State Street Corporation (STT) Earnings Call Transcript & Summary

[Audio Gap] who is the Vice Chairman and Chief Financial Officer of State Street Corp. As many of you know, State Street is one of the leading custody banks in the world with assets of over $300 billion and a market cap of $32 billion on a price-adjusted basis, adding back the AOCI into book value and tangible book value that traded at about 1.3x book and 2x tangible and about 10.5x forward earnings. Some of you might remember, Eric joined State Street back in 2016 as their CFO. He had a short stint over at Citizens. And prior to that, he was with Citigroup for many years, lastly being the Treasurer, if I recall correctly. Well, Eric, thank you again for coming. I always appreciate you taking some time out for us here.

It's my pleasure.

I'd like you to maybe start off with your opening comment.

I think my forward-looking statement, courtesy of our General Counsel, just to remind everyone before I get started, today's discussion may contain some forward-looking statements. And you know that actual results may differ materially from those statements due to a number of important factors, including the risk factors in our 10-K and our SEC filings. Our forward-looking statements speak only as of today. We may not update them even if our views change. And with that, over to you?

Sure. Maybe we could just start off with a macro question for you, Eric. State Street is obviously very involved in the financial services business. And what are you guys sense in terms of when you look at the global markets, obviously, we have started off a little stronger this year versus last year? And do you have a sense of which way it's going or what you guys are planning for with the global markets?

Gerard, I think the way I'd describe it is we're -- from a business management standpoint, we're trying to be careful given the uncertainty. Equity markets were up nicely for the first 15, 20 days of the quarter and then have kind of tamped down. Global interest rates now seem like they're going to be up and continue to move in that direction. And the whole notion of where they're going to come up, and we're going to -- they're going to cut and have a soft landing seems to be off the table. I think when we look internally at our custodial data, right, the $38 trillion, $39 trillion that we have and we look at our price stats indicators, right, one of the areas of our research group in markets, we see inflation slowing, but not at the pace that I think the market would have expected when you look at all the online pricing, which we churn through on a -- literally on a daily basis. So clearly, there is more to come here. I think rates are moving as folks can tell in the last couple of weeks, international rates continue to move upwards. I think equity markets are trying to settle through how is this going to play out and how is that going to affect levered companies versus those that are more stable. And I think from our standpoint, we'd rather go in with some conservativeness in how we manage the business. And so we're very focused on our client franchise, being out there with our clients, helping them with their immediate needs, servicing them well, looking for opportunities for growth. Private continues to grow for us as an example. And at the same time, our productivity agenda is -- remains unchanged and on plan because we feel like we need to both work on the top line growth and the expansion that we want as well as the earnings growth. And then finally, I think we feel, while we're conservative about the kind of range of economic environments, we do feel confident in our balance sheet and our capital position. And so as we said in December and again in January, we're quite comfortable returning quite a bit of capital to investors this year. We said up to $4.5 billion according to our Board authorization, and we're -- we've got quite a bit of confidence. We're on track to do that.

Yes. It's unique for the fee-based or trust banks as you guys are often called, you and your peers, that in a recession since you often don't have the exposure to credit, there's less of a risk there. So if we were to go into a recessionary environment, what kind of risks are there? Again, it's not credit -- now granted, I'm not assuming the markets will go down 30%, which would be a big risk. But any other thoughts about that?

I think there are a couple of things that will happen in a recessionary environment. And the question really is what happens externally? And then how does the Fed and the other central banks react, right? Because there's multiple layers that play out. I think from our standpoint, we've got a $300 billion balance sheet roughly. And on that just over $30 billion of loans. So we're asset-light. We're capital-light, and our lending is actually typically to investment funds and mutual funds and collective funds as A, AA. So it's quite a pristine portfolio. And so we have a lot of confidence that, that navigates through relatively well. We've got a range, obviously, but it's -- it will navigate well. I think from our perspective, what happens next is what happens to the economic environment? Does that change the demand equation a little bit, right? Sometimes clients and companies hunker down. Sometimes, they have a tougher time economic and they're like, hey, what can we do? Who can we turn to, to help improve our cost position. Sometimes that's an opportunity for us and some of our offerings because we, in many ways, can help them bring their cost down as they -- as we help them with their front office, their middle office and back office operations because that's what we do well, right? We bring scale to them. And then I think the question is what happens with equity markets, what happens with bond markets because that will just literally go through our fee line, as you mentioned, because we've got exposure just given how our pricing schedules are geared. And then there's the eventual question of what happens to the Fed and the other central banks? Do they cut? Do they stand back? I think right now, they're facing a fair amount of just ongoing inflation, it's getting -- it's coming down some, but not at the pace. So we don't see any real reaction there for us.

And just speaking of the equity and fixed income markets for a moment, can you remind us the exposure -- I mean if equity markets were to go up or down by a certain percent, versus fixed income, are you more impacted by the equity activity in the markets versus fixed income? And maybe just share a little color there.

Yes. In the scheme of things, our custodial book, right, is tilted a little more towards equity than fixed income relative to some of our -- some of the industry. That's partly how we grew up. We've got clients we serve. And so as the equity markets move up, we do particularly well as they go the other way, we -- it comes down a bit. The equity market or market sensitivity of our book is about 60% now of fees. And why is that? Because over time, we've kind of simplified the fee structure for our clients and they like that our fees are aligned with how they earn fees, which is on an AUM basis. And then the rough gearing -- I'll say it's rough because it's not every quarter or every year, but about a 10% change in equity markets up or down, will flow through our servicing fee lines by about 3 percentage points, is kind of the rough order of magnitude. I think what we have found in particular over the last year or 2, but we saw it, I'll say, 4 or 5 years ago and further back is as equity markets go up and down, we also sometimes have a nice offset in our currency trading operations or finance operations because there's more activity in the market-based areas than in the traditional custodial areas. And so we've actually had more diversification over the years. And so last year, for example, servicing fees and management fees were down year-on-year because equity and bond markets were both down, no surprise. On the other hand, our software revenues and our FX trading revenues were both up in the double digits, right, which creates nice ballast and offset. And that's -- we like that because it creates the opportunities for us to continue to grow even through recessions.

Sure. So speaking of your businesses, maybe you can share with us your outlook for the first quarter. Any updates or updates for the full year or what you're thinking in these lines of businesses?

Sure. And it's still early for the year. So let me try a little bit of texture on the first quarter and share with you how things are playing out, just given some of the moving pieces. And I'll say the uncertain economic environment that you described because quarter-to-date, on a macro level, equity markets are slightly better than we had expected. And I say that on average because the averages matter for us. And so let me just go through the P&L kind of area by area. First, we now expect first quarter fee revenue outlook on an ex notables basis, to be towards the better end of our prior outlook range, which was down 1% to 2% quarter-on-quarter. Obviously, it was down because equity markets on average are still down even though the point-to-point feel better. And that's with servicing fees expected to come in at the better end of the prior range of up 1% to 2%. And management fee is expected to show a slight improvement over the better end of the prior range of down 1% to 2%. So some slight adjustments. A little more texture. As a reminder, 4Q revenue included a $23 million of notable revenue recoveries reported on the FX trading revenue line, which is excluded from the outlook. And this benefit is obviously not going to recur in the first quarter. So you've got to keep that in mind. And then additionally, I would say that we had a larger-than-usual on-premise revenue in front office software and data in both the first quarter of last year and the fourth quarter of last year, which impacts the compares. And we don't expect to see that this quarter. And as a result, first quarter software and processing fees will be lower than a year ago, kind of timing as you go through the year. So that's fee revenues. We continue to expect NII to be flattish quarter-on-quarter. I'd kind of remind everyone that there's lots going on in NII as you'd expect. We saw the seasonal uptick in deposits from 3Q to 4Q. And we're also seeing the seasonal downtick in deposits from 4Q to 1Q, right, as you'd expect. And average deposits are coming in roughly in keeping with that trend. And then 2 other areas on expenses ex notables. We expect first quarter to be slightly higher than our prior guide and come in at about 3% on a year-on-year basis. And the uptick there is primarily driven by some timing on vendor credits in the technology area that we now expect to receive in second quarter instead of first quarter as well as some higher head count, largely due to lower-than-expected attrition, right, over the last few months. All that said, we expect no change to our full year productivity and expense guide. And then finally, because everyone always cares about the tax man. We expect first quarter tax rate to be slightly higher than the 21%, though still expect the full year guide to be the same as we've previously been.

Very good. When you look at the investment services businesses, can you update us on the flattish growth when you look at it. And how should we look at the new business wins in that business? And when you win new business, how much comes from existing customers versus just an onboarding of a completely new client?

It's a fair question. And what I described is the large majority comes from existing clients. And why is that? Because we've got a 225-year history. In custody and accounting, we've been a lead player over the last, whatever, 40, 50 years, let's say, so I'll say we do some amount of activity with almost all the large and medium-sized clients, right? And so in a way, the -- for us, it's really a shared wallet opportunity. The existing clients generate 70%, 80%, 90% of new business, but there's 10%, 20%, 30% of occasionally that comes from new to new, which is good, too. And what I'd say is that the intensity of our coverage activities what really matters, right, our Global Client division, for example, our largest 60 clients have very -- have a coverage force dedicated to them, they account for nearly 60% of our revenues, right? So it's quite concentrated. And there, our share of wallet is about 35%, right? And so as the CFO, I look at that and say there's 65% opportunity with folks we know. And that's the hard work we do every day, which is how do we serve clients with excellence on the 35% share of wallet that we have with them. And then over time, how do we expand that, consolidate business, go from the back office custody, the middle office and the front office or bring a broader range of services to them.

In fact, on those 35%, is there a concentration of products that people use? And what are some of the opportunities to sell incremental products to that group of customers you know so well?

Historically, we've tried to count the products. And I think over time, we've come to the view that there are dozens of products and sub products that we offer our clients. And so the old fashioned, count the products of -- are there 10 or 20 or 30 products for client is not as helpful as it's been -- I think maybe many, many years ago. I think what we have found over the last 4, 5 years is really engaging with clients around. Do we serve them in the back office, custody and accounting and there are variance about performance analytics [indiscernible], but let's call it custody and accounting broadly defined. We then serve them in the middle office, right, which is their operations, the asset manager's operations, we call the middle office. And -- or do we serve them in the front office, right, their order management system, whether it's Charles River or -- many times they have a whole home grown potpourri of technology systems and that's everything from portfolio construction to order management. And what we found over time is working with clients for back office only, ensuring with them the other areas is the real opportunity or in some cases, as we bought Charles River, for example, but clients who are on Charles River never did custody accounting with us. And so it's kind of the -- it's the opposite side of the coin. And so really, in our minds, those 3 areas -- front office, middle office and back office. And then how much have they consolidated with each one of those with you and then how much of those do we offer. So I think that's the way we think about the product arrays. I think the one -- did a text right at to that over time, data has become more important and data flows. And sometimes that's embedded in front, middle and back. Sometimes, it's an additional service if you have just the back office with us, but you need us to connect in a more industrious and value-added way to your existing front office system -- we may include a data layer as well as part of our -- what I'll describe as the software offering.

No, very helpful. You've, in the past, showed us or shared with us, I think that the nature of the custody business has always been pricing pressure. And I think if I remember correctly, you guys kind of target about $1.5 trillion of new custody assets just to kind of neutralize that pressure, everything else being constant. Ron, last year pointed out that you started to approach clients about price increases, which was very different. That had not happened before. Can you give us an update and share with us how that's going? How is that proceeding?

Yes, we've made some progress on pricing, but I'd say it's a tactic and part of the toolkit, not something that we do across the board. Pricing in this industry has a certain cadence, a sort of competitiveness. And we want stay within that range and deliver good value to clients. What we have found is that there are areas where I would describe them as supply-constrained areas, private market servicing, bank loan servicing, complicated, manually intense for anyone who provides them, not just us. Less platform systems oriented, but we're building up the -- we're adding technology to these areas. And there's a lot of growth, right, whether it's the fundraising of the private equity firms, the credit firms, the infrastructure funds and so forth. And so we've got a supply-demand imbalance, and that's where we've gone to a series of clients and said -- look, for us to deliver the service excellence that you want, given your growth, the limited capacity the market has, we need to adjust pricing somewhat so that we can put the best people in front of you, we can hire, we can retain. And we've done that kind of work on pricing in private, a couple of other very tactical areas with a few hundred clients. I'd say it's not going to make an enormous difference at the top of the house. But it's the way for us to preserve margin, right, where we're seeing wage inflation on one hand because that's what happens to those supply-constrained areas. And then we need to find a way to -- and with the clients collaboratively make it up. I think the good news is clients understand, right? They've seen their own turnover spike in certain areas and as long as it's done in an open way and highly communicative way, by and large, we've gotten good engagement, and we'll continue to look for pockets like that where we feel there's a need and a reasonable ask and engagement we can make.

In terms of that neutralizing the pricing pressure with the new wins, how challenging is it to bring in that new business, the assets and the custody? Is it more challenging when markets are going down or markets going up? Or is it just always a competitive business?

I guess there are a couple of ways to think about that. I think when the markets are up or down within 10, 15 percentage points, there's not a lot of difference. I think there are 3- or 5-year contracts that are rolling over, industry contracts where we may bid. It may be a relationship we're developing. I think there -- I think the asset managers, broadly the asset owners, the insurers, 5 or 10 years ago were -- felt quite good. I think now they're becoming -- they've become, I'll say, more economically sensitive just given the pressure on their own fees. And so there's -- I think through thick or thin, there's an interest in where can a custodian or a custodian with a front, middle and back offering help and support them in their -- both their economic objectives and their effectiveness objectives. And let them focus on what they're great at. So I think that plays out both in up markets and down markets, and we see that demand continuing. I think from our perspective, we've had several good years of wins. Last year was $1.9 trillion against our $1.5 trillion target. As CFO, I'd like it to be even higher, and we work towards that. The year before $3.5 trillion. And now we have a backlog of $3.7 trillion, $3.8 trillion, which is almost 10% of our book, right, that's sitting on the -- bringing a quarter to finish line, contracts have been signed, but now it's about implementation. And some of that is the work we need to do to implement and onboard, some of them is the work clients need to do. And so we've been very focused not only on continuing to sell at that pace, but onboard the revenues. And those together, I think provides the basis for growth.

You mentioned a moment ago about the 3- to 5-year kind of contracts that may come up for rebid. How important -- because that 2 years ago, that number was gigantic, as you just said. Is that a component of if you have $20 trillion of assets to be bid on for the industry in 2023, how does that play into the wins? Is that a key component to the win store -- is what comes up for rebidding?

I think to some extent. In core custody, there's a certain amount that's going to come up each year. Core custody tend to be 3-, 4-, 5-year contracts, your own come up. So that will be whatever, 1/3 to 1/5 of our contracts. We also referred to 1/5 of all the contracts that are out there in the industry that all our peers have. And remember, we have, I don't know, 10% of the world's assets that we custody for and there are 90% out there that we're looking at where can we make a differential case that State Street is a better provider. So there's certainly opportunity there. I think what we're finding increasingly though is that there are opportunities to help our clients not just with core custody and accounting, which have a certain cadence of 3 to 5 years. But when we engaged, especially at the C-suite, right, with its front-to-back offering from Charles River to the middle office to the back office, that's new and that's different. And it's an ecosystem that -- we're the only ones who can provide a full ecosystem that we can invest in and thus deliver on in a unique way. And that -- those -- what we find appealing are there -- the engagement is not just with the head of operations, that person is important, but it's also with the CIO; CFO, so my counterpart; COO; and CEO, right? And so those are different. And what we find is those as we contract them and this is a big part of our $3.8 trillion backlog is of this front, middle and back, those contracts are 5, 7, 10 years in maturity as opposed to the old 3 to 5. So we're starting to create a different environment. And we think that creates over time for clients of stability, right? Because they don't want to make these changes that often and for us a stickiness that matters and can help create more stability for both our core revenue activities as well as an ability to grow off of that in an even better way.

I want to go back and pivot to your comments about the stock repurchase program. It was a $4.5 billion authorization that you mentioned. Where are you in terms of what percentage of that might be completed? And once it is completed, is there a thought that maybe you go back for another stock repurchase program, what's your thinking on that?

Well, there are a couple of pieces to this. I think for -- to start, we've got higher-than-usual capital levels right now. Part of that was that equity raise, part of this we've accreted capital in the last 1.5 years. And so we did $1.5 billion buyback in the fourth quarter. We have an authorization for up to $4.5 billion for this year. And we said we do it at pace. We've said it we do a little more at the beginning of the year just to get going. But we like a little bit of -- you want some consistency in the marketplace, and then there's some caps with the New York Stock Exchange rules that we want to say well clear of. So that's going along on pace. It will continue through the quarter and through the year. And then I think what we move into because we're such a capital-generating company, and we're asset light back to the smaller size of our markets book or lending book. We've committed to returning 80% or more of the capital we generate to investors through dividends and buybacks every year. So what we'll do is as we get through this authorization, we'll see exactly where we are at the end of the year. That will be a natural time for us to engage with the Board. And then obviously, keep in mind of what else is coming, economic environment getting better or maybe not to your point, but to see what might be coming in 2024, 2025, right? And it's really in '25, I think that Basel III end game plays out. So we need to see what that means for the industry. But we're -- given that we're a capital-light, our intention is to return in a typical year 80% or more of the earnings to investors through capital reserve.

Which is obviously quite strong. Just coming back to the Basel III end game, when should we expect them to announce -- here it is. I thought it was about now, but I could be wrong. Is it any day now? Or is it first half of this year? Or at the end of year?

We've heard different things. I think we -- like you probably monitor the speeches of the Fed governors and some of the other senior policymakers as well as the OCC and the FDIC, right? They do this together. It sounds like it could be late spring, it could be summer time. Sometimes, it seems like the middle of this year, and what we've heard more recently. And our -- what we're doing, as you'd expect with the rest of the industry, the CFOs do this, the CROs do this is what do we know so far? And there's kind of elements of the Basel III end game that have been disclosed over the last almost 5 years with the quantitative impact studies done many years ago, but it's stale. We're trying to navigate through what this looks like. And I think from our perspective, it seems like there'll be more capital in the banking system. That's what our -- we hear from policymakers, but we're -- we've got real time, I think, as well, implementation date of 2025. Sometimes there's even a phase in, we'll see.

Yes. Speaking of capital ratios, can you remind us the binding constraint, I believe the CET1. Could that number change or what would make -- because I thought at one time, it was more of a leverage ratio for you folks some years back, but I could be wrong on that.

Yes, it's changed. There was a time where the leverage ratio was the preeminent constraint for the trust and custody banks until some of the rules were adjusted because even our policymakers felt like, hey, that's not the signal. They want the leverage ratio to be a bag stop, not the primary metric. The most important metric for us, typically, I'll say, is CET1. And so we manage that quite actively. We've got a target range we want to operate into or above that range, which is why we want to bring get capital back to shareholders. From time to time, leverage or SLR could come into play, we tend to have a few more levers there. Sometimes it depends on where we are in the cycle. So -- but I'd say typically CET1 with some occasional movement on the others that we manage through.

Yes. And just -- though we're running out of time, I do want to ask one last question, just about -- have you seen the impact of quantitative tightening on your deposits? Even though I know the Fed is doing it, I don't know if it's hit the system as hard as maybe we would have all thought by now.

No, we certainly have. I mean, since they began last summer, they've actively been reducing their balance sheet. And we saw deposits come off some, to some extent because of higher rate to some extent because of the quantitative tightening. We saw deposits come off from their peaks of $230 billion for us have come to the $200 billion into the teens, right? And we think that will continue. And it's partly embedded in our guide. I think part of what we're trying to distill is we know deposits tend to have a seasonal uptick in 4Q. So that tends to offset a seasonal downtick in the first quarter, which we're seeing. But it's really hard to read, to be honest, [indiscernible] and risk-on, risk-off, flows with our clients locally or internationally. And so we want to be careful. We have a view that we can -- we'll navigate through the deposit environment, but it's hard to read every month. And so I'd like to take one quarter at a time, to be honest with it. I think what we have seen which is comforting even with deposits, sometimes being -- running a little higher, running a little lower in either of those scenarios, we've seen good NII performance, partly because it's inversely related to interest rates, right, deposit balances. And so we've -- but we'll see. More to come on this one. I think every month, you call in for earnings. I bet you'll ask this question, and we'll share more updates as we go.

As you go. Well, Eric, I wish I could ask more questions, but we've run out of time. It's always a pleasure, and please join me in a round of applause for thanking him.