State Street Corporation — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018; comparison with the same 2017 periods. Financial statements are unaudited and were subject to an independent accountant’s interim review. State Street provides custody, administration, investment management and related services to institutional investors worldwide.
Financial performance and condition
| Metric | Q2 2018 | Change vs. Q2 2017 | Six months 2018 | Change vs. 2017 |
|---|---|---|---|---|
| Total revenue | $3.026 billion | +8% | $6.045 billion | +10% |
| Fee revenue | $2.358 billion | +6% | $4.736 billion | +7% |
| Net interest income | $659 million | +15% | $1.302 billion | +20% |
| Net income | $734 million | +18% | $1.395 billion | +24% |
| Diluted EPS | $1.88 | +23% | $3.51 | +30% |
| Total expenses | $2.159 billion | +6% | $4.415 billion | +7% |
| Pre-tax margin | 28.6% | Up from 27.6% | 26.9% | Up from 24.8% |
Q2 return on average common equity was 14.7%, versus 12.6% a year earlier. Common dividends declared were $0.42 per share for Q2, up 11%; a $0.47 per-share Q3 dividend was declared in July.
- Revenue drivers: Higher management and servicing fees and NII supported growth. Q2 management fees rose 17%; servicing fees rose 3%. Higher U.S. interest rates and disciplined liability pricing lifted NII, partly offset by investment portfolio changes.
- Offsets and costs: Q2 securities finance revenue fell 14%, mainly from lower enhanced-custody lending activity. Expenses increased with new-business investments, technology and compensation costs.
- Cash flow, six months: Operating cash flow was $3.402 billion, down from $3.999 billion. Investing activities used $1.732 billion, compared with $5.016 billion provided in 2017; financing provided $109 million, versus $7.173 billion used. Cash and due from banks ended at $3.886 billion, up $1.779 billion from year-end.
- Balance sheet at June 30: Assets were $248.308 billion; deposits $186.663 billion; long-term debt $10.387 billion; shareholders’ equity $22.571 billion. Compared with December 31, 2017, assets rose from $238.425 billion, deposits from $184.896 billion, and long-term debt declined from $11.620 billion.
- Capital and liquidity: CET1 was 11.3% under the standardized approach (12.4% advanced approaches), compared with 11.9% and 12.3%, respectively, at year-end. Tier 1 leverage was 7.1%, down from 7.3%. Parent-company SLR was 6.2%; State Street Bank’s was 6.8%. Average parent-company LCR was 108% for Q2, versus 112% in Q4 2017, with average HQLA of $87.0 billion. Management said the company and bank exceeded applicable regulatory capital requirements.
Material changes and management outlook
- Adoption of the new revenue recognition standard increased both revenue and expenses by approximately $70 million in Q2 and $135 million in the first half; management said it did not materially change revenue-recognition timing or cash flows. The gross-up contributed about 3 percentage points to Q2 revenue and expense growth.
- A $77 million Q2 repositioning charge related to organizational changes and management streamlining included $61 million of compensation costs and $16 million of occupancy costs. Beacon generated approximately $120 million of net pre-tax year-over-year savings in the first half. Management expected $200 million of savings in 2018 and said $444 million of its $550 million savings target had been realized by June 30; the target was expected by early 2019.
- AUCA was $33.87 trillion and AUM $2.72 trillion at quarter-end. AUM was up 5% year over year, but State Street reported Q2 net outflows of approximately $14 billion. Newly announced servicing mandates were about $1.5 trillion year to date; approximately $300 billion remained to be installed.
- A large client began transitioning approximately $1 trillion of assets to another provider; the transition was about 50% complete. State Street said it remained a significant provider to the client.
- On July 20, State Street announced a definitive agreement to acquire Charles River Development for $2.6 billion in cash, expected to close in Q4 2018 subject to approvals and closing conditions. The company expected to suspend about $950 million of share repurchases and, subject to market conditions, fund the remainder through equity issuance, roughly two-thirds common and one-third preferred. No shares were repurchased in Q2; management did not intend to repurchase shares for the rest of 2018 and expected to resume in Q1 2019.
- The investment portfolio was repositioned through approximately $16 billion of non-HQLA securities sales in the first half, with $11 billion reinvested mainly in HQLA. Average portfolio duration increased to 3.2 years from 2.7 years at year-end.
Risks, contingencies and unusual items
- Billing practices and regulatory matters: State Street expected cumulative customer payments related to historical invoicing errors to be at least $360 million. Government investigations and litigation continued; the filing warned that sanctions, penalties, further remediation or reputational damage could be material. A $4.9 million shareholder class-action settlement was agreed in principle, subject to court approval.
- Legal and regulatory loss-contingency accruals totaled approximately $14 million. The estimated reasonably possible loss range was $0–$45 million, but excluded significant matters for which a loss range was not feasible to estimate.
- Other material exposures include regulatory compliance obligations under a Federal Reserve/Massachusetts Division of Banks written agreement, the DOJ deferred prosecution agreement and SEC-related compliance oversight; operational and cybersecurity risks; market and interest-rate risk; client deposit and liquidity volatility; and evolving capital and liquidity rules.
- A credit downgrade could affect funding access and costs, prompt deposit withdrawals, or require additional collateral. Derivative agreements could require up to approximately $2.19 billion of additional payments following specified rating downgrades, assuming no change in fair value.
- Off-balance-sheet commitments included $26.654 billion of unfunded credit facilities and $396.801 billion of indemnified securities financing. The latter was supported by $416.084 billion of collateral held as agent; contractual totals are not estimates of expected losses.
Important facts for investors to verify
- Whether organic fee growth and NII gains persist after separating the revenue-recognition gross-up, and whether securities-finance weakness continues.
- Progress, client retention, regulatory approvals, integration costs and actual financing/dilution for the proposed Charles River Development acquisition.
- The financial and regulatory outcomes of the invoicing review, related investigations and litigation, including payments beyond the stated minimum expectation.
- Completion of the approximately $1 trillion client transition and installation of announced servicing mandates.
- Capital-ratio trends, liquidity metrics, deposit pricing and the company’s ability to meet evolving G-SIB, TLAC and other regulatory requirements.