State Street Corporation (STT) Earnings Call Transcript & Summary

Great. Thanks, everybody, for joining us. We are pleased to have with us today, Eric Aboaf, Vice Chair and CFO of State Street. I do have a disclaimer to read. For important disclosures, please see Morgan Stanley Research disclosure website at morganstanley.com/researchdisclosures. Also the taking of photographs and use of recording devices is not allowed. If you have any questions, please reach out to your Morgan Stanley sales representative.

Thanks, Betsy. Let me do my version of that. Just to remind our audience that today's discussion may contain some forward-looking statements, and the 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 other SEC filings. Our forward-looking statements speak only as of today, who we may not update them even if our views change.

We were saying in a prior session, maybe we could figure out an AI for these disclaimers. So talking about strategic priorities, let's kick off on just how you and the rest of the management team is thinking about your strategic priorities around servicing existing clients and then I want to get into a question on just expanding some of the offerings and more global side to what you're doing. But you've mentioned in the past that you don't necessarily need to expand your product or client set, but are looking more for expanding your existing clients use of all your products, for example, taking a back office clients and encouraging them to use your full suite of front to back. Can you give us a sense as to how you're going after that opportunity? And how far along you think you are on the journey to fully servicing your clients' needs?

It's a fair question because most of what we do is start with our existing client base. We serve the world's leading investors around the world, 10% of the world's investable assets, which means we have, as our clients 90%, 95% of the largest investors. What we do is we actually think about our clients and groups. And we start with our top 60 clients, which represent 60%, 65% of our revenues. And if you think about them, there are good microcosm for how we proceed. And we do this with other groups and segments. But for the top 60%, we do some back-office servicing for all of them. We have all their back office. Now, we've got 35% share of their back office, which means there's always more back office to be gained with our existing clients. Then we add another layer of well, middle-office services. It turns out about 30% of those clients, we do middle office processing for. And then you go once that -- or we do middle office and back office. In fact, it's more than 30%, typically 50%. So most of our clients, we have back office with of some amount, 50% have back office and middle office. And almost 30% have some version of an alpha proposition, right, back office, middle office, front office together, maybe not on their whole book, right, which is why I say we have 35% mark share of wallet, but they have some of those components, and so they can experience State Street. And so as we think about the opportunity, what we think about is how would we lead? What do we do that we can differentiate ourselves with? A big part of that over the last few years has been the alpha proposition? Why? Because it's new, it's different, it's unique. It offers that whole front-to-back offering. And what that allows us to do is go to clients and say,"Look, there's a new offering that is different than what others have and one that has an opportunity in front of it." And then what's appealing for us is as we do that with the new offerings alpha, especially the front office and the middle office, there is a big opportunity to then bring along the next part of the back office, which is core custody and accounting, which is very, very kind of economically beneficial to us. And how we serve our clients. So there's a whole sort of I describe process we use that has -- that is centered around the client's wallet. What part of the wallet we penetrate and what group of clients? I think if you go further, what we've done is, we've continued to spend time in markets that we think are fragmented and ripe for disruption. So the alpha front office Charles River proposition, we and Aladdin, the top 2 providers have 25% of the market. The rest is small software companies were internally provided. So it's growing, it's fragmented. There's a lot of opportunity for us, middle office, no one else really does middle office and scale. And so there are opportunities there to differentiate and then bring the full package. And then finally, there's always the other parts of the product array, right, whether it's offshore funds in Europe, ETFs, privates, where what's important is having an industry standing offering and then having the kind of the client coverage sales and execution capability that matters. So there are many different ways we think about it. But may that's just a start, Betsy.

Okay. And the follow-up question I have here is just on how you're thinking about the global piece of the footprint. And part of the reason for asking is, as you know, BBH was going to be giving you some of that footprint, not that you are not pursuing that anymore. How should we think about where you are on the journey to expand on the global side? You've done a few acquisitions of late, maybe we could speak to as well on it.

Yes. I mean if you step back, remember, the Brown Brothers deal, at least as it was conceived, it was really a bolt-on deal, right? It's about 10% of the size of what we do. And it was a way to actually deepen our scale position. It had a little more of Japan, a little less of North America, but by and large, it mirrored what we did and was really about expanding scale and actually coincidentally even though we weren't able to consummate that deal, which was $4.5 trillion investments under custody. And during that 18-month period, we actually won $4 billion of assets under custody mandates on an organic basis, right? So it's just another way to move the franchise forward. In terms of international, we've had some of our best years over the last 2. I think Asia was -- had its best year ever in 2022. Europe, in 2021, was particularly strong. We've been spending time, more time in the Middle East, right, an attractive area for us where we actually bring all State Street together. Oftentimes, asset management and custody are brought together in places like the Middle East from some of the sovereign wealth funds. Latin America is another area that we've been expanding into partly by buying and establishing a bank footprint in Brazil. Part of it is some of the deal announcements that we've seen. And so it continues to be attractive. And part of the reason is that internationally, we see more growth than in some of the core markets like our U.S. And the fee rates are -- tend to be better. Part of that is the product complexity, the product differences, right, that we can deliver at scale because we're so large in these jurisdictions, but everyone else can bring a set of revenues, fees and margins that are attractive for us.

Got it. Okay. And along the journey, when you think about what you think you should be able to accomplish, call it, over the next 5 years or so, how far along do you feel you are on this execution of client -- increasing client product and service penetration?

What I'd say is, what you tend to do is get the seventh or eighth inning, and then you try to innovate so that you have a new set of products and offerings that can create the next round of growth that makes you feel like you're in the third inning, but there's a lot more ahead of you, right? And so part of what we did with the purchase of Charles River in the front-to-back offering, they said, "Look, here's another $7 billion addressable market of revenues we can tackle, " right, with outsourced trading that we had started to build, but we bolted on. With our CF Global acquisition, there is an addressable market of about $600 million of revenues out there that's highly fragmented. So what we're doing is we're finding ways to innovate or bolt-on capabilities and then tackle a market in size. And in our minds, that's going to be something that we do on a continual basis because client needs are evolving. If we move forward, we can satisfy more of those needs and actually then penetrate more of their wallets and some of their new wallets and some of their growing wallet areas, or we can be left behind and obviously, we'd rather lean in.

Okay. Makes sense. So moving from strategy to more tactical questions here. As I'm sure you know, there's been a lot of debate discussion questions around how things are going with regard to deposits, net interest income. I'm sure that's on your question list for yourself. Maybe you can give us a sense of how deposit flows have been going this quarter, and how we should think about the stickiness of your deposits?

Let me -- those are 2 separate, but...

Separate well, let's start with #1.

All right, deposit flows. So we printed average deposits in the first quarter of $210 billion, right, for context. And that was roughly between the highs and the lows that we've seen over the last 3 or 4 years, right? The high was about $235 billion just after COVID hit, and we had that influx of deposits. And then -- which lingered obviously with quantitative easing. And then, several years back, we were at $165 billion. So we're somewhere in the middle. We've been seeing a gentle rotation of deposits that continues. And what I mean by that is we have some evolution deposits from noninterest-bearing into interest-bearing. And then just some clients who are actually trending down their levels of deposits because they're looking at some of their alternatives. We are exposed to all the industry trends that you see in the H.8 report, and this quarter, second quarter is kind of coming in line roughly as we had expected. We had expected to be down in deposits 1% to 2%. I think the industry H.8 reports are around that 1% to 2% sequentially. And so the deposit book is behaving roughly in line with the industry.

Okay. And then on to the question 2, the stickiness?

Stickiness is a long and complicated question because you have to think about it in pieces. First, deposits, there are a number of different deposit types out there, which have different characteristics, right? There -- we all know about insured retail deposits, right? We all learned in early March about those commercial deposits that seem to move around quite a bit. There's corporate like cash management, payroll type deposits. There's wealth deposits and there's custodial deposits, right, at least as major categories. And each of those has a different set of stability levels and characteristics. We operate primarily in fact, solely in the custodial deposit space, right, not in commercial, not incorporate by and large. And what we find is, our -- the deposit accounts that our clients have are hardwired into our systems. Why? Because we're their custodian. We're processing thousands, millions of transactions through their accounts each day, or each minute or second because we actually do it throughout the day. And so they need a deposit account there are to actually cover the flows of transactions. It's not something that they can pick up and move, right? As a result, you get a lot of stickiness. And remember, those custodial contracts tend to be 2, 3, 4, 5 years in duration, again, another level of stickiness. So it's not like a custodial client say, "Hey, I'd like to close an account here, open it there." They actually need it for us to provide the custodial service with us. And so it's deeply embedded. The next thing that you find when you drill into our deposits is we have clients with several billion dollars of deposits, but the average deposit account that they have because they each typically have thousands of accounts, it's about $1 million. And each of those tends to be associated with a legal entity, a mutual fund, a mutual fund board who needs to make a decision about the account. So there's kind of this embedded, I'll call it, complexity and hard wiring that is -- that sits with our accounts, which is one of the reasons, if I step all the way back and ask the question, how sticky are they? They're actually relatively sticky, which is why early on in Basel II and Basel III, the regulators actually developed an assessment of custodial deposits. They put them in different bucket, just like the retail insured is a defined category. Operational deposits for custodial banks like us is a defined area of regulation. It's got a set of rules of tests of oversight. And we report about 75% of our deposits are operational. Anyway, long answer to a short question, they're pretty sticky and pretty hardwired into our funds.

Okay. Now that said, there is a mix, right, between noninterest-bearing and interest-bearing. And I think you saw in the 2Q earnings call that you would expect some NIB outflow, $4 billion to $5 billion or so. Is that still playing out like that?

Yes. Through the end of May, so 2 months into the year, net interest -- noninterest-bearing deposits have been rotating out by about $5 billion, $5.5 billion so far. And part of that is just clients are going through their process of assessing what they earn on deposits. Could they earn more, and is it worth the switch? And what we find is that the clients with large accounts, if you have $10 million or $50 million in noninterest-bearing account, you'll move that over time. If you've got $1 million, it's worth about, I don't know, $30,000, $40,000 a year. And if you think about it, if you're a mutual fund board, if you're a collective fund, like it's -- there's a question of whether it's worth that amount to actually move, maybe over time, but there's a fair amount of then behavioral stickiness there. But we have seen this trend. We saw it this past quarter in -- from fourth quarter to first quarter, we saw about $5 billion rotate out. Through May, I said $5 billion, $5.5 billion, we'll probably see another couple of billions. So we might be down $6 billion, $7 billion by the end of the quarter, we'll see because the -- we still have a few more weeks to print here.

And that's moving into interest bearing.

It tends to move into interest-bearing -- sometimes it moves -- it tends to flow down and out of the system. It comes back into interest-bearing. Sometimes it's converted right away. What clients realize is they need a certain amount of deposits to handle those very significant payment flows that they have. And if they test the frontier of that, they end up overdrawing. They have overdraft charges and a little bit like consumers, they don't really like to have those because there's accounting that comes with it, and there's a little bit of, "Hey, that's why I have my deposits here." So you'll see some ups and downs until -- and over time, some stabilization probably.

So with all of that as a backdrop, how should we think about your NII guide for 2Q '23?

So in April, we guided that NII would be down about 5% to 10% sequentially, larger range than usual just because there's a fair amount of activity going on quarter-by-quarter. And we still feel like that range is appropriate for where we're coming out. We're seeing deposit rotation, noninterest-bearing, some of it back into interest-bearing. We're seeing the effect of -- the rates on the back book continue to creep up in the U.S. On the other hand, we still get some benefits from the betas and the lags in some of the international jurisdictions that offset some of that. But we still feel, at this point in the quarter with 3 more weeks to go, the minus, the down 5% to 10% around -- is about right.

So while we're on second quarter outlook, any other topics or themes that you could share with us about what you're seeing so far 2Q to date?

Sure. Let me do the -- let me give you the update because it's a good time. And I guess what I'd preface it is that the macro environment is slightly better than we had expected, right? Equity markets are up a bit, although we've seen subdued volatility in some of the trading markets in April, May, which I think other dealers have noticed. So let me go through the P&L, right? Total fee revenues are expected to be up 4% to 4.5% on a quarter-on-quarter basis, which is largely in line with our prior guide. And if I break it down, servicing fees will be up 3% to 4% as compared to our previous expectations of up 1% to 2%, reflecting higher equity markets and [ even an ] onboarding that we talked about at the earnings call and some underlying revenue performance. Management fees are now expected in the second quarter to come in slightly above our previous outlook range of flat to 1% quarter-on-quarter, primarily driven by those same uptick in equity markets. FX trading, however, has seen lower volatility and lower industry trading volumes quarter-to-date, and that obviously means lower markets revenues for this particular quarter as clients have ended up on the sidelines partly as they've tried to define the direction of interest rates, probably the debt ceiling kind of concerns have led some risk off behavior. And then in the front office software, we continue to expect to see a significant sequential increase in second quarter, reflecting strength in the on-premise renewals and SaaS conversions. And then, finally, in other revenues, we expect to see a sequential uptick of about $5 million to $15 million.

Okay. And that $5 million to $15 million in other revenue is -- any sources there, or...

Yes. And I chuckle because this is the area where we have the accounting change that we talked about in April, which has to do with some of the tax advantage investments for wind farms, where the accounting is getting changed this quarter. So let me try to describe what's happening here. If you remember, for most tax advantage investing, the accounting is simple and logical and that's true except for wind farms, where what we have is a situation where the amortization of the investment goes through the other fee revenue as a contra revenue, so you end up with negative revenues. And then that's offset by a tax credit in the tax line, which offsets the amortization and provides a modest benefit in the -- on a net basis, much like affordable housing credits. What's changing now is the -- something called proportional amortization method. And that effectively means that, starting in the second quarter, there won't be a contra revenue in the revenue line. There'll just be an appropriate tax benefit in the tax line and it simplifies the accounting and actually harmonize it with the rest. All that said is we've got a year-to-date catch-up in second quarter, which is related to the second quarter guide that I gave. And then what it also means is that in this other fee line, which folks have found difficult to model, including your team in that -- and have asked us more about it, the wind farm, affordable housing, BOLI and so forth, elements of that line are worth typically $30 million to $35 million a quarter, relatively stable. There's another piece there, which is around investments in areas like -- some vehicles like some Rabbi Trust and so forth associated with the asset management business, which tend to fluctuate with equity markets. Those can move around by plus/minus 10% with equity market moves about those same magnitude. And so you get volatility, plus/minus $10 million. And then there's another piece of minority investments and balance sheet [ readouts ] that are actually quite hard to forecast, and we'll just give guidance. So all in, it's a lumpy line, but now there'll be a base amount that is more consistently going through this of $30 million -- $35 million, but with a range around that.

So less volatility going forward?

Yes.

And is this second quarter reset now fully baked? Or is this something that we should expect in the next 2 quarters? Or you're...

There's a modest catch-up in the second quarter that's included in our guide. And then on a go-forward basis, the $30 million to $35 million per quarter will be relatively stable, but there'll be the range around that, that we'll have to guide to -- around the investment vehicles and the balance sheet [ readouts ].

Well, anything that's cleaner and smoother is good for us, so I appreciate that.

All right.

And just to wrap up on that, then the tax rate guide that you have for 2Q, 21% is still in place?

Let me finish the -- let me do the rest of the outlet.

I jumped on the line item, sorry.

I know. So we covered fee revenues, right, up 4% to 4.5% sequentially. NII, we said was in line with what we had previously expected is down 5% to 10% sequentially. Loan loss provision, we expect some puts and takes in the second quarter with the release of the provision related to our support of a U.S. financial institution, right, which we did within the others. And we'll release that provision but it will be offset by a little more than half by some credit rating downgrades and some loan growth in the portfolio. So that will come through as well. And then finally, before I get to taxes, turning to expenses. We now expect the second quarter expenses will increase 1.5% to 2% on a sequential basis, excluding the first quarter seasonal compensation cost of $181 million as compared to our previous expectation of sequentially flat expenses. This is due to higher revenue-related costs, partially associated with the higher servicing fees and higher equity markets I just mentioned as part of servicing fees and management fees. And with that, we'll obviously continue to remain focused on driving productivity and controlling our costs given the environment and actually expect quarterly cost to stabilize roughly at this second quarter level for the rest of the year. And then finally, on taxes, we've been continuing to do some good work on tax planning. There'll be some discrete elements coming through. So instead of the tax guide of about 21% that we gave at earnings, we think it will be closer to around 19% for the quarter.

Okay. Excellent. Well, there's a lot there. Appreciate it. I'll just take a pause and see if there's any questions in the room before we move on. Okay. I did want to lean in a little bit on the business yet to be installed, right? You're announced, but not yet installed flows because clearly, that can be a nice driver for your fee lines going forward. Can you just give us a sense as to how we should think about the run rate for the rest of the year?

Sure. The -- I mean, the important part of our business model, especially as we launch the output proposition, is to win some of these alpha front-to-back deals. At first, it was some small and midsized deals. And then there were several trillion dollar deals that were -- that were won and effectively sit in our backlog, right, the $3.5 trillion of backlog. We're now starting to get to the point because remember, the bigger the deal, the more complicated they are, the longer it takes to install to actually start to pull them through. The first one of those will start in the second quarter and start to contribute some of the revenue uptick that I described. And then what I'd say is that the deals don't come through kind of all or nothing, right? You may put in place custody first, or you may put in place middle office first that comes with the backlog coming into the books and records, but there tends to be a stack of products that are coming through. And so part of what Ron and I were signaling at the April earnings is we're starting to see some of these larger deals come through, but it will take time. I think we've said that they'll come through in revenue or AUC/A terms over the course of roughly a 2-year time period with about half this year. But it takes time, and our view is we want to install them right. We want to -- the clients need to make a lot of changes for them to secure the benefits and that will come through over time.

And is the majority of this happening on your SaaS model?

For the new Charles River offering sales and the front-to-back offering, they are typically on a SaaS model, just because it's the way we can provide the most functionality for our clients, yes.

And that's a model that is more profitable for you?

It's at scale, and we are at scale. It tends to be more profitable for us and actually more beneficial for clients, right? Because they're not calling up and saying, "Can you send over a developer to recustomize my system to add some functionality," it's where we can push functionality to clients in a consistent way.

Right, so it's a win-win. Obviously -- okay. And when you think about the installed business that you've got and your migration of new clients towards SaaS, do you feel that SaaS is a model that will become the majority over time of your client interface? Or is this as new business comes in, it will be SaaS and you'll just have the 2 different models?

No, very much. So this will become the predominant model that we have. In fact, in any given quarter, we're trying to win is 4, 5, 6 new clients in Charles River or as part of the front-to-back offering. And we're actually, at the same time, trying to convert that many 4, 5, 6 clients in a particular quarter in the installed base. Because to us, it's -- like you say, it's a win-win. It's better for us as a way to deliver our offering and better for us in terms of scaling what we do and it's better for clients.

So you talked a little bit about expenses for the quarter specifically. But could we take it up a notch and just think about how you're thinking about driving operating leverage for the business over time? Last year, you were successful in holding expenses flat, obviously. I just wanted to get a sense as to how you're thinking about operating leverage as you go through, not only the full year or '23, but in your medium-term outlook?

So I guess the context I'd give you on this to step back from the quarter, as you've said, is that, for 3 consecutive years, we've actually widened our margins and expanded ROE by about 1 point per year. And if you go back to 2019, we had margins in the 26% range, and we've steadily taken them out to 27%, 28%, 29%. We had some quarters even hit 30% from time to time. And so I think we've been on the right trajectory, and part of that is finding ways to grow the top line, part of that is controlling costs and driving productivity while we reinvest in the franchise at the same time. I think clearly, we'll have some headwinds as NII floats downwards quarter-by-quarter on margin. But our view is, we need to continue to drive fee revenue growth, on one hand, and then continue to drive the kind of productivity programs that have made the difference on the bottom line. And our view is that, that's an ongoing process. In a way, State Street's core custody accounting offering was built over the last 30 years really. And I wouldn't say there's 30 years ahead of us on that, but there's a number of years ahead of us that continue to automate, simplify, consolidate centers, simplify with clients, which you do at client rollover points because they are part of the complexity that we have. And so there are a number of initiatives that we continue to work through. And in fact, we're working now, right, this summer on the initiatives for 2024 because it's that kind of lead time that we need to build into some of these more systemic change.

And obviously, very big investment in tech that drives these efficiency improvements. Can you just give us a sense of the tech budget today? And any sense on how you're thinking about leveraging today's hottest tech topic, AI?

Sure. Tech budget for us is north of $2 billion, about 1/4 of our expense base. And in truth, we've been working on a wide range of technology simplification, automation processes, I'd say, for the last 3 or 4 years. Robotics was important several years back, that was the talk of the day. There's machine learning in terms of how we process NAV. When we process NAVs, we need to check them. You can do that with human beings watching. You can do that with machine learning. There's a set of tools that we've developed over time. I think the ChatGPT is more natural language processing not as applicable to the core of what we do. But I'd say the broader range of AI tools are actually quite valuable for our business. In truth, what we want to do is, we want to automate to the core, right? So there is no checking or discretion that's needed. On the other hand, there is a layer of checking of NAVs, of accounts, of report that's necessary, and that's where the AI technology is actually quite valuable for us.

Great. All right. Last question for me has to do with Basel Endgame capital and buybacks. Maybe you could give us a sense as to how you're thinking about the impact of Basel III? And if it does impact at all your buyback plans, I think you mentioned that you have $4.5 billion in 2023. So maybe you can give us some updates there.

Yes, we're making good headway on our buyback for this year, and we had an authorization of up to $4.5 billion. In the first quarter, we bought back $1.2 billion, so more than 1/4 of the authorization. This quarter, we're north of $1 billion. And what we're trying to do is get capital distributed back to shareholders at pace, and that's our goal, get it down into the 10% to 11% CET1 range that we should be operating at. We printed 12.1% last quarter. And so I think our path is pretty clear in that direction and comes with significant buybacks this quarter and into the second half. What we do want to do though is we need to stay conscious of everything that's going on, right? The economic environment, we have this FDIC assessment coming in third quarter for some of the bailouts they had to engineer, but which will come back to the industry. And then, to be honest, we need to keep an eye on the Basel III Endgame, as you mentioned. It's hard to know when -- what that's going to mean for banks, but the work that we did with some of the industry associations a couple of years back suggested capital is going up. So we expect that to be the case. It could be up double digits in terms of percentages. We'll see for the industry. We don't know how we'll be affected, but we're one of the industry participants so that's on our mind. I think we'll see more in June. I mean that's 2 more -- or 2, 3 more weeks of July is what we continue to hear. And I think at that point, we'll have an assessment. But we're also conscious it's going to come with an implementation horizon. Is it 3 years, 4 years, 5 years, maybe something, we'll see. And so it will factor in, but I think it will factor in over time to our capital return. And what we'd like to do is continue to do what we can between now and then.

Right. To migrate to your CET1 of 10% to 11%. Great.

Yes.

Eric, thank you so much for joining us today. I appreciate your time.

Thanks very much.