NORTHERN TRUST CORP quarterly report, Q3 FY2014

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Northern Trust Corporation — Q3 2014 Form 10-Q

Business context and reporting period

Northern Trust provides asset servicing, fund administration, asset management, fiduciary and banking services through Corporate & Institutional Services (C&IS), Wealth Management and Treasury and Other. This unaudited quarterly report covers the three and nine months ended September 30, 2014; comparisons are with the corresponding 2013 periods unless otherwise noted.

Financial results and key metrics

  • Q3 revenue: GAAP revenue was approximately $1.079 billion, up 3%. Net income was $204.5 million, down 1%; diluted EPS was $0.84, unchanged. Pretax income was $304.2 million.
  • Nine-month results: Revenue was approximately $3.201 billion, up about 5%; net income was $567.8 million, up 1%; diluted EPS was $2.34, up 2%.
  • Revenue mix and margin: Q3 noninterest income was $829.6 million (+2%) and net interest income was $249.3 million (+5%). Fully taxable equivalent (FTE) net interest income was $256.2 million. Q3 net interest margin was 1.05% FTE, versus 1.14% a year earlier. Nine-month FTE net interest income was $764.0 million (+8%), while FTE margin declined to 1.08% from 1.13%.
  • Expenses and credit: Q3 noninterest expense rose 5% to $774.7 million; provision for credit losses was zero, versus $5.0 million in Q3 2013. Nine-month expense rose 7% to $2.354 billion; provision declined to $3.0 million from $15.0 million. Q3 net charge-offs were $5.2 million.
  • Profitability: Q3 return on average common equity was 10.09% and return on average assets was 0.77%, versus 10.64% and 0.86%, respectively. The nine-month measures were 9.52% and 0.74%, versus 9.84% and 0.81%.
  • Balance sheet and funding at September 30: Assets were $111.2 billion, deposits $91.7 billion and stockholders’ equity $8.5 billion. Loans and leases totaled $30.7 billion; the allowance assigned to loans and leases was $269.4 million. Reported debt and other borrowings included $786 million of federal funds purchased, $867 million of repurchase agreements, $1.758 billion of other borrowings, $1.497 billion of senior notes, $1.599 billion of long-term debt and $277 million of floating-rate capital debt.
  • Cash flow and liquidity indicators: For the nine months, operating cash flow was $1.274 billion, investing cash flow was negative $9.066 billion and financing cash flow was positive $7.491 billion. Investing outflows mainly reflected increased Federal Reserve deposits, securities purchases and loan growth; financing inflows mainly reflected deposit growth and preferred-stock proceeds. At quarter-end, Federal Reserve deposits were $21.3 billion and interest-bearing deposits with banks were $15.3 billion.
  • Capital and client assets: Corporation common equity Tier 1 was 12.7% under the Advanced Approach and 12.8% under the Standardized Approach. Management said applicable well-capitalized regulatory thresholds were exceeded. Assets under custody were $5.910 trillion and assets under management $923.3 billion, up 6% and 4%, respectively, from December 31, 2013.

Material changes versus prior periods

  • Q3 servicing fees increased 11% to $718.2 million, supported by new business and equity-market effects. C&IS custody and fund administration fees rose 15%; Wealth Management servicing fees rose 10%.
  • Foreign-exchange trading income fell 26% in Q3 to $46.4 million, which management attributed to lower currency-market volatility and client volumes. Nine-month FX income declined 23% to $149.4 million.
  • Q3 reported earnings comparisons were affected by a $32.6 million pretax building-sale gain in Q3 2013. Excluding that gain, Q3 2014 net income of $204.5 million compared with $186.2 million, and diluted EPS of $0.84 compared with $0.76.
  • Nine-month 2014 results included $42.3 million of pretax charges and write-offs, including severance, software write-offs and office-space reductions. Excluding these items, management reported net income of $595.6 million, diluted EPS of $2.45 and return on average common equity of 10.0%. The comparable 2013 period included the building-sale gain; excluding it, net income was $541.3 million and diluted EPS was $2.21.
  • Expenses grew faster than revenue in both comparisons. Q3 compensation and employee benefits increased, and equipment/software costs rose; nine-month equipment/software expense increased 14%, including $9.5 million of software write-offs.
  • Assets, deposits and equity increased from year-end 2013. Northern Trust issued $388.5 million of Series C preferred stock and repurchased $315.2 million of common stock during the first nine months.

Outlook, risks, contingencies and unusual items

  • The filing provides no specific numerical earnings or revenue guidance. Management cited a low-interest-rate environment as pressure on margins and money-market fee waivers; market levels, new business and foreign-exchange activity influence servicing and trading revenue.
  • Residential real estate remained the principal credit concern: it represented 67% of nonperforming loans and leases at September 30. Total nonperforming assets were $231.2 million, down 19% from September 2013 but still above pre-2008 levels. The allowance for credit losses was $298.3 million, down from $317.5 million a year earlier.
  • The securities portfolio had $82.5 million of gross unrealized losses at September 30, offset by $142.4 million of gross unrealized gains. Management attributed the largest loss components mainly to market-rate changes and stated it did not intend to sell, and did not expect to be required to sell, securities in unrealized-loss positions before recovery or maturity. Nine-month OTTI charges on certain CRA-eligible securities were $3.9 million.
  • Legal and regulatory matters include securities-lending litigation and an SEC subpoena concerning securities-lending activities; Northern Trust said it was cooperating. For certain matters with estimable reasonably possible losses, the estimated aggregate upper end was approximately $130 million. Management cautioned that other matters could not be reasonably estimated and that litigation could affect results in a particular period.
  • Standby letters of credit outstanding were $4.3 billion. Securities loaned subject to client indemnification were $99.9 billion; the securities were fully collateralized under the stated policy, and no related liability was recorded. These are contingent exposures, not reported debt.
  • Gross cross-border exposure to Irish obligors was approximately $660 million; the filing reported no exposure to sovereign debt securities or obligors in the other listed European countries experiencing significant strains. Management said interest-rate risk and foreign-exchange trading VaR had not changed significantly since year-end 2013.
  • The Series C preferred stock carries a 5.85% noncumulative dividend rate, ranks senior to common stock and is redeemable at the company’s option on or after October 1, 2019, subject to stated terms. The filing also notes adoption of a new revenue-recognition standard was being assessed.

Most important facts for investors to verify

  • Whether servicing-fee growth and new business can offset ongoing pressure from lower net interest margins and reduced FX trading income.
  • Whether expense growth moderates, particularly compensation and technology/software costs, and how reported results compare after the disclosed unusual charges.
  • Whether residential real-estate credit quality continues to improve, including nonperforming balances, charge-offs and allowance coverage.
  • The nature, possible range and developments in securities-lending litigation, the SEC investigation and other contingencies; the $130 million estimate excludes matters that could not be reasonably estimated.
  • How deposit growth, securities deployment, capital ratios and the preferred-stock dividend affect liquidity, funding costs and returns to common shareholders.