DBRS Comments on State Street Corporation’s 2Q12 Earnings - Sr. at AA (low)

DBRS, Inc. (DBRS) has today commented on the 2Q12 earnings of State Street Corporation (State Street or the Company). DBRS rates the Company’s Issuer & Senior Debt at AA (low) with a Stable trend.

State Street reported net income available to common shareholders of $480 million for the second quarter, up from $417 million in 1Q12, but down from $502 million in 2Q11. On an operating basis, State Street reported net income available to common shareholders of $494 million for the quarter, up from $410 million in 1Q12 and from $483 million in 2Q11. DBRS views the results as acceptable for the rating level, especially considering the difficult operating environment characterized by low interest rates, considerable economic uncertainty and risk aversion.

Operating results excluded $74 million in conduit-related accretion, a $46 million loss related to the sale of Greek securities, $37 million of acquisition and restructuring costs, and $7 million in litigation settlement costs. The linked quarter improvement in operating earnings reflected higher seasonal securities finance revenues, higher net interest revenue and lower expenses. The Company continues to win new business, adding $133 billion in new custody assets during the quarter. However, State Street experienced modest net outflows in its asset management business. Overall, assets under custody declined 3.1% to $16.4 trillion, while assets under management fell 3.6% to $1.9 trillion reflecting weaker international markets. DBRS notes that clients de-risked their investment appetites towards the end of the second quarter by moving from equities to fixed income and government funds.

The Company announced the acquisition of the hedge fund administration business of Goldman Sachs for approximately $550 million in an all-cash transaction. The business administers approximately $200 billion in single manager hedge fund assets acquisition, further establishing State Street as the market leader in servicing hedge funds. State Street expects the deal to be accretive on a cash basis in the first year of operation. The deal is expected to close in 4Q12, subject to regulatory approval. Management estimates the acquisition will negatively impact Basel I Tier 1 risk-based capital, which ended the quarter at 19.9%, by 75 to 80 basis points.

Operating revenue in 2Q12 was $2.426 billion, up 1% from $2.403 billion in 1Q12, while operating expenses of $1.728 billion were down 4% from $1.799 billion in 1Q12 resulting in positive operating leverage. Servicing fees were up a modest 1% during the quarter to $1.086 billion despite weaker international market valuations driven by net new business. However, excluding the $105 million of expenses related to the 1Q12 seasonal accounting effects of equity-based compensation for retirement-eligible employees and payroll taxes, expenses would have increased 2% resulting in modest negative operating leverage. DBRS notes that the business operations and information technology transformation program is on track to achieve an expected $94 million of annual pre-tax, run-rate operating-basis expense savings in 2012 when compared to the Company’s 2010 run rate.

Market sensitive revenues were mixed in the quarter. Specifically, foreign exchange revenues of $129 million were down 13% sequentially and 24% year-over-year reflecting lower volatility, while securities finance revenue benefited from seasonality and was up 47% to $143 million sequentially. Positively, securities finance revenues were 4% higher compared to 2Q11 benefitting from higher spreads.

Positively, net interest income, excluding discount accretion, increased 4% to $629 million during the quarter driven by a larger securities portfolio and a modest increase in the margin to 1.54% from 1.52%.

The investment portfolio increased $8 billion during the quarter to $114.4 billion. The added securities have an average yield of 1.95% with a duration of approximately 2.54 years. Overall, 89% of the securities portfolio is rated AA or higher and has a duration of 1.59 years. Moreover, 57% of the investment portfolio is invested in floating rate notes. The Company reiterated that it has no direct sovereign debt exposure to Greece, Spain, Portugal, Italy or Ireland, but does have approximately $900 million in securities from these countries. DBRS notes that State Street sold all of its Greek securities totaling $91 million for a pre-tax loss of $46 million during the quarter.

With State Street taking into account recently published proposals, Basel III capital metrics declined substantially by approximately 300 basis points each. Specifically, the Company’s Tier 1 common ratio fell to 9.8% from 12.7% as a result of the new guidance. Nonetheless, DBRS believes the Company’s strong capital generation and management mitigation will allow State Street to maintain strong capital levels, especially given the lower risk profile of the balance sheet.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents, the Federal Deposit Insurance Corporation and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Michael Driscoll
Approver: Alan G. Reid
Initial Rating Date: 11 November 2005
Most Recent Rating Update: 20 December 2011

For additional information on this rating, please refer to the linking document under Related Research.