Northern Trust Corporation — Q3 2016 Form 10-Q
Business and period: Northern Trust is a financial holding company providing asset servicing, fund administration, asset management, fiduciary and banking services. Its principal reporting segments are Corporate & Institutional Services (C&IS) and Wealth Management. This unaudited quarterly report covers the three and nine months ended September 30, 2016; comparisons are primarily with the corresponding 2015 periods.
Key financial results
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Revenue (GAAP) | $1,213.7 million | $1,155.5 million | $3,720.4 million | $3,545.9 million |
| Net interest income | $303.1 million | $268.9 million | $910.6 million | $780.7 million |
| Noninterest income | $910.6 million | $886.6 million | $2,809.8 million | $2,765.2 million |
| Provision for credit losses | $(3.0) million | $(10.0) million | $(4.0) million | $(24.5) million |
| Noninterest expense | $843.0 million | $812.3 million | $2,596.8 million | $2,455.8 million |
| Net income | $257.6 million | $234.6 million | $766.0 million | $734.5 million |
| Diluted EPS | $1.08 | $0.96 | $3.21 | $3.00 |
| Net interest margin (FTE, non-GAAP) | 1.14% | 1.08% | 1.17% | 1.06% |
Q3 revenue rose 5%, net income 10% and diluted EPS 13% year over year. For the first nine months, revenue increased 5%, net income 4% and diluted EPS 7%. Return on average common equity was 11.7% for Q3 and 11.9% for the nine-month period; return on average assets was 0.9% for both periods.
Balance sheet, funding and capital
- At September 30, 2016, total assets were $120.1 billion, deposits $99.5 billion and stockholders’ equity $9.6 billion. Versus December 31, 2015, these increased 3%, 3% and 10%, respectively.
- Loans and leases were $33.4 billion, compared with $33.2 billion at year-end 2015. Securities totaled $44.7 billion, up from $37.6 billion.
- Reported debt and borrowing categories included $4.0 billion of other borrowings, $1.5 billion of senior notes, $1.4 billion of long-term debt, $277.4 million of floating-rate capital debt, $378.5 million of federal funds purchased and $301.8 million of repurchase agreements.
- Capital ratios remained above regulatory “well-capitalized” thresholds. Corporation CET1 was 11.8% under the Advanced Approach and 11.2% under the Standardized Approach; total capital ratios were 14.5% and 14.0%, respectively. The supplementary leverage ratio was 6.6% under the Advanced Approach; the filing notes a 3% minimum effective January 1, 2018.
Cash flow and liquidity
For the first nine months of 2016, operating activities provided $671.5 million, investing activities used $5.3 billion and financing activities provided $2.8 billion. Cash and due from banks declined $1.5 billion to $4.9 billion over the period. Investing outflows primarily reflected net purchases of securities; financing inflows primarily reflected higher deposits and the issuance of Series D preferred stock, partly offset by share repurchases and dividends. The filing does not provide a single summary liquidity ratio in the text provided.
Material changes and operating drivers
- Higher net interest income reflected both earning-asset growth and an improved margin. Average earning assets increased 7% year over year in Q3 to $107.8 billion; the FTE margin increased to 1.14% from 1.08%, partly reflecting higher asset yields.
- Trust, investment and other servicing fees rose 5% in Q3 to $788.3 million, supported by market values, new business and lower money-market fee waivers. Assets under custody/administration were $8.50 trillion, and assets under management were $945.8 billion at quarter-end.
- Foreign-exchange trading income fell 15% in Q3 to $53.6 million, which management attributed mainly to lower client volumes. Other operating income declined 14%, partly due to impairments and losses on sales from a non-strategic loan and lease portfolio.
- Q3 noninterest expense increased 4%, with higher compensation, employee benefits and other operating expense. Compensation growth reflected higher staffing and performance-based incentives; full-time-equivalent staff rose 6% year over year to approximately 16,900.
- Segment net income was $132.1 million for C&IS, up 6%, and $135.5 million for Wealth Management, up 18%. Treasury and Other recorded a $10.0 million net loss, compared with a $4.5 million net loss in Q3 2015.
Outlook, risks and unusual items
- Outlook: The filing provides no specific forward earnings or revenue guidance. Management identifies market levels, interest rates, client activity, new business, expense control and regulatory requirements as factors that could affect results.
- Accounting change: Northern Trust early adopted ASU 2016-09, changing the accounting for share-based payment tax benefits. The adoption increased diluted EPS by $0.06 for the first nine months of 2016; Q3 included a $6.4 million tax benefit. The company’s reported nine-month figures reflect the adoption.
- Nonrecurring items: The second quarter included a $118.2 million net Visa Class B share-sale gain, a $46.5 million securities-lending litigation settlement charge, $18.6 million of C&IS client-contract modification charges, $17.5 million of severance and related charges, and $14.1 million of non-strategic loan and lease portfolio impairment and sale losses. Q3 included a further $3.5 million charge for settlement of a securities-lending claim.
- Credit quality: Nonperforming assets were $181.0 million, down 13% year over year but up from $166.4 million at June 30, 2016. Residential real estate represented 57% of nonperforming loans and leases. The allowance for credit losses was $224.9 million, versus $254.7 million a year earlier.
- Legal and contingent matters: Management estimated the upper end of reasonably possible losses for certain matters at approximately $35 million in aggregate; other matters were not reasonably estimable. The company continues to cooperate with an SEC investigation into securities-lending activities. A French court decision concerning a subsidiary’s estate-tax-fraud charge was expected in January 2017. Visa interchange litigation remains unresolved after an appeals court reversed approval of a settlement; timing and conversion terms for Northern Trust’s remaining Visa Class B shares are uncertain.
- Other risks: The filing highlights sensitivity to markets, foreign exchange, interest rates and client assets; credit and counterparty risk; cyber and operational risks; competition; regulation; litigation; and the ability to control expenses and retain clients and staff. Interest-rate simulations estimate pre-tax earnings impacts of +$12 million for a 100-basis-point increase and $(15) million for a 200-basis-point increase, relative to market-implied forward rates; management cautions that these are model estimates, not forecasts.
Most important facts for investors to verify
- Reconcile GAAP net interest income with management’s FTE non-GAAP figures and assess how much margin improvement is sustainable.
- Separate recurring earnings from the Visa gain, litigation and restructuring charges, and the ASU 2016-09 tax benefit.
- Track client asset flows and fee drivers, including market performance, new business, foreign-exchange effects and money-market fee waivers.
- Monitor nonperforming commercial and residential loans, allowance coverage and the effects of the revised credit-loss estimation methodology.
- Review the status and potential financial consequences of securities-lending litigation, the SEC investigation, the French proceeding and Visa litigation.
- Assess the impact of securities purchases, deposit movements, collateral requirements, borrowing levels and planned capital returns on liquidity and capital.