State Street Corporation — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012; comparisons are to the corresponding 2011 periods unless noted. State Street provides investment servicing and investment management services. Interim financial statements are unaudited and were reviewed by Ernst & Young, not audited.
Business context and key financial metrics
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $2.356 billion | $2.427 billion | $7.200 billion | $7.279 billion |
| Net income | $674 million | $555 million | $1.591 billion | $1.539 billion |
| Net income available to common shareholders | $654 million | $543 million | $1.551 billion | $1.511 billion |
| Diluted EPS | $1.36 | $1.10 | $3.19 | $3.03 |
| Net interest revenue | $619 million | $578 million | $1.916 billion | $1.727 billion |
| Net interest margin, fully taxable-equivalent | 1.53% | 1.56% | 1.63% | 1.71% |
| Income before tax | $941 million | $629 million | $2.179 billion | $2.004 billion |
| Income tax expense | $267 million | $74 million | $588 million | $465 million |
- At September 30, 2012, total assets were $204.52 billion, deposits $146.29 billion, total liabilities $183.77 billion and shareholders’ equity $20.75 billion. At December 31, 2011, these were $216.83 billion, $157.29 billion, $197.43 billion and $19.40 billion, respectively.
- Long-term debt was $6.42 billion, down from $8.13 billion at year-end 2011. The filing reports $2.50 billion of commercial paper outstanding at quarter-end.
- Nine-month operating cash flow was negative $404 million, versus positive $225 million in 2011. Investing activities provided $19.48 billion and financing activities used $14.84 billion; the reported net increase in cash and due from banks was $4.24 billion.
- Consolidated net liquid assets were $128.78 billion, compared with $144.15 billion at December 31, 2011. Management considered liquidity sufficient for commitments and business needs. Quarter-end excess central-bank balances were approximately $25.23 billion.
- State Street reported Tier 1 risk-based capital and total risk-based capital ratios of 19.8% and 21.3%; State Street Bank reported 18.0% and 19.9%. Both exceeded regulatory minimums and “well capitalized” thresholds.
- Assets under custody and administration were $23.44 trillion; assets under management were $2.065 trillion. The company had 29,650 employees at quarter-end.
Material changes versus prior comparable periods
- Q3 revenue declined 3%, while net income rose 21% and diluted EPS rose 24%. The increase in earnings chiefly reflects a $362 million pre-tax benefit from resolving Lehman-related claims; it is not indicative of recurring operating growth on its own.
- For the first nine months, revenue declined 1%, while net income increased 3%. Fee revenue fell 7% in Q3 and 4% year to date; net interest revenue rose 7% and 11%, respectively.
- Trading services revenue declined 31% in Q3 and 19% year to date, primarily from lower foreign-exchange volatility and reduced electronic trading volumes. Management fees increased 10% in Q3, supported by stronger equity valuations and installed new business. Servicing fees fell 1% in Q3, affected by the weaker euro and asset mix.
- Q3 operating expenses, before the separately presented unusual items, declined 3%; compensation and benefits fell 5%, partly reflecting the transformation program. Total reported expenses declined 21% in Q3 and 5% year to date, including the Lehman benefit and litigation-related provisions.
- The effective tax rate was 28.3% for Q3 2012 versus 11.7% in Q3 2011; the prior-year quarter included a discrete $91 million tax benefit.
- Available-for-sale securities had a pre-tax net unrealized gain of $988 million at September 30, compared with a $181 million net unrealized loss at year-end 2011. Investment securities were approximately 88% rated AAA or AA.
Outlook, management commentary, risks and unusual items
- Lehman settlement: Final resolution of U.S. and U.K. indemnified repurchase and securities-lending claims generated a $362 million Q3 benefit. The related certified claims were sold in October 2012, producing an additional approximately $10 million gain expected to be recorded in Q4.
- Legal and other charges: Q3 included a $60 million provision for previously disclosed asset-management and securities-lending litigation and a one-time $25 million charitable contribution. Nine-month provisions for litigation exposure and other costs totaled $107 million. Management stated that some legal outcomes could materially affect results in the period resolved; certain potential exposures cannot be reasonably estimated.
- Cost program: Management expected incremental 2012 annual pre-tax run-rate savings of approximately $90–$100 million from its Business Operations and IT Transformation program. It projected total annual savings of approximately $575–$625 million by the end of 2014 versus 2010, with the full effect in 2015, and aggregate restructuring charges of approximately $400–$450 million through 2014. These are program estimates, not overall expense or earnings guidance.
- Acquisition after quarter-end: State Street completed its cash acquisition of Goldman Sachs Administration Services on October 15, 2012, for approximately $550 million, subject to adjustments. GSAS had approximately $200 billion of hedge-fund assets under administration, excluded from State Street’s September 30 reported assets.
- Capital returns and preferred stock: State Street issued Series C preferred shares for net proceeds of approximately $488 million and redeemed Series A preferred stock for approximately $500 million on October 4. It repurchased $960 million of common stock in the first nine months under a $1.8 billion authorization through March 31, 2013; the common dividend declared was $0.24 per share for Q3.
- Rate and margin sensitivity: Management attributed higher net interest revenue to asset growth and lower funding costs, partly offset by lower asset yields. Central-bank placements of client deposits supported asset growth but weighed on margins. A 100-basis-point rate decline was estimated to reduce next-12-month net interest revenue by $294 million under a shock scenario; a 100-basis-point increase was estimated to raise it by $205 million.
- Portfolio, regulatory and operational risks: Risks include low rates, market volatility, European sovereign and counterparty stress, investment-securities impairment, client deposit outflows, securities-lending indemnification, FX-pricing litigation and investigations, and execution of the transformation program. Management estimated that a further 10%–13% decline in U.S. home prices from June 2012 levels could increase portfolio impairment by approximately $5–$40 million. Proposed U.S. Basel III capital rules, particularly securitization risk weights, could materially affect capital ratios, business profitability and portfolio composition; final requirements and their effects remained uncertain.
- Foreign-exchange transition-management revenue continued to face possible reputational and regulatory effects from U.K. compliance issues. The company also disclosed pending FX-pricing matters, including a California action and class actions, and had not reserved for those proceedings.
Important facts for investors to verify
- How much of Q3 and year-to-date earnings growth remains after excluding the one-time $362 million Lehman benefit and considering litigation, tax and other unusual items.
- Whether fee revenue stabilizes, particularly trading services and servicing fees, and whether awarded but not yet installed business converts into revenue.
- Whether management achieves the stated transformation savings and restructuring-cost estimates without disrupting operations or client relationships.
- Developments in FX-pricing, securities-lending and asset-management litigation and investigations, including possible exposure beyond recorded reserves.
- Effects of interest rates, client deposit behavior and proposed capital rules on net interest margin, liquidity, investment portfolio mix and capital ratios.
- Integration, purchase accounting and subsequent results of the GSAS acquisition, and the actual Q4 gain on the sale of Lehman claims.