STATE STREET CORP quarterly report, Q3 FY2015

State Street Corporation — Q3 2015 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2015. State Street provides investment servicing and investment management services to institutional investors worldwide. At quarter-end, it reported $247.27 billion in assets, $186.37 billion in deposits, $21.50 billion in shareholders’ equity, $27.27 trillion in assets under custody and administration, and $2.20 trillion in assets under management.

Financial performance and condition

Metric	Q3 2015	Q3 2014	Nine months 2015	Nine months 2014
Total revenue	$2.619 billion	$2.582 billion	$7.838 billion	$7.665 billion
Net interest revenue	$513 million	$570 million	$1.594 billion	$1.686 billion
Net income	$585 million	$560 million	$1.416 billion	$1.545 billion
Net income available to common shareholders	$543 million	$542 million	$1.313 billion	$1.500 billion
Diluted EPS	$1.32	$1.26	$3.16	$3.45
Total expenses	$1.962 billion	$1.892 billion	$6.193 billion	$5.770 billion

Q3 revenue rose 1%, while nine-month revenue rose 2%. Fee revenue increased 5% in both comparisons; net interest revenue fell 10% for the quarter and 5% year to date.
Q3 net income increased 4% and diluted EPS increased 5%; nine-month net income declined 8% and diluted EPS declined 8%. Q3 return on average common equity was 11.3%, versus 10.6%; nine-month return was 9.2%, versus 10.0%.
Fully taxable-equivalent net interest margin was 1.00% in Q3, down from 1.12%; for nine months it was 1.02%, down from 1.19%.
Q3 pre-tax margin was 25%, versus 27%. Nine-month pre-tax margin was 21%, versus 25%.
At September 30, total assets were $247.27 billion, down from $274.12 billion at year-end 2014. Deposits were $186.37 billion, down from $209.04 billion. Long-term debt rose to $12.03 billion from $10.04 billion.
Cash and due from banks was $3.66 billion. Parent-company net liquid assets were $6.75 billion. The company’s liquidity coverage ratio exceeded 100%; reported high-quality liquid assets were $104.84 billion.
For the first nine months, operating cash flow was negative $4.78 billion, investing cash flow was positive $29.79 billion, and financing cash flow was negative $23.21 billion; cash and due from banks increased $1.81 billion overall.
Regulatory capital ratios at September 30 included common equity tier 1 of 12.1% under advanced approaches and 12.0% under the standardized approach. The estimated fully phased-in supplementary leverage ratio was 5.4%.

Material changes and business trends

Q3 fee revenue growth reflected higher foreign-exchange trading and securities-finance revenue, as well as an $83 million pre-tax gain on sale of commercial real estate acquired through the Lehman Brothers bankruptcy. Currency translation reduced Q3 revenue by about $80 million.
Servicing fees fell 1% in Q3, primarily from the stronger U.S. dollar and weaker international equity markets; net new business and transaction volumes partly offset the decline. Management fees fell 9%, reflecting currency effects, weaker international markets, net outflows and lower performance fees.
Assets under management fell to $2.203 trillion from $2.448 trillion at December 31, 2014. Net outflows over the nine months were approximately $133 billion; a single client’s reallocation drove significant Q3 outflows and was expected to continue into 2016. Approximately $22 billion of awarded asset-management business was not yet installed.
State Street secured an estimated $141 billion of assets to be serviced in Q3; approximately $101 billion was installed by quarter-end, with the balance expected later.
Expenses increased 4% in Q3 and 7% year to date. Q3 included $75 million of pre-tax severance costs. Year-to-date other expenses included $400 million of legal accruals related to indirect foreign-exchange business.
Q3 income tax expense included a $59 million reduction in an Italian deferred tax liability. The nine-month effective tax rate was 13.4%, compared with 18.2%.
State Street repurchased approximately 15.6 million shares for $1.17 billion during the first nine months and declared common dividends of $0.98 per share, up from $0.86 a year earlier. It issued $750 million of Series F preferred stock, netting approximately $742 million.

Outlook, risks and contingencies

In October 2015, management announced a multi-year operational-efficiency and digitization plan targeting approximately $500 million in annualized savings when fully implemented over about four to five years.
Management cited low global interest rates, a strong U.S. dollar, elevated client deposits and the mix of deposits invested at central banks as pressures on net interest revenue and margin. Further rate declines or dollar strength could add pressure. Q3 period-end client deposits had fallen $44 billion from June 30, mainly following management actions.
The company reported approximately $605 million of aggregate accruals for legal loss contingencies and regulatory matters. Of this, $585 million related to indirect foreign-exchange business. State Street cautioned that settlements could exceed accruals and further claims could arise.
Other significant matters include a pending California action and related inquiries concerning indirect FX pricing, a proposed SEC enforcement action concerning public-retirement-plan business solicitation, and a Federal Reserve/Massachusetts written agreement requiring improvements to Bank Secrecy Act, anti-money-laundering and sanctions compliance. Failures or identified historical deficiencies could lead to fines or other sanctions.
Credit risk includes a growing portfolio of senior secured bank loans to non-investment-grade borrowers: $2.93 billion outstanding, with $37 million of the loan-loss allowance associated with these loans. The filing reports no loans on non-accrual status or 90 days past due at quarter-end.
Other risks include market and counterparty exposures, cybersecurity and operational risks, regulatory and capital requirements, and potential Volcker Rule impacts. State Street held approximately $2.35 billion in CLO investments; a determination that these or other holdings are covered funds could require sales and result in losses.
The Federal Reserve’s proposed TLAC and external long-term debt requirements could affect future funding and capital needs. S&P placed certain long-term ratings on CreditWatch with negative implications after the proposal was announced.
The company’s financial statements were reviewed, not audited, by its independent registered public accounting firm. The firm reported no material modifications needed for GAAP conformity.

Important facts for investors to verify

Whether the $500 million savings target is achieved, and the implementation costs and timing of the efficiency plan.
Whether the large client’s asset-management reallocations continue as expected, and the effect on AUM, flows and management fees.
Progress toward resolving indirect FX litigation and investigations, including whether the $585 million accrual is sufficient and whether non-financial settlement terms are reached.
Whether deposit-management actions, interest rates and currency movements stabilize net interest revenue and margin.
Future regulatory capital and liquidity requirements, including final TLAC rules, G-SIB surcharges and SLR compliance, as well as any resulting effects on capital distributions.
Credit performance of the non-investment-grade loan portfolio and any changes in collateral, securities-lending or other contingent exposures.