State Street Corporation (STT) Earnings Call Transcript & Summary

Hello. This is Dick Manuel. I'm an equity research analyst at Columbia Threadneedle. I am here joined by Eric Aboaf and Ilene Bieler from State Street. Eric is the Chief Financial Officer. He's been in this position for 4 years in that capacity. And before State Street, he was the CFO of Citizens. But I first got to know him when he was at Citigroup, where he was the Treasurer and the CFO of the Institutional Client Group. So with that, thank you, Eric, for joining me and Ilene, for joining me. And I will swing it over to you, Eric, for your traditional disclaimer, and then we'll roll up our sleeves.

Perfect, Dick. Thanks for having me and us here at State Street. My usual legal disclaimer, I'd like to remind you that today's discussion may contain forward-looking statements. Actual results may differ materially from those statements due to any number of important factors, such as those referenced in our discussion today in our SEC filings, including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today, and we disclaim any obligation to update them even if our views change. With that, over to you and happy to jump in.

Super. Thanks for joining us. So I'd like to start off with the Charles River acquisition. On the last call, you highlighted that about 1/3 of your new business wins were on the new front-to-back Alpha solution built on the Charles River capability that you acquired a couple of years ago. So a whole series of questions around that, how it's going and so forth. So could we just start with what is the value proposition for the Alpha platform? Like what is the elevator pitch? Is it cheaper to clients? Is it less prone to processing error? Is there more opportunity for them to get some good data and analytics coming off of it? Just the elevator pitch.

It's actually a long elevator pitch because there's a lot there. And in truth, for clients, it's around functionality. It's around ease of doing business across what has historically been a set of difficult areas for them, the back office, the middle office and the front office. And it is about economics because what we have found is and clients have found over time as they've grown and expanded and built out their own asset manager offerings around the world, across product elements, they've got a potpourri of systems. I think we described the typical $500 billion asset manager, many of those are represented on the call and video today. They have 20, 25 systems that actually operate in their front office and their middle office. And it's that kind of cleanup that's necessary on one hand. And on the other hand, creating integration between those is really what the State Street Alpha front-to-back platform offers. It's an offering that lets the investment manager at the front end actually make investment decisions, do trade compliance. The company do the middle office work, oftentimes by State Street, and then are providing the custody and accounting. So it's an integrated offering, which is just so different than the potpourri that exists out there today.

Is the -- how would you compare the functionality of the Alpha solution to just taking your traditional middle and back office and trying to integrate it using one of the other providers?

What you find when you do it in pieces, Dick, is not dissimilar to any stack that you have on your computer. As PC users, we've all got burdened with that on our cell phones. But when you have a stack, a software stack or services stack that includes the front office, the middle office and the back, you can look for the best of each of those. And then what you find is you've got good functionality within, but then you're doing reconciliations from the front to the middle, from the middle to the back. And that reconciliation actually creates not only costs and work, but it also creates latency. It creates an inability to look through. So for example, if I want to find the assets that I have that could be repo'ed out or that could be monetized, I actually need to look all the way through into my custody systems from my front office system. And it's very hard to do that if you have a set of layered but segregated, separated system. And that's what we started to break through. It's creating the kind of the data pipe in a front-to-back offering is what's different than when you try to do it in a bespoke and kind of a clunky way.

Let's switch perspectives, Eric, and talk about it from State Street's standpoint. How do the economics compare on a front-to-back solution for you? Like are -- and how do you think about that? Are the clients stickier? Would you expect the duration of these relationships to be longer? Does it cost you more to kind of make it happen? Does it give you a better platform for selling ancillary services and so forth? How do you look at it?

Let me do that from a kind of a client or deal life cycle standpoint. Let me try to answer that question, Dick, because we're out there today continuing to sell our Charles River offering because some clients want to buy just that, our middle office and our back office. That, we do every day, right? And we're going to continue to do that. And that's kind of the bread and butter. That's our core. That's what drives core growth for State Street. When you go and start to offer a front-to-back offering, a couple of things start to come through. One is there are more discussions that you have to have at the client. So the discussions actually tend to take a little longer. Why? Because you've got the Chief Investment Officer, the Head Trader, the Head of Operations. You've got the ops head that focuses on custody. All need to get aligned. And so the sales cycle actually takes a bit more time. The benefit is the deals are actually bigger, and they are more integrated. So it's not as if I have to sell custody one day and then the middle office the next day and then [indiscernible]. You're starting to assemble the whole package. So what we're finding is that we've gotten an enormous amount of interest upfront in the offering, actually working through that pipeline takes some time, but as we're seeing it, we're seeing lumpier and bigger deals and more complex deals start to come through. And on top of that, what we're also seeing is that it's appealing not only for existing clients, but our new clients, right? Historically, about 80% of our sales came from existing clients. We've not got sort of almost brand-new clients to State Street, folks who we historically have not sold who are starting to say, wow, that's appealing. That's completely different than what I've had before. So it's also opening up a new set of client opportunities for us. So I'd say it's a bigger deal, more complicated, take a little longer to complete the sale. But you know where you are in that process, which is why we've been positive in describing our pipeline. And then the implementations will obviously take some time. But as we think about implementation, we think about how do you bring in, say, the custody first, which tends to be able to be moved a little more quickly or some of the trading activity, getting on an FX panel for a client early on. And then the pieces that take a bit of time get feathered in. So there's sort of a -- it's, I think, a bigger, but if there's more upside in our minds, both for us as a company and obviously, for our clients and prospects.

So you disclosed those and you break out the revenues and the pretax earnings of CRD. And from the most recent disclosure, it looks like something like $190 million might be contributed of profit to the overall organization. So the question is where do you think we are sort of in terms of the ability to sort of look at that profit relative to the price that you paid for it? Are we in the second or third innings of it hitting its economic stride, and we can compare that $200-ish million to the purchase price? Or is it really kind of right now is not -- we're kind of early innings. And if you look at it 3 years from now, the ROI will be totally different.

I would tell you, we've reached our benchmark in a -- comfortably as we have brought the Charles River on. We brought in a company that was growing at about 7% a year. And you've seen from our results this year. And they are lumpy, right, on the top line that the results have been comfortably in the double digits, right, which is what our expectation was, right? Try to take a business that's growing single digits, put the State Street backing on, the sales force, the credibility, right, and scale the offering. And as we've done that, to your point, we've added the earnings. And if you do the math, back to our deal model, when you layer in some of the expense synergies, which are moving along very quickly, we're now 2 years in. So the large majority of those are now booked. The revenue kind of growth is starting to come through or, I'd say, growth acceleration, which is what we're looking for, both in Charles River itself and in its knock-on benefits, right? Those Alpha deals, we've now comfortably crossed the point of earnings accretion, which we had said would be at the end of the 2-year point and have gotten to the milestone. I think the real upside here is not just getting here, though, it's to just continue to scale Charles River and its impact on the rest of State Street. And I think that's what we're looking to do sort of continue, on one hand, the Charles River specific, right, top line growth of that in those -- in the double-digit and drive that year after year after year. On one hand, get the earnings that come from it. But even more importantly, it's the effect that Charles River has on the rest of the offering, right? It's that front-to-back offering that now can be sold in ways that no one else can sell it. Anyone can sell the pieces. And we're still out there selling the pieces. But it's that broader offering that we think we're probably in the, I definitely say, the early innings. It's the second or third inning of this. And why is that? Because there's a whole market out there that is wrestling as clients around how do I optimize my infrastructure? How do I get the functionality to the trading desk that I can actually benefit from? And there, there's real upside, and it will take time. I think what we need to do as a company and for you all as investors is demonstrate that, that's starting to come through. And we -- one of the reasons why we've described our wins in the servicing sort of part of State Street is how much of them are Alpha-driven or driven with an inclusion of Charles River in the offering, and that was about 1/3 this past quarter. And it's because that's kind of the real benefit for the larger franchise. And it's that, that creates the tipping point for us and helps to, I think, reestablish the growth that we're looking for at the top line for the broader servicing and trading parts of our business.

Great. Thanks for that. Moving on from CRD to net interest income. So looking at NII relative to -- or NIR relative to the total revenue. We're talking about 17% of total revenue. It's probably higher than that as a percentage of net income. Deposits been growing year-to-date something like 8.5%, 9%. On the call, you talked about with the Fed's actions that it's possible that we could continue to see the balance sheet growing driven by the deposits. Any comment along the lines how that feels? I know it wasn't that long ago that the call was, but just does that -- does it feel like the balance sheet is going to grow? And then we're going to talk about the fun topic of net interest margin.

Sure. We, at State Street, are a combination of a bank and operations company and a technology company, right? That's what we do. And you've seen us build out different elements of that as part of the expansion of the company. The balance sheet will continue to grow, I think, in my mind. I think it's clearly had a significant uptick. Deposits are up $20 billion, $30 billion since the start of the year on a base of about [ $150 billion ]. So we've had some real significant growth. And as we look at the drivers of that, remember, they were up many times more than that, right? Our deposits peaked at about $250 billion. They're now hovering in the $185 million, $190 billion range. And so the specific -- the kind of COVID sort of crisis, March-April peak has come and gone. I think what we're seeing now is actually a stable and over time growing set of deposits because what they're really driven by is the amount of cash and liquidity in the system. The Fed has expanded its balance sheet by a couple of trillion dollars. And to the question you've asked, what do we see as the trajectory, I don't think we're looking at another spike in deposits. But from here, we are continuing to expect some amount of nominal growth in deposits, really driven by just the Fed's continued expansion of its balance sheet, right? It's adding $100 billion here, $100 billion there in a regular manner. And that in and of itself comes back into the banking system, and our clients leave those deposits with us. So we do see some expansion. I think it will be modest at this point. But what it does do, and I think it's probably to the next question you're going to ask, it gives us an ability to then take some of those deposits and put those to work.

Great. Yes, we'll get to that one in a second. So looking back historically at the net interest margin. It bottomed in the last ZIRP cycle at 95 basis points. It sounds, based off of your comments on the third quarter call, that we're going to be in the low 80s on this cycle. And just from a broad perspective, why is the NIM bottoming at a lower level? What are you looking at that would kind of find that inflection point on NIM? Which is an important question, obviously, for the stock because when the NIM finally started to go up, the stock went up about 84%. So we're all kind of interested in trying to find the -- when we don't have to worry about that NIM anymore. So why is it lower? How do you find the bottom? And then I'll ask a little bit about how you can defend it if things continue in this fashion.

Okay. Let's do those in steps, and let's make sure we get to each of them because I think each of them is a question-and-a-half in and of itself, and it's the kind of thing we wrestle with because it matters. So I appreciate your asking. So first question is, the last time around, we were at, you said a little closer to 100 basis points. Now we're 10, 15 basis points below that. Why is that, right? What's the difference this time around? And I think what you have to remember is we made a very conscious decision about 2.5, 3 years ago to reconfigure our investment portfolio. Historically, we had run an investment portfolio that was about half credit and the other half was liquid securities, governments and agencies. And what we found as we analyzed that is it did give us somewhat slightly better NIM in a low rate environment. But what it also did is it actually created quite a bit of OCI and stress test cost, in the sense that it would stress poorly under the Fed CCAR, now SCB process. And as a result, we had to hold an unusually large amount of capital for that portfolio. Now we may or may not have agreed with the stress test results, right? A lot of it was AAA security, collateralized and so and so forth. But that's just how the mechanics and the impact that we -- that was modeled by the Fed. And we absolutely say you have to operate by those rules. And so what we consciously did, Dick, is we decided to actually remix the portfolio to shift it out of credit and make it actually a very traditional agency treasury, foreign sovereign portfolio. And while we've lost a little bit of relative ability to deliver NIM, I tell you the payback on that and our ability to run the capital-light structure is quite significant. I think that trade probably improved our ability to run at capital levels by $1 billion or more. I'd have to go back to when we shared that analysis. And ultimately, that will come back as buybacks and dividends to shareholders, obviously, once we're -- once the -- once we're permitted and economically able to, or when the economy makes it possible for banks and regulators to feel comfortable with us proceeding.

So on the -- you spawned a couple of interesting questions, the capital and CCAR and so forth. So we'll circle back to those in a second. Continuing to sort of drill a little bit more, though, on the NIM. Could you talk a little bit about what you could do and the operational nature of the deposits like the massive flood in deposits that's somewhat receded. But you have extended duration as you start to see a little bit more confidence in the duration of the deposits. So one question would be like, do you feel like you could go a little bit further? Or is there more that you can be moving out on the curve? But then the other question about what else you can do to defend the NIM is your losses under the CCAR are way below the 2.5% minimum, which mean that, to me, that you could take some credit risk. So I'm just wondering about the loan portfolio. You have $25 billion of loans roughly. Is that something -- the spreads are much higher? Is that something that you would look to do or that has its own kind of growth rate and you don't push it any further than what it's doing? Like how do you think about that as well as extending duration in the securities [ portfolio ]?