State Street Corporation (STT) Earnings Call Transcript & Summary

Hello, everyone. We have our second fireside chat with State Street Corp. Joining me is their CFO and Vice Chairman, Eric Aboaf. As many of you know, Eric joined State Street back in 2016. He had a short stint over its Citizens Financial prior to that. And then before joining Citizens, he was at Citigroup for a number of years. Many of you know that State Street is our tenth largest bank in the United States with assets of almost $300 billion. It has $42 trillion of assets under custody, and it drives 78% of its total revenue from noninterest income, which differentiates it from a traditional bank. In the fourth quarter, it put up an ROTCE of about 18.8%. So Eric, thank you for joining us. Maybe we can start off with...

And just to satisfy in terms of legal requirements, I'm going to remind everyone before I get started, today's discussion may contain some forward-looking statements. And as you know that actual results may differ materially from those statements due to any number of important factors, including the risk factors in our 10-K and other SEC filings. Our forward-looking statements speak only as of today. We may not update them even if our views change. And with that, back to the Q&A.

You remind me of the guy, that FedEx commercial guy from 20 years ago talking a mile a minute.

Are you saying I'm old enough?

One of the key strategies for our successes for State Street is winning new business on the servicing fee side. You attained your $300 million servicing fee wins last year, you're looking to up that a little bit to $350 million to $400 million this year. Can you speak to the areas you're currently seeing the most success? And are there segments where you have to have opportunities to gain more traction?

Sure, Gerard. I think the context is important here. Last year was a good year on sales, about $300 million of sales in our servicing business. The years before that, we're in the $200 million, $250 million a year. And what we've really come to terms with is for us to grow organically at the pace we'd like to this -- in this business, we need sales of $350 million to $400 million, and that would be the goal is for this year. And what's nice is we're on that positive trajectory with how we finished last year and finished strong. There are really a couple of areas of emphasis. And then maybe I'll describe a little bit about what the pipeline looks like. Areas of emphasis are around back-office custody, right? That's the core of what we do. It's the highest variable contribution to State Street. And just you've got to focus on the core traditional as well as the new and exciting and that balance matters. In terms of the new and exciting and high-growth areas, private markets, I'd describe as a market that we think is growing 10% to 15% a year from a servicing fee side, we think we can expand at a rate of 15% plus in that market, this year and in the coming years and see that as a way to kind of average up the growth rate of State Street. And then Alpha is another area. Alpha has been a real success for us. It's been the tip of our sphere as we sell front, middle and back with Charles River, the middle office services and the back office custody. And we've been selling 5 or 6 Alpha deals a year. We're taking that upto 6 to 8 this year, and in fact, our targets are even higher than that because we think there's a real opportunity, but we think we can deliver on that, and that creates growth across our franchise, whether it's software, middle office or back office. So far, so good. It's been a good start to the year. I think clients are continuing to be interested and engaged at the C-suite level in particular. CIOs are inventorying their stock of systems and realized a lot of it is old, crumbling on-prem and their looking for better and they want to see the benefits of data aggregation more and more, and that really comes from this front-to-back offering. And so the areas of growth, in addition to privates and Alpha, I think I described regionally, Europe was very strong last year. It continues to have a very strong momentum in the -- in our pipelines. The Middle East, important area. Actually, we're going to have our April Board meeting in the Middle East this year, and that will be an opportunity for many of us to visit with our clients and our Board members to go visit with our clients, and you've got sovereign wealth funds there. That are -- that have real capacity both in servicing asset management, everything we trading, everything we offer. And then North America is coming around. We were clear that we felt we've underperformed in North America last year. And over the last, I'd say, 2 years, we're seeing a stronger pipeline. We've got clients that are [indiscernible] expanding what we do for them and others who, in some cases, are do very little business with us and are saying, hey, let me consider a change given what we at State Street can offer. So a strong pipeline. And we're optimistic. We're feeling confident in being able to deliver this higher revenue growth and with higher revenue growth and -- or I'm sorry, with higher sales growth than we can as we install that, we get higher revenue growth and get the momentum that we'd like to see.

Yes. You touched on Alpha. And obviously, you and Ron have talked about it for a number of years. Can you walk us through from those beginning days to where you are now? Do you think we're at an inflection point where customers are now more comfortable with that full front-to-back model that you're offering them?

The answer is yes. And I'd say it in a couple of ways, we've reached an inflection point. I think early on, we had several midsized clients that kind of partnered in and said, yes, can you just take all this stuff or just [indiscernible] of it. So there was that kind of reaction. And so we had Charles River, the middle office, the back office and consolidate it, and these are clients with a couple of hundred billion dollars of assets under management. These are substantial clients. Then I think in 2000, 2001, we had a couple of trillion dollar deals that we announced for Alpha and what we found there and some of these clients have been public is that they were effectively co-development partners because the kind of connecting that front office to the middle office and to the back office, it's easy to talk about on paper, but it's a lot harder to do when you've got the full range of products and geographies that an asset manager is offering. And I think what has evolved since then and what's changed is we've become much clearer about what the proposition is, because that co-development has been done, right, especially with the largest, most complex organizations. And so now Alpha is much more of a menu and set of modules. It's a lot clearer to a client what they need to do to change. So it's a way for us to test their commitment, like qualifying a sales prospect into a real likely [ client ] is that they're willing to make the internal changes of processes, systems and approaches. And what that's done is also give us real manuals for how do we -- once we sell, implement it more quickly. And that's attractive to clients. They want to actually get on with it. They know it takes time, but they want to get on with it. So we've reached an inflection from, I think, a clarity of the proposition, the -- I don't say simplicity because nothing simple to implement in these areas, but the pathway to implementation is really clear now and the examples of how we've done it are now very well regarded in the marketplace. Yes, we got 28 [indiscernible] forward. Two things. One is we've taken up our sales target for alpha 6 to 8 this year. And I think I'd like to do better than that, that my budget calls for better, but I'm trying to be careful and conservative with all of you, but we'll see the -- how we do. And then the other thing that we found with Alpha is that not only are we emphasizing the sale of the front, middle and back office. But how we -- what we agree with the client has changed in the sense of early on, it's let me work on the front office or the middle office, your pain points and then you'll bring custody along. Now we've done it -- and that ends up with a back-loaded revenue kind of implementation. We've actually turned that the other way and said, look, Alpha is so [ precious ] to use clients. You have to bring custody honorary. And then we'll work through the other pieces. And that gives us a way to actually bring on a client and instead of having a tail of higher revenues, we can bring revenues on more earlier on in the process. So I'd say we're at an inflection point in terms of more Alpha deals, and I think ones that are even more revenue accretive to us on a -- from a time frame standpoint, and we're seeing clients respond.

Yes. So it sounds like with Alpha, you don't necessarily have to be an existing custody claim with State Street. You can actually bring in new clients with the Alpha product and then tie custody to it as well?

That's right. I think you've got -- when you step back, remember, we're responsible for [ cutting ] enormous percentage of the clients -- the clients, the world's assets, right? And we have relationships with a large majority of the top, call it, 100 asset managers and asset owners. It's -- we do something for most of them. There are situations where they don't do custody with us or a small amount of custody. And that's attractive for us because then there's a whole offering, front, middle and back-office custody kind of that comes together. And that's an attractive segment for us. And then there are other groups of clients where we might have, I don't know, 35% share of wallet of custody and not -- and we don't have their middle office or we may have Charles River in there, but not different share of the back office, right? There's all sorts of mixes out there. And what this -- what Alpha allows us to do with those clients say, look, let's actually work with you to knit together the front, middle and back. And the effect of that is to take our share wallet up for the client because we love the client where we might have had 30% share of wallet. And now we got 50% or 60% or 70% or 80% because in a way, we can really serve that client as a superb partner, and they can take full advantage of the offering.

No. In terms of implementing the Alpha products for the clients, is it all bespoke or is there some commonality between that the clients that you build -- its a chassis that you then build on the individual client means?

Early on, it was bespoke and that's what we've really modularized. So I think it's much more of a chassis as you described, with modules that fit in. And so that works well with equity funds, mutual funds, offshore funds and luck. So we've got all the pieces -- the core pieces, the institutional funds, the CITs and so forth. The areas where it's still a new fertile ground, right, because it's not a modular everywhere. Let's be honest is in the alternative space, Alpha for the -- for alternatives because what we have is we've got a number of managers who've got everything from old [indiscernible] and active mutual funds to ETFs, institutional funds, and then they have alternatives. And that CIO or Chief Risk Officer wants to see their entire data aligned in one place And so we started to build out Alpha for privates, right, to bring in that data, which comes in a different kind of shape and size into the data architecture. So that's a good example of where I think it's still in development. We signed our first Alpha for private market clients in the fourth quarter, and there is more to come. And over time, we'll modularize that. Right? But right now, it's in development client by client. And in some ways, it lets us sharpen the offering, make it better, figure out what is scalable, and then it lets us roll it out in a way.

Speaking of the private markets, you've, in the past, pointed out, it's more manually intensive to service that market, but you intend to get commensurate pricing for that. What's the outlook for that area, especially now that you have your first Alpha client from privates?

We're bullish on the private market servicing because it's -- in some ways, it feels like custody, core traditional custody did, I don't know, I want to say, 10 years ago. It's fragmented. I think there's no dominant player who's got 50% market share. We're #1 or #2 depending on how you count. We've got maybe 15% share of market. It's hard to tell because it's less well defined. It is a marketplace with a lot of specialized verticals, real estate, infrastructure, private equity and so forth. And in some ways, there's a regional cut to each of those, and they have -- right? And then to be honest, privates is exciting and really fits our client profile in a double manner. First, we have privates through the private market firms, right? And the multiline firms who have big private asset businesses, but we also serve asset owners, right? And asset owners are often the ones who invest in the private markets, and we may be doing custody for asset owners. So in some ways, we're on both sides of privates. And that to us is exciting because it helps us sharpen the service offering in the first place for both the kind of the provider and the end investor. It is highly manual still. There are no standardized systems. The waterfalls are complicated. The structures have signed cars. Everything has been invented here. And -- but in truth, what clients are looking for is who's going to invest consistently and intensely in this area because many of them are trying to democratize privates meaning they need the servicing functionality, but they needed for smaller and smaller fund units, right, and investment in LP units. And that's something that State Street is terrific at, taking a market that's kind of complex and over time, systematizing it. And so as we talked about our investments for the year, it's a big part of our investment area. And our view is just with what we do today, we can grow 15% per year in privates on the servicing side. I'd like to see if we can build on that year after year after year and make it a bigger part of our business, so that there's real -- so that there's a real area of growth over and above the traditional activity, which grows more in the low to mid-single digits.

Right. Maybe we can shift over, Eric, to the outlook for the first quarter. It's obviously the markets have started off strong this year. The equity markets, in particular, now there appears to be maybe fewer interest rate cuts coming this year, if the forward curve is better at forecasting today than it was in January. What's the outlook? Any updates for the quarter or the year that you'd like to share with us?

Yes. I appreciate it. We've now closed 2 months of the quarter. So we got 1 month left, but we have some sense for where we're coming out. Maybe to start on the points you've made on a macro level, as you mentioned, quarter equity markets have been a bit better than expected, better than expected back in January. At the same time, we've seen FX volatility continues to trend downwards and less specials activity at the same time. So there are some ups and downs depending on what part of the business. And in terms of rates, we're now seeing an expectation for 3 to 4 rate cuts, we'll see what happens. We monitor that in the U.S. and internationally at the same time. So we'll see how that plays out, and we still plan on the forward curve at this point. So there are puts and takes in the macro environment. But we believe it's a net positive to our fee operating leverage for the quarter. And so let me describe that. Given the factors we now expect our first quarter fee revenue outlook to be a bit better now up 2% to 2.5% year-over-year relative to the prior outlook above just 2%. So a bit better. Servicing fees are expected to be in line with the prior guide of plus 1%, management fees are expected to show an improvement above the better end of the prior range of up 7% to 8%. And we still expect front office software and data to be up over 20% year-over-year, largely due to the increase in SaaS, new business conversions and renewals, so good momentum. We continue to expect NII to be in line with our prior guide of flat to down 3% quarter-on-quarter with total deposits largely coming in as expected over the first 2 months of the quarter. Though, as we've said before, deposits are just difficult to predict in this environment. And we take it month by month and obviously update as we can. Before I move to expenses, I would note that while our overall credit book remains high quality and quite healthy relative to the $20 million in provisions that we saw last quarter, we expect to take a provision in the first quarter between $25 million to $35 million, largely due to 2 CRE names as we just work through the economic environment. On expenses, ex notables, we continue to effectively control costs and expect first quarter to be slightly better than our prior guide and come in at the better end of our previous range of up 1% to 1.5% year-over-year. And then lastly, we expect the first quarter tax rate to be about 1 point higher than the high end of our full year range of 21% to 22%. But we still expect the full year tax guide to remain the same as our previous guide. So we've got some quarterly variability. And finally, I would remind everyone of the guide I gave last week regarding our preferred equity shares. We would expect to see roughly $10 million and a $15 million increase in onetime preferred costs in the first and second quarter, respectively, relative to the approximately $40 million that we had at the end of last year. And then we'll revert to around $40 million per quarter going forward, starting in the third quarter with dividends subject to Board approval, as you'd expect.

Coming back to interest rates for a moment. We've been through a period here when you think back, pre-pandemic, then we hit the pandemic, we go back to 0, then we go up to over 5%. Can you share with us as we go forward in an environment you would ideally prefer, I mean, is it a steeper yield curve with maybe the shorting coming down to 3% long end staying at 4%, 4.5%. What's -- if you had a magic launder, what would you paint as your ideal environment for State Street?

The way I would describe that, Gerard, is that we'd like just to see consistency in our NII. And in truth, our NII should grow in line with our fee growth or medium-term targets of 4% to 5%, right? Because as we bring on custody business, custody accounts come with deposits and deposits are part of client P&L and the balance of trade that we have with clients. For that to be healthy because we've seen the book ends now, right? We were in that 0 rate environment for a while. We saw kind of the rise 4 or 5 years ago, then a collapse in rates back to 0, then this faster than we've seen rise in a couple of decades. What would be, I'll say, better because there's nothing perfect when it comes to interest rates is. We'd like to see some moderate levels of rates that we can count on, that's not 0, and it's probably not 5% in this economy, but 3%, 4% prevailing rates, they'd be healthy. We'd like to see at least not an inverted yield curve, you can see I'm setting my expectations -- self-expectations carefully. We'd like to see some slope to the yield curve, that would be appropriate over time. And that would give us some ability to actually earn based on the maturity spectrum. We'd like to see a little bit of volatility and convexity premium in the agency mortgage-backed space, just because we invest in that, given it's government guaranteed and very low risk weights. And then internationally, we'd like to just see a range of rate curves across the euro market, pound sterling, Aussie dollar and so forth because we do business in every one of those currencies. And we have an ability to actually shift our investment portfolio between currencies and take advantage of the basis advantages. So that would be helpful as well. So I mean that's what I would describe as a better environment, and we'll see. It will be interesting to see whether the back end of the curve sticks to where it is as the Fed begins to cut through 4x, obviously what happens in Europe and Asia as well, but time will tell.

Yes. Can you frame out -- you mentioned earlier that the best growth last year was in Europe, you're holding your annual meeting in the Middle East, when you frame out the different central banks, is there any way of waiting that the Fed's actions are 70% or 80% most impactful to you versus the ECB? Is there any way of framing that out on who's the most important? And how it might affect you folks?

Yes, with our Investor Relations team, I think it's done a very nice job with our business teams to actually map out our balance sheet across currencies. And so you got a dollar, we show an abbreviated dollar balance sheet, euro, sterling and then you get the all other. The U.S. is 60%, 65% of the balance sheet. But you got 30%, 35% in the foreign currencies. And then -- and sometimes what will happen is the asset side of the balance sheet could be even more foreign currency or less so, depending on where we see the relative opportunities. We do seem to sense that in the developed markets, the U.S. set is leading. It's leading on the way up, and it feels like it may lead on the way down and that's a barometer for other central banks to move. They're looking at purchasing parity and so forth. In the emerging markets, it's a little less clear there the emerging market currency rate levels, which also mattered to us, right? Because that's where we've -- we do real servicing in those areas. We collect deposits in many of those emerging markets or higher growth markets. There tends to be a little more dependent on inflationary expectations. And then to be honest, the health of the -- and confidence in the global asset managers, investing in emerging markets, that demonstrates, I'll call it, a risk on kind of environment, and that's good for us too. And that's part of what we'd like to see was interest rates kind of settle into a rhythm is just cash come off the sidelines. That will help our asset management business, that helps our trading business because then we're facilitating the currency translation or hedging or what have you. And we still see a lot of cash on the sidelines. And in truth, the thing I'd like to see in 2024 is enough confidence. Now there's always political economic disturbances and so forth. That's probably the biggest holdback, but confidence in economic growth, because that means investors are looking around the world and taking advantage of everything State Street can do, and we can support them in that and monetize at the same time.

Sure. Coming back to the balance sheet and deposits, custody banks, Germany State Street included -- have a different deposit base than some of our regional or even the large money center banks not having obviously a consumer interest -- noninterest-bearing checking account customer. If they start or when they start cutting rates, how quickly would you envision you being able to cut your rates, meaning the deposit beta now, if you will, on the downside, how quickly should we see that take place?

Gerard, we've -- as rates rose, right, betas, where we lag rate rises in -- with clients, so we had to catch up, right? That's kind of the normal course of events. And so you had kind of a low beta to higher beta and even now, we kind of continue to have a little bit of this catch-up going on. As rates get cut, and we all saw some mix shift, right, between different pricing tiers. Our perspective and belief in plans is -- are that betas, as rates get caught, will be relatively symmetric to where they were on the upswing but symmetric by, I'll call it, currency and pricing tier. So remember, in deposits, we've got some -- we've got noninterest-bearing at least in the U.S. Then we have interest-bearing, very transactional, I'll call them, very standardized rates. Those are pretty modest where there's enormous transaction flows, and it's a way for a client to cover their overdrafts and support the balance sheet usage they take. Then there's some higher rates like money market rates or some exception rates or some initiative rates. So there are different tiers. And with sophisticated clients, we tend to have a breadth of their deposits in different tiers because that's what they serve to have, right? They have deposits for different categories of their needs. And so what we'll tend to find is that beta should actually be relatively symmetric on the way up and down within those tiers. What we don't really know is how we'll see some deposit mix across tiers or across geographies. That's -- we saw some of that. That will be the uncertainty, but I'd say relatively symmetric. And we'll see. We want to be fair with our clients, and so they've learned and we have reestablished that NII is part of the economic environment -- relationship with the client, fees matter, NII matters, client profitability. And in truth, clients want us to be a strong partner and a lasting partner, and they know we need to earn a reasonable amount so that we can continue to reinvest in our business, and that tends to be a healthy partnership.

As we finish up here, maybe one last quick question. Just on capital and what's the CCAR, we've got the scenarios. How do you view that for State Street? And then any comments on Basel III end game, what your thinking there as well?

Yes. CCAR has come out as -- you've seen you've been written about relatively in line with last year. I think the exploratory scenarios [indiscernible] has been very healthy, right? Some of that is the result of the regional bank situation and challenges that we saw last March and so you're expecting them to do that. In fact, we do a lot of that internal scenario-ing too. So we think that's a healthy way to run a financial system and are obviously filing the reports that we need to, but roughly in line. Basel III end game, as we said, if the headline number, list price for State Street is up about 15%. Brothers, it's 30%, 40%. So we're feeling -- we're not feeling unlucky. But we'll see. There are a lot of changes coming through. I think there been a lot of healthy debate down in Washington across the political spectrum, even Congress has been involved. So we expect it to be less and less price, but we'll just have to see. We originally expected something this summer. I don't know if that's on track. I don't know if they're going to do something before or after the elections. You just don't know. And -- but we're optimistic in either way, we can navigate Basel III. It's not a big deal for us. And in truth, it's -- it will actually encourage us in a couple of areas where it actually makes the risk weights more economic to kind of reinvest and support our clients even further. And so we're optimistic.

That's good. We've run out of time. Please join me in round of applause thanking Eric.