DBRS: BNY Mellon 2Q14 Earnings Hurt by Non-core Items; Delivers Adjusted Positive Operating Leverage

Summary:
• Reported lower net income applicable to common shareholders of $554 million, but excluding non-core items, earnings would have been higher at $715 million.
• Company has taken additional actions to better align expenses with the difficult revenue environment.
• DBRS rates the Bank of New York Mellon Corp. Issuer & Senior Debt at AA (low) with a Stable trend.

DBRS, Inc. (DBRS) views the Bank of New York Mellon Corporation’s (BNY Mellon or the Company) 2Q14 results as mixed. Importantly, on an adjusted core basis, the Company was able to generate positive operating leverage both quarter-over-quarter (QoQ) and year-over-year (YoY), while assets under management (AUM) reached record levels. Moreover, BNY Mellon announced new steps to realize additional cost savings going forward to better align expenses with the difficult operating environment and improve returns. Conversely, the loss of a few major custody clients over the past year has slowed servicing fee growth relative to the other trust banks, and Investment Management experienced net outflows this quarter primarily driven by one liability-driven investments client taking their money in-house. DBRS notes that with the most recent expense initiatives, the Company believes it can get back above its 10% return on equity target without higher interest rates.

During the quarter, the Company announced a $122 million severance charge and a $109 million charge related to potential tax liabilities from certain off-shore funds, which first surfaced in 1Q13. In aggregate, these items resulted in an after-tax loss of $161 million.

Adjusted revenues were down YoY, but adjusted expenses declined even more resulting in positive operating leverage. Sequentially, adjusted revenues were higher, while adjusted expenses declined with management remaining highly focused on aggressively managing expenses. Most fee-based business showed decent growth, especially investment management and performance fees. Securities lending benefitted from seasonality sequentially, but was down from 2Q13. Meanwhile, foreign exchange revenue was pressured from lower volatility despite higher volumes both QoQ and YoY. Lastly, net interest revenue was down sequentially driven by a seven bps decline in the net interest margin, but the Company expects to be able to maintain net interest revenue going forward.

Overall, BNY Mellon’s assets under custody and/or administration and AUM increased a modest 2.2% and 1.0%, respectively, from 1Q14. While growth rates have trailed its trust bank peers, DBRS notes that BNY Mellon’s asset mix is less sensitive to the equity markets, especially U.S. equities, which have performed the best over the past year.

The balance sheet remains strong and supportive of the rating including robust liquidity, sound asset quality, and strong risk-based capital. While the Company’s fully phased in Basel III tier 1 common equity ratio under the advanced approach declined to 10.0%, the decline was entirely attributable to an increase in risk-weighted assets from certain consolidated investment funds, and the harsher treatment could be temporary in nature. Management also noted that the supplementary leverage ratio was stable at approximately 4.7% even with a larger balance sheet.

Positively, DBRS notes that with the sale of the Company’s equity investment in Wing Hang, as well as the pending sale of its corporate headquarters, BNY Mellon expects to report an aggregate after-tax gain of approximately $520 million in 3Q14, which will allow the Company to pay down debt and continue returning capital to shareholders.

DBRS rates the Company’s Issuer & Senior Debt at AA (low) with a Stable trend.

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