State Street Corporation (STT) Earnings Call Transcript & Summary

Good morning, everyone. This is Gerard Cassidy from RBC Capital Markets. Welcome back to another fireside chat at our 2022 Financial Institutions Conference. With us for this fireside chat is State Street Corporation. Many of you obviously know State Street is the 10th largest commercial bank in the United States, with just around $314 billion in total assets. As you know, they also are one of the largest custody banks in the world. They have over $47 trillion under supervision. The company's stock trades at a small premium to book value, at around 1.2 to 1.3x as the market cap of almost $30 billion. And with us from State Street is Eric Aboaf. He's the Chief Financial Officer. He joined State Street back in 2016 after spending some time as CFO at Citizens Financial Group. And then prior to that he was the CFO at Citi Group in the -- I'm sorry; he was global treasurer at Citi Group for 12 years prior to joining Citizens Financial. So Eric, thank you for joining us. I know you have some opening comments. So I'm going to hand it over to you for your opening comments. And again, thank you so much for joining us this year.

Thanks, Gerard, and Good morning, everyone. Just to remind our audience that today's discussion may contain forward-looking statements, and that actual results may differ materially from those statements due to a variety of important factors, including the risk factors in our Form 10-K and our SEC filings. Our forward-looking statements speak only as of today, and we may not update them even if our views change. That's our typical language for these sessions. With that this morning, let me make some brief opening remarks about some refinements we're making in our financial disclosures beginning with our first quarter earnings release. After which I'll hand it back to Gerard for Q&A. So let me turn to Slide 3, which you should see up on your screen. As you know, State Street has evolved from a back-office custodian to be the only true front-to-back provider of solutions to the investment community. We've done this through a series of custody acquisitions like the proposed Brown Brothers Investor Services acquisition, middle-office lift out and the purchase of Charles River Development in 2018. This evolution has been the back-office, the middle-office and the front-office, which has allowed us to differentiate our services including offerings such as the Alpha front-to-back proposition, both to reinvigorate growth in our core custody and to access faster-growing revenue pools. Turning to Slide 4. We're going to refine our disclosure for you to better measure our progress as we accelerate revenue growth and consistently deliver on our 4% to 5% medium-term target. Beginning with our first quarter 2022 earnings release, we will be disaggregating servicing fees and software and processing fees to provide the detail into underlying business growth areas, back-office, middle-office and front-office, while still disclosing the overall line items as we do today. Let me provide a bit of color on these 3 categories, some of which I've covered with many of you in the past and how our enhanced disclosure will allow you all as investors to see our progress more clearly. First, our core heritage has been back-office services, such as custody and fund accounting, which we highlight on the left side of the slide and is an estimated $29 billion revenue opportunity. The market for back-office is largely outsourced with State Street already the #2 provider and expected to be the #1 provider after the close of the proposed Brown Brothers Investor Services acquisition, subject to the usual regulatory approvals and customary closing conditions. We would expect back-office growth to be in the lower single-digits. And I would note, however, that there are pockets that are growing faster than that, such as private markets and European cross-border funds, where we are focused on capturing even more of our clients' wallet share. In back-office servicing, we would generally expect to see 3% to 4% revenue growth over time, but it is equity market-dependent. You see we delivered 4% growth over the last 2 years. Let me move to middle-office at the center of the slide. As the industry has evolved, we've also extended our capabilities into middle-office outsourcing. Alpha and Charles River have allowed us to move up the value chain. And we continue to see opportunity in this space as we win more Alpha deals and clients continue to outsource middle-office for the first time. As you can see on the slide, we estimate that the middle-office is a $6 billion to $7 billion industry revenue pool with expected high single-digit growth rates. And it's an area where we've grown at 6% over the last 2 years. Lastly, there's the front-office software and data, which represents another estimated $7 billion to $8 billion of market opportunity. Given the highly fragmented nature of this market, we see a great deal of opportunity to further take advantage of the outsourcing trend. We estimate that Charles River, for example, has only a small share because it's such a fragmented market. We expect the front-office market to grow at high single-digit growth rates, which is very attractive to us. As the slide indicates, the growth expectations we present in these 3 segments are industry revenue growth rates. And in some cases, we have expectations that we would do better than the industry since the front-to-back Alpha proposition is focused on the faster-growing segment and our access to the C-suite provides the ability to have faster than industry back-office servicing growth as well. To that end, we believe that the disaggregation of these revenue lines to provide our investors with more detail to measure our progress in these areas of focus as we deliver on our 4% to 5% medium-term revenue growth target. Turning to Slide 5, you'll find the specific adjustments that we will be providing in our quarterly earnings presentations going forward, and which our Investor Relations team can cover if you have any questions as a follow-up. With that, Gerard, I'll hand it back to you for some Q&A.

Great, Eric. Thank you for that presentation. And a really big thank you speaking for probably my peers and investors for disclosing that information before earnings so models can be adjusted accordingly. So on behalf of my peers and myself, thank you very much. And also a very good way of just presenting the data as well which is great. So I think that's going to help people get a better understanding of what drives State Street, which will be very helpful, so thank you.

Good.

Moving to some discussion on what's going on in the world today. Clearly, there's a lot going on with the conflict over in Ukraine of course. We have the pandemic hopefully finally ending. We still have labor shortages. I saw the JOLTS number came out today. And we still have over 11 million jobs available in this country when there's only about 6.5 million people unemployed. So inflation pressures are there. Price of oil is, as you know, well over $100 a barrel. So maybe could you kind of size up how this is affecting your businesses? And how are you managing through this period as well as what are you hearing from your clients and your customers?

Gerard, we're clearly living in times that are more volatile than we had expected. On one hand, the macroeconomic environment of underlying economic growth I think has been steady and moving at pace. As you say, we've seen price inflation. We ourselves have seen a little bit of wage inflation. And we've planned for that as part of our expense outlook for the year, so nothing new since January. The political environment in Europe is obviously concerning with the war. And we're clearly supporting our clients and being quite diligent in terms of supporting them around the world. We have quite limited exposure in Russia. It's a very, very small piece of what we do and we're happy to describe that in more detail could be helpful. I think as we step back and think about the drivers of growth in our business, there are still either relatively neutral to the positive I'd say. If you think about equity markets, for example, they've been very volatile and clearly down on a year-to-date basis against the -- in the first 60, 70 days of trading. That said the year-to-date daily average of global equity markets is basically flat to the full year average of 2021. And that's important to us because the daily average is the basis for pricing most of our custody services or asset management services. And that sort of provides a good stable base for us to grow. Assuming equity markets continue at around the levels that they are -- they've been at in the first month or two of this year. At the same time, the interest rate environment, I think continues to be positive. We expected 3 rate hikes with we announced earnings in fourth quarter earnings in January. For the year, we could get a 4, we'll see. I think I've been on record to say. I want to see the first one and take it one rate hike at a time. We've seen the Bank of England hike in back in December and likely, again, 2 hikes this quarter. And so I think we're seeing some buoyancy in the interest rate market because I think notwithstanding everything that's going on around the world. We have central banks who know they need to either avoid or fight inflation. And while they -- in the U.S., we might not get to the 7 or 8 hikes that were temporarily predicted by the market. We certainly expect the 3% to 4% to play out. And we think that kind of interest rate, I think, modest rise in interest rate and prevailing interest rates in the U.S. and around the world is supportive to our growth and our economics. Let me pause there maybe just to get started.

Sure. No, very helpful, Eric, very helpful. And obviously, you guys are not traders. You don't execute like Goldman Sachs or Morgan Stanley on a trading desk. But there's been such great volatility in the commodities markets in particular. And there's some concern that there may be some counterparty issues coming out as a result of this volatility. In your custody capacity and supporting customers, is there any risk that State Street ever runs into if there is a disruption caused by excessive volatility in a market like the commodities market? Are you guys pretty much insulated from that?

I think we're pretty much insulated by the nature in which we participate. We're an asset manager in one of our businesses. We're a custodian in the other in our servicing business. And then we have a fairly tight and well-controlled balance sheet, so whether it's commodities or Russia for that matter. We operate just to speak probably in 100 markets around the world. We follow our clients to where they operate. And we have, as I mentioned, relatively minimal exposure to Russia as an example. To be precise, our balance sheet and counterparty exposure is quite limited. If you think about it, we have no direct exposure to the central bank in Russia to Russian private sector banks or any of the funds or corporations there. We do provide FX services, right, FX conversion services. But we do those with counterparties of the U.S. banks or European banks or subsidiaries of those banks. And we also know in times of volatility or even crisis to actually operate on a DVP basis to protect ourselves and our clients where transactions are done at value and instantly as opposed to taking that kind of counterparty risk that you want to avoid. We have, as of the beginning of March, less than $75 million of deposits and denominated in rubles. That's obviously smaller and smaller as that currency declines. But it fits with our sub-custodian, which is a division of a major U.S. bank. It sits in our nostro account there. And so it's relatively safe. And they're very strong legal protections that we'd have. And we have really no lines of credit exposed. So whether it's Russia or whether it's commodities, we have quite a limited stance. And then if you kind of open up the aperture and say, how much we custody or do we manage in a country like Russia or pulling the data and you have to add a lot of decimal places to it is, I guess what I'd say. On the Investment Services business, it's 0.05% of our assets under custody or in Russia. And so the revenue implications are relatively like and asset management is even smaller. It's 0.01%, like I said, the decimal points matter and mostly around indexes and index tracking. So we've gotten used to operating in volatile markets over the last 1.5 decades for better or worse, we're quite good at it. And I think given that we don't have an extensive balance sheet, like most of our supporters of our clients, we're relatively insulated for the more immediate effects that other banks might see.

That's very helpful, Eric. So I really thank you for that. You touched in your opening remarks, you touched on the Brown Brothers transaction that's pending. Can you give us an update on how that transaction is moving along the regulatory process? And then second, just as a reminder, you've talked about this in the past, what drove you or what attracted you to do that transaction? What does it bring to State Street once the deal closes?

Sure. As I mentioned during our fourth quarter earnings in January, we're continuing through the standard regulatory review process for the deal. It's been a bit slower than anticipated. And as you're familiar, there's a high level of volume of M&A activity in front of our regulators. And there's a general slower pace of activity just given everything going on. That said, as I mentioned in January and over the last inclusive of the last couple of months, we've continued to see more of the regulatory approvals. If you recall, there's 1,500 or so regulatory approvals. And those have been kind of coming in as we go. We do have limited transparency or control over the exact timing of the remaining reviews. And so we believe at this point that the regulatory reviews should be completed though by the end of the second quarter. What we are doing is that as we go through that process is we're progressing very closely in partnership with the Brown Brothers team. We have daily, weekly calls among the teams. They're paired up in operations and technology, in the corporate functions and the client areas, so that they are well prepared for a close in the day 1 operations. We've exchanged list of employees, organizational structures and so forth so that we're well prepared. And we're -- we've even embarked and voiced the customer activity to make sure that we're actually thoughtful about providing the best of both institutions to those clients. So there's a lot of work that's gone on and part of the benefit of it taking a little bit of time to get the regulatory reviews complete as we can actually advance that work and be highly prepared to integrate the 2 franchises. As you know, as you step back, we did this acquisition for a number of reasons. First, scale matters in our business, right? We are large, we have very large clients. And the more we can serve them around the world, the better we can be and the more we can both benefit from a client and from an economic standpoint. So scale was a very important reason for the acquisition. Secondly, they bring a very extensive international franchise in particular they're particularly strong in Japan, where we have a nice sized business. But they brought a real bulk and functionality in Japan as an example. They're strong in Latin America. And so we're quite excited about what they bring. And then they bring a set of, I'll say, tools and expertise in different areas. There's a product called infomediary that will kind of fit into our Alpha front-to-back offering. There are some trading services that they're particularly good at. And so I think there are some functional and product suite capabilities that they bring that actually we can bolt-on and integrate and bring more to our clients, so in our minds, a very -- another way to expand our franchise and drive success here.

Very good. Maybe you can give us an update on your outlook for the quarter. Again, a lot of activity out there, both in the volatility of markets and everybody's expectation next week that the Fed does move from quantitative easing to -- or I'm sorry, monetary using to monetary tightening. And maybe you can give us an outlook on net interest income and again the fee revenue growth as well?

Sure. Let me do that. I think I can affirm our first quarter outlook. So we feel like we're tracking in the right direction. As I mentioned, equity markets, while they're down year-to-date on an average basis, which is what matters the first 2.5 months of the year are relatively flat to all of last year. So that gives us some amount of stability. And then on the interest rate side, like you, we expect the Fed to move by 25 basis points next week that will help. And then we've had a couple of moves by the Bank of England. And then we've seen higher long-end rates, which is actually constructive as well. At this point, it's still a little early to fully determine the quarter. But we currently expect that first quarter total fee revenue will be in line with our original guide of up 2% to 3% year-on-year. But we do expect some puts and takes between some of the lines. First quarter servicing fees and management fees will be slightly below the lower end of the prior guidance ranges, mostly given equity market performance. At the same time, we are seeing better performance than we had initially expected in FX trading. So currency markets have been active. The volatility has been higher, and we've seen very strong flows. And CRD is also expected to have a strong first quarter as well. We also expect to recognize about $20 million to $30 million of net positive adjustments on certain minority investments that we've been holding and some other positions that we have on our books. Those have historically been recognized in our software and processing line and will now flow directly into the other fee revenue line, just to make things a little simpler from a modeling standpoint. Regarding NII, on a sequential quarter basis, we expect first quarter NII will now be a couple of percentage points better than we had -- than our previous guide of flattish. And that's due to lower premium amortization as we've seen higher long-end rates as well as the Bank of England hike in February that I mentioned earlier. So I think good overall performance there, a nice start to the year. Regarding expenses, ex-notables, we currently expect first quarter year-over-year expenses to be in line with our previous guide. And finally, first quarter TAC to be around 20%.

Very good. Obviously, the Fed move -- because the bulk of the assets or deposits, et cetera, are here in the U.S. Can you kind of frame out for us because you mentioned the Bank of England's increase is favorably impacting you folks. Is the Fed 90% -- if we assume -- and I'm not asking you to make this projection. But if the Fed raises rates 3x this year, your net interest income, obviously, is going to be favorably impacted by it. And let's assume the Bank of England is the same. Can you kind of weigh like how much more important the Fed moves are than maybe the Bank of New England moves?

Yes. The U.S. Fed moves have been the bulk of the driver of the -- of our guidance and expectations for NII for this year. I think we've described that every 25 basis point move by the Fed is worth about $20 million to $25 million per quarter, and that's true for the first couple of moves. So that's a healthy amount. And hopefully, that will start in March and then play through later in the year. We do operate though, to your point, in other currencies in Britain and Canadian in euros and Aussie dollar around the world. And area like the U.K. pound with a 25 basis point move by the Bank of England. That would probably be worth about $3 million to $4 million a quarter. So not the same amount, but it does help. And I think we're eager to see how the other central banks move, the other Anglo-Saxon countries Canada and Australia have I think a possibility of uptick. And then we'll just have to see what -- how Europe plays out. I think there was some anticipation of rate rises there that's been pulled back because of the political, economic and situation there. But that could, at the right time also be supportive. But I think it's early to count on that one.

Sure. Is the ECB with you that it's backed off, but if they were to raise rates similar to the Bank of England, is the favorable impact similar? Is it about similar? Or is it a little larger, a little smaller then what you think you're going to see from the Bank of England?

Yes. I've spent less time on a possible ECB move because it's been less likely and they've been deeply negative for a number of years. But it's a bit -- the impact will be a bit larger than what we see from, say, the Bank of England, but also quite a bit smaller than what we'd see from the U.S. But it's probably the second largest driver of interest rate tailwind once it decides to move.

Got it, very helpful. With these likely rate increases coming and hopefully I know I like how you presented it, you'll count on the first Fed fund rate increase and let's not want the chickens before they're hatched. Just let's assume that we're sitting here in the end of 2023 and the Fed has moved 200 basis points, let's say, over 8 quarters. Can you kind of give us how you're taking this into account in managing the deposit side of the balance sheet, whether maybe surge deposits, if you will, because the balance sheet of the Fed has grown so dramatically versus your core operational deposits that your customers leave with you through thick and thin.

Sure, Gerard. It's been an important topic as folks have asked about interest rate rises, some quantitative tightening. I think at this point, we do expect some quantitative tightening towards the second half of this year from the Fed. But we think that will have a relatively modest impact on our deposit. It's relatively neutral because, in fact, if they tighten even to the tune of $100 billion a month, which is more than they've ever tightened before, their balance sheet would get to approximately, where it was in the second quarter of last year. So think about it, they would have gone up to come down. And so I think at the end of this year, we would expect it to be fairly neutral and within more of a rounding kind of bit of deposits. We've done a good bit of modeling. And it's hard to really dimension how much tightening would affect the size of our balance sheet. So we've been open for business on deposits, the more deposits we have, the more uptick we have in this interest rate rise cycle. And in fact, our balance sheet could be larger than it was in 2017 when we last saw interest rates rise. So in truth, we have more NII upside, right, with this cycle just in outright dollar terms. We've done a fair amount of modeling and for every $1 trillion of Fed balance sheet compression. It could be $5 billion, $8 billion of deposits, something in that order of magnitude. And part of the way we've estimated that as we've looked at how much our balance sheet expanded as the Fed expanded its balance sheet. Remember, we also have to keep in mind that equity markets rose as well during that time period. And that increased our assets under custody. And you know our business well as we have more custodial assets clients need to typically leave more deposits. So they can handle all the transactional flow. So a good part of the deposit increase we've seen over the last couple of years has been because of the larger custodial amounts that we're holding for our clients and then some part has been driven by the Fed. But we'll see. I think we'll have more information as this plays out. And we'll certainly be able to update you and our investors as we see it. But we think of it as a modest kind of -- it's a 2023 kind of topic. And we think of it in the $5 billion, $10 billion range per trillion, but have to just see where -- how it plays out. On our balance sheet of, I don't know $240 billion of deposits. It's important to model, but it's not large.

Yes. No, no, very helpful. And I know we're running out of time, but just maybe one last question. When we look about -- look at quantitative tightening and the Fed obviously raising rates and very beneficial as you described already for your organization. What are some of the risks that you guys are keeping an eye on because it is a change and a very meaningful change in Fed policy and there's always seems to be casualties when this happens. And what are you guys keeping an eye on just to make sure that nothing comes out of left field on you?

We're doing a couple of things because you don't really know the path of interest rates or the level of deposits. So obviously, we're -- we continue to run a fairly vanilla and safe investment portfolio on the margin. We've been holding duration to current or even trimming duration a little bit. We continue to only invest in high-quality, primarily treasury, Supras and Agency MBS. We've actually limited and actually brought down our extension risk, what we think of as convexity in the mortgage-backed securities market because we don't want to be exposed as rates rise. And so there's a fair amount of carefulness we have on the investment portfolio, just given the nature of our kind of trust custody and reputation. And then on deposits, we're just careful in working with our clients. We've not -- we've been careful about not having a ballooning balance sheet. But we've been there to accommodate our clients because we think that's important. We're ready to help them to the extent that as there's some quantitative tightening and they want to selectively reinvest their deposits in other areas. We do -- we've got what we call the cash cascade, right? We do a repo for them. We do money market sweeps for them into our asset management business. We do sweeps into other venues. So we have mechanisms to support our clients. But I think our view is we're there for them. And to the extent that they hold deposits with us that can be remunerative for us and for them because we have a good economic set of arrangement. But to the extent that they're interested in finding other places to leave liquidity, we're very willing and connected and make sure that we support them as well. And some of that may play out as we see the Fed adjust its policies and we'll be there to respond.

Great, I want to really thank you, Eric. This has been great, a lot of great content, always insightful discussions with you. And I really appreciate you joining us again this year. Thank you.

Thank you, Gerard. Thank you, everyone, and I appreciate your hosting again in March. It's a good timely conference and we really enjoy coming. And hopefully, we could do it in person next year.

Yes, same here. Thank you. Okay. Have a good day, Eric. Take care.