Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended September 30, 2007, for The Bank of New York Mellon Corporation (BNY Mellon). The reporting period is significantly impacted by the July 1, 2007, merger with Mellon Financial Corporation. Consequently, third-quarter and year-to-date 2007 results include three months of the combined company's operations, whereas prior periods reflect only legacy The Bank of New York. BNY Mellon operates as a global leader in asset management, wealth management, asset servicing, issuer services, clearing, and treasury services.
Key Financial Metrics
| Metric | Q3 2007 | Q3 2006 | YTD 2007 | YTD 2006 |
|---|---|---|---|---|
| Net Income | $640 million | $352 million | $1,519 million | $1,222 million |
| Diluted EPS | $0.56 | $0.49 | $1.76 | $1.69 |
| Total Revenue | $3,600 million | $1,614 million | $7,534 million | $4,946 million |
| Fee and Other Revenue | $2,931 million | $1,263 million | $5,986 million | $3,898 million |
| Net Interest Revenue | $669 million | $351 million | $1,548 million | $1,048 million |
| Noninterest Expense | $2,706 million | $1,196 million | $5,367 million | $3,403 million |
| Provision for Credit Losses | $0 | ($4) million | ($30) million | ($5) million |
| Assets Under Custody | $20.8 trillion | $12.2 trillion | $20.8 trillion | $12.2 trillion |
| Assets Under Management | $1.106 trillion | $131 billion | $1.106 trillion | $131 billion |
| Return on Avg. Tangible Common Equity | 46.01% | 21.44% | 41.20% | 26.15% |
| Tier 1 Capital Ratio | 9.12% | 8.17% | 9.12% | 8.17% |
Material Changes vs. Prior Period
- Merger Impact: The primary driver for all significant increases in revenue, assets, and expenses is the July 1, 2007, merger with Mellon Financial Corporation. Fee and other revenue increased 132% sequentially and 132% year-over-year.
- Revenue Composition: Fee and other revenue now represents 81% of total revenue (FTE), up from 78% in Q3 2006. Asset and wealth management fees surged to $854 million from $133 million in Q3 2006.
- Expense Growth: Noninterest expense rose to $2.706 billion, driven by the merger, $218 million in merger and integration expenses, and $131 million in intangible amortization. Staff expenses increased 99% year-over-year.
- Asset Quality: The company recorded no provision for credit losses in Q3 2007, compared to a credit of $4 million in Q3 2006. Net charge-offs were $35 million, primarily related to leased aircraft.
- Unusual Items: Q3 2007 included a $27 million pre-tax benefit from a contract termination settlement, offset by a $32 million write-off of a hedge fund manager interest and a $6 million software write-off. A $22 million reduction in net interest revenue occurred due to a tax rate recalculation on leverage leases.
Guidance, Outlook, and Risks
- Capital Targets: Management established a Tier 1 capital target of 8% and a secondary target of 5% adjusted tangible common equity. As of Sept 30, 2007, the Tier 1 ratio was 9.12% and adjusted tangible common equity was 5.31%.
- Tax Outlook: The projected effective tax rate for Q4 2007 is expected to range between 33.5% and 34.0%, higher than the Q3 rate of 28.2%, due to the adverse effect of the merger on New York state taxes and increased foreign taxes.
- Strategic Focus: The company expects an increasing percentage of revenue and income to be derived outside the U.S. and aims to increase fee revenue per employee and pre-tax margins over time.
- Key Risks:
- Legal Proceedings: The Russian Federation is pursuing a claim alleging $22.5 billion in losses related to funds transfer activities. The company intends to defend vigorously.
- Subprime Exposure: The company holds $1.62 billion in mortgage-backed securities with subprime exposure and $382 million in CDOs with subprime exposure. A $13 million loss was recognized on CDO exposure in Q3 2007.
- Market Volatility: Performance fees were negative $3 million due to market volatility impacting alternative and quantitative strategies.
- Regulatory: Ongoing IRS examinations regarding LILO and SILO transactions and U.K. tax credits.
Investor Verification Checklist
- Merger Integration Costs: Verify the trajectory of the $218 million merger and integration expense and the $131 million intangible amortization to assess future earnings quality.
- Subprime Exposure: Review the specific vintage and rating distribution of the $1.62 billion subprime mortgage-backed securities and $382 million CDO holdings to gauge potential future credit losses.
- Legal Contingencies: Monitor the status of the Russian Federation claim ($22.5 billion) and the outcome of IRS examinations regarding tax credits (LILO/SILO).
- Capital Adequacy: Confirm that the Tier 1 capital ratio remains above the 8% target and that the adjusted tangible common equity ratio stays above 5% as the balance sheet grows.
- Fee Revenue Sustainability: Analyze whether the 132% increase in fee revenue is sustainable post-merger integration or if it is primarily a one-time step-change due to the acquisition.