Bank Of New York Mellon Corp quarterly report, Q1 FY2010

Business context and reporting period

The Bank of New York Mellon Corporation (NYSE: BK) filed this Form 10-Q for the quarter ended March 31, 2010. BNY Mellon provides asset and wealth management, custody, securities servicing, clearing and treasury services. At quarter-end it reported $22.4 trillion of assets under custody and administration and $1.1 trillion of assets under management. Unless noted, results below are for continuing operations; net income and EPS include discontinued operations.

Financial results and key metrics

Metric	Q1 2010	Comparable period
Total revenue	$3.379 billion	$2.911 billion in Q1 2009; $3.319 billion in Q4 2009
Net income applicable to common shareholders	$559 million; diluted EPS $0.46	$322 million and $0.28 in Q1 2009; $593 million and $0.49 in Q4 2009
Continuing-operations income applicable to common shareholders	$601 million; diluted EPS $0.49	$363 million and $0.31 in Q1 2009; $712 million and $0.59 in Q4 2009
Net interest revenue	$765 million; FTE net interest margin 1.89%	$775 million and 1.87% in Q1 2009; $724 million and 1.77% in Q4 2009
Noninterest expense	$2.460 billion	$2.280 billion in Q1 2009; $2.582 billion in Q4 2009
Credit provision / nonperforming assets	$35 million / $459 million	Provision: $59 million in Q1 2009 and $65 million in Q4 2009; nonperforming assets were $550 million at Q4 2009

Fee and other revenue was $2.549 billion, including $7 million of net securities gains. The filing separately reports $65 million of income from consolidated asset-management funds, with $24 million attributable to noncontrolling interests. GAAP pre-tax operating margin was 26%; management’s adjusted non-GAAP margin was 34%. Annualized reported return on common equity was 8.2% and return on average assets was 1.09%.

Operating cash flow was $1.191 billion, compared with $425 million used in Q1 2009. Investing activities provided $512 million and financing activities used $2.126 billion. Period-end cash and due from banks was $3.307 billion. Management reported approximately $73 billion of available funds, comprising $55 billion of liquid funds and $18 billion of cash.

At March 31, total assets were $220.6 billion, deposits $131.6 billion, loans $33.9 billion, and long-term debt $16.3 billion. The Tier 1 capital ratio was 13.3%, total capital ratio 17.2%, and Tier 1 common equity to risk-weighted assets 11.6%. The quarterly common dividend was $0.09 per share.

Material changes versus prior periods

• Year over year, revenue rose 16% and common net income rose 74%; the comparison benefited from the prior-year $295 million net securities loss. Continuing-operations common income increased 66%.
• Compared with Q1 2009, asset and wealth management fees increased to $678 million from $616 million, while securities lending revenue fell to $29 million from $90 million and foreign exchange and other trading revenue declined to $262 million from $307 million.
• Noninterest expense increased 8% year over year, primarily because of $164 million of litigation reserves and the Insight acquisition. Excluding those and other specified items, management’s adjusted measures showed stronger operating performance.
• Compared with Q4 2009, continuing-operations common income fell to $601 million from $712 million, partly reflecting seasonally lower performance fees and the litigation charge. Revenue increased modestly and total noninterest expense declined.
• AUC rose 15% year over year to $22.4 trillion, mainly on higher market values and new business. AUM rose from $881 billion to $1.105 trillion, largely reflecting the Insight acquisition and improved markets; quarter-end AUM was slightly below Q4 2009.
• Adoption of new variable-interest-entity accounting rules increased reported assets by about $13 billion from year-end. The filing also says that, after the first-quarter earnings release, BNY Mellon consolidated an additional $10 billion of CLO funds and reclassified $19 million of asset-management revenue as fund income.

Outlook, risks and unusual items

• Management expected the higher yield from the restructured investment-securities portfolio to contribute approximately $320 million to net interest revenue for full-year 2010; its estimated Q1 net contribution was about $100 million.
• Management expected a second-quarter operating effective tax rate of approximately 31%, about $15 million of Q2 expense related to the U.K. bonus tax, and litigation costs for the remainder of 2010 above historical levels.
• Bank-subsidiary dividend payments required regulatory consent following 2009 securities-portfolio restructuring charges. Management expected current quarterly dividends to remain supportable and projected the restriction could be lifted in Q4 2010. Any dividend increase would require consultation with the Federal Reserve.
• BNY Mellon agreed to acquire Global Investment Servicing for $2.31 billion in cash, with an intended approximately $700 million equity raise, and BHF Asset Servicing for EUR 253 million. Both transactions were expected to close in Q3 2010, subject to approvals, and were expected to be earnings-accretive.
• For capital purposes, the company deferred recognition of the full impact of the new consolidation accounting. It estimated that full phase-in would reduce the Tier 1 capital ratio by approximately 140 basis points absent mitigating actions.
• Credit risks include $77.3 billion of total loan and unfunded-commitment exposure, including $26.3 billion to financial institutions and $24.7 billion to commercial borrowers. The allowance for credit losses was $638 million. The filing highlights mortgage delinquencies, airline exposure and commercial real estate as areas to monitor.
• The investment portfolio had a $247 million pre-tax unrealized loss, improved from $1.048 billion at year-end, but retained exposure to mortgage-backed and other securities. Management reported $11.2 billion of watch-list securities; 85% of the total investment portfolio was rated AAA/AA.
• Potential maximum exposure under client support agreements was approximately $134 million. Legal matters include the Sentinel bankruptcy and related CFTC inquiry, securities-lending claims, Madoff-related litigation, and a disputed tax transaction with approximately $900 million of potential exposure including interest. Management said legal outcomes could materially affect income in a period, although it did not expect a material adverse effect on consolidated financial position or liquidity.
• Proposed regulatory changes, including a Financial Crisis Responsibility Fee, could affect costs and capital. If enacted as then proposed, the company estimated that fee could cost approximately $200 million annually.

Important facts for investors to verify

• Reconcile reported GAAP results with management’s non-GAAP adjusted figures, particularly the effect of litigation reserves, fund consolidation, securities gains or losses and discontinued operations.
• Track the size and resolution of litigation and regulatory matters, including the disputed tax exposure and any additional reserve requirements.
• Confirm the timing, funding, regulatory approvals and expected returns of the GIS and BHF acquisitions, including the planned equity raise for GIS.
• Monitor capital ratios as consolidated funds enter regulatory capital calculations, and confirm the status of dividend restrictions and the company’s liquidity cushion.
• Assess credit quality and reserve adequacy, especially mortgage delinquencies, commercial real estate, airline leasing and exposures to financial institutions.
• Review whether securities-portfolio improvement and discount accretion support the stated 2010 net-interest-revenue outlook, and whether asset-management flows and securities-lending spreads recover.