Summary
- STT reported better than expected earnings, but there was weakness underneath results alongside disappointing guidance.
- Negative fund flows and lower transaction volume will lead to a sequential drop in fee revenue.
- Lower interest rates will take out nearly $0.50 in annual EPS.
- STT faces earnings at or below $6 in secularly challenged businesses, leaving no apparent catalyst for shares to rally.
Shares of State Street (STT) fell by over 4% on Friday as investors digested the company’s earnings release, despite a strong earnings beat in the second quarter. While the company has done an impressive job in controlling costs, which is supporting profitability, earnings face significant pressure, some within and some outside of management’s control. The Q2 earnings release may have helped crystallize those challenges for investors and sparked the sell-off.
While shares may appear cheap, the company faces sustained earnings pressure given low interest rates and headwinds on its fee-based revenue. With these pressures unlikely to abate for years, there is downside risk to its earnings capacity, which will weigh on shares. Aside from collecting a well-supported dividend, there is little reason to own shares of STT. Lower interest rates have provided a substantial and immediate shock lower in the company's earnings power. Fee pressure and a low-rate of new client wins pose a longer-term challenge to the company that opens the door to steadily eroding earnings over the next several years. That is a negative combination for the stock.
In the second quarter, EPS of $1.86 was up 31% year over year and $0.28 ahead of consensus. Fee revenue of $2.4 billion (up 5%) offset a 9% drop in net interest income to $559 million. Critically, the company pushed expenses down 3% with compensation down 3%, which helped to boost pre-tax profit margins to 27.3%, up 2.3%. State Street essentially operates two business units, an investment management arm, and an investment custody arm providing custody and trust services. It is best to look at them separately.
The investment management arms service institutional clients under its banner, State Street Global Advisors, and it also has a large ETF business, most notably, the SPDR funds, like the S&P 500 ETF (SPY). At first glance, it seems encouraging that assets under management (AUM) rose from $2.7 trillion last quarter to $3.05 trillion this quarter. That is also up about 4% year over year. However, there are several troubling development under the hood.
One aspect asset managers cannot control is overall market performance. When markets rally, AUM goes higher, even if there are no inflows, and vice versa. The severe market moves of the first six months of the year explain much of the AUM volatility. This, the company cannot really control. The other aspect though are fund flows; is the company winning or losing customers? However, not all fund flows are equal because management fees are different in different products. Cash funds are extremely low fee; in fact, on money market funds, State Street has been waiving fees given how low interest rates are. And ETFs, which are largely passive, tend to be lower fee than long-term institutional flows.
During Q2, total fund flows were up $23 billion, but excluding cash funds, which don’t drive much revenue, there were $5 billion of outflows. On balance, the company lost non-cash customers in the quarter. Indeed, over the five quarters long-term flows were -$35 billion. This flow picture, combined with fee pressures across products, points to a challenging revenue picture ahead as the company will see a lower average fee rate on its AUM.
(Source: State Street)
Indeed even though AUM was up 4% from a year ago, management fees were 3.6% lower at $425 million due to negative mix shift and fee compression. Based on fund flows this quarter, there is no reason to expect revenue to rebound in the near-term, barring a continued, large rise in financial markets. Additionally, at some point, there is a diminishing return on cost cuts as STT would risk a “brain drain” of talented employees looking elsewhere if they continue to pressure compensation expenses. Perhaps recognizing this on the company’s earnings call, management guided to expenses being down close to 2% this year, less than the 3% in Q2. Expense cuts that shield profitability from revenue losses like this have largely occurred. Unless State Street can generate better fund flows, we are likely to see declining earnings from its asset management arm.
