Northern Trust Corporation (NTRS) Earnings Call Transcript & Summary

All right. Well, good morning. Thanks for joining. Welcome, everybody. We're going to get going with our next session. Up next, I would like to welcome management from Northern Trust. With us today are Mike O'Grady, Chairman, President and CEO; and Jason Tyler, Northern Trust CFO. Over the course of 2021, Northern Trust continued to drive multiple organic growth initiatives across both of its institutional and wealth management businesses, while obviously preserving significant earnings upside to rising interest rate environment, which hopefully will be upon us sooner than later. We'll spend some time with Mike and Jason on how they're positioning the business into next year, and we'll conduct this in the fireside chat format. So thank you both for being here. Great to see you. Thank you extra for making the trip from Chicago. So great to see you in person.

Great to see you.

So Mike, I want to start with you, maybe before we get into some of the typical topics. We're almost your 3 or 3 -- year 3 really of you being the CEO. Can we start with an overview at the kind of the corporate level in terms of the progress you made, key kind of top of the house initiatives you're focusing on into 2022?

Yes. So I think it is interesting to go back to that time period because if you think about, call it, 2018, and what we, as a management team, were focusing on as far as the strategy and the priorities, 2 things I would say. One is we were looking long term, so what do we want to accomplish in order to position the company well 3, 5 and further out. Second is we clearly were not expecting or predicting a pandemic. And so it's been interesting to see how that's played out. So just to highlight some of those priorities. So first -- the first one we call reimagining the foundation. And the point on that is our clients are counting on us to be there all the time and be reliable and be strong regardless of the conditions. And they're also counting on us to be able to operate in the modern contemporary world. And so we had a lot of focus around operational resiliency and around digital and -- digitalizing our business, if you will. So that was the first one. What obviously transpired changed it. But I think very importantly, it's a good thing we were focused on operational resiliency because we experienced something that, again, had not contemplated, but we're prepared to be able to operate in that environment. And then with regards to digital, even though there were some bumps because of the focus on the pandemic and dealing with that, we've been able to continue to execute on the plans for progressing it across our businesses. Second priority was around continuing to drive organic growth in each of the businesses. And when you do that and you lay out the strategies for it, you don't necessarily know what the business conditions are going to be for that. And I know we'll talk about growth more. But I would just say upon reflection, we had the right organic growth strategies in place and initiatives in place for the conditions that have played out. Third was around talent. And our focus was on developing the talent that we thought we needed for the future, and that was both from a diversity, equity and inclusion perspective, but also from a technology perspective. And we have planned to and have looked to train and give experiences for our existing employees so that they can operate in that environment, but importantly, bringing in new talent over this time period that have the types of skills and capabilities and expertise to execute on that strategy. And we'll come back to talent because that's obviously been a big area of focus and change. And then the fourth one I would mention is around productivity. Plenty of initiatives around productivity, so through automation, through capacity utilization and using tools in order to be able to do that. And what's interesting there, Alex, is that we have achieved meaningful productivity over this time period. It just has happened in a completely different way. Those initiatives have been good, but really, this remote operating environment that we've been in, or hybrid environment, has produced a number of efficiencies essentially in what we're doing. That said, it's -- in my view, it's not sustainable really at this level. And so it's not the best operating environment there, but it did enable us to operate more efficiently. So those are kind of the -- some of the key initiatives and how they played out.

Great. Well, let's dig into some of these, obviously, starting with organic growth. I know that's a topic that's near and dear to myself, probably most investors as well. So we'll spend a good amount of time on that. So when you look at the growth in the business for Northern Trust, custody and fund administration up 17% or so year-to-date, year-over-year. Obviously, strong equity markets have a lot to do with that. But underneath it, your commentary around organic growth has also sounded pretty positive this year relative to where we come from in the middle of pandemic last year. So maybe unpack a little bit what the organic growth has been in the institutional business this year, key areas of strength and how is that momentum looking into next year.

Yes. So -- as you mentioned, really strong growth in asset servicing. And that's both because of the market, but to your point, organically as well. And our strategy in that business, which is led by Pete Cherecwich, has been to have -- focus on 4 components. The first is around the existing clients, making sure you're doing a great job with them. Not only does that retain that client base and provide the recurring revenues, but also it provides you the opportunity to expand with those clients. A good example of that more recently is Pendal, has been an asset manager that's been a client for some time period, and they decided they want to consolidate providers. And so we were able to meaningfully grow that relationship as a part of that consolidation. The second is we've had a focus on the middle market or midsized asset managers and asset owners. And the reason why is because we think that we have the opportunity to differentiate in that part of the market. Those types of asset managers are more inclined to have the needs that we can support. So more outsourcing that is beneficial for them in order to get scale that we can provide for them that they couldn't achieve otherwise. And on the asset's owner side there as well, I would say that they're looking to leverage our team, our partners in a way that service is very important to them and that's an area that we try to differentiate. So it's intentionally trying to pick that part of the market. Now the third component you might say, well, then what about the largest of the large on both sides, their asset owners and asset managers? And it's not to say, okay, well, we don't participate in that part of the market, but rather it's to say we look for opportunities to do specific things with them. So it may not be the largest mandate that they have, but it may be a specialized area. And again, that has worked very well for us. So the largest asset managers and some of the largest asset owners are clients of ours, but we're doing very specific things for them. And then the fourth is innovation and new products and new services. And we've talked about certain things like integrated trading solutions. We're coming up with something different to do, which is additive to the growth. So overall, those are the, I'd say, 4 legs of it. And over this time period, Alex, both the business with the asset managers has grown and the asset owners, a little bit faster with the asset managers that gets you to that blend of the 17% year-over-year.

Got it. And the challenge we always have is kind of from outside looking in and actually dissecting what is really organic growth and kind of how do you guys think about it. So any way to frame what organic growth has been this year? And importantly, as you think about the pipeline opportunities, I know you guys don't guide explicitly, but just a framework around the opportunity set into next year and the year after in the organic growth momentum that we -- relative to what we've seen this year?

Yes. So part of the reason why it's difficult to perfectly -- do a perfect attribution of where that growth is coming from, but certainly, like you, I mean we do it as well, is that -- yes, you have things like markets and currencies, et cetera, you can try to adjust for. And then you have the new business that you won and if you've lost business or that it's been repriced in a certain way. But the other component that is really important, and we've seen this, is the growth of your clients as well. So -- yes, some of that happens through the markets, right? So you get that benefit. But then also successful asset managers are the winners when it comes to net flows, that benefits us as well. And the same thing with some of the large asset owners as well where they have greater needs or serving more beneficiaries. So that's the other part, which, again, perfect dissection is difficult, but it's not something that we just take for granted, but rather, we're trying to be aligned with successful companies. The only thing I would do on the institutional side to frame it further would just be to say that going into 2020, we had good momentum in that business there. It did dip down initially in 2020 or, I should say, part of the pandemic, right? And then it kind of picked up at a very high rate because certain things that were in the pipeline just were deferred, say, for a quarter or something like that. And then now I would say we're at a more normalized level as far as onboarding new business as we end this year -- excuse me, and as we go into 2022.

Got it. So maybe a little bit of acceleration from the pent-up demand in '21, and now it's kind of back to the more normal number.

Yes.

I got you. Look, similar line of questions around the Wealth Management business, and you guys occupy a pretty big part of Wealth Management. Again, the public investor community kind of looking at the space as a whole. Wealth Management can mean a lot of things to a lot of different people. You guys specialize, obviously, in high net worth and ultra high net worth part of the market. It's become increasingly competitive. It's always been competitive, but we hear certainly a lot more around sort of competition in that space, whether it's RIAs or other firms trying to branch kind of further into that corner of the market. So again, similar line of questions, how are you thinking about organic growth? What differentiates Northern Trust in this business and your competitive advantage in that kind of sweet spot of your -- or your client base?

So you talked a little bit about where we target our strategy. And I mentioned before that when we think about strategy, it is about positioning, I'd say, the long term, but also it's under different sets of operating conditions, meaning the market. And I would just start, Alex, with talking a little bit about what those conditions have been, which is very favorable for that market in general and I think specifically for us. So if you just think about high valuations, asset valuations, business valuations, low interest rates, potential tax changes and plenty of private equity firms and other firms that have raised capital that they're deploying. All of these things play towards more activity, whether that's selling the business or taking a company public and having a liquidity event as a part of that or redomiciling as an individual to a different state. And when there's more activity like that, then there's greater need for our expertise, and I would say, particularly with regard to that ultra high net worth sector where the needs tend to be more complex. And back to the strategy then and why we think we're so well positioned there is the fact that we've talked about holistic advice, and that is our long-term strategy here. I think about it as breadth and depth, right? The breadth is we need to be able to meet all of those various needs, everything from investment advice through banking, but also things like business advisory services, which essentially is saying if you're a client and you're contemplating what you do with that family business, we can provide advice, even if we're not the investment bank that is going to execute that type of transaction. So having that breadth, which has been in place, and then the depth is more think about the Northern Trust Institute. So very, very deep in particular expertise, which we think, again, enables us to differentiate ourselves. And I would say one example there, just thinking about potential tax policy changes. That has been an area, which not only do we have the expertise, can you go to the Northern Trust Institute site and access that, but very proactively on the part of that business, which, as you know, is led by Steve Fradkin, saying proactively, we are going to go out to all of our clients where this could be applicable. So thousands of clients, to not say you should do something, but to have that conversation and to be able to say. That level of engagement and discipline around making sure that we're doing that across the business has really been beneficial to us and I think has differentiated ourselves. The other part, as you said, it's very competitive, but there's no better way to, I'd say, confront that and spend a lot of time with your client so that there's not somebody else who's doing that. So it's been a good market.

Yes. It's a great point around complexity and clearly there's lots going on. You mentioned tax policy, which -- and the activity that could come surrounding that. Can you give us maybe a couple of examples of where some of the value-added services will actually result in stronger revenue growth, stronger profitability on the back of somebody coming in and starting to use more of the products, right? If I'm a client of Northern Trust, do I already sort of get all of this, and it just comes part of the package? Or there's actually an incremental opportunity to monetize some of the things on the back of this activity?

Yes. So a very straightforward example, which you've seen in the numbers as well, is in banking, right? So you've -- we've seen this higher level of growth, even relative to others in the industry that are more focused on lending, because of additional needs where we've been able to provide that type of lending, which, again, for us, tends to be very focused on particular credit needs. And that absolutely drives not only the loan growth but the net interest income that comes with that.

Yes. Makes sense. Let's talk a little bit about the Asset Management part of the business, which is kind of embedded within both the institutional business and the wealth business, just kind of sits underneath, but it is a stand-alone business in and of itself. We've seen really nice growth and market share gains for you guys there in money market funds. Maybe a little bit less so on the long-dated part of the business, so equity fixed income. So maybe spend a minute on how are you thinking about accelerating organic growth and your competitive position outside of money market funds. And when it comes to money market funds, clearly, a ton of assets flew into this sector on the back of the pandemic. So as we start to go through the QE unwind, how much of that is ultimately going to stick around?

Yes. So I think we will start with the money market funds. And this again -- this goes back to strategy, all of this and this business, again, being led by Shundrawn Thomas, who put the strategy in place about the time period that we talked about. And the reason why it's important, again, is that conditions are going to change. Are you well positioned for those conditions? And with money market funds, yes, there are aspects of that where we're just naturally positioned with our particular institutional clients and our wealth clients when there's more liquidity. But the strategy was in place to also develop a portal beyond other portals. So make sure that we do have greater exposure for those types of conditions. So that's why we've actually benefited more than the market with regard to that. And in the third quarter, we're above $300 billion in AUM with that. So that's worked out extremely well. But to your point, it's not just about whether it's liquidity or some of the other products on that front, but rather, thinking about some of the areas that are longer-term growth opportunities for us. So ESG is certainly one that is important and cuts across the entire industry, but it's something that we've been doing for a very long time. And part of that as well is not just to say, okay, we have a -- I'm going to say, "ESG fund," but rather developing a number of different products to meet different needs, both on the wealth side, but also certainly as well on the institutional side and doing separately managed accounts where you have very specific mandates from the clients and where you can really integrate the specific ESG thinking of the client to do that. So, again, significant growth. I think through the third quarter, we were up about 40% in the ESG funds, over $150 billion there. Next, I would say thinking about quant. And, again, a long-term strategy there. And the sector itself has not performed as well, but for us, has been a net positive in flows and through mandates. And again, a lot of that happening with our institutional clients, much of it outside of the United States as well. So the importance of being a global asset manager. And then just the third one I would mention is our ETF franchise, which is FlexShares, where we're over $18 billion there. And I think on that front, once again, being well positioned for different operating conditions where we've seen a lot of growth against about 40% this year with ETFs that are focused on real assets. And we've just gradually and consistently grown that offering over time. I know you're very familiar with it, Alex. But now we're up over 30 different ETFs with, once again, very specific strategies that are around the same themes that I just mentioned. So it is things that are quant-based, so low vol type strategies or their ESG-type strategies. But again, we're trying to be a differentiated provider there, not one of the just kind of larger general type ETF providers.

Great. Very helpful. Right. Why don't we switch gears a little bit, Jason, bringing you into the conversation a little more on net interest income and just the balance sheet dynamics we're seeing so far. So if you look at Northern Trust's results over the last couple of quarters, NIR has definitely gotten better and exceeded expectations on the back of some of the kind of structural things or maybe idiosyncratic things that are happening with the balance sheet, right? We talked about loan growth and that's certainly helped. But the rate environment feels a little bit better. It hasn't moved a ton, I guess. Lots of volatility, but not a lot of movement at the short end of the curve, Q4 versus Q3. But any updated thoughts on Q4 NIR? Why don't we start there?

So just to answer the question first, no big headline changes that we'd want to communicate in what we're seeing so far in the quarter. But that can change. Obviously, there's a lot of activity that comes late in the year given the fact that we're in fourth quarter. To unpack a couple of things that you mentioned. One, we're still experiencing some reinvestment of a nicer yield curve environment. And we're 85%, 90% of the way through that, but it's that reinvestment still costing us $1 million a quarter. And so we're still trying to over -- we're still overcoming that. And you mentioned loan growth. And even though the -- if people look at the size of the balance sheet, it's obviously -- that's going to be driven by what's happening on the deposit side. But the incremental NIR impact to that is lower. The driver of what's happening with revenue there has been loan growth. And it's hung in well, and it continues to hang in well and continues to be driven by client demand. And we've talked about the fact that we've been more strategic in talking to clients about the fact that we want to be there for their growth, and we don't want to be seen as a reluctant lender. We want to be seen as an institution that wants to participate. And that's borne fruit early on. Hard to see that if that will continue, but it seems like the demand is there. At the same time, we've got to continue to analyze every loan dollar we put out into the marketplace and make sure it's something we want to do as well. And so overall, size continues to be robust. It continues to be what we've seen in the pandemic, and we're still able to benefit from the interest rate environment. It hasn't improved that much. The really low end of the curve, it's -- 30 day hasn't really moved up a basis point. 90 day is up, but so much of our loans are driven on that 30 day. And so we've gotten some lift, but it hasn't been dramatic.

Great. Great. Well, it's not a headwind for sure. So that's good news. So looking on the first -- fourth quarter of this year, thinking about '22 and beyond, with a caveat that you guys don't provide explicit guidance, so I'm not going to ask for one. But I am curious to go through just a couple of themes and building blocks, right? In the last cycle, we've seen deposit betas start off low and then really kind of accelerate, maybe more so on institutional side than retail. We've seen the balance sheet sizes for your peers and yourself come down because a lot of the excess liquidity was kind of coming out of the system. How do you -- to the best of your abilities, I guess, nobody has crystal ball. How do you think that's going to evolve this time around based on either customer changes that you've seen over the last couple of years or anything else?

Yes. It's -- I mean you're giving us a nice caveat coming in. So it's just hard to predict. And our clients -- I do think something that hasn't been talked about a ton is the fact that equity -- think about where equity markets were before the pandemic and where they are now. And so for clients who are just thinking about their liquidity positions as an asset allocation, that's going to -- that creates a higher expectation of where we might land than in prior cycles. I think that's an important dynamic. And then the other component in terms of thinking about betas, our net interest margin is -- it's low right now. It's even low relative to where we were in prior 0 Fed fund environment, but not much to -- for us to expect that over a couple of hikes, we wouldn't expect the same type of trajectory from a beta perspective. And so I think our clients see that right now, the -- with being at 0, the first hike, we probably will be able to benefit the same way we did previously. But as we get second, third, and I won't stop, although I'll hope, I think they'll -- the conversations will be stronger about how to share those increases.

Got it. That makes sense. And in terms of the balance sheet composition and the mix, again, it sounds like the loan dynamic remains fairly constructive. Are you seeing opportunities to expand further into the securities portfolio as well? Now that the curve looks a little bit steeper, but also the forwards look a lot deeper than they did a couple of months ago.

Yes. It's interesting. The categorization of what's in the securities portfolio versus not, and people ask a lot about HQLA, non-HQLA, and when we think about those, practically speaking, just the way we really manage it is a little bit -- is different than what I think people interpreted sometimes. And for us, the movement of cash into the securities portfolio, sometimes it's driven by how much cash do we not just want to, but do we need to have in different central banks across the world to support what we're doing in the custody business. And so that sometimes can be the key. That's really the first bucket that we fill. The second bucket that gets filled is it's loans, the loan demand. And -- so that has been the bigger driver of the balance between the overall asset size of the balance sheet and cash versus loans versus securities, the fact that loans have grown. And then that last bucket is where the securities are driven with kind of what's left. And even within that bucket, the key drivers between what might be classified as cash versus securities, we don't -- sometimes we're looking at opportunities and what might be classified as cash, and we're thinking that's a good risk-return dynamic, not an IOER at the Fed, but in other instruments around the world that have higher yield to them. And then in the securities portfolio, we don't feel constrained right now by any factor around HQLA or non-HQLA. We feel like the way we're investing and the asset allocation we have right now is reflective of good risk return dynamics between those first and third buckets. And then, of course, that loan bucket is just organically driven by what do our clients want and what do we feel is good return on that incremental use of the balance sheet to support loans.

Got it. Makes sense. Right. Since we're on the rates topic, I got ahead of money market funds as well. So look, $77 million in fee waivers, I think, last quarter, I'm assuming not a whole lot of change, but I'll let you answer that.

Your assumption is exactly right.

All right. Nice and easy. Move on to the next question. I'm not sure you're going to like the next one much more, but we are going to talk about...

We can go back to...

So you provided a framework on the last earnings call, kind of how to think about expenses. Mike, you talked about earlier like work from home that help productivity to some extent, probably not sustainable. We're probably going to see more T&E. Obviously, everybody is investing in the business. So any way to frame expense growth outlook? And Mike, to bring you in on this as well, I guess you have always talked about expense to fee ratio is almost kind of the governing factor, right, because, look, nobody knows what the markets are going to do and that's going to have an impact on expenses. So you're not going to guide to an expense number because you don't know what the market is going to be, right? So it's a bit of a chicken and the egg. So if it's easier to talk about the framework for the next couple of years in this kind of expense to fee ratio relative to, I think, you guys have been around 100-ish percent, that might work as well.

Okay. Do you want to start and then...

Yes. I'll give a shot. Well, first of all, I think people have commented a lot about the expense and trust fees that, "Wow, can you get to 100?" And nothing magically happens at 100. So -- I mean we'll -- we can talk about it more. But we're trying to think more about what is the right balance of different key factors in the business to make sure we're managing the algorithm right. In terms of looking ahead, I'm going to call out 2 things. One is inflation, and two is technology, okay? On inflation, every company is experiencing inflation. And it hits us in a couple of different categories. First, it clearly hits on the top line. The first expense line we show everyone is what compensation is, and it's going to hit us -- it hit us there. It's already hitting us there, frankly, in the incentive accruals that we've been doing in anticipation and reflection of what's happening from an inflated labor environment. And then we're also going to have that hit as we think about base pay increases and things like that going into next year. Labor inflation has hit every firm hard. We're going to make the right business decision and make sure we're addressing that properly. So that's a theme. Inflation is also hitting in -- the same labor inflation is hitting even in line items like equipment, software and outside services because in some of those line items, we're paying consultants. And the consultants are feeling the impact. And so those line items are going to be hit hard. And we've talked about our continued investment in technology. And so you think about that continued investment plus the inflationary environment, and we're going to see -- in equipment and software, we'll see growth in that line item that's even higher than what we experienced in third quarter. And then you think about outside services, and third quarter came -- it was flat, down-ish a little bit. We think fourth quarter for outside services is going to be more like or a little higher than what we saw in second quarter. And again, reflective of those 2 dynamics, one, we want to make sure that we're doing -- making the right business decisions to make sure we feel good about the strength of our technology base and also these inflationary environment.

Right. And just that I catch that correctly. So the equipment and software higher than the growth you saw in the third quarter. That's a Q4 comment on a year-over-year basis than sequential growth Q4 to Q3.

That's right.

Got it. Thanks for clarifying that.

And, Alex, the reason I wanted Jason to give that context first and then coming to your question is because then if you think about how you're trying to manage that business -- manage the business overall and thinking about the ratios and the operating leverage, that's why being in a range is what you're trying to do because things like that ebb and flow. And to your point, we're down dramatically in the sense of much more efficient than we were years ago, and we'll kind of be able to grind that down. Now we think we're in a pretty good range for that. And so how do we stay in this range that we're in and then also then pick up operating leverage. So to your point, with rates, et cetera, and see that flow through to your pretax margin, which will then flow through to ROE. So that's kind of the broader longer-term framework.

Got it. Great. Well, we're out of time. We didn't have time for audience questions, but I think we've gone through a lot. So thank you guys both for being here. Happy holidays. Great seeing you both.

Congratulations on getting the conference in person, Alex.

Thank you. [indiscernible].

Good. Thanks.

All right. Take care.

Appreciate it.

Thank you guys so much.