state street's blue chip turnaround

7/31/2019 State Street's Blue Chip Turnaround

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21/12 Sae See' Ble Chip Tnaond, Pa 1 - Seeking Alpha

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State Street's Blue Chip Turnaround, Part 1

March 20, 2012by: Saibus Research

about: STT

This is the first part of a three part series on State Street Corporation (STT). The three parts are broken down as: 1)Recommendation and Overview, 2) Valuation Analysis, and 3) Risks and Outlook.

Recommendation

We are maintaining our Strong Buy recommendation on State Street Corp. common stock and increasing our FairValue share price estimate to $54.63, approximately 19.5% above current levels and about 30% above the pricewhere we first recommended it in January. We expect to see the company generate earnings per share of $4.24 in2012 and to increase EPS by 8-11% annually over the following three years.

We recommend STT to aggressive investors who are interested in a potential corporate reorganization, turnaroundand special situations restructuring as well as conservative investors interested in high-quality blue-chip companieswith a wide economic moat and an exceptional business operations franchise.

We have raised our Fair Value Share price estimate after the company announced that it passed the Federal ReserveStress Tests, that it will boost quarterly dividends 33% (From $.18/share to $.24/share, representing a 2.2% yield)and repurchase $1.8B of stock (representing about 8% of the outstanding shares).

Compan Overview

State Street Corp is the holding company for State Street Bank and Trust (world's second largest custody bankinginstitution) and subsidiaries. The bank provides institutional asset administration and servicing through its StateStreet Global Services division, investment research and trading services through State Street Global Markets, andinstitutional asset management solutions through State Street Global Advisors.

Management: The current CEO and President, Joseph (Jay) Hooley has been Chairman and CEO since 2010,succeeding Ronald Logue, and has been with the company since 1986. He was name the head of the bank's globalinvestment servicing business and played a leading role in the acquisition of Deutsche Bank's Securities business in2003 and Investors Financial Services Corporation in 2007.

Ownership: While executives and board members own less than one percent of the stock, we note that the outgoingCEO owned $52M worth of stock and Jay Hooley, the new CEO has $25M worth of stock, which shows that it has avested and personally material economic interest in the company. All current directors and executives collectivelyown $153M worth of stock, including $113M directly.

Before State Street released its Q3 financial results, Nelson Peltz of Trian Fund Management L.P issued a pressrelease announcing that it owned 3.3% of STT's outstanding shares and that a letter was sent to STT's Board ofDirectors setting forth its assessment as to why State Street has underperformed and delivered negative shareholderreturns over the last 1 to 10 year periods, as well as time periods in between. Trian also issued a Detailed ActionPlan White Paperidentifying operational and strategic initiatives that State Street should undertake in order toimprove operating performance and unlock shareholder value.

While State Street has not directly responded to Mr. Peltz's program, we believe that the $200M in share


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repurchases in the fourth quarter of 2011 plus the 33% increase in dividends and the new $1.8M repurchase programrecently announced will satisfy Mr. Peltz. Already, the company has seen a total return of over 30% since Peltz wentpublic with his concerns back in October 2011.

Summar of Observations

The company's net interest margin of 1.40% for the Q4 2011 period is low relative to the industry average. However,this was slightly higher than its direct competition in the investor services industry (BNY Mellon (BK) 1.27% andNorthern Trust (NTRS) 1.28%). STT's net interest margin and revenue declined due to a flatter interest rate curve,which was partially offset by higher deposit volumes resulting in a greater volume of investable assets, which we

noticed throughout the financial services sector.

STT uses its net interest revenue in conjunction with its asset management and investment services businesses,enabling them to offer lower direct fees to clients in exchange for compensating client deposit balances. State Streethas a strong capital position and we believe that it has already met the potential capital increase requirements of theFederal Reserve under Dodd-Frank as well as the BASEL III agreements. With a Tier 1 common capital ratio of16.9%, it significantly exceed the BASEL III requirements assuming its final capital requirements are 9.5%, which isthe worst case scenario that has been proposed for large systematically important banks.

We read Peltz's White Paper and we agree with much of what he had to say. State Street has made a number ofdilutive acquisitions in the past and because of the $9.5 Billion losses associated with the asset backed conduitsecurities programs and reimbursements of asset management clients; it was forced to make a dilutive issuance of

shares in 2009 to shore up capital pursuant to Federal Reserve requirements in the aftermath of the financial crisis. Inour professional opinion, we believe that STT suffered a first degree burn while other banks suffered second to fourthdegree burns or demise during the financial crisis.

However, because STT was treated like other banks by regulators, it made a number of notable and unforcedoperating errors as well as a forced dilutive share issuance to exit the TARP program. It cut its dividend to $.01 perquarter and were refrained from buying back stock. This certainly helped contribute to State Street seeing a decline inits PE ratio from about 20 times trailing earnings in 2008 (18X historical median PE) to about 8 times trailing earningson October 2011, before rebounding to under 11.

An increase to 13.5 would contribute to an increase of about 28.4% in shareholder value, which would be in line withcomparable large asset management firms. We believe that though STT's primary subsidiary is a chartered bank, thenature of what it does makes it most closely reflected to other asset managers, as it is a wholesale bank providingasset management and administration fees and it generates 77% of its revenues from these fee-based operations andsold off its commercial banking operations in 1999 in order to focus on these businesses.

We believe what provides them a wide economic moat is its scale and market leadership in the asset managementand administration industry.

Consider the following markets in which State Street and its subsidiaries are a Market Leader:


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We also believe that the firm can achieve operating leverage improvements. In 2011, its Non-Interest Expenses

represented 74% of net revenue and 98% of fees. We are expecting that Non-Interest Expenses will grow at 10%annually for the period, which is less than the 12% growth we expect for fee based revenue streams.

We expect that Non-Interest Expenses will be 91% of Revenues, allowing for the company to preserve its operatingmargins in case Net Interest Income does not improve and to steadily expand operating margins with Net InterestIncome improvements. We look for the bank to steadily reduce Non-Interest Expenses as a percentage of fees whileensuring that the firm maintains and expands its strategic investments in its businesses.

In 2010, STT invested in technological upgrades to drive its operating efficiencies through improved data analysis andautomation of manual operating processes. Its operating margin of 26% in 2011 was amongst the lowest in the assetmanagement industry and Trian suggested that it set a target of 35% for the Investment Servicing Segments and 39%for State Street Global Advisors and limit expense growth relative to revenue growth was the basis for its over 100%

increase in estimated EPS for the company for the five year period ending in 2015.

One area of expense improvement that we believe is achievable is in its real estate facilities expenses. In its homestate of Massachusetts , it operates out of nine facilit ies, six of them are in ultra-expense Downtown Boston and theBack Bay Neighborhood and the other three are in Quincy, a smaller city southeast of Boston. Only two of theselocations have front-office business units like State Street Global Advisors or Global Markets; the rest haveoperations and business unit staff personnel for State Street Global Services asset servicing division. We believe thatit would be prudent for State Street to move some of these team members from Boston to its Quincy offices in orderto reduce occupancy expenses as these leases expire.

Disclosure: I am long STT. Saibus Research has not received compensation directly or indirectly for expressing therecommendation in this report.

Disclaimer: Under no circumstances must this report be considered an offer to buy, sell, subscribe for or tradesecurities or other instruments.


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about: STT

This is the second part of a three part series on State Street Corporation (STT). The three parts are broken down as:1) Recommendation and Overview, 2) Valuation Analysis, and 3) Risks and Outlook.

Valuation and Projections

Our $54.63 value is based on applying a 14 times price to earnings multiple to estimated 2015 earnings per share of$5.54 and discounting the terminal value back to 2012 at a cost of capital of 11%. We raised our forward estimatesand projected PE ratio after STT announced that it passed the stress test and boosted its dividend and sharerepurchase programs.

Although STT's forward PE, P/B and Price to Tangible Book ratios are higher than the average banking institution, webelieve it is justified due to its superior franchise and strong and growing presence in fee-based businesses,particularly asset management and asset servicing. Also we noticed that it is t rading below similar assetmanagement companies, even though it is the second largest asset manager in the world and we believe that themultiple used is justified considering that the firm has grown faster than its industry and traded at a multiple of nearly20 times trailing earnings before the 2007-2009 financial crisis.

Currently, asset management firms are trading at a forward PE ratio of 18. Furthermore, in his White Paper on StateStreet, Nelson Peltz suggested that STT's PE Ratio could reach 13.5 times price to earnings multiple for 2015 if itundertook his action plan. Based on his proposed initiatives, State Street could potentially earn $7.35/share in 2015,which would result in a value of $99 per share.

Click o enlage.


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Soce: Saib Reeach foeca

We believe that the company will continue to grow its fee-based revenues faster than its net interest income. In ourmodel we estimated that STT would see a 12% annual growth in its fee based revenues from 2012-2015, based onadding new investment management and administration mandates, market appreciation of assets overseen andpotential bolt-on acquisitions of smaller firms or acquiring the asset management or securities services divisions ofEuropean banks.

We estimated that the firm would be able to generate an increase in Net Interest Income of 1% because we feel thefirm will maintain its high emphasis on short-term, high quality investment securities for its balance sheet and thatwhile interest rate spreads will improve, that interest rates will be low for an extended period of time due to centralbank interventions. The key driver of revenue and profitability for STT is its fee-based services and solutions business,Net Interest Income represents less than 25% of revenue, unlike traditional banks.

We also believe that the firm's Information Technology and business operations transformation program should ensurea slower growth in non-interest expenses (10% annually) versus fee revenue growth, which will mitigate the impact ofslow growth in Net Interest Income and when the yield curve normalizes, allow a greater percentage of revenue to fallto the bottom line to reward shareholders and bolster its balance sheet instead of being utilized to hire newemployees or buy new (in)tangible assets.

The bank announced that it will increase its 2012 dividends by 33%, and we estimated that it will increase dividendsby 12.5% annually in the following three years and the steady repurchase of about 1% of its shares annually. Wealso assumed that loan loss provisions, gains on sale of debt securities and impairments would have an immaterialimpact on the bank's net income and offset each other.

Kes to Investment Thesis


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We like that the firm has a ver low risk balance sheet. 89% of the bank's investments are in AAA or AA issuers.Furthermore, it has 59% of its assets are in floating rate securities, which minimizes the risk of rising interest rates.Non U.S. investments only account for 23% of investment securities and only 6% of those assets are in weakerEuropean Countries (Italy, Spain, Ireland, Greece, Belgium and Portugal).

Nelson Pelt's shareholder activism. Though our EPS estimates are a little more conservative than Trian FundManagement's, we appreciate Peltz's analysis and evaluation of STT's underperformance. We were shareholders ofInvestors Financial Services, who State Street acquired in 2007. We were pleased that State Street seemed tonavigate the crisis better than traditional banks, though we have been disappointed with operational missteps with itsconduits and asset management activities and recurring charges of an ostensibly non-recurring nature. We believethat Peltz's activism is just what the doctor ordered in order to force STT to refocus its efforts on organic operationsgrowth, profitability and rewarding long-suffering shareholders.

State Street paid off the TARP preferred stock as soon as it was permitted to do so. In 2008, State Street wasone of 19 large, systematically important banking institutions who were required to take a preferred stock capitalinjection from the US Treasury Department under the Troubled Asset Relief Program. It was required to accept a $2Billion preferred stock investment in 2008 and received permission to pay it back in June 2009. It also spent $60M tobuy back warrants issued to the government injunction with the TARP investment in State Street.

Like its trust bank competitors, Bank of New York Mellon (BK) and Northern Trust (NTRS), State Street did not reallywant the TARP money in the first place, especially considering that STT invested in short-duration high gradeinvestment securities for its Asset/Liability Management proprietary account and could easily handle the losses

associated with those assets versus commercial loans and subprime mortgages of over banks like RBS CitizensBank, who bought STT's commercial banking business in 1999 and needed a bailout from the British Government.

State Street Global Advisors has $1.866 Trillion AUM. With $1.866 Trillion in AUM, SSgA is the world's secondlargest asset management institution and it nearly exceeds the collective $1.9 Trillion in AUM from its two closestcompetitors in the trust banking sector (BK and NTRS). SSgA is the second largest ETF provider with nearly $247Billion in ETF assets under management and distribution and the second largest passive index manager with $1.33Trillion. Another $400 Billion is in Cash, Money Market and Liquidity Strategies and the remainder are in activelymanaged strategies.

SSgA introduced the first Exchange Traded Fund, the Standard & Poor's Depository Receipts S&P 500 ETF, whichtracked the S&P 500 Index and traded on the American Stock Exchange under the ticker symbol SPY. It has grown

to be the largest individual Exchange Traded Fund with nearly $97 billion in assets under management. SSgA is alsothe distribution agent for the SPDR GLD Shares, which is the largest and most liquid physical gold backed offering inthe financial marketplace. It acquired the Bank of Ireland's Asset Management division, which added $23 Billion in

AUM and added 32 new ETF strategies in 2011.

The Dodd-Frank Wall Street reform law will not hurt STT as much as other banks. In September, State Streetannounced the launch of its swaps clearing platform, enhancing its comprehensive derivatives solution that includesservicing, custody, accounting, risk, analytics, valuation and collateral management, as one of the requirements ofthat law is for swap contracts that are currently traded over the counter to migrate to a centrally cleared counterparty.The new regulations impose collateral and real-time reporting requirements designed to reduce counterparty risk.Plus, State Street has typically had higher levels of capital in spite of its low-risk balance sheet and fee-basedbusiness model and did not participate in the proprietary trading or consumer lending activities covered by Dodd-Frank.

We also like STT's position in the asset servicing segment. State Street Global Services is the second largestglobal custodian bank, with $21.8 Trillion in assets under custody and administration, an increase of 1.3% in thecomparable period. We like the fact that there are maybe one or two dozen companies that have significant scale inthe asset servicing segment and many of them have been acquired by other firms. We also believe that assetmanagement and servicing specialists like State Street offer better execution and a stronger service commitmentthan financial conglomerates like Citigroup or JPMorgan Chase.

It earned a new investment manager operations outsourcing mandate from AllianceBernstein for more than $360Billion in assets. PIMCO renewed its manager operations outsourcing mandate representing $1.3 Trillion in assets.40% of its new service mandates won in 2011 came from non-US clients, which shows that its efforts to expandglobally are yielding new contracts. It added 38 new alternative asset mandates and its alternative assets serviced


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increased by $23 Billion during the Q4 Period.




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about: STT

This is the third part of a three part series on State Street Corporation (STT). The three parts are broken down as: 1)Recommendation and Overview, 2) Valuation Analysis, and 3) Risks and Outlook.

Click o enlage.

Risks to Achieving $54.63 Common Stock Fair Value Target Price

Soce: Saib Reeach foeca.

Financial Health

State Street has a strong balance sheet. It has over $201 billion of cash and other investment security assets, whichrepresents 93% of its balance sheet assets. It has a solid stockholder equity capital base ($19.4 billion). It hasgenerated about 10% annualized return on equity YTD and restored its dividend to $.72/share annualized in 2011 and$.96 in 2012, which is equal to what it was before the crisis hit.

We are also pleased that it generated over $1.8 Billion in adjusted free cash flows (Net Income plus Depreciation andEquity Compensation minus Deferred Tax Benefits, Net Capital Expenditures and Cash paid for Acquisitions), whichwas 90% of its Net Income, which shows that it is able to convert net income to free cash flows which it can use tobenefit shareholders and reinvest in its business to generate incremental returns.

Also, it returned nearly $950 million in cash to shareholders in the form of dividends and share repurchases, whichshows a prudent balance between building capital for future use and providing an immediate reward to shareholders.We are also pleased by its profit margins which were nearly 20% in 2011, despite the fact that it was facing a weakerinterest rate environment. STT announced a significantly higher dividend increase and share repurchase programversus Bank of New York Mellon (BK) and Northern Trust (NTRS), who also offered plans to return capital toshareholders.

Banking and Asset Management Industr Outlook

We expect the banking and diversified financial services industries to continue to consolidate, as weaker banks andnon-bank institutions either get seized by the government or sell out to stronger banks. Overall credit losses areexpected to have reached its zenith in Q2 2010 and to decline for the rest of the year and in 2011, which will strongly


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lift bank earnings. However we are concerned that the European debt crisis will serve as an economic headwind aswell as potentially impact balance sheets of banks and other financial institutions.

However the banking industry has been facing declines in loans and total assets as banks attempted to mitigate thedamage from the recession and credit crunch by letting its loan and security portfolios runoff while reducing theamount of new credit it extended in order to improve its capital ratios as well as to build its loan loss reserves. Weexpect loan and total asset balances for the industry to remain either stagnant or declining in 2011 and into futureyears, until there is more certainty with regards to an economic pickup and also greater regulatory clarity. We feelthat banks that derive a large proportion of its revenues from asset management, administration, and other fee-basedbusinesses other than those impacted by Dodd-Frank will outperform its peers in the industry.

We are noticing a bifurcation of the asset management between boutique firms that can add value through activemanagement and large quantitative-style low-cost index driven passive managers. We are seeing consolidation of the"middle class" of asset managers globally and the remaining firms are typically pure play firms, who have theadvantage of no longer being trapped under the bureaucracy of a commercial bank, brokerage or insurance institution.

State Street is the second largest ETF provider with nearly $247 Billion in ETF assets under management anddistribution and the second largest passive index manager with $1.33 Trillion index assets under management and webelieve that it can either acquire other passive managers or small, innovative asset management boutiques through itsState Street Global Alliance joint venture with APG, a Dutch Pension Fund. This joint venture currently has a majorityinterest in five managers who oversee nearly $19B in assets under management and are involved in private equity(Shott Capital), real estate (Tuckerman), healthcare sector specialties (Sectoral), emerging markets (Rexiter) and

absolute return multi-asset class strategies (SSARIS).

We have noticed the demand for Global Assets Growing Faster than US Assets. With more than 50% of the globalmarket capitalization represented by non-U.S. companies, U.S. investors are increasingly looking to diversify itsassets through non-U.S. investments. We believe U.S. investors are under-allocated in global equities relative toglobal benchmarks, particularly in the defined contribution channel, with only 7% of defined contribution assetsinvested in non-U.S. equities. In response to increased demand, Cerulli Associates indicates that 65% of managersare allocating over 30% of new products to international strategies and 47% are allocating over 70% of new productsto international strategies. According to the Investment Company Institute, flows to foreign stock funds increasedmore than 210% in 2010 relative to 2009.

Demand by U.S. investors for life cycle funds has been driven by investors' desire to diversify its investments across

various asset classes as well as to automatically shift to less risky asset classes as these investors near or enterretirement. Cerulli Associates estimates assets in life cycle funds will increase by 40% per year from 2009 through2015. As part of the Pension Protection Act of 2006, target-date funds have become a default option of 401(k) plansthat have an automatic enrollment feature subject to safe harbor protections for plan sponsors.

A study by Hewitt Associates and Financial Engines found that participants that receive help in the form ofprofessionally-managed target-date funds, managed accounts or online advice achieve better returns than participantsthat do not receive help. As a result of the Pension Protection Act of 2006 and subsequent U.S. Department of Laborguidelines, plan sponsors are now actively seeking automatic retirement savings solutions for its employees. Underthe Pension Protection Act of 2006, employers who automatically enroll its employees in what are known asQualified Default Investment Alternatives, or QDIAs, are safeguarded from fiduciary and legal risk if it adheres tocertain regulatory guidelines.

Increased Risk Management Interest based on a reaction to 2008 and 2009 crisis. Following the credit crisis andglobal bear market that began in 2008 and early 2009, investors and financial advisors have become increasinglyinterested in absolute return strategies, or strategies that seek positive returns over full market cycles. A 2010 surveyof financial advisors and brokers by Putnam Investments states that 59% of advisors were likely to recommendabsolute return strategies to its clients. The study states that advisors generally see the benefits of absolute returnstrategies as minimizing portfolio volatility and serving as an asset class diversification strategy.

We believe our active and unconstrained investment approach within our blended asset class portfolios is well suitedto meet the demand for absolute return strategies using traditional asset classes and is likely to be less expensivethan alternative investment-based strategies with similar absolute return goals. Industry consultant Casey, Quirk &

Associates predicts that over the next 10 years, managers will increasingly be paid for investment solutions asopposed to investment products, and Pensions and Investments notes that top money management firms are starting


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ekingalpha com/aicle/447051 ae ee ble chip naond pa 3

to strengthen its solutions units in an effort to provide highly customized investment solutions for its clients, with agoal of forming strategic partnerships, and, as a result, stronger relationships with clients.

Overall, we feel the industries are fairly valued, however we would use declines in the market to add to positions inhigh quality banks and asset managers like State Street and gains in the market to sell weaker banks and assetmanagers.



state street's blue chip turnaround

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