DBRS Comments on State Street Corporation’s 3Q12 Earnings - Sr. at AA (low)

DBRS, Inc. (DBRS) has today commented on the 3Q12 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 $654 million for the third quarter, up from $480 million in 2Q12 and from $543 million in 3Q11. On an operating basis, State Street reported net income available to common shareholders of $473 million for the quarter, down from $494 million in 2Q12, but largely flat from $476 million in 3Q11. The quarter was highlighted by positive operating leverage and solid net new business wins in both the custody and asset management businesses, but market-sensitive revenues remain weak. Benefitting from higher market valuations and the net new business wins, assets under custody and administration increased by 4.5% to $23.4 trillion, while assets under management grew 8.2% to $2.065 trillion.

In addition to $40 million of discount accretion and $28 million of acquisition costs and restructuring charges, reported results included a net pre-tax benefit of $277 million that was excluded from operating earnings. The benefit was composed of a $362 million benefit related to claims associated with the Lehman Brothers bankruptcy, a $60 million provision for previously disclosed litigation related to securities lending and asset management, and a $25 million charitable contribution.

New asset servicing mandates totaled $211 billion (of which $125.2 billion has yet to be installed) including 32 new alternative asset servicing mandates, which does not include the Goldman Sachs Administration Services business (closed in 4Q12). Including the recent acquisition, State Street now services over $1 trillion in total alternative assets, an asset class which has been growing at a faster rate than traditional asset classes. After meeting with most of the newly acquired clients, management indicated that they were confident in achieving their 90% client retention target. Meanwhile, SSgA added $78 billion of net new assets. Moreover, the pipelines for both asset servicing and management remain strong across asset classes and geographies.

State Street was able to deliver positive operating leverage primarily from strong expense controls, as the Company continues to make progress with its Business Operations and Information Technology Transformation Program, which remains on track to achieve annual pre-tax operating-basis expense savings of at least $90 million. Specifically, operating revenues of $2.3 billion declined by 3.2%, while operating expenses declined by 3.7% resulting in 50 basis points of positive operating leverage. State Street commented that it has had good success in clients accepting fee increases, but the Company is primarily focused on improving profitability by cross-selling additional products. Given the weak revenue environment, DBRS notes that State Street’s targeted 39.2% compensation and employee benefit to operating-basis revenue ratio for 2012 will be difficult to achieve.

Net interest revenues (FTE, but excluding conduit-related discount accretion) totaled $611 million, a decline of $18 million, or 2.9%, compared to 2Q12, as average earning asset growth was more than offset by margin pressure. Specifically, the net interest margin contracted ten basis points during the quarter to 1.44% with asset yields continuing to decline more rapidly than funding costs.

Market-driven revenues remain pressured from risk aversion among market participants, low interest rates, and weak trading activity. Indeed, trading services revenues, which includes foreign exchange trading and brokerage and other fees declined 9% to $232 million. Foreign exchange trading declined an even more pronounced 10.9% sequentially and 43.6% year-over-year reflecting lower volatility even with higher volumes. Meanwhile, securities finance revenue decreased $52 million, or 36.4%, sequentially reflecting the strong seasonal results from the international dividend season in 2Q12.

The $115 billion securities portfolio had an unrealized after-tax gain of $577 million, up considerably from a small loss in 2Q12. DBRS notes that approximately 88% of the securities are rated AA or AAA. Moreover, the portfolio’s duration remains conservative at 1.52 years and the duration gap is 0.28 years. Net gains from sales of available-for-sale securities were $18 million and included $6 million of other-than-temporary impairment charges.

Capital metrics remain strong even with the repurchase of $480 million of common stock leaving $840 million remaining under the Company’s $1.8 billion program, which should be completed by the end of 1Q13. Indeed, State Street’s tier 1 common ratio was relatively stable at 17.8%, while its tangible common equity ratio improved 40 basis points to 7.6% benefiting from the improved mark in the securities portfolio. The Company estimated a tier 1 common ratio under Basel III guidelines of 11.3%.

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: Roger Lister
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.