State Street Corporation — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. State Street provides institutional investment servicing and investment management services. Financial statements are unaudited and prepared under U.S. GAAP.
Business and financial position
At quarter-end, State Street reported $34.00 trillion in assets under custody and/or administration (AUCA), $2.81 trillion in assets under management (AUM), $234.01 billion in total assets, $168.20 billion in deposits, $24.55 billion in shareholders’ equity, and 39,020 employees.
Financial results
| Metric | Q3 2018 | Q3 2017 | Change | Nine months 2018 | Nine months 2017 | Change |
|---|---|---|---|---|---|---|
| Total revenue | $2.951B | $2.846B | +4% | $8.996B | $8.324B | +8% |
| Fee revenue | $2.280B | $2.242B | +2% | $7.016B | $6.675B | +5% |
| Net interest income (NII) | $672M | $603M | +11% | $1.974B | $1.688B | +17% |
| Total expenses | $2.079B | $2.021B | +3% | $6.494B | $6.138B | +6% |
| Net income | $765M | $685M | +12% | $2.160B | $1.807B | +20% |
| Diluted EPS | $1.87 | $1.66 | +13% | $5.38 | $4.35 | +24% |
| Pre-tax margin | 29.4% | 28.9% | +50 bps | 27.7% | 26.2% | +150 bps |
Q3 return on average common equity was 14.0%, up from 13.0%; Q3 operating leverage was 0.8%, while fee operating leverage was negative 1.2%. The effective tax rate was 11.8% for Q3 and 13.4% for the nine-month period, versus 16.7% and 17.2% in the comparable 2017 periods.
For the first nine months, operating cash flow was $8.824 billion, investing cash flow was $11.431 billion, and financing cash flow was negative $18.217 billion; cash and due from banks increased by $2.038 billion to $4.145 billion. Operating cash flow included a $7.236 billion change in collateral deposits, so it should not be read as recurring earnings-based cash generation without considering that movement.
Material changes and drivers
- NII growth reflected higher U.S. interest rates and disciplined liability pricing, partly offset by a shift toward high-quality liquid assets (HQLA). Fully taxable-equivalent net interest margin rose to 1.48% in Q3 from 1.35%.
- Management fees rose 13% in Q3, reflecting stronger global equity markets; servicing fees fell 1%, amid a client transition, industry fee pressure, outflows and weaker emerging-market asset levels. Securities finance revenue declined 13%, partly due to balance-sheet repositioning.
- The new revenue recognition standard added approximately $70 million to both Q3 revenue and expenses and $205 million to both nine-month revenue and expenses, primarily reflecting gross presentation of certain third-party costs. Management said adoption did not materially change revenue timing and did not affect cash flows.
- Expenses reflected technology and new-business investments, partly offset by Beacon savings, management delayering and lower discretionary spending. Beacon generated $183 million of year-over-year pre-tax savings net of investments in the first nine months; management expected about $200 million for 2018 and reported $509 million of its $550 million savings goal realized by September 30.
- AUCA was up 6% year over year and AUM up 5%; State Street reported approximately $8 billion of Q3 net AUM inflows. However, a client’s largely completed transition of approximately $1 trillion of assets to another provider will eliminate associated revenue after transition.
Balance sheet, liquidity and capital
- Total deposits declined to $168.20 billion from $184.90 billion at December 31, 2017; long-term debt declined to $10.34 billion from $11.62 billion. Total assets were $234.01 billion, down from $238.43 billion.
- State Street sold approximately $16 billion of non-HQLA securities in the first nine months, reinvesting a significant portion in HQLA. The investment portfolio was about 90% AAA- or AA-rated. Its average duration increased to 3.3 years from 2.7 years at year-end 2017.
- Parent Company daily average liquidity coverage ratio (LCR) was 107% for Q3, compared with 112% for Q4 2017; average HQLA was $94.37 billion. The filing reports a 7.1% supplementary leverage ratio (SLR) for the Parent Company and 7.8% for State Street Bank.
- At September 30, CET1 was 13.0% under the standardized approach and 14.1% under advanced approaches; the Tier 1 leverage ratio was 8.1%. The company said it exceeded applicable regulatory capital requirements. Capital ratios rose from year-end, supported by equity issuance and suspended buybacks.
- Unfunded credit commitments totaled $27.78 billion, with approximately 76% expiring within one year. Indemnified securities on loan were $380.39 billion, supported by $399.25 billion of collateral held as agent; these client agency balances are not recorded on the balance sheet.
Outlook, events and risks
- State Street completed its approximately $2.6 billion all-cash acquisition of Charles River Development on October 1, 2018, after quarter-end. Funding included approximately $1.15 billion from a July common-stock offering, approximately $500 million from a September preferred-stock offering, and approximately $950 million of suspended repurchases. It expected approximately $200 million of acquisition and integration costs through 2021.
- The company did not repurchase shares in Q3, did not plan repurchases in Q4 2018, and intended to resume in Q1 2019, potentially repurchasing up to $600 million through June 30, 2019. The Q3 common dividend was $0.47 per share, up from $0.42.
- Management said NII sensitivity remained positioned to benefit from rising rates, although sensitivity to an instantaneous 100-basis-point increase had moderated. The filing’s scenario estimate was a $346 million NII benefit for a +100-basis-point shock and a $171 million exposure for a −100-basis-point shock over the next 12 months, assuming no management action. Economic value of equity remained exposed to rising rates.
- Key risks include deposit and funding volatility, interest-rate and market movements, client fee pressure and asset flows, cyber and operational risks, evolving regulatory capital/liquidity requirements, and integration and execution risks related to Charles River Development.
- Legal and regulatory matters remain significant. The company had $13 million of accrued legal and regulatory loss contingencies and estimated reasonably possible losses of zero to approximately $45 million for certain matters, but said it could not estimate potential losses for some important proceedings. Its historical invoicing review was expected to require cumulative customer payments of at least $360 million; investigations and related claims could result in further payments, penalties or reputational harm.
Important facts for investors to verify
- Whether the Charles River Development acquisition delivers expected strategic benefits and how its integration costs, funding and capital effects develop.
- Whether servicing-fee pressure, the $1 trillion client transition and future asset flows offset market-driven management-fee and NII growth.
- Whether Beacon savings persist as planned while technology, regulatory and new-business expenses rise.
- Progress and potential exposure from the invoicing review, DOJ/SEC and other regulatory matters, including any amounts not currently estimable.
- Deposit trends, liquidity ratios and capital levels as regulatory standards change; also assess the effect of the investment portfolio’s longer duration and interest-rate sensitivity.
- Underlying cash generation excluding material collateral-deposit movements, and the extent to which revenue growth reflects the gross-presentation effect of the new revenue standard.