State Street Corporation (STT) Earnings Call Transcript & Summary

Thank you very much for joining us for our 10 p.m. session. We are very pleased to have with us today, Eric Aboaf, Vice Chairman and Chief Financial Officer of State Street. Thanks so much for joining us.

It's my pleasure, delighted to be here.

So I just wanted to kick off with a question on how you're thinking about the macro environment?

And do you want me to start with my disclosure?

Oh, disclosures.

Like you may have one too.

I have to go first, actually, you're right. For important disclosures, please see Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. The taking of the photographs and the use of recording devices here today in this room is also not allowed. If you have any questions, please reach out to your Morgan Stanley sales representative.

And just to remind our audience that today's discussion may contain some forward-looking statements, and those 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, and we may not update them even if our views change.

So State Street is truly a global firm operating in more than 100 markets, and as a result, you do have a very comprehensive view of the world. So I'd just like to understand what you're seeing in the macro environment that's making you more excited; on the flip side, what's adding to uncertainty as you look around the world; and how does this view on the macro backdrop inform your strategic priorities for '24 and beyond?

It's a great place to start, Betsy. I think we see more positives than negatives right now in the macroeconomic kind of environment, broadly defined. I think positives are strong equity markets continue to float upwards that creates a good tailwind for our various businesses. We see investors as cautiously optimistic. That's important because we've been through a period where they put more cash on the sidelines, they've sat waiting and watching, and that actually has more of a headwind effect on our underlying activities just based on how we perform them, whether it's in the servicing or trading areas or what have you. And then I think on the positive side, we're seeing some reasonable stability in rates, maybe a little bit of cutting in Europe, stability in the U.S. A bank like ours is relatively insulated from whether we're operating at rates at 5% or 4% or 3% or thereabouts. And I think, to be honest, what we'd like to see is a little more of a yield curve or less of an inversion, and we're seeing a little bit of that. We'll see if that plays out. And the negatives are the areas for concern, just a couple. I think we are seeing this for this time period where U.S. dollar dominance divergence is starting to play out, strong dollar or weaker foreign currencies. Does that put pressure on various pension funds or emerging markets or what have you? Does that change the international amount of trade in flows? That's kind of on our watch list. We'll, of course, continue to be vigilant on geopolitical risk those are everywhere and can crop up, and then obviously, always worry about cyber or something happening a little bit out of the blue. The net of all that, though, is that we're leaning into growth. We continue to build on our service quality and everything we've done to sharpen our support of our clients, and that helps raise or keep retention at very high levels and actually puts us in a position where we avoid more and more RFPs and RFIs than we used to. And so that's a positive. We're leaning into our Alpha proposition, our private markets propositions, new feature functionality, which is bringing in new clients towards us. And so we feel like this is a good time to continue to reinvest in the franchise and drive the next round of growth. And then finally, there are particularly strong growth areas. We see rising demand for private market servicing, probably the biggest growth area growing, we think we can grow that 15% a year. We've talked about that becoming a $1 billion business for us. As we've built out Alpha, we do that front office, which is software-oriented, the middle and the back office. We've described that as way to continue to drive growth in the franchise. And our strategic goal there is to build a software business that's $1 billion in size over the next 5 years. And so our view is this is a good time for us to continue to lean forward, and we're optimistic and seeing some real momentum.

And the $1 billion in privates that you referenced, is that also over a 5-year period?

Yes, that's right.

From what level today?

Well, it's somewhere around $450 million, just shy of $500 million, but the growth dynamics in that business, whether it's for the market -- the market is probably growing at 10% plus. We think we can grow 15% plus just given that it's a fragmented market. It's highly bespoke. It tends to be done. It's largely in-sourced still. And the provider set has a mixed set of offerings. And so the differentiation we can bring to it, the feature functionality and the sort of solid execution that we can bring, put us in a position to build that out and really distinguish ourselves and drive, I think, some real substantial growth over the coming years.

Great. I do want to ask a little bit about the balance sheet, deposits, higher for longer implications for NII, the usual suspects?

All right. Where do we start?

Let's get this out of way, right? Okay. So turning to the balance sheet. State Street saw strong deposit balances in 1Q, and that did help to improve your full year NII guide relative to the January call. And I guess I'm wondering, how are deposit balances trending this quarter? It's only a few weeks left to go. And then how is it trending in noninterest-bearing deposits? And is that -- should we expect that as a percentage of total to track down from where it is today at 12%?

Let me take each of those parts of the question, Betsy, because they both matter. We continue to see, I think, healthy levels of deposits on our balance sheet. If you remember, a few quarters ago, we were hoping to be at $200 billion to $210 billion. We've been closer to $215 million to $220 billion, over the last quarter or 2 and deposits have stabilized more or less at that area. Part of it is just the deep engagement we've been having with clients. And our view is there's different deposits. Clients put deposits with us for different reasons, usually across a stack, some for transactional reasons, some for discretionary and earnings reasons, some for liquidity. I mean there's a number of different reasons they'll leave deposits with us. And then sometimes they'll do repos, sometimes they will do money market sweeps. So there's a whole sort of what I described historically as the cash cascade. And what we found is just engaging with our clients about deposits that makes a big difference. Because they know we are there for them. They know we have a broad variety of different offerings. And that -- I think that's put us in a position where deposit balances have continued at this level of around the first quarter amounts of $219 billion, which is what we printed as the average. And as that happens, what we found is it's actually helped across the deposit stack and we have the range of different deposit levels. On noninterest bearing, we continue to see the rotation away from noninterest-bearing. It's slower than it used to be. We had periods 1.5 years ago, where we might have had when we had the peak amount of noninterest-bearing deposits was $50 billion. We had quarters when we would shed $7 billion of [indiscernible]. We had last year -- first half of last year, we were shedding $5 billion per quarter. This year, it's been slowing down. It was down about $3 billion from 4Q to 1Q. We're looking at another $2.5 million-ish, maybe $3 billion into second quarter. And I think we'll continue to see a little more erosion. That would probably take us down into the $25 billion-ish range in the second quarter thereabouts. And then we're expecting a little more erosion and then probably some stabilization in the second half of the year, somewhere above the $20 billion range, but it's just hard to call. It's just hard to call.

And that's being made up for by interest-bearing deposits?

Yes, because in truth, remember, our clients need to leave deposits with us. Those deposits are handling the trillions of transactional flows that they're running through our pipes that we're executing for them. What they don't want to do is have too much in deposits so they have cash just lying around unused, but they also don't want to overdraw their balances. And then they also have to be careful about their intraday positions and have deposit balances for there. So the deposits need to be sit someplace. And our view is as long as they sit with us and it's reasonably economic, we're quite supportive.

And is Q2 having any impact on the deposit picture here?

I think early on when the Fed started to tighten its balance sheet, we started to see an impact of Q2. But that would have been 6 to 12 months ago, maybe even more. I think once they start to reduce their overnight reverse repo operation, which effectively is like being a repo counterparty for asset managers for the clients we serve, by the way, right? So they were an intermediary competitor, so to speak, and I say that in a nice way. As they brought down that operation, they were effectively quantitative -- they were easy, right, while they were tightening their own balance sheet. So they were having offsetting effects. I think now that's probably going to continue to run down. It's my guess. So that still has a bit of an easing effect. They've slowed down their tightening. And so we've seen, I think, the last 4, 5, 6 months, more stability in total deposits in the system. And we don't see their tightening as being particularly impactful at this point. I mean, it seems like we've gotten to, I'll call it, an equilibrium when it comes to deposit and deposit levels in the system.

And then last on this point before we move to a guidance question is just on the State Street's sensitivity to hire for longer. Obviously, the forward curve has shifted a few times since Jan 1. So how should investors view State Street's NII sensitivity to higher for longer rates?

I describe us as relatively neutral. And I say that because there are a number of different measures. We describe NII sensitivity, which is over a 1-year time period. And on that basis, we're neutral in the U.S. We're slightly open to rising rates in Europe. It's a little bit of the configuration of our balance sheet and the kind of the asset and liability mix that we have in different parts of the world. But if you look over a 2- or 3-year time horizon, relatively neutral, and we like it that way. We're not trying to run a big position at the top of the house one way or the other. We found it helpful to be in this relatively neutral position. Why? Because you've got an inverted yield curve. So you can make money both on the front end and you can protect NII with some amount of maturities, but that costs you some money. So there's a bit of a mix effect going on, and so I describe it as roughly neutral over a year or 2.

Now on NII, you did raise your guidance back in April for the full year 2024. And I was wondering how is net interest income shaping up this quarter? And is there any other guidance you'd like to share for the second quarter?

So maybe it's a good time just to do the breadth of guidance, and I'll cover NII as part of that because I think it factors in a way that will make sense. I think as we said, our expectations are broadly in line with where we were in April in terms of guidance, although there are always some moving parts and let me go through them. For context at a macro level, daily average global equity markets remain strong and at this point in the quarter are roughly at our expectations back from April. Remember, they were up, they were down, they're back up. And so we're roughly in that zone. At the same time, FX volatility and spreads are somewhat more muted than what we had previously expected and specials activity and securities lending continues to be light. And at the same time, client volumes are generally a bit higher as we've seen some of that client confidence that I described. And then while the Fed continues to hold rates steady, we have seen a reduction in the pace of quantitative tightening. So that's been beneficial in deposits, but slightly. And just last week, we saw the ECB -- I was about to say, start to cut, but I think I'll say, cut once because that may be all they wrote for a bit. So anyway, a fair amount of dynamic activity, right? It's a fair amount of movement. Given these factors, we now expect 2Q fee revenues to be up more like about 1% quarter-on-quarter, which is slightly below our prior outlook of up 1.5% to 2% sequentially, primarily reflected the muted FX volatility and muted equity specials activities and levels that I mentioned just a moment ago. However, this should generally be offset by our 2Q NII coming in towards the better end of our range of down to 5% quarter-on-quarter as the deposit levels that I just mentioned have been relatively healthy quarter-to-date and more in line with the first quarter. So taken together, our revenue outlook is broadly in line with our prior expectations. Expenses are expected to come in within our previous range of up 2% to 2.5% sequentially, perhaps towards the higher end, but generally in line, still early to be sure. We're got one more month to print. And I would remind everyone that our expense outlook excludes both first quarter seasonal cost and the notable items that we have. And then, of course, with a few weeks left to go in the quarter, and we still need to see how those play out. But overall, I think we're consistent with what we said in April, back on the top line business momentum and the expense guidance as well.

Okay, great. And tax rate stays the same, 22%? Super, all right.

Yes. Just same as where we were in April.

So let's dig into some of the businesses and some of the drivers of that. Just starting off with Asset Services business clearly. A major driver here. You have yet to be installed business, right, that had been running at something like $4 trillion or hit a peak there. And now it's running at around 2.6%. At the same time, I think you've been talking about implementing a little bit more rapidly. So the yet to be installed business. Should we be expecting that, that will be implemented, maybe at a faster pace than had been the case years ago?

Yes. And the way I think about it is in a couple of ways. I think for context, $2.6 trillion at the end of second quarter to be installed and about $300 million of servicing fee revenues. So both matter, right, volumes and actually the fees. I think the background here is that, as we started to sell the Alpha proposition several years back when -- I should say, when we designed it, developed it and then started selling it, it was broad-based, as you'd expect, front office, middle office, back office. And one of the things that we've decided to do is we've sharpened it and it's become increasingly valuable, is made a commitment that we'd always bring custody in with the front-to-back offering and actually get custody converted first. Why? Because for clients, it's easier. Some of the other aspects take longer. And then for us, it's valuable because custody has very healthy margins and is attractive to our franchise. So we've shifted the way we, I'll describe sell, contract and plan our installations. Beyond that, within the core Alpha offering, which is front, middle and back, so it has breadth, depth and complexity by definition, we've done a number of things to actually speed the implementation process. First, we've actually further defined the product proposition, right? Earlier on, we were codeveloping with clients. But that's years behind us now. The proposition has been sharpened in each of its pieces. It's become more modularized so that clients can -- and we can implement different pieces at different stages more quickly. And then it's come with, I think, a sharper understanding with our clients about what we need to do and what they need to do, right? So the client agreements are that much stronger in terms of what we both need to do because they need to unwind processes and unwind systems. And we need to install processes and install systems and the harmonization of that coming together over typically a 24- to 36-month process takes some time. And then lastly, we've done what you'd expect as we've continued to build our talent and our experience base to do it smoothly and effectively. Some of that's detailed work planning, some of that's the type of people that actually can bring this together. And so that's been another piece. All told, we see that as accelerating our implementations. And that's important because you've seen us, on one hand, say we're going to accelerate implementation. We've also said we're raising our sales targets, right? Our sales targets were -- sales last year, about $300 million; servicing fee sales, we said $350 million to $400 million this year. The only way we're going to deliver on that is to not only sell more, but implement more and actually drive that positive dynamic.

So -- and is that $350 million to $400 million for 2024?

That right.

Right. So you expect some acceleration from here given that I believe 1Q was $67 million, is that right of servicing fee wins?

That's right. So there's always a little bit of seasonality. There's always a little bit of lumpiness quarter-on-quarter, but we've got good visibility into 2Q. We've got a strong pipeline as you'd expect. And even looking back at first quarter, we had a nice breadth of wins. We had a nice breadth between North America and Europe, nice breadth of asset manager wins and private market wins, right? And so we're feeling that the client coverage organization is really working well, effectively with our clients, both at the C-suite level down and then down deep into the organizations that we work with and see good momentum there.

You did mention the Custody has healthy margins, which I'm sure some listeners might have had their ears perked with that because long debate for many decades on. Hey, isn't Custody margins under pressure. So maybe, you could explain the healthy margins?

Yes. Here's what I describe is that every product we have just -- it's generally true, has a fully loaded margin and a variable contribution margin. And on average, our products coming with fully loaded margins in the high 20% to almost 30%. That's what we'd like to -- and that's part of our medium term target. What we find is some of our products are more fixed cost versus variable cost oriented. Custody, high-fixed cost product. So you sell an extra custodial product and the variable contribution is very high, and that's what I meant by that statement. Middle office processing, still manually intensive. Private markets processing, still manually intensive. They have lower variable contributions, but they still have decent fully loaded margins. And so it gets to how we're growing and where we're growing, and it's part of that kind of economic balance of trade that we want to do with clients and the way we want to price our services.

Okay. That's very clear and also nice to have scale, right? That's also help you on that.

When you're the second largest custodian globally, you have $44 trillion of assets under custody, that's where we can distinguish ourselves. And so the next 1, 2, 3, 4, 5, 6 percentage points of growth over the coming quarters can fall to the bottom line.

Separately on fees, we already talked through quite a few of the drivers there. I'm wondering how is the limitation of T+1 settlement in the U.S. equity market impacting your opportunities in your fee lines that are related to that?

Yes. I'd say -- the first part of that answer is implementing T+1 was table stakes for any custodian because this was really about helping our clients prepare for the notion that they have to trade and settle within 1 day instead of 2 days, which is a historical anachronism to be honest, and there are 2 ways to do that. One is to tighten the climb custodial bank process. The other way is just to prefund a lot of cash and end up with a bunch of overdrafts, neither of which we or clients wanted. So there's a lot of work that went through our custodial group with our clients in partnership to actually streamline their processes, become prepared for the -- that new transactional structure and all this happened over a holiday weekend as they tend to do. Canada went first, the U.S. second, and I think it was quite smooth as a result. In terms of business opportunities, I think there are really 2. One is any time you go through a tough set of circumstances declines, T+1 there was worries and you do it smoothly, you build up your reputation. And I think we were able to do that. And that will come back to help us over time, right? It's the stronger reputation means that a couple of fewer RFPs or more confidence that we should expand our share of wallet clients. The other one that is more tactical and maybe immediately remunerative is for our FX trading franchise, right? Because as a client transacts with one day, they actually -- if they're buying or selling a corporate bond or an equity in an emerging market or a foreign jurisdiction, then they actually need to transact the foreign exchange at the same time. And so part of what we did is we introduced a new service offering called Street FX that let them do that literally with T+1 in view. And that's been a nice way to get out ahead of clients and help them. It creates a little more revenue in the FX books and a net positive for the franchise.

Okay, great. I would also think there might be a little bit more outsourcing that clients choose to do with T+1. Is that part of the opportunity set?

It is. Back in February, we closed on an outsourced trading acquisition that solidified our position and offering outsourced trading. And so now we can do outsourced trading, typically for midsized asset managers, right, who are too small to run global trading desks or who wanted to run trading desks in one product that they're perhaps they are strongest in, but they don't want to do it in all of FX and equities and fixed income and equity futures and derivatives and so forth, and so we can provide that kind of offering. And as T+1 comes through, it's becoming harder and harder for them to actually deliver on what they need to do from a trading desk standpoint. So it's another driver of opportunity. Outsourced trading, we've seen the estimates of $600 million revenue market growing at 20% to 30% per year. And to us, it's about serving our clients even more broadly. In a way, State Street grew up as an outsourcer of custody of middle office or the front office order management system. Outsourced trading either for midsized asset managers is a growth opportunity or for some of the largest asset managers who know that the last 3 or 4 trading desks out of 20 that they run, right, aren't scale. And so it's become a relationship opportunity with them as well.

Okay. I'm going to turn to expenses now. Two questions. Let's start the first one, is, I believe the expense guide for this year is 2.5%. It could be a little higher if revenues punch out but that would be a good reason. And anyway, 2.5% is less than 3%, which was last year's 2023 expense growth year-on-year. And I realize that this improvement is coming from productivity savings, right? And I think you mentioned a 1.7x increase in productivity savings. So could you help us understand what's driving those productivity savings? And is there any -- what's left to harvest?

I'm thinking back, Betsy, that we started our journey on productivity back in 2019, right? And I think you had asked me about it back then. And the question we got after the year -- the first year is how you are going to do it again. And then after the second year, people ask, well, how are you going to do it again? And now we're continuing to ask. It's a good question, but I think, part of the point I'd make is that we found ways to actually tackle productivity in different ways over time. And they've really built it into our culture, into our planning process. I don't do budgets any more with what are your expenses last year and this year. My budgeting right now is, what are your inflationary events like [indiscernible]? How much are you investing? What's the size of your productivity? And then just what are your expenses likely to be for next year. So it's kind of become a part of what we've done. I think there are a couple of categories that are particularly large this year in terms of expense productivity. I think first, we've announced the consolidation of 2 of these India joint ventures. The background of that is we had split our operations between our own operations and our joint venture operations. And so that is really a catalyst to actually drive the next round of simplification and standardization that we're embarking upon, let alone taking the margin out of the JV structure. And so there's some real benefits there, and I think that's a catalyst for change. We continue to be automating and simplifying on standardizing our processes. We disclosed back in February that we've reduced our non-standard processes by 7% to 10%. We're doing that again this year. So trying to take stuff that's complex and simplifying it, makes it more efficient. And then finally, just how we deploy our resources globally. More and more of our resources are -- that are operational in nature. We're stretching the spans of control. And in operations, we described how spans are moving from 5:1 to 8:1. And part of that is really the effect of actually that process standardization and part of it is just how we appropriately resource. All that said, what we found is better processes lead to fewer errors, more standard processes, more satisfied clients. And so a lot of this is coming together, both in improving service and quality and lowering our costs over time.

And can you remind us what your tech budget is today. I think last year was just north of $2 billion?

Yes. It's grown since I originally made the statement. So it's almost $2.5 billion in size out of the $9 billion expense base that we have.

And just turning to capital. I wanted to understand how you're thinking about just excess capital utilization and how that feeds in to buyback outlook. And part of the reason -- I understand we don't have Basel III endgame and all that. So I'm not going to ask you what your excess capital dollars are at this stage. But you do have a targeted, what is it 100% payout ratio, and last year was a little higher at 200%. So as you sit here today and think about CCAR that's coming up and the earnings generation rate that you've got, how would you suggest to investors how they should think about buyback trajectory here over the course of the rest of this year?

Yes, the way we described it in our medium-term targets is returning more than 80% of earnings per year to investors, and that was what we would typically do. Last year, as you said it was multiples of that because of our excess capital position. This year, we said it'd be around 100% of earnings between the buyback and the dividend, and we've begun that process in the first quarter, but we're also managing quarter-to-quarter, right? What are the levels of RWA that we have. We have some fluctuations. We've just got to be careful with the economic and external environment. We're lean positive, but we've got some of the risks we want to be careful around, but that's -- the guidance is, as we had said it around 100% of earnings back -- as capital back to shareholders for the full year.

And when you say leaning positive, what are you referring to there?

Just the -- I think back to positive equity markets, perhaps some positive investor sentiment about putting more cash to work. We think it's a good time in general, but we've all watched geopolitics, economics, change and now we've had a whole set of elections, right, to speak of around the world, and some of those may create more stability and some of them may create more instability. And so there's always more to watch.

And then on CCAR is coming up, it looks similar to last year, year-on-year. So does it make sense to expect a flat SCB or are there things going on that we should be thinking that SCB could creep up?

For us, we've had a relatively flat SCB for the last few years, and we don't expect a lot of change. We have a fairly simple balance sheet when it comes from a CCAR standpoint. And like you said, the stress tests are roughly in line with the past, notwithstanding that there's are some experimental ones that we've also been processing as you would expect us to and the Fed will. But we're -- the SCB, we think, is roughly in line with what it's been in the past, and I'll stay in that zone.

Okay. Great. So last question. What do you see is the biggest fee opportunity outside of core custody?

I think for us, because core custody is really around the core institutional fund, collective fund, mutual fund and ETF. I think outside of that, I'd actually say there are 2. I'd say there's the administrative services around private markets, is probably the single biggest servicing opportunity that we have in front of us and that we can really distinguish ourselves with. And then the other one is to be on a software. In a way, we've redefined what the custody offering has been over the last 5 years since we bought Charles River into something that is really a mix of servicing and software and each of those can be large businesses in of themselves.

As you described earlier?

As I described earlier.

Yes. Thank you so much, Eric, for joining us today.