-agreement obligations and potential collateral requirements from credit-rating downgrades.