Description

State Street

Background on custodian banks

The name custodian ‘bank’ is a little misleading as accepting deposits and making loans is a relatively small component of their business. Custodian banks are not engaged in ‘traditional’ commercial banking such as mortgage or personal lending, branch banking, operation of ATM networks etc. Rather custodian banks are often described as providing the ‘plumbing’ to the global financial industry. Custody involves the holding (and normally also administering) of securities on behalf of third parties. In the past when securities existed only in paper form, investors needed a safe place to keep these certificates of value. That safe place could either be a safe on their own premises or a bank vault.

Having the physical securities in safekeeping provided opportunities for custodian banks to provide additional services related to settlement and asset servicing. Although custodian banks’ main function today is no longer safekeeping of physical securities, the scope of their services in settlement and asset servicing remains relatively unchanged: when securities are bought or sold, the custodian takes care of the delivery, receipt and record keeping of securities against the agreed amount of cash. This process, the exchange of securities against funds, is commonly called ‘settlement’.

The holding of securities in an investor’s portfolio attracts benefits, rights and obligations; the services provided by the custodian to ensure the investor receives that to which they are entitled are commonly called ‘asset services’. These services usually fall into several broad categories: collection of dividends and interest; corporate actions such as rights issues, re-denominations or corporate reorganisations; payment and/or reclaim of tax; voting at shareholders’ meetings by proxy.

Typical clients of custodian banks include mutual funds, pension funds, endowments, insurance companies and hedge funds.

Custodian banks have developed economies of scale to provide services to their customers at a lower price and with fewer errors than customers can do it themselves. These economies of scale and replication of processes across clients have further widened the scope of services that custodians are able to offer more economically than if the clients were to do it themselves. Over the past decade custodian banks have increased the scope of services they offer to include outsourced ‘middle office’ functions in addition to the more traditional services discussed above. Middle office functions include trade matching, trade processing and the set-up and operation of data warehouses to enable customised reporting for clients.

The two largest players in the industry are Bank of New York Mellon and State Street which each have approximately USD28 Trillion of assets under custody and administration. Combined they have ~40-50% market share of total global assets under custody. Other major players include JP Morgan, Citigroup, Northern Trust, BBH and BNP Paribas.

At first glance, the custodian banks looked interesting given the share of revenue they generate from predictable recurring fee income and what we suspected were ‘sticky’ customer relationships. Also given the fact that we operate in the same ecosystem as the custodian banks, we had many industry contacts that we could reach out to and conduct primary ‘scuttlebutt’ research by talking directly to customers and competitors. When we did this, we received a very consistent message about the competitive landscape and underlying economics of the industry.

Competitive landscape

The majority of industry participants that we spoke to agreed that the competitors can be split between a top tier which includes State Street, BNY Mellon and Northern Trust and a second tier including JP Morgan, Citigroup and BNP Paribas with a number of smaller players operating in niche areas or regional markets.

It also quickly became clear that State Street is considered the gold standard in the industry by both competitors and customers. Several people commented that the saying “No one ever got fired for buying IBM” would be equally applicable for State Street in the asset servicing industry.

Moat

Speaking to customers confirmed our hunch that there does indeed exist a very ‘sticky’ relationship between a custodian and its client. This is a consequence of the unfavourable risk vs. reward trade-off to switching custodian provider. Clients must weigh the effort required and potential for operational and reputation damage.

Custodian and asset servicing fees typically range from single digit to mid-teens basis point fees on assets under custody and administration (depending on the size of assets under management and services offered). Customers stated to us that they would need a reduction of at least 2-3bps in fees for them to consider switching. This means that competitors need to offer price reductions of over 20% to entice clients to switch.

We also began to appreciate that State Street has a significant scale advantage in the provision of outsourced middle office services. State Street provides higher value added middle office services on US$11 Trillion of the US$28 Trillion of assets it has under custody and administration. This is more than five times its nearest competitors in this specific segment of the market. There is evidence that State Street’s relative market share of 4-5x versus its competitors is generating a cost advantage via the leveraging of fixed investments made in technology (State Street invests ~10% of revenue each year back into technology) and movement down the experience curve. Competitors have admitted to struggling to compete profitably in this segment of the market with several looking at potentially exiting the business.

Valuation

The company currently trades on a price to consensus 2018 estimated earnings multiple of 11x. At this price we believe the market is undervaluing the business given the relative predictability of cash flows, the prospects for future growth and the potential for higher returns on its investment portfolio discussed below.

If the company is able to maintain its current market share, which we believe is an extremely plausible scenario given its entrenched position, its revenues should be correlated with the growth of financial markets over time. This is because a proportion of the fees and income it earns are linked to the size of assets its clients have under management and the value of financial securities on its own balance sheet. If the company is able to grow in line with markets over the long term while earning over 20% on tangible equity it looks to be extremely attractive from a valuation perspective. 

The company should also benefit from any increasing interest rates as it will be able to earn a higher return on the loan and high-grade investment securities portfolio of ~US$200Bn it has sitting on its balance sheet (predominantly financed by low cost deposits, sometimes at zero or even negative interest rates, from its asset servicing clients).

Bear case

1. One of the concerns we often came across is the correlation between profitability and global market levels. This is because approximately ~50% of State Street’s revenue is generated by charging a percentage fee on the assets it has under custody and administration. There is a fear that, if there was to be a market crash, profitability would be severely impacted. However, the company has estimated that a 10% decline in global equity markets would only result in a 2% decline in total revenues. This is because the company also has other annuity service type revenue streams such as tax reporting and business analytics that are impacted less by short-term market fluctuations. Furthermore only ~55% of assets under custody are equity versus less volatile fixed income and cash securities.

2. The general pressure in the industry for asset managers to reduce fees is raising fears that this pricing pressure will be passed on down through the value chain to the asset manager’s suppliers, including the custodian banks. However, we think the custodian banks may, on the contrary, be entering a period of more ‘rational’ pricing. In recent years, competitors to State Street have been pricing aggressively to try and win middle office servicing business. However, from our discussions with competitors, they are starting to discover that some of these contracts were mispriced and are struggling to breakeven on them. There is evidence now that they are pricing less aggressively and are being more selective regarding the business they are willing to take on.

3. In addition to its custodian and asset servicing business, State Street is the 3rd largest money manager in the world behind Blackrock and Vanguard managing US$2.25 Trillion of assets. The vast majority of these assets are managed on a passive basis with low costs being the key selling point. There is a concern that State Street is growing assets under management slower than its competitors Blackrock and Vanguard as they lower prices on their products.

It is certainly true that State Street’s asset management business is poorer quality than its main custodian and asset servicing business. However, it is a relatively small part of the company’s overall business with it only contributing ~10% to total revenues.

4. In January 2009 the company’s share price collapsed 60% when it was forced to consolidate previously off-balance sheet commercial paper programmes. These off-balance sheet vehicles were initially set-up as a way for its mutual fund clients to invest excess cash they had overnight in high quality longer duration securities. The securities its clients invested in lost 30% on a mark to market basis during the financial crisis. State Street was forced to take these securities onto its own balance sheet resulting in a non-cash pre-tax charge of US$6.3Bn to the income statement. Though there was a 30% loss when valued mark to market the securities in the commercial paper funds never experienced a ‘credit event’. State Street eventually got every cent back on the dollar.

Today State Street is a very different company in that it does not have any off-balance sheet commercial paper programmes. As such we believe a repeat of 2009 is very unlikely. However, the company still operates in some businesses, such as securities lending, which have risks associated with them. We are reassured though that all of the financial market transactions it enters into, such as securities lending, are marked to market on a daily basis and have excess collateral as security against them. However, this still adds extra complexity to the business that we try to avoid when looking for investment candidates.

5. Since the financial crisis the regulatory burden on custodian banks has increased considerably. In the future custodian banks may be required to hold even more capital against their assets. We believe that this is a legitimate concern. However, we also believe there is a margin of safety against this in that the business currently earns over 20% returns on tangible equity even though it holds a significant buffer of capital above current regulatory requirements. If capital requirements were further tightened the company should still be able to earn attractive returns on incremental capital invested.

6. Even though management is highly respected in the industry the company has had a surprising number of missteps over recent years including for example the overbilling of clients, FX trading pricing issues and off-balance sheet exposures.

This does appear as a bit of paradox to us as in general we do like the company’s management as they come across as detail-oriented, conservative in nature and correctly incentivised. If it was not for this apparent discrepancy, in addition to the complexity of some of its financial market operations, we would have would have ranked State Street as one of the highest quality businesses in our portfolio. We have adjusted for these factors by reducing the maximum position size it can have in our portfolio.

7. In July of this year the company announced the $2.6bn acquisition of Charles River Development which the market responded negatively to.  We actually think the acquisition is rational from both a strategic and valuation perspective.  The acquisition will enable to company to provide an integrated back to front office offering for its clients.  The valuation multiple of 18.2x estimated 2018 operating income seems a fair price for what appears a very high-quality business with a sticky customer base especially if management is able to achieve its forecast revenue and cost synergies which would bring the multiple closer to 10-11x.

Catalyst

We have not identified a particular catalyst which will close the gap between the current share price and intrinsic value.  We believe the market will eventually come to the conclusion that the multiples it is currently trading on are too low for a company earning attractive returns on tangible equity with a long runway of growth.