STATE STREET CORP quarterly report, Q2 FY2017

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State Street Corporation — Q2 2017 Form 10-Q

Business context and reporting period. State Street provides institutional investment servicing and investment management worldwide. This unaudited filing covers the quarter and six months ended June 30, 2017; comparisons are with the corresponding 2016 periods, unless otherwise noted. At quarter-end, assets under custody and administration (AUCA) were $31.04 trillion and assets under management (AUM) were $2.61 trillion.

Key financial results

  • Q2 revenue: $2.81 billion, up 9%. Fee revenue was $2.24 billion (+9%); net interest income (NII) was $575 million (+10%).
  • Q2 earnings: Net income was $620 million, essentially flat year over year; net income available to common shareholders was $584 million versus $585 million. Diluted EPS rose 4% to $1.53, supported in part by fewer average diluted shares. Return on average common equity was 12.6%, versus 12.4%.
  • First-half results: Revenue was $5.48 billion (+8%); net income was $1.12 billion (+14%); diluted EPS was $2.69 (+20%). A $40 million net securities loss compared with a $1 million gain in the 2016 first half.
  • Fees and drivers: Q2 servicing fees rose 8% to $1.34 billion; management fees rose 36% to $397 million, including about $72 million from acquired GEAM operations. Trading services rose 8% and securities finance rose 15%. Processing and other fees fell 68%, largely because 2016 included a gain of about $53 million from the WM/Reuters sale and 2017 included unfavorable FX swap costs.
  • Margins and expenses: Q2 fully taxable-equivalent net interest margin was 1.27%, up from 1.14%. Expenses rose 9% to $2.03 billion, including $62 million of restructuring charges, versus $13 million a year earlier. Q2 income before tax was $776 million; the effective tax rate was 20.1%, versus 12.9%.
  • Cash flow (first half): Operating activities provided $4.00 billion, investing activities provided $5.02 billion and financing activities used $7.17 billion. Cash and due from banks increased $1.84 billion to $3.16 billion. These cash-flow totals reflect significant movements in deposits, securities and collateral.
  • Balance sheet and funding: Total assets were $238.27 billion, down from $242.70 billion at December 31, 2016. Deposits were $181.42 billion, down from $187.16 billion; shareholders’ equity was $22.07 billion. Long-term debt was $11.74 billion, up from $11.43 billion. Loans and leases increased to $24.36 billion from $19.76 billion.
  • Liquidity and capital: The company reported an LCR above 100%; average HQLA was $78.44 billion. State Street’s CET1 ratio was 12.0% under the advanced approaches and 11.2% under the standardized approach; State Street Bank’s ratios were 16.5% and 15.4%, respectively. The filing says both exceeded applicable requirements.

Material changes and notable developments

  • Revenue growth reflected higher equity markets, new business and client volumes, higher U.S. interest rates, and GEAM. AUCA rose 12% year over year and AUM rose 13%; positive markets and the acquisition contributed, while institutional investment-management flows remained negative.
  • GEAM, acquired July 1, 2016, contributed approximately $72 million of Q2 management fees; related AUM was $125 billion at June 30, 2017.
  • State Street secured approximately $135 billion of new asset-servicing mandates in Q2. Won but uninstalled servicing mandates totaled about $370 billion; uninstalled asset-management business was about $14 billion.
  • A large client plans to move approximately $1 trillion of assets, principally common trust funds, to another provider, mainly during 2018. State Street expects to remain a significant provider but expects to lose revenue on transitioned assets.
  • State Street sold $2.7 billion of available-for-sale securities in Q1, primarily agency mortgage-backed and U.S. Treasury securities, recording a $40 million pretax loss.

Outlook, risks and contingencies

  • Beacon transformation: Management estimated annual pretax net run-rate savings of $550 million by the end of 2020, relative to 2015, with full effect in 2021; it expected at least $140 million of annual pretax savings in 2017. The program was expected to incur aggregate pretax restructuring charges of approximately $300 million to $400 million through 2020. These are estimates, not guarantees.
  • Capital returns and funding: Following the Federal Reserve’s non-objection to the 2017 capital plan, the Board authorized up to $1.4 billion of common-stock purchases through June 30, 2018. In July, it approved a Q3 dividend of $0.42 per share, up from $0.38. State Street issued $750 million of fixed-to-floating senior notes in May 2017.
  • Invoicing review and litigation: The company expected cumulative client reimbursements of at least $340 million, including interest; approximately $32 million remained unpaid and accrued at June 30. The review and related regulatory investigations and lawsuits continued. Potential fines or other sanctions could be significant, and the company said losses in certain matters could not then be reasonably estimated.
  • Other legal matters: State Street paid a $32.3 million DOJ fine and entered a deferred prosecution agreement concerning transition-management conduct; it accrued a further $32.3 million for a proposed SEC settlement, which remained subject to approval. It also accrued $3 million for a proposed SEC settlement concerning the GovEx platform. Aggregate legal and regulatory accruals were approximately $45 million, excluding the invoicing reimbursement accrual; the estimated reasonably possible loss range for certain other matters was $0–$15 million, excluding matters for which estimation was not feasible.
  • Financial and operational risks: Key exposures include interest rates, FX and markets; client deposit behavior and funding access; counterparty and credit risk; cyber and operational risks; regulatory compliance and resolution-plan requirements; competition and fee pressure; and execution of Beacon. A credit downgrade could raise funding costs, prompt deposit withdrawals or require additional collateral. The 2017 resolution plan was submitted June 30; regulators could require remediation or impose more stringent requirements.
  • Credit and off-balance-sheet exposures: The loan-loss allowance was $54 million. Senior secured loans totaled about $3.8 billion and were largely rated BB or B externally; management noted greater credit-loss exposure than for higher-rated loans. Unfunded credit commitments were $26.71 billion. Indemnified securities on loan totaled $370.47 billion and were collateralized above 100%, but expose State Street to borrower and collateral-management risks.

Most important facts for investors to verify

  • Whether the expected $1 trillion client asset transition in 2018 occurs as described, and its actual impact on servicing fees and client relationships.
  • Progress converting the $370 billion servicing pipeline and $14 billion asset-management pipeline into installed, fee-generating business, alongside institutional outflows.
  • Beacon’s realized savings, restructuring charges and implementation costs versus management’s targets.
  • Final costs and outcomes of the invoicing review, DOJ/SEC matters, other investigations and litigation, including whether additional liabilities or sanctions arise.
  • Deposit trends, funding costs, interest-rate sensitivity, liquidity ratios and capital ratios as regulatory requirements phase in.
  • Credit performance as loans grow, particularly investment-fund, municipal and lower-rated senior secured lending, and the adequacy of the allowance.