State Street Corp (XLF) Q2 2020 Earnings Call Transcript

Good morning and welcome to State Street Corporation’s Second Quarter 2020 Earnings Conference Call and Webcast. Today’s discussion will be broadcast live on State Street’s website at investors.statestreet.com. This conference call is also being recorded for replay. State Street’s conference call is copyrighted and all rights are reserved. This call may not be recorded for rebroadcast or distribution in whole or in any part without the expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. Now, I would like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street.

Good morning and thank you all for joining us. On our call today, our CEO, Ron O’Hanley, will speak first. Then Eric Aboaf, our CFO, will take you through our second quarter 2020 earnings slide presentation, which is available for download in the Investor Relations section of our website, investors.statestreet.com. Afterwards, we will be happy to take questions. During the Q&A, please limit yourself to two questions and then re-queue. Before we get started, I would like to remind you that today’s presentation will include results presented on a basis that exclude or adjust one or more items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our slide presentation. In addition, today’s presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors such as those factors referenced in our discussion today and in our SEC filings, including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today and we disclaim any obligation to update them even if our views change. Now, let me turn it over to Ron.

Thank you, Ilene and good morning everyone. We released second quarter results this morning. Let me begin by saying that I am very pleased with our continued strong financial performance. I am proud of our team members worldwide, who continue to put our clients first and deliver these results for our shareholders. Turning to Slide 3, I will provide a brief update on how we are successfully navigating the COVID-19 operating environment, while also delivering earnings growth for our shareholders. Providing exceptional service quality through improved client engagement, driving product performance, supporting the overall financial system, and safeguarding our workforce are all key priorities for us. We demonstrated success in each of these areas this quarter and delivered strong results for our shareholders as a result. Our clients are at the center of everything we do. You will recall that in 2019 we took a number of actions to improve client service quality, engagement, and decision-making. These measures have led to improved client engagement, which is critically important in the current environment, and its impact is evident in our results and business performance. Our clients are continuing to turn to State Street for our operational capabilities and solutions. During the second quarter, we effectively managed to onboard a number of new client projects across various client segments, including a large asset manager, a significant asset owner, and a national wealth manager in CRD. Indeed, we see true sustainable momentum developing in our Alpha CRD platform. All this occurred while processing 13% and 35% increases in back and middle office transactions, respectively. We were the first service provider to support the launch of the semi-transparent ETF product, and we see strong demand in the market for this innovative solution. Our service quality is being recognized across the industry. For example, we are particularly proud of our ranking in the 2020 Euromoney FX Survey, where State Street was named the number one FX provider to asset managers for the third consecutive year, with a number one ranking in overall customer satisfaction globally. This strong client engagement is reflected in our product performance. Our investment servicing assets under custody and administration, which increased 5% quarter-over-quarter to $33.5 trillion, had another healthy level of new wins amounting to $162 billion in the second quarter. Assets yet to be installed stood at a strong $1 trillion at quarter end. At Global Advisors, assets under management totaled $3.1 trillion and we recorded $23 billion of total net inflows during the second quarter. Our SPDR range of ETFs recorded its best quarter of inflows since the fourth quarter of 2017, while SPDR GLD, the gold ETF, had its strongest ever level of inflows at $12 billion. Further, we are competing and winning in key strategic areas of focus for us. Our recently expanded and re-benchmarked range of low-cost ETFs also recorded its highest quarterly level of inflows at $11 billion. Our sector SPDRs made strong market share gains with almost half of sector industry flows going into the product during the second quarter. And we remain a flight to quality for cash management and liquidity solutions across a suite of product options. We continue to play a critical role in supporting the financial system. The operating environment remains uncertain as the pandemic continues to impact many parts of the world. While we have seen a partial recovery in some areas, many economic indicators continue to point negatively and unemployment remains high, reflecting the real human cost of this health crisis. State Street continues to support the broader economy and markets and is actively assisting client access to various Federal Reserve programs that support the flow of liquidity and credit. Currently, State Street is involved in five Federal Reserve programs either directly, such as with the Money Market Mutual Fund Liquidity Facility, or as those programs’ custodian and administrator, such as the Main Street Lending Facility. Lastly, developing a high-performing organization and planning ahead for our global workforce also continues to be a priority. We continue to have about 90% of our employees working from home as we optimize a work-from-home model while leveraging technology to enable better collaboration and more effective ways to serve our clients. Last quarter, we took measures to protect our employees and announced that through the end of the year we suspended any workforce reductions other than for performance or conduct reasons in light of the COVID-19 crisis. Now, we are going further for our employees by increasing their opportunities for mobility by launching an internal talent marketplace. By supporting our employees as they take on new roles and learn new skills, the marketplace will better develop and redeploy our internal talent to meet our evolving business needs and the growing demands of clients and stakeholders. Turning to Slide 4, in our second quarter and first half performance highlights, I am pleased by our continued strong performance and the progress we are making toward achieving our medium-term financial goals. Relative to the prior-year period, total revenue increased 2% and fee revenue increased 5%. Second quarter EPS was $1.86, up 31% year-over-year and ROE was 12.1%. I am pleased to report that our second quarter pre-tax margin improved by over 2 percentage points year-over-year to 27%. Our first half pre-tax margin increased by 3 percentage points. The front-to-back Alpha platform strategy provides an attractive value proposition for our clients. Our second quarter performance was helped by the strong revenue performance at Charles River Development, where we had key business wins and renewals. The Alpha CRD pipeline continues to develop well with a good mix of deal sizes, functionalities, and scope. We expect to be announcing new major wins between now and year end. Turning to expenses, the pandemic created an immediate challenge to our expense reduction planning relative to our original expectations at the start of the year. To help offset this impact, we took immediate action by implementing a hiring freeze, launching the talent marketplace I just referenced and reassessing all discretionary expenses. I am pleased to report that through our continued expense management efforts, further IT optimization, and operational productivity measures, we reduced total expenses by 3% in the second quarter relative to the year-ago period. While we continue to invest in our business, first half 2020 expenses are now down 2% net of those investments relative to the year-ago period. For us, productivity management is a way of life as we continue to build on the strong culture of expense management we successfully established during 2019 when we undertook significant actions to improve our operational efficiency and reduce expenses through a comprehensive firm-wide expense savings program. We cannot control the economic environment, but we can control our expenses. Despite the challenges the COVID-19 pandemic has created, we remain highly focused on driving productivity improvements and automation benefits as we strengthen our operating model and enhance service quality even during this challenging period. Turning to our balance sheet and capital, we are pleased with our 2020 CCAR results and the inaugural determination of our preliminary stress capital buffer at the minimum 2.5% level. The COVID-19 pandemic has provided an unprecedented real-time stress test and our strong capital position has enabled us to operate effectively, help stabilize the financial markets and support our clients, employees and communities. While the environment remains uncertain, State Street’s performance under the Federal Reserve’s severely adverse scenario is another reminder of our business model’s resiliency and our capital stability. We recently announced our intention to continue our quarterly common stock dividend of $0.52 per share in the third quarter. Consistent with the Federal Reserve’s instructions to all large banks, we will be suspending share repurchases for the third quarter. As we look ahead, given our strong capital position, we will consider a full range of capital actions, including the resumption of share repurchases in upcoming quarters. We will of course take into account economic conditions, safety and soundness, the Federal Reserve supplemental CCAR scenarios and review process, our capital levels and any interim regulatory limitations. To conclude, I am very pleased with this quarter’s results, which demonstrate continuing revenue improvement even during difficult times as well as further evidence of our ongoing ability to tightly control expenses while continuing to safeguard our employees and serve our clients. And with that, let me turn it over to Eric to take you through the quarter in more detail.

Thank you, Ron and good morning everyone. Let me begin my review of second quarter by summarizing our year-over-year results on the left panel on Slide 5. EPS is up 31%. Revenue is up 2%. Expense is down 3% with expanding margins and healthy ROEs. And I think it is useful to point out that while we continue to operate in an extraordinary environment for the COVID pandemic, our results this quarter show strong underlying momentum and durability in our State Street operating model. Our bellwether servicing fees are up year-on-year. Our prior investments in our global FX and CRD franchises have yielded strong results. We have been able to carry reserve builds. And throughout all of this, we have continued to drive expenses lower and lower. And so our pre-tax margin is up 2.3 points year-on-year and our ROE is up 2 points. Turning to Slide 6, period end AUC/A levels increased 2% year-on-year and 5% quarter-on-quarter. The year-on-year move was driven by higher period end market levels and client flows partially offset by a previously announced client transition that had a de minimis effect on revenue during the quarter. Quarter-on-quarter, the AUC/A increased, which is partially reported on a lag, and was mainly due to higher period end equity market levels. AUM levels increased 5% year-on-year and 14% quarter-on-quarter to $3.1 trillion driven largely by higher period end market levels and net inflows. Amid continued uncertain economic conditions, Global Advisors saw net inflows of $23 billion driven by cash and ETF flows partially offset by institutional outflows. I highlight that our U.S. SPDR ETFs saw another strong quarter with $24 billion of inflows, which was well-diversified once again. As Ron mentioned, our low cost SPDR portfolio ETFs saw their largest quarterly inflow yet and continue to gain share. Our commodity ETFs and sector ETFs saw strong inflows too. Moving to Slide 7, servicing fees were up 2% year-on-year reflecting higher client activity and net new business only partially offset by some pricing headwinds, which continue to moderate. Servicing fees were down 1% quarter-on-quarter driven by lower average market levels partially offset by higher client activity. Despite the recovery in equity markets since the first quarter, average domestic and international equity markets were still down sequentially impacting servicing fees. However, client activity remained elevated though down from March levels as market volatility persisted throughout the quarter. Amidst the ongoing pandemic, we have maintained business continuity and continue to provide clients with the benefits of our scale and diverse capabilities. On the bottom right of the panel, we have included again some sales performance indicators that underline this dynamic. As you can see, AUC/A wins totaled $162 billion in 2Q with several deals coming through. Assets to be installed as of period end 2Q are strong at $1 trillion. We continue to have a strong pipeline of front-to-back Alpha deals and expect multiple Alpha announcements in the second half of the year. Turning to Slide 8, let me discuss the other important revenue lines. Beginning with management fees, 2Q revenues decreased 4% year-on-year driven by institutional product outflows and mix partially offset by strong net inflows from both ETF and cash products. With the second quarter now complete and a better sense of the forward rate picture, we now anticipate that the likely impact of money-market fee waivers, net of distribution expense, will be at the low end of our previously announced range or just $10 million to $15 million for the full year. As I mentioned earlier in my remarks, FX trading services saw another strong quarter, with revenues up 26% year-on-year, but down 25% quarter-on-quarter as the business again saw elevated volumes and increased client demand, but down from the record levels seen in 1Q. The FX trading franchise continued to see market share gains and increased client engagement. As Ron mentioned, we saw strong results across the recently released 2020 Euromoney Survey, securing the number one spot in global customer satisfaction service as well as the number one spot for all products and for electronic trading for our asset manager clients. Securities finance revenue decreased 27% year-on-year as lending demand for assets lightened and shifted towards lower spread fixed income assets and as ongoing hedge fund deleveraging in falling markets drove down enhanced custody demand. Securities finance revenue was flat quarter-on-quarter. Finally, software and processing fees increased 46% year-on-year and more than doubled quarter-on-quarter driven by significant revenue adds from CRD, which I will talk more about shortly, and positive outcomes in our market sensitive activity, which includes certain currency translation impacts and marks on employee long-term incentive plans. These other items were positive this quarter in contrast to first quarter when they were notably negative. Moving to Slide 9, CRD generated standalone revenue of $145 million, which was up 59% year-on-year and 45% quarter-on-quarter driven by a large wealth implementation and several large asset manager renewals. We have always talked about the lumpiness inherent in ASC 606 revenue recognition standards. So, while we are extremely pleased with these results, we remind you not to read across any one quarter. Moving to the right-hand side of the page, we were quite pleased to see the momentum in CRD this quarter overall and the progress we have made to extend the CRD presence in the wealth segment in particular, which you may recall was one of our key synergy commitments at the time of acquisition. Wealth now represents approximately 20% of CRD revenue and represents another area of growth for us. Turning to Slide 10, NII decreased 9% year-on-year and 16% quarter-on-quarter. Excluding the impact of episodic market benefits of $20 million in the first quarter, NII was down 13% quarter-on-quarter. The sequential decline in NII was primarily driven by the full quarter impact of lower market rates, including the impact of central bank intervention with more USD liquidity driving lower than expected sponsor repo volumes. We continue to support clients’ use of the Federal Reserve’s Money Market Mutual Fund Liquidity Facility. As a result this quarter, MMLF balances averaged $19 billion and finished the quarter at $11 billion. You will see on the left-hand side of the slide, this quarter we are also showing our NIM excluding the impact of the MMLF. While MMLF had a positive impact on NII this quarter, its impact on our NIM was a negative 5 basis points. Average assets increased 13% quarter-on-quarter, and average deposits increased 9% quarter-on-quarter. However, period-end deposits decreased 22% or $57 billion quarter-on-quarter as a portion of the uptick in the deposits we saw at the height of the pandemic receded in the last few months. Given the Fed’s expansion of the money supply, however, we do expect a good portion of the current deposits to stay with us, which we will reinvest in a mix of both loans and securities. Moving to Slide 11, we have again included some color on the loan portfolio as well as the company’s allowance for credit losses. On the top panels of this page, you can see updated detail around our high-quality loan book and its characteristics compared to first quarter. Average loans decreased 4%, while period-end loans decreased 17% primarily driven by reduction in client overdraft levels we saw during March. Overall, the loan book remains healthy with our largest lending category, capital call financing to private equity funds, seeing no change in borrowing pattern, but with continued strong demand for new facilities. Moving to the bottom panels, the allowance for credit losses increased to $163 million, primarily due to $52 million in provisions for credit losses driven by changing economic conditions and ratings migration offset by $14 million in net charge-offs. You will note we took advantage of a rally in the leveraged loan market to selectively de-risk our leveraged loan portfolio and exited certain positions, which effectively cost us $6 million given the necessary reserve build, so a good trade. On Slide 12, we have again provided a view of expenses this quarter excluding notables so that the underlying trends are readily visible. Our 2Q 2020 expenses were down 3% year-on-year and down 1% quarter-on-quarter, excluding both notable items and seasonal expenses, with favorable trends across most expense categories. As we said last quarter, amidst the ongoing pandemic, we continue to execute on many of the investments and optimization savings initiatives detailed earlier in the year. And while we suspended workforce reductions for the year end other than for performance or conduct reasons in light of the COVID crisis, we have found additional expense opportunities to act upon. We continue to make progress on lowering compensation and benefit costs, occupancy costs and other costs, while IT costs are lumpy, but on track. We are particularly pleased that our results reflected continued and sustainable expense reduction, notwithstanding the extraordinary market conditions, while also delivering top-line revenue growth. Moving to Slide 13, on the right, you can see the evolution of CET1 and Tier 1 leverage ratios. We are thus navigating this challenging environment with strong capital levels. In 2Q, our standardized CET1 ratio increased 1.6 percentage points quarter-on-quarter to 12.3% driven by solid retained earnings and a reduction in RWAs as market volatility receded. The Tier 1 leverage ratio was essentially flat at 6.1% due to higher capital levels offset by higher deposits. We were also pleased with our 2020 CCAR results. Our capital resilience under the Fed stress scenarios continues to demonstrate our low risk profile. And this year, we received a preliminary stress capital buffer requirement of 2.5%, which would have been much lower if it were not floored at 2.5%. As you know, the Fed has had large banks suspend share buybacks in the third quarter. However, we expect to continue to pay a quarterly dividend of $0.52 per share. And finally, as Ron noted, the firm’s capital position remains strong amidst the uncertainty created by the COVID-19 pandemic. Accordingly, we will consider a full range of capital actions, including the resumption of share repurchases in upcoming quarters, but we will do so considering economic conditions, safety and soundness, the Fed’s supplemental CCAR scenarios and review process, our capital levels and then any interim regulatory limitations. Turning to Slide 14, we have again provided a summary of our 2Q results. As we mentioned earlier, we are pleased with the results and believe they are a reflection of the durability and resiliency of State Street’s business model as well as our focus on delivering on our strategy of both growth and productivity. Throughout this crisis, we have differentiated ourselves by proactively reaching out and assisting clients through these difficult times. We believe that our resiliency during this extraordinary period and our constant attention to service quality has created goodwill with our clients and positioned us for share gains over the medium to long-term. Last quarter, I outlined our full year financial outlook under a certain set of assumptions, noting that there was a range of possibilities as a result of the potential length of the COVID pandemic and the associated economic impacts. I would like to update those expectations with our current thinking, again, noting there remain a broad range of possible outcomes. We now expect global central banks will keep short rates at current levels for the remainder of the year and long end rates will stay at a June 30 spot rates through year end. We also now assume that average global equity market levels for the remainder of 2020 will be flat to current levels. As a result of our client engagements, moderating pricing pressure and CRD and Alpha front-to-back wins, we now expect that full year fee revenue will no longer be down 1% to 2% year-on-year for the full year 2020, but instead will be up approximately 1.5% to 2% with servicing fees expected to show a year-over-year improvement relative to 2019. Regarding NII, given the impact of continued lower long end rates on the investment portfolio and central bank intervention with more USD liquidity driving down the expected repo volumes, we now expect NII to be down approximately 9% to 11% on a sequential quarter basis and expect the fourth quarter to be relatively in line with the coming third quarter. Turning to expenses, we remain laser focused on driving sustainable productivity improvements and achieving automation benefits. We expect that full year expenses will now be down at the better end of our previous guide of down 1% to 2% year-on-year, excluding notable items as we continue to find ways to control and drive down expenses. In regards to our provision for credit losses, we continue to see a range of outcomes based on evolving economic conditions and any ratings migrations. On taxes, we expect our tax rate for the full year to be closer to the lower end of our 17% to 19% range. And with that, let me hand the call back to Ron.

Thank you, Eric. Operator, can you open the call to questions?

Thank you. Operator instructions were provided. Your first question comes from the line of Brian Bedell from Deutsche Bank. Your line is open.

Great, thanks. Good morning, folks. Thanks for taking my questions. Eric, if you could just unpack a little bit the NII guide just in terms of what you are seeing for client deposit levels moving into 3Q, and to what extent your guidance for 3Q and 4Q includes more reinvestment or more shift of deposits into longer term securities? I am sorry, also one more on that is the repo financing business in terms of the impact, it looks like that was much lighter in the second quarter, so just your thoughts on that for the second half as well?

Eric, you are muted.

Brian, it’s Eric. Thanks for the question. We are clearly navigating through some challenging times with the interest rate environment and obviously trying to do our best to navigate through. When you think about the NII guide, there is clearly the continued downtick in long-term rates, which is affecting the investment portfolio, and we will continue to feel that some extent in the coming quarters. And then there is lower volume sequentially in overdrafts and then the MMLF balances that are also contributing to that second quarter to third quarter decline. I think once we get to that level, part of what happens is that you have offsetting factors. On one hand, the lower long end rates tend to flow through the investment portfolio for another couple of quarters, which creates a downdraft. Those can be offset by the growth in the investment portfolio and lending base, which is really supported by the higher levels of deposits that we are operating at. Now, it’s hard to tell exactly what the deposit levels are going to be, but if you stare at the data that we have shown here, we used to run at $155 billion to $160 billion of deposits. First quarter average was solidly at $180 billion. Second quarter average was solidly at $197 billion. We think we are going to land somewhere between those two points, which means that off of the original base of about $160 billion of deposits, there is an ability to expand the investment portfolio, put on duration carefully and selectively invest in some high-quality positions to maintain our HQLA, and we think that together should create some stability on NII in the coming quarters. The sponsored repo program, as you mentioned, did create a downdraft from 1Q to 2Q. And what we are seeing there is that the overnight repo rates are less attractive than they have been relative to 1-month Treasury rates, and so that creates reduction in volumes. If that were to persist, then we are not going to get a lift there and we are not going to get the volumes we would like to see. On the other hand, if that normalizes back, there could be some upside in the coming quarters, but more time will tell before we can incorporate that into our forecast.

Okay, great. That’s super helpful. And then maybe on CRD, you had a very strong quarter, very encouraging on the wealth management wins, maybe just a two-part question, Eric, on the revenue trajectory, obviously, it’s lumpy like you said, maybe if you can just try to characterize what you thought was one-time licensing fee revenue within the second quarter? And then maybe Ron, if you want to talk a little bit about that wealth strategy, it sounds very encouraging in terms of the win that you have announced and potential new wins down the road? And maybe just in terms of sizing that space for you, what you are doing there on the wealth side that’s different than the institutional asset manager side at CRD?

Brian, why don’t I start and then I’ll turn it over to Eric. As I mentioned, when we acquired Charles River in addition to its core institutional client segment, it had developed a fair amount of technology applicable to the wealth segment, particularly the larger wealth manager segment, large private wealth managers, and warehouses. We have continued that R&D and also leveraged our own client relationships to be able to help propel that growth, and that’s what you are seeing play through. We see it as a solid and additional form of growth on top of the core institutional business. Right now, it’s about 20% of the business, up significantly from when we acquired it and we would expect it to grow at a slightly higher rate than the institutional business. The good news about this is that it shares the same technology and operating platform. There are certain sub-applications that are different, but we can do this at scale easily. The way I would say you should think about the lumpiness is that when you start to see this positive lumpiness, it’s essentially a client being installed, and it’s at the point that we can start to recognize revenue and following that will be ongoing recurring fee. So that’s how you should interpret the lumpiness. It’s not necessarily one-time as it relates to that client, but it’s certainly not one-time as we continue to grow. You will see that same kind of lumpiness.

Brian, let me add some texture and even some numbers to that so that you can get a better sense of the underlying revenues here. We are quite pleased with the growth trajectory and the pipeline. The revenues broadly fall into two buckets: SaaS revenues and professional services, and then on-premise installations for some clients. SaaS revenues are straightforward: you win a client, it's often a multi-year contract and the revenue recognition is ratable over those years. Those are the recurring revenues we want to grow. The on-premise installations have an upfront piece and a trailing piece. For example, an on-premise contract might have roughly 60% upfront and the balance ratably over the contract length. Contract lengths can range from about three to eight years. So, there is a front-loaded recognition when the implementation goes live and then recurring revenue behind that. In the second quarter, the $145 million in CRD standalone revenue included just over $80 million of recurring SaaS and professional services revenue, and the balance was in the lumpier on-premise installation category. Back in 2Q 2019, total revenues were about $91 million, and roughly 65% of that was SaaS and professional services, which gives you a sense of the recurring base that has been building. We see good underlying metrics—pipeline, contracted but not yet installed—and strong sales performance indicators. So while you will see quarter-to-quarter lumpiness, the underlying trend is one of growing recurring revenues plus periodic on-premise implementations that are more lumpy.

That’s great color and a lot of detail. Thank you very much.

Your next question comes from the line of Betsy Graseck from Morgan Stanley. Your line is open.

Hi, good morning.

Good morning, Betsy.

I wanted to understand a little bit on the expense side. I know you called out improvement there in part from things like market data, which is really impressive given that market data cost for most participants is moving higher every quarter. So just want to get a little bit of color on that and on the sub-custody savings and to what degree is there more legs there in that specific line item in your expenses?

Betsy, both of those are sizable expense categories and both are part of the transaction processing line item that we report. For sub-custody, we have worked with some of the largest banks as well as country banks to find the best mix of service at a declining cost level; that is something we need to keep managing year after year and we have been able to deliver good savings this year with more opportunity ahead. Market data is more complicated. There are three parts: we need to manage the ingestion pipes to avoid buying more than we need, we need to work with the vendors to get the best cost-quality mix, and third, some of our market data costs are borne by us while in other cases market data costs are borne by clients. We are working with vendors and clients to secure the best outcomes and to drive down our portion of costs while maintaining quality. This intense focus on transaction processing is an example of the broader work we are doing to drive technology, hardware and software costs lower. It’s an expertise we will repeat year after year to keep reducing costs.

Okay. And so you have got some more legs there is the nut of that answer. And I appreciate all the color. The follow-up I have for you, Eric, is regarding net interest income and net interest margin outlook and I know you have a 9% to 11% down guide for 2Q to 3Q and then stabilization into 4Q. Maybe you could give us some color on the assumptions around that stabilization—what has to happen for that to come through?

The 4Q stabilization is primarily driven by the interest rate environment. We are assuming short-end rates stay more or less where they are and long-end rates stay more or less where they are. The forward curve often implies more movement, but we are planning using current levels. The second part is some normalization of deposits—while we believe a portion of the elevated deposits are stickier, the speed of reinvestment of those deposits into the investment portfolio and the mix of assets we add will factor into NII. So it’s a combination of stable rates and disciplined reinvestment of deposit balances into assets that produce yield while maintaining liquidity and credit quality that underpins the implied stabilization in the fourth quarter.

Your next question comes from the line of Glenn Schorr from Evercore ISI. Your line is open.

Hi, thanks. Quick follow-up question on the expense side, I heard your overall comments. Within this quarter’s 3.3% drop, 40% of the reduction in expenses was lower marketing and travel, I am assuming that’s the product of the environment. How much of that is sustainable or works its way back and again, I appreciate that’s probably part of your overall expense comment?

Glenn, that’s fair. We are trying to find sustainable expense reductions. Travel and some medical claims are lighter which provides tailwinds, but we also had headwinds where we paused layoffs because of the pandemic. That pause would have been worth at least half a point of expense reduction per quarter on a full year basis. Next year we will go back to driving down compensation and benefits and third-party spend costs. We see a path to continue driving expenses lower year after year, but there will be ins and outs of headwinds and tailwinds in the near term.

Okay, I appreciate that. And then during the quarter, you announced a venture with FNZ on servicing in the wealth management space. I am curious if you could talk a bit about what the target of that venture is, FNZ seems to have a really strong operation in Europe—what you bring to the table, what they bring to the table that will be great?

Glenn, FNZ has a very strong operating platform and they target a segment that is somewhat smaller than Charles River’s typical wealth segment. It’s complementary to Charles River. We would be their custodian and administrator as they move into that space. We view it as a way to expand further into wealth, a segment where we wouldn’t naturally have leading capabilities at scale, and we can get interesting technology that we can use elsewhere. So it’s a way to gain technology leadership and incremental revenue at relatively low cost.

Okay, thanks very much.

Your next question comes from the line of Brennan Hawken from UBS. Your line is open.

Good morning. Thanks for taking my questions. First, I would like to follow up on the Charles River commentary and the front-end fees versus that trail dynamic. It sounds like that’s a little less than half of this quarter’s revenue. Wanted to confirm that’s the case? And then is the onboarding, the installed front end, a multiple quarter dynamic or a single quarter dynamic? How does the trail in those arrangements compare to the upfront? How should we think about the continuing revenue dynamic? And then how long are those contracts? And what’s the typical retention rate? I’d love to get better dimension for the cadence of those revenues if you can provide some of that.

Brennan, it’s Eric. There is a range of details; let me give you the broad picture. Recurring SaaS and professional services revenue is the stable piece, and we've been growing that consistently. The lumpier on-premise installations vary by contract. Contracts can range from roughly three to eight years. On shorter contracts you may see around 70% upfront and 30% ratably over the contract length; on longer contracts, you might see about 50% in the first year and the rest ratably over the following years. The upfront piece is recognized when the system goes live and begins to serve clients; thereafter you see ratable revenue over the contract term. Client retention rates in this business are very high because implementations are significant and clients build integrations; we generally have very high renewals. I will follow up with a precise retention number via Reg FD. The key point is the recurring SaaS and professional services piece has been building, and the on-premise piece is larger and lumpier but also has trailing recurring revenue. So, while quarters will be lumpy, the underlying trajectory is favorable.

One more piece I asked was the retention rate—what’s the historical retention rate on those three-year contracts?

We can follow up with a precise number in a Reg FD. It is very high. The nature of the implementations makes renewals quite likely because clients integrate significantly with their internal systems, which creates high switching costs.

Brennan, to reinforce why retention is high, these conversions often involve significant operating model changes at the asset manager or wealth manager. Typically, a new client is not simply displacing a single provider; it’s an enterprise move from bespoke, scattered technology to a comprehensive front-to-back system. That creates high switching costs and strong client stickiness.

Got it. Thank you for that. Appreciate all that color, Ron and Eric.

Your next question comes from the line of Kenneth Usdin from Jefferies. Your line is open.

Thanks. Good morning guys. Eric, I was wondering if you give us a little bit more color underneath your full year fee outlook. I know you’ve got the CRD comments you talked about and transaction activity, but can you walk us through how you are now seeing the bigger buckets move both sequentially and year over year given average asset pricing and your earlier comments about income pressure moderating?

Ken, part of the reason we gave an overall fee guide is that there will always be ins and outs across fee categories. If you think about the different buckets, servicing fees are positive year-on-year—deliveries in both first and second quarters—and we expect servicing fees to remain a positive in the full year. Management fees were weaker earlier in the year and we’d like to see some improvement there in the second half. FX trading was a clear positive in the first half, although quarter-to-quarter it can fluctuate. Securities finance was lighter and we are looking for stability there. Charles River contributed meaningfully in the second quarter and may be more first-half weighted this year, though software businesses often have strong fourth quarters as well. Taking all that together, we believe fee revenue of 1.5% to 2% for the full year is a reasonable view today. If we continue to grow fee revenue in the low single digits and drive expenses down, the results should be favorable.

And one big picture for Ron. Last quarter you talked about a bit of a push off in installations and client discussions because of COVID. Your win rate in servicing was about flat. Can you talk about the conversations that are happening now and how that’s evolving, just in terms of the core business and any sense that’s starting to open up?

Ken, as we discussed last quarter, we thought some clients might delay moves because of the operational burden their teams faced. What we’ve seen in the second quarter is an increase in conversations and interest in outsourcing and operating model transformation. Clients are not just looking for the lowest cost back office; they are looking to comprehensively improve their operating models across front, middle, and back office. That has resulted in renewed pipeline activity and we expect to announce significant new wins between now and year-end, some of which will be front-to-back and include notable names.

Got it. Thank you, Ron.

Your next question comes from the line of Alex Blostein from Goldman Sachs. Your line is open.

Hi, thanks guys. Good morning, Ron and Eric. Building on the last comment, as you think about the pipeline in CRD and this sizable implementation opportunity you see, what percentage of that is on-premise versus SaaS-type contracts? And then secondly, could you give a bit more color on the wealth strategy—types of clients in the wealth management space that are warehouses—independent broker-dealers and RIAs? Which channels is incremental growth coming from?

Alex, on the wealth channel, it tends to be larger wealth managers: larger private wealth managers and warehouses. They can be RIAs or other large wealth managers. They bring scale and asset allocation capability and often want control with some customization, which CRD supports well. It’s a bespoke application for wealth, but it leverages much of the same underlying technology as our institutional business, so we get scale on development and improvements.

Alex, to round out the earlier point on financials, we had a range of on-premise implementations this quarter and they tend to run the gamut of contract lengths from three to eight years. On the shorter contracts you might see 70% upfront and 30% trailing; on longer contracts you might see about 50% upfront and 50% ratably over the contract. The largest implementations we had this quarter were closer to the longer end of that range.

Thanks. And then just to round up the discussion around NII—your comment around stabilizing NII toward the end of the year contemplates reinvestment of liquidity you’ve built up into securities and loans. Could we see some reinvestment into 2021 and potentially growth from the trough level of NII?

Alex, it’s a bit early to get into 2021 with confidence, but the guide into 4Q does contemplate some reinvestment in the investment portfolio. We have a path to offset some near-term pressure, but visibility into rate moves and the pace of reinvestment will determine the trajectory into 2021. At this point we see a path to relative stability into 4Q rather than clear growth.

Thanks very much.

Your next question comes from the line of Gerard Cassidy from RBC. Your line is open.

Morning, Ron. Good morning Eric. Ron, can you follow up on the new wins that you guys gave us this quarter? You mentioned stickiness of not losing customers, and the wins primarily coming from existing customers where you are adding more products and services and in the cases where you win a new customer, is it price-driven that the new customers are coming over or a combination of price and better products that you are offering them?

Gerard, it’s a mix. For the Alpha front-to-back pipeline, we are seeing both existing clients expanding the wallet with more products and services, and new clients moving to our platform. In many cases, these are not simple custody-to-custody moves; they are comprehensive operating model changes—moving middle office and other services to improve efficiency and control. The attractiveness of our front-to-back value proposition and the ability to consolidate more activities on a single platform is a key driver of wins. Pricing is a factor in some cases, but the primary drivers are operational improvements, scale, and the data and functional advantages of a front-to-back solution.

Very good. And then Eric, a question on the loan portfolio: you mentioned you exited some leveraged loans. Can you give any color on the industries in which you de-risked the balance sheet and what kind of pricing you saw when you sold those leveraged loans?

Gerard, we de-risked roughly about $160 million of leveraged loan balances. One of the names included a cinema chain. On average we exited those positions around $0.92 on the dollar, so roughly in the low 90s. It cost us a modest amount given reserve needs, but we viewed it as a good tactical decision to reduce exposure in areas we judged prudent given uncertainty. The overall loan book remains healthy, and we will continue to be selective and proactive in managing exposures.

Thank you.

Your next question comes from the line of Mike Mayo from Wells Fargo Securities. Your line is open.

Hi. So, you are guiding for better fee growth for this year, 1.5% to 2% versus down before. How much of that is already reflected in the first half results and how much should be coming in the second half? You mentioned servicing fees, management fees, FX processing, but is this mostly reflecting what you have already done or is it mostly to come? As a subcomponent, on CRD, linked quarter revenues were up $45 million and pre-tax was up $42 million. That looks like about a 93% incremental profit margin. So are there some upfront revenues with the new business wins and how does the timing between revenues and expenses work out? And finally, you are going to be a client of CRD—how is that moving along internally?

Mike, some of the fee guide is driven by the first half and some by continued progress in the second half. Servicing fees have been good in the first half and are expected to remain positive; management fees we hope improve in the second half; FX was a first-half positive with some quarter-to-quarter variation; securities finance was lighter in the first half and we are looking for stabilization; and Charles River drove a large part of the second quarter gains and may be somewhat first-half weighted with potential contributions later in the year. On Charles River and professional services, professional services revenue tends to be billed as incurred and the related costs are incurred in the implementation period. So while the upfront license revenue may show up at implementation, professional services expenses are generally aligned and recognized as they are performed. That means near-term margins on a given quarter can look high, but they reflect both the timing of revenue recognition and the related expense recognition. We can provide more granularity in future disclosures. Regarding State Street Global Advisors becoming a client of our Alpha platform (including Charles River), that implementation is underway and well over halfway complete. It’s a comprehensive conversion and includes back office and middle office moves; it’s complex given the size of the asset base but progressing.

Mike, for the internal implementation note: State Street Global Advisors is moving to the full Alpha front-to-back platform including Charles River. The project is well over halfway complete and includes moving legacy GSAs back office systems to our middle office and integrating various components. It’s a major program, but it’s progressing.

Great. Thanks a lot.

Your next question comes from the line of Jim Mitchell from Seaport Global Securities. Your line is open.

Hey, good morning. Maybe we could talk a little bit about the new business wins and the cadence and impact. If I look at assets to be installed, you have about $1 trillion to go. That’s been pretty stable since the big wins in 3Q 2019. Is it that these bigger wins just take this long? Is there something unusual here? Going forward with the new business wins you have alluded to in the second half this year, is it a similar kind of multi-quarter installation?

Jim, good question. Assets to be installed often reflect multi-tranche projects: custody, fund accounting, middle office, etc. Custody conversions can be done quickly and sometimes complete intra-quarter, while comprehensive front-to-back conversions across multiple functions take longer. The $1 trillion backlog includes clients with multiple tranches and larger, more comprehensive moves. So yes, some of these larger deals will be multi-quarter installations, while others may be faster. The mix of quick custody moves and longer, multi-functional implementations explains the duration of the backlog.

Right. And should we assume those more complex deals have higher fee rates and therefore a more material impact on servicing fees when they close?

You should expect fees to come from multiple sources—custody, fund accounting, middle office—and that’s how you should think about the revenue impact. The comprehensive nature of these deals typically leads to revenue from multiple fee lines.

Okay, thanks.

Your next question comes from the line of Vivek Juneja with JPMorgan. Your line is open. We cannot hear Vivek. The caller may be on mute. There are no further questions at this time. I will turn the call back over to Ron O’Hanley for closing remarks.

Well, thank you operator and thanks to all of you on the call, who joined us. Thanks for the questions and we look forward to the follow-up.

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.