State Street Corporation (STT) Earnings Call Transcript & Summary

Good morning, everybody. Next, I would like to welcome Ron O’Hanley, CEO of State Street; and Eric Aboaf, the firm's CFO. Over the course of 2020, State Street remained focused on driving growth across its platform with accelerating momentum from its integrated front-to-back servicing offering. While the low interest rate environment is clearly challenged, State Street has also accelerated its focus on structurally reducing its expenses in order to drive more sustainable profitability in the business over time. Now, we look forward to getting an update around these initiatives. Before we jump into the Q&A portion of the day, Ron is going to kick us off with a number of slides, go through a brief presentation, and then we'll go through the questions. And if there's a little bit of time, I'll try to take some questions from the webcast as well. So Ron, Eric, welcome, and Ron, over to you.

Thank you, Alex, and good morning, everyone. Before we get started, as is customary in these, I must 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 discussions today and 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, this morning, I will provide you with a brief update on some of the progress we have made towards improving our performance in 2020 and then outline how we are positioning the investment servicing part of our business for long-term success before handing it back to Alex for some Q&A. I'll be referencing a presentation that you should all be able to see. The presentation is also available for download on our Investor Relations website, investors.statestreet.com. Turning to Slide 3. Let me begin with our 3Q 2020 year-to-date highlights. For context, and for those of you less familiar with our investment servicing business, we faced a number of challenges in the 2018-2019 period, some industry-wide and some particular to us. These included an elevated level of client pricing pressure, declining interest rates and an overly complex operating model that was, in turn, creating service and expense issues. Throughout 2019, we took a number of decisive actions, strategic and tactical to address these issues. These included improving our client coverage model for our top clients as well as implementing better pricing governance and building out our differentiated State Street Alpha platform, offering on top of our 2018 acquisition of CRD, all while simultaneously driving efficiency and effectiveness gains across our operating model. As you can see across the top of the Slide 3, our business metrics highlight some of the progress we have made this year. Within our asset servicing business, we onboarded approximately $1.3 trillion of client assets, contributing to solid AUCA growth. Meanwhile, our Alpha platform solution continued to gain momentum, and we have announced 7 client wins since rolling out the platform. Approximately 1/3 of the $249 billion of third quarter AUCA wins or alpha deals. Within our -- within our Investment management business, as global adviser, assets under management reached a record $3.1 trillion. Progress across these business metrics is reflected within our year-to-date financial performance and efficiency measures, which you can see on the middle and bottom of the slide. Fee revenue increased and we reduced total expenses, generating positive operating leverage and increased EPS, excluding notable items. Our year-to-date return on equity was 10.6%. Notably, that ROE was generated on a base of capital that we consider to be well in excess of our regulatory capital requirements and the level necessary to support our clients and our business growth. Turning to Slide 4. Approximately 1 year ago at the same conference, I emphasized revenue growth as our overriding objective and noted that 3 of our key strategic priorities were to reignite servicing fee revenue growth, innovate to grow diversified revenue streams and deploy the leading front-to-back office platform. While we have much more yet to accomplish, Slide 4 illustrates some of the 3Q 2020 year-to-date revenue improvement we have achieved as we executed on those priorities. As you can see, we have stabilized our servicing fee revenue, which increased 2% year-to-date relative to the year ago period. This is a reversal of 11 percentage points when compared to the down 9% year-over-year decline experienced during the first 9 months of 2019. This result was the strong performance of our global markets franchise, better investment management fees and the growing revenue contribution of our front office solutions business, CRD, led to year-to-date revenue fee growth of 4%, which was more than enough to offset the impact of the very low interest rate environment on NII. Accordingly, as you can see on the bottom right hand side of this slide, total revenue increased 1% year-to-date. This is a total reversal of 5 percentage points when compared to the 4% year-over-year revenue decline experienced during the first 9 months of last year. As you know, State Street's franchise goes beyond investment servicing, while driving revenue growth across our business, including asset management, remains a priority, the remainder of my comments this morning will focus on how we are strategically positioning our investment service business for future growth over time. Turning to Slide 5. The custody and asset servicing industry is mature and the clients of this industry, asset managers, asset owners and insurance companies face a number of challenges. As a result, these client segments are increasingly seeking help to overhaul their operations and technology models. Slide 5 outlines how we are positioning State Street to meet these needs. We are strategically pivoting the business from its traditional role as a fund servicer to a broader model as an enterprise outsourced solutions provider. We are off to a strong start, though this pivot will take some time. Ultimately, with this strategic pivot, not only will we be better positioned to meet our clients' needs, but it will also facilitate access to new revenue pools across the entire investment life cycle. To help achieve this goal, we have refreshed our strategy and are focused on 3 areas: first, leveraging the differentiated client value proposition of our front-to-back alpha platform, which underpins our enterprise outsourced solutions model across the investment life cycle; second, enhancing our institutional services strategy by improving client coverage and developing our servicing capabilities, driven by a stronger go-to-market approach across client segments and regions; third, continuing to improve our operating model through productivity and automation with the aim of transforming how we compete and operate in the years ahead. Turning to Slide 6. The State Street Alpha platform is the first fully interoperable front-to-back asset servicing platform from a single provider. We consider Alpha to be the future of the investment servicing industry and a significant asset as we continue our strategic pivot to become an outsourced solutions provider. The platform creates a unique set of client benefits alongside an attractive set of revenue and efficiency opportunities for State Street. Starting with the first top left quadrant, through Alpha, State Street will partner with clients across a full range of outsourcing capabilities that link the back, middle and front office, including trading, analytics, liquidity, third-party execution venues, financing and data. Moving to the second quadrant, the offering will enable our clients to modernize their infrastructure, accelerate time to market for new products and build resiliency into their operations, and it has the potential to reduce their technology and operating cost. Looking at the third quadrant, we expect the platform will also drive revenue opportunities for State Street as a result of its strong value proposition, which I've just mentioned. While Alpha deals typically take longer to win and implement, they can be larger in size and scope as well as duration. Last, looking at the fourth quadrant, in addition to helping our clients improve their operating models, the platform should also help streamline our own operating model as we aim to operate a simpler, more resilient, more automated environment. Turning to Slide 7. Institutional services remains the core originator and engine of our servicing business. Work has already begun to enhance our institutional services business model. And during 2021, we will leverage improvements in client coverage segments and regions to drive future growth over time. On this slide, you can see some of our key objectives, along with the respective initial actions planned for 2021. As many of you are aware, servicing sales cycles are long and outsourcing cycles are even longer. We expect that these actions should assist us in achieving our goal of a sustainable revenue growth over time. First, as I noted earlier, we have achieved meaningful success with the improved global clients division's coverage model for our top clients, which are typically large asset managers as we face challenges with other subsegments, such as medium-sized asset managers, we are leveraging these learnings and refreshing our client coverage model strategy and rolling it out to the next 150 clients. We expect that over time, this will drive progress similar to the success that we have seen in our global clients division for larger asset managers. Second, we are focused on an enhanced client segment strategy, covering asset managers, asset owners, insurance, alternatives and official institutions. Each of these client segments has their own challenges, sometimes specifically by region, which require relevant client solutions to address them. We have already seen progress, for example, in alternatives, asset owners and insurance, where we have enhanced our offerings and technology solutions. And third, our regional approach will assist us in areas like EMEA asset managers, where we have more work to do as we implement refreshed local strategies. Turning to Slide 8. Since early 2019, we have been on a journey to transform our operating model through the simplification and standardization of our operations in our technology estate and increased automation, which is -- all of which is driving increased productivity. On the right-hand side of the slide, you can see some of the KPIs we track in these areas. On the left side of the slide, you can see how these efforts are hitting the bottom line. Adjusting for the CRD acquisition in late 2018 in notable items, total expenses fell 2% during 2019. This year, we expect to record a second consecutive year of net cost reduction despite significant investments in our business, with total expenses expected to fall by about another 2% in 2020, excluding notable items, but including CRD. Importantly, these productivity and efficiency successes allow us to invest in our business and drive innovation for our clients while also providing returns for our shareholders. Turning to Slide 9 and to conclude. Through the execution of our strategy, plus a number of corrective actions, we have made notable progress as demonstrated by our 3Q 2020 year-to-date results despite the difficult operating environment. While we have stabilized our servicing fee revenue, we are now implementing further strategic actions to position our investment servicing business for long-term success. As a result, we are continuing our strategic pivot from our traditional role as a fund service provider to a broader model as an enterprise outsourced solutions provider. This strategy is based on 3 core areas of further leveraging the differentiated client Alpha proposition of our Alpha platform, enhancing our institutional services strategy and continuing to improve our operating model through increased productivity and automation with the aim of transforming how we compete and operate in the future. And with that, Alex, I'll hand it to you for some Q&A.

Great. I'm going to turn my cam back on here. Thanks, Ron, for the strategic update. Maybe we'll kick it off there with a couple of questions around the servicing business and consider the pivot that you've described. Now we've seen increasing momentum, as you pointed out, and some of the bigger wins within the servicing business. It feels like it's going to become harder to really differentiate what sort of the legacy sort of core servicing versus what's coming through some of these pivot initiatives and the Alpha strategy because like some of them are going to start to kind of blend together a little more. So a question for both of you, really, how do you think the organic profile and organic growth profile of the servicing fee revenue will change and evolve on the back of that pivot? I mean I recall maybe a year or so ago, Eric, I kind of went through several buckets in terms of like, hey, new businesses x pricing is y, a little bit of how the growth algorithm could evolve on the back of things you just talked about.

Yes. So why don't I start quickly and give the strategic context. The fund servicing business is a very -- remains a very attractive business. I mean, one should expect it to be propelled by the growth of investment markets by the growth of just investing worldwide. But having said that, it's also a mature business. You're not seeing a lot of new fund formation, for example, in fact, you're seeing fund consolidation. Having said that, the asset management business and the core offerings to asset managers and asset owners, it's -- these have tended to be older estates, lots of it was proprietary technology and proprietary operations, because at the time they were installed, there weren't good third-party options. So it's an area ripe for change. And in fact, clients need change as they're trying to lower their own costs as they're trying to make better use of data, as they're trying to upgrade their technology estate. So for us, it's an and, not an or. What we're seeing so far is that Alpha and the front-to-back platform is as expected, initially been going to existing clients. So if you will, rounding out offering to existing clients moving from the back office to the middle and front office, but increasingly, and as I think we've disclosed before, 2 of those 7 Alpha wins were brand-new clients that we did nothing for. So now we've not only providing them with the Alpha tool, but we've got an attractive back offices client that we didn't serve before. And that's how you should see this going forward. You should see it both as a complement and in addition and an edge-out from where we are now, but also driving new core servicing fee revenue.

And Alex, what I would add is that the underlying model of growth is a bit different, right? We are inherently leveraged to equity and bond market. So that's a comfortable tailwind, not every quarter or every year, but it comes and goes. We used to have more tailwinds from flows and client activities, right? So it's holding. And I think that's probably become a little lighter than it has in the kind of several years back, and we're still seeing bumps there where we saw some upticks in 1Q and 2Q. And then in 3Q, we saw that receding. So that's a little bit different. Net new business is the core of what we do, and I'll come back to this one in a moment. And then there's always some pricing headwinds, which I think ballooned up, and we've gotten back to a level of control and comfort. I think as -- Ron, as I think about it, this is really an execution business. So while Alpha gives us a real upside and opportunities with some of our largest clients and midsized clients, it's an execution business. And if you think about it, servicing fees is $5 billion of revenue a year. But in fact, we break it down between the segments, asset managers, asset owners, insurance, sovereign wealth fund all -- even in all the hedge versus the private equity and real estate, and then we break it down by region, right? And so you can imagine the grid. And then we actually break it down by size, right, and where we've carved out our top 50 clients, and now we're going down to the next 150. And if you think about that, that's the execution envelope that we're incredibly focused on. And while we find ways to drive growth in some areas, if we see something else happening in other area, that's where we intervene. And in a more mature business, that's the normal on how we have to operate at that level of specificity so that we get the most out of the total franchise, but also the individual opportunities where we can roll out new products, new services, put in place a different sales coverage for us. And that's where we can get some further uptime.

Right. And you talked about pricing a little bit as part of that, mosaic. And I know pricing pressures have started to subside a little bit. I know in the past, when equity markets through strong clients come to you guys and say, "Hey, listen, like you're doing the same thing for me, but I'm getting charged more. Are you worried at all that we're going to see reacceleration in some of the pricing pressures here with equity markets where they are or a lot of that has been kind of put to rest? So going back closer to that minus sort of 2% per year in pricing pressures, is how we should be thinking about that?

I'll begin on that. Listen, clients are always going to ask for a better price. But I think a few things have changed from that last time. Mostly, the biggest change is us, in terms of how we price and the discipline we put into it. And I think as I may have mentioned to you last year, for many of our relationship managers, these are long-term relationships. They're going through a pricing exercise maybe once every 3, 4 years. They don't have the skills, right? So we very much changed that process a couple of years ago so that there's a pricing committee that looks at it. There's a whole strategy that's in place. There are substitutes that are offered instead of we can't reduce your price, but what we can do is extend what we think is a great price to some of the other business that you have elsewhere. So that would be number one. Number two, I think as more and more of the business discussion turns to Alpha, there's simply less of the same kind of pricing pressure on the servicing fees. And number three, the big change here is NII. And these are very sophisticated clients. They know that NII is part of our revenue calculus. And with that going away, I think they understand it. So will there be pressure? Sure. Will it be easier to overcome and deal with? I think both between are the skills that we have and the changed environment, we have some confidence there.

Great. So another one around this topic, and I want to zone in a little bit on CRD and incorporate some of the things you guys showed us on the slides here with Alpha. So one, I wanted to get a mark-to-market on some of the revenue synergies with CRD that you guys have outlined at the time of the deal, which I think was about $260 million to $280 million in gross revenue synergies, $75 million to $85 million net of some of the delivery cost. And I think the time frame was '21. So curious how you're progressing against those? So that's kind of Part A. And maybe somewhat related to that, when you talked about opportunities for Alpha, you said Alpha expansion expected to drive 5% to 15% revenue growth from certain existing clients. Can you help us think of the base sort of what is the base for that revenue -- on the revenue side for that customer base? And over what time frame do you expect to achieve that 5% to 15%?

So Alex, let me start on the mark-to-market on Charles River. because we did this deal in July of 2018. And to be candid, there was a mixed reaction, right? Some said, yes, this is about an investment in the future and understood, going after a new $8 billion revenue pool, building this front-to-back offering and others were, I think, appropriately in the show me camp or even the, hey, that software is pricier than your custody business in NPE terms. If I step back and actually just think about it 2 years in, I'd say, we've achieved, in some cases, actually exceeded our expectations. We said this would turn accretive within 2 years, and it has, actually did earlier in the year towards the middle of the year. And so that's been a real positive. That's been driven very quickly by expense synergies, which I said recently, we're about 80% through. So those always tend to come in a little more quickly. And then on the revenue, I think we described the size of the revenue opportunity in 2 ways. One was, as you bring about $250 million of revenue and EBIT from that revenue in the $80 million bucket range. The other way is we talked about it as accelerating the growth of the CRD franchise and to be honest, the State Street franchise. And I think whether you look at it in that framework or the framework of accelerated growth, we're on track with our synergy and revenue expectations. And just to be straightforward about it. You saw when we bought Charles River, it was growing at about 7% a year in 2019, that was kind of 2018 back, in a relatively consistent mix basis. 2019, we vested that, got it up to 8%. And this year, we're on track to be up in the low double digits. We said 11%, 12%. And I think If you look at the backlog that we've shown in some of the recent conference proceedings, the backlog also points to continued low double-digit growth rate in the next couple of years. So I think we've gotten to the benefits we wanted on the Charles River side. And at the same time, the other part of it is the benefit on the State Street side, and that's where our trading businesses have been plugged in. So we've realized that bucket of revenue synergies, some of the data analytics has come through. And I think as you started to see the Alpha sales, those are actually kind of a Charles River-driven way to drive what I'll call the more traditional custody. So all in all, I think the mark-to-market is strong here, and we're incredibly pleased with what we've done, and I think the financials show that.

Got it. Great. All right. Why don't we switch gears a little bit, turn to financials for a second. During the time of the year, Eric, maybe over to you to talk about Q4 mark-to-market on both the fee side, the NIR side, expense side. Anything that is worthwhile noting as people kind of sharpening their pencils towards the end of the year?

Sure. And let me provide our current thinking that there's still almost a month to go in the year, we're all sprinting to December 31, and we know markets can change, right? So there is a little bit of fluctuation. Overall, we expect to be in line with the full year guidance that I gave during our third quarter earnings call. What we do expect is a bit of some puts and takes in the fee revenue line item. So let me just summarize those. We continue to expect that full year 2020 fee revenue will be up approximately 2.5% to 3% and likely between the middle to upper end of that range at this point. Servicing fees are expected to be a little lighter than the 2% we originally thought for the full year. and probably closer to up 1.5% as we're seeing receding levels of higher client activity from some of the first and second quarter levels and some sluggishness in a few asset managers subsegments, including in the European domestic funds segment. In terms of FX trading, we expect 4Q to be strong, up approximately 15% year-over-year. And we continue to see double-digit momentum in CRD and expect that those stand-alone revenues on a full year basis will be in the low double digits as we've forecasted. Regarding NII, we are reaffirming our 4Q and full year guidance that we gave during October. And given the impact of the continued low long-end rates, we still expect full year NII to be down approximately 15% as we had expected. Turning to expenses. We have transformed the cost base by driving sustainable productivity improvements, operating efficiencies, and as Ron mentioned, and we still expect that full year expenses will be down approximately 2% year-on-year excluding notable items. And finally, on taxes, we continue to expect our full year tax rate to be at the lower end of our 17% to 19% range.

Great. Just maybe one follow-up to that. When you talk about on the servicing fee side, sort of some of the sluggishness with respect to some of the European asset managers. Is that a market dynamic? Is it a flow dynamic? Is it a client attrition dynamic? Is it a pricing dynamic? Kind of what's been driving that sluggishness relative to your guys' expectations?

Yes. I think we're seeing 2 things. I think on one hand, we're seeing a little lower client activity, right, from the kind of the receding kind of COVID spike in volume. But we're also seeing more pressure on fund complexes to consolidate funds to kind of narrow their offering. And as they go from, say, 100 funds to 90 or streamline their ETF rank, that's creating a dynamic. And I think what we're realizing is we need to -- if that's what all that happens, then the revenues in that business tend to compress them, just as -- due to the underlying structure. And what we really need to do is, we need to shift our coverage model and really find a more intense way to coverage -- cover those clients. And you've seen us take -- create a coverage model for the top 50. That's one of the reasons we're pushing down to the next 150. We've got to do that in particular, segment by segment, so asset managers, insurance asset owners, but also by region. And EMEA is one of those focus areas where we think that the market is shifting. And in one hand, if we stay still, we'll feel defensive. And if we go and are proactive, there's opportunities to be had.

Got it. Maybe shifting gears a little bit. I want to touch on -- back to NIR for a second. And just thinking about the interest rate dynamic that we've seen. Most people probably expect some steepening of the yield curve, albeit it's all happening in the very long end of the curve. So my understanding that generally, that shouldn't matter as much to you guys, given the short end of the curve sensitivity, but certainly could be helpful. So maybe help us kind of frame whether or not a steepening of the yield curve and to what extent would that be helpful to '21 as we think about NIR probably bottoming sort of in the earlier part of the year and potentially may be growing off that level?

Yes. We're -- I mean, overall, we'll take any steepening of the curve, any rise in the curve that we can get. So every basis point is well appreciated, and we feel like someone is smiling on the banking system. The truth is, like you say, we run a portfolio duration of about 3 years. It moves around the data, and we pick our spots on the curve. We run in and make up treasuries and sovereign and MBS. And so right now, we've seen a small uptick in long-end rates, but we've also seen slightly higher-than-expected industry premium amortization. So that's kind of I think keeping our current guidance intact and why we affirmed. We're optimistic that there'll be some uptick in rates. Just hard to count on that. And I think the rough estimate that we share in our Q is that for every 10 basis points of a rise in the long end of the rate because we're pretty confident the short end is anchored, could be worth in the order of about $15 million per year, if it happens instantaneously. Now on $2 billion of NII, Alex, I'll take that because that goes right to the bottom line. But it's not enough to make a big, big difference. And I think while we see -- while we're hopeful, let me say it that way, that there's some steepening, our view is we can't count on that and what we have to do is keep working on areas that we can control. And so some of those are the rest of the balance sheet. You saw us expand our investment portfolio by $10 billion in one quarter, right, from $96 billion to almost $106 billion. So that was the decisive action we took. And we'll continue to do some expansion. You've seen us continue to drive loan growth in very high-quality sectors at about 10% a year, and we'll continue to lean into that trade, obviously, in a careful way. So we'll do our best. But NII will be probably range-bound and our view is that then what we do is we turn our attention to back to the execution on fees and to the expense side of the equation.

Right. Well, speaking of the expense side of the equation, I guess, you guys, both Ron and Eric, you talked about the fact that the cost of the model are structurally too high, and you've been working your way down to improving profitability, which you've done obviously a great job on. Clearly, 2020 had some expenses that were naturally suppressed. So curious to what extent do you think that's going to come back in '21? And any broader thoughts around your 2021 expense management plans relative to 2020?

Why don't I start there, Alex? There were certainly some things that were suppressed, but there were also some things, costs that we had to keep on that we wouldn't have anticipated. So as you would expect, a long-term kind of expense program that includes a lot of automation, we are routinely substituting technology for labor, yet we made a commitment that we stuck with that we were not going to displace anybody throughout. So that will go away. So Eric can give more color to it, but I think that will balance it out. What we couldn't do, what we could do probably balance out. Listen, costs have a momentum to them, either up or down. And the way you get momentum down is, at least in this business, is really about focusing on productivity and automation. Productivity is hard in service businesses, but that's where we spent a lot of time now. And my view is we are still in early innings on this in terms of driving productivity, productivity management through the organization. The benefits of automation, we started to realize some of those, but there's more yet to come. So we are quite confident in our ability to continue to manage expenses while also investing in the business. I mean this is a business that has a voracious appetite for both innovation and technology to go along with it. So we have to manage those expenses in a way that we can keep a good outcome for shareholders, but also recognizing that we're investing, too. So while you'll see a net that's modestly down, the gross is actually significantly more than that to take account of the investments that we will continue to make, and we're committed to making.

Got it.

And I'd just add, Alex, that as you think about the financials, we've been successful driving expenses down now 2 years in a row. And it's a little soon. We're still finalizing our budget for next year, and that we'll share with all of you in January. But I think we've been clear that we believe expenses need to continue to come down. in this for us. And to be honest, we're continuing to be conscious of our financial performance, as you'd expect, and margins in particular. And we're -- well, we have to absorb some of the margin impacts of a sharp drop in interest rates, perhaps a partial offset for equity market, but only partial. Our view is expenses is a lever. And part of what I think we feel good about is we've been able to begin to close some of the margin gap relative to some of our peers, over the last couple of years and narrow it. And in our minds, that's real progress and part of our objective.

And we feel especially good about it because a fair amount of that investment has gone into the revenue-generating side, and you saw some of those fruits of that in 2020, and we're continuing to do that.

Got it. Understood. Well, with that, look, I think we're unfortunately out of time. We'd love to continue chatting. But we've got to run, and I know you have to run. So thank you for being here. I always appreciate you guys supporting the conference. So on behalf of myself, my team, Goldman Sachs, thank you for being here, and hopefully next time is in-person.

Thank you. Hopefully, next year is in-person. Thank you.

Thanks.

Thank you.