State Street Corp (XLF) Q2 2023 Earnings Call Transcript

Good morning and welcome to State Street Corporation Second Quarter 2023 Earnings Conference Call and Webcast. Today's discussion is being 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 part without the expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on State Street's website. Now I would like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street. Please proceed.

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 2023 earnings slide presentation, which is available for download in the Investor Relations section of our website, investors.statestreet.com. Afterwards, we'll 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 excludes or adjusts one or more items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measures are available in the appendix to our slide presentation, also available in the IR section of our website. 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. Earlier today, we released our second quarter financial results. Relative to the significant volatility experienced by investors in the first quarter, market conditions in 2Q were more subdued and global financial market performance varied. Global equities generated positive returns for the third consecutive quarter as investors saw continued strength in developed equity markets, but weakness in emerging markets. Fixed income markets faced challenges as investors had to contend with still elevated levels of inflation and further central bank rate hikes, including the Federal Reserve raising interest rates above 5% for the first time since 2007. The second quarter was also characterized by falling currency market volatility, which created headwinds for our foreign exchange business. Turning to slide three of our investor presentation, I will review our second quarter highlights before Eric takes you through the quarter in more detail. Beginning with our financial performance, second quarter ROE was 13% and pre-tax margin expanded by 1.2 percentage points year-over-year to 29.5%. Relative to the year-ago period, 2Q EPS increased by 14% to $2.17 supported by our common share repurchases, significantly higher NII, strong front office software and data revenue growth and an increase in securities finance revenue. Our results also benefited from the release of an allowance related to the support of a financial institution as well as an accounting adoption. Taken together, these factors more than offset headwinds in some of our other fee-based businesses and the impact of higher-than-desired year-over-year expense growth. Turning to our business momentum, in Q1, I highlighted that by strengthening our implementation capabilities, we have a line of sight into a meaningful amount of client onboarding this year. We began to realize the benefits of this plan and onboarded $1.2 trillion of AUC/A during the second quarter, primarily driven by State Street Alpha, underscoring the power of the Alpha value proposition to our investment services strategy and long-term growth. As a result, our AUC/A installation backlog declined to $2.4 trillion, while total AUC/A increased by 5% quarter-over-quarter to $39.6 trillion, both at quarter-end in part as a result of this new business. We also recorded over $140 billion of asset servicing wins in the second quarter, largely driven by strong sales in the desirable asset owner, official institutions and alternatives client segments. Our sales pipeline grew and we expect substantial onboardings in the coming quarters. We continue to advance and broaden our enterprise outsource solutions strategy across our clients' front, middle and back-office activities, as demonstrated by the expansion of Alpha's capabilities to ETFs, which we announced in 2Q. For the past 30 years, State Street has continuously innovated to support what has become a $10 trillion ETF market. Today, State Street is the largest ETF administrator in the world with more than 2,700 ETFs serviced in 13 countries. That long cycle of innovation continues as State Street Alpha now supports the entire ETF lifecycle. By integrating CRD's front office products with State Street's industry-leading ETF servicing capabilities, Alpha now provides a centralized platform for ETF issuers across the entire ETF lifecycle, including portfolio management, trading, and compliance to enable the growth across a variety of ETF strategies and increased speed-to-market. Turning to the front office software and data business, our overall CRD pipeline is strong. In the second quarter, we converted a meaningful number of on-prem CRD clients to recurring SaaS revenue, which when coupled with new SaaS client implementations, increased annual recurring revenue by 12% relative to the year-ago period. In addition, Charles River Wealth Management Solution continues to resonate with clients and drove a significant increase in on-prem revenues this quarter. Year-to-date, CRD's wealth-driven revenue has more than doubled compared to the first half of 2022, and we remain on track to grow CRD's wealth revenue this year. The State Street Global Advisors quarter-end assets under management totaled $3.8 trillion, supported by higher period-end market levels and $38 billion of net inflows from all three business lines: ETF, cash, and institutional. Our SPDR ETF business gathered $27 billion of net inflows in the second quarter, including $20 billion of net inflows into SPY, the industry's largest ETF. We also delivered a solid performance in our US low-cost ETF segment, which gathered $7 billion of net inflows in the quarter, continuing to gain market share. Our cash business gathered a solid $10 billion of net inflows in the second quarter, as our US government money market funds benefited from the attractiveness of the cash asset class in the higher-rate environment. Turning to our financial condition, State Street's balance sheet, liquidity and capital positions remain strong. Our CET1 ratio was a strong 11.8% at quarter-end, well above our regulatory minimum. The ongoing capital generation of our business, coupled with effective balance sheet management and our strong capital position has enabled us to deliver against our goal of returning significant capital to our shareholders. In 2Q, we returned approximately $1.3 billion of capital, buying back more than $1 billion of our common shares and declaring over $200 million of common stock dividends. This means that cumulatively over the last three quarters to the end of June, we have returned approximately $4.4 billion of capital to our shareholders through a combination of share repurchases and common stock dividends. The strength of our balance sheet was also highlighted with the release of the Federal Reserve's annual CCAR stress test results in June, following which, we announced our intention for the third year in a row to increase State Street's common stock dividend by 10% in the third quarter, subject to consideration and approval by our Board of Directors. It remains our intention to continue common share repurchases under our existing authorization for up to $4.5 billion in 2023, subject to market conditions and other factors. To conclude, financial market conditions in the second quarter were mixed. Although global equities recorded another sequential quarter of growth, there was weakness in emerging markets, and we witnessed the negative impact of persistent inflation and further central bank rate hikes on fixed-income markets. Meanwhile, both equity and currency volatility continued to decline. Despite this varied backdrop, we achieved a number of positive outcomes in the second quarter, including significantly reducing our asset servicing backlog, further developing our Alpha capabilities, continuing to record new asset servicing wins, driving strong growth in front office software and data revenue and gathering solid net inflows at Global Advisors. And while we reached double-digit year-over-year EPS growth supported by our capital management and the higher interest rate environment, our results were below our potential. First, while we achieved sequential fee revenue growth in areas of our business this quarter, we need to demonstrate the fee growth every quarter, especially as NII is no longer a tailwind. And second, we are highly focused on controlling our expense base. We have a well-established track record of reengineering our processes and transforming our operations in order to improve our efficiency and realize productivity growth. We plan to utilize additional tactical expense levers at our disposal in addition to our ongoing structural productivity efforts in order to support our financial performance for the benefit of our shareholders. Now let me hand the call over to Eric, who will take you through the quarter in more detail.

Thank you, Ron, and good morning, everyone. I'll start with a review of our second quarter results. We reported earnings per share of $2.17, a 14% increase compared to the same quarter last year. Revenue rose by 5% year-on-year, driven by growth in our front-office solutions, a strong performance in the securities finance sector, and increased net interest income. This growth helped us counterbalance some challenges we faced in other fee areas due to a mixed macroeconomic environment. Additionally, an accounting change for tax credit investments simplified our reporting for the future. While our year-on-year fee growth was modest, we observed improvement in sequential revenue momentum and an increase in the sales pipeline, which we plan to leverage in the upcoming quarters. As we pursue growth, we are carefully investing in the business while managing costs in the current operating landscape, and we are prepared to make further expense adjustments if global conditions remain soft. Looking at our assets under custody/administration, we saw a 4% year-on-year increase and a 5% rise from the previous quarter, driven by higher equity market levels and client net inflows. In our Global Advisors segment, assets under management increased 9% year-on-year and 5% sequentially, primarily due to higher market levels. On the topic of servicing fees, we recorded a 3% year-on-year decline as new business was offset by reduced client activities, primarily related to custody and transaction volumes. However, sequentially, servicing fees rose 3%, aided by higher average market levels and net new business, despite some pricing pressures. The onboarding of a significant $1.2 trillion in assets related to an Alpha client positively impacted these results. Management fees for the quarter totaled $461 million, a 6% decrease year-on-year, primarily due to net outflows from prior periods and pricing pressures, though they increased by 1% from the previous quarter. Our investment management franchise remains strong, with notable net inflows across various products including ETFs and cash management funds. Foreign exchange trading services revenue decreased 8% year-on-year and 11% sequentially, primarily due to reduced client volumes and lower industry volatility. However, our securities finance revenue was up 9% year-on-year and 7% sequentially, driven by increased agency spreads. Software and processing fees grew significantly, driven by higher revenue from front-office software and data, while lending fees saw a slight decline year-on-year but increased sequentially. Additionally, other fee revenue rose significantly, owing to the earlier accounting change and the absence of certain market-related adjustments. In terms of net interest income, it increased 18% year-on-year but fell 10% sequentially. The yearly rise was largely due to higher short-term and long-term rates, while the sequential decline reflected a rotation in non-interest-bearing deposits and pressure in our US back-book. Looking ahead, we anticipate a decrease in net interest income for the upcoming quarter due to expected lower deposit levels and continued rate hikes. We also expect modest expense control measures to lower costs slightly sequentially while maintaining investments in key areas of the business. Overall, we remain committed to managing our expenses effectively and returning value to shareholders while navigating the challenging market conditions. Let’s continue with more detailed insights into the quarter.

Thanks, Eric. Operator, we can now open the call for questions.

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions) And our first question comes from Brennan Hawken from UBS. Your line is now open.

Good morning. Thanks for taking my questions. Eric, I'd like to sort of double-click on some of the comments that you made about deposits. So you talked about back-book pricing in the US dollar book. Does that mean that we should be thinking about the potential for betas to exceed 100% here when that starts to work through? And what kind of magnitude do you think that could reach? And could you also help me understand the euro because when I look in the financial supplement in the breakout by currency, it looks like the euro deposit costs were up about low 40s bps quarter-over-quarter which seems like a beta that's a good deal higher than the 50% you referenced. I know there's some swap noise so maybe that's what it is, but could you maybe flesh that out a bit for me?

Sure. Let me begin with the betas we observed, especially concerning the US book. We're currently in a phase of rising interest rates, having experienced several 50 basis points increases. This shift sends a strong message to our clients that rates are significantly higher and rising quickly. Concurrently, the highly inverted yield curve has provided clients with real alternative investment options that were not previously available, such as treasuries, money market funds, and repos. Our larger, more sophisticated clients are actively exploring these alternatives, a trend accelerated by the rapid pace of this cycle. Looking at US deposit betas, they were in the 80% to 90% range in the last few quarters. This quarter, we reached 100%, and we anticipate that next quarter, we will exceed 100%. This increase is primarily driven by a catch-up in our existing portfolio. Just like retail banks experience with retail deposits, our clients are approaching us to adjust their lower transactional or mid-tier rates. What we’re witnessing now, after a period of widening spreads on deposits, is a return to where things ought to be. We initially had several quarters with betas below 100%, but now we are at 100% and foresee a quarter where they will exceed that level. This catch-up in the back-book is influencing the notable increase in net interest income reduction this quarter, which is a 10% decrease from the previous quarter. As I mentioned in my outlook, we expect a 12% to 18% reduction in net interest income in the upcoming quarter. If we break that down, part of it results from clients moving away from non-interest-bearing accounts, but a significant portion is due to the adjustments in the back-book. We believe we have seen the bulk of this adjustment and expect it to stabilize over time. I'm open to discussing this further and sharing our insights as we delve deeper into our areas. Regarding your question about euros, we should follow up on that. We estimate quarter-on-quarter betas of about 50%, but it would be best to discuss that offline, as it is detailed in the supplement, and I can coordinate that with you and the Investor Relations team.

Sure, I can help with that. You mentioned the large client migration is part of the outlook. Can you clarify how much this will affect the third quarter? Additionally, what should we anticipate regarding the timeframe for the remaining impacts and when they might materialize?

Yeah, I think the broader context, as you recall, Brennan, is that we disclosed that large client deconversion was going to happen over multiple years. We announced it well over a year ago, and we described it in our K at about 1.7% of fee revenue. So you can calculate that through. I think in our fourth quarter earnings call in January, I described that we had seen about $20 million on a run-rate come out, but I can reconfirm that. In the next quarter, this coming third quarter we'll see about $20 million come out sequentially. And then in the fourth quarter, there's another piece of about $15 million that will come out as well. And then after that, it's several more quarters before we see the later and final installments. But that's incorporated into our guide.

Hey, good morning, guys. So just maybe staying on the deposit question for another minute. Why do you guys think this catch-up is happening now, sort of late in the cycle? We've obviously been in a higher rate environment for well over a year. So curious if you can provide more color on particular customer segments in the US that's driving that and sort of the discussions around that? And then maybe as you sort of think about the end state for US interest-bearing deposits, I think you're at 3.5 or so today. The cumulative beta on that is, I think, is around 70% relative to the Fed funds rate. Should we think of that approaching, I don't know, 85%, 90% kind of how do you think about where that deposit price in the US will stabilize?

That's a good question. We are clearly navigating an interesting environment that hasn't been seen in two decades. We have to look back to before the crisis to find prevailing rates at 5%. Considering how quickly we've reached this point, we've included information on page 16 of our materials. This cycle has experienced a significant uptick in rates in half the time of the previous cycle. As rates rise, clients begin engaging with us about what would be appropriate, such as implementing multiple balance tiers and discussing expectations, which leads to negotiations. These discussions can take place over three to nine months, and some may have started in the second, third, or fourth quarter of last year as both we and our clients considered the possibility of rates rising to 5% or potentially dropping to 4% or 3%. The speed of the current situation is noteworthy, and the inverted yield curve, along with the attractiveness of money funds and treasuries, offers clients a more compelling alternative compared to previous cycles. Upon reviewing our book, we've noticed activity in non-interest-bearing deposits declining and some clients wishing to convert their non-interest-bearing accounts to interest-bearing at specific rates. There is a clear segmentation in client accounts; for example, across around 30,000 non-interest-bearing accounts, the average is just over $1 million. Our analysis reveals that higher balance non-interest-bearing clients have decreased by 70% year-over-year, while smaller accounts have dropped by 15%. We are currently addressing how many larger non-interest-bearing deposits have transitioned to interest-bearing accounts and at what rates. Our perspective is that we are in a catch-up phase regarding the back-book, with non-interest-bearing deposits moving to interest-bearing and interest-bearing accounts being adjusted in terms of pricing. We anticipate that the peak of this catch-up will occur in the third quarter as we analyze deposit types across larger and smaller clients. We expect this process to continue into the third quarter, peak there, and then begin to moderate in the fourth quarter.

Got it. And then like just the end game in terms of what you ultimately think US deposit cost is going to look like relative to kind of the 3.5 and the Fed funds at 5?

I haven't directly calculated the cost versus rate on a net interest margin basis, but we could figure it out if that would be useful to you. Regarding our outlook for net interest income, I've provided some estimates for the third and fourth quarters. We believe net interest income will stabilize in the range of $550 million to $600 million per quarter. If you find it helpful, we can also work on calculating the spread on assets or the cost of funds for deposits and get back to you.

Great. Thanks for taking my question. Amidst Ron, I guess I wanted to come back to your comments on the, basically, the overall revenue per client, if I can sort of summarize it that way. Obviously, there are different components of how clients, the asset servicing clients pay for the business, and there are many different ways aside from the core fees that they can do that. So as you think about that across the client base, I know you have looked at this more holistically across clients over many, many years. But with the deposit beta going up, is that sort of revenue per client going down? Or do you think you're able to actually improve the fee rate given that they aren't paying as much on the compensating balances?

Brian, that's a great question. I'm referring to how we approach this tactically on an individual client basis, but I also want to touch on the broader strategic aspects. There isn't a single answer for each client because, in our core back office business, we deal with custody and fund accounting, which includes a pricing component along with related deposits. Increasingly, clients may engage us for middle office support, where we function as their back office and extend all the way to Alpha. We also need to consider whether we are managing foreign exchange and securities financing for them. FX usage depends on whether clients find it necessary, and most managers do require it, including those focusing on securities finance. That’s why I emphasize a tactical approach; we need a comprehensive discussion. It’s crucial for both parties to clarify what we’ve done for them over the years, especially when navigating fee challenges. This was based on certain assumptions, and if those aren't materializing, we need to address this together. This may result in higher fees in some cases, but more commonly, it leads to exploring new opportunities, possibly with services or funds we've yet to discuss. While this presents a challenge, it also opens doors for new conversations, which is a positive outcome. Senior personnel are deeply engaged in these discussions because they don't happen often. This is a crucial time for such dialogues. We see it as a potential opportunity, even as the net interest income outflow represents a significant challenge. Regarding the strategic aspect, I don't want to overlook it. Following our acquisition of Charles River and the launch of Alpha, we are beginning to see onboarding progress. Typically, we start with lower-fee and more complex middle office services, followed by additional offerings. It's essential that we implement these follow-on services as quickly as possible. Earlier, I mentioned that we moved over $1 trillion to be onboarded, which will lead to other services and higher revenue per asset. This is the operational model of Alpha and how it will evolve. Despite the short-term challenges Eric mentioned concerning client transitions, we are optimistic about the revenue outlook as we move into 2024.

That's great information. On the expense side, Eric, you talked about the expense levers. Are they more tactical, or do you see the potential to continue reengineering the cost base? You have already done an excellent job of reducing costs structurally over the past few years. I'm not sure if we have mostly finished that process, and when you achieve cost savings, do you reinvest them in growth initiatives, or is there a possibility to further reduce the overall cost structure?

Brian, let me address that first, and then Eric will comment. We are definitely not finished with this. When we started this journey a couple of years ago, we focused on addressing the easier challenges that didn't require significant technology investment or reengineering. However, there is still more to do, and we are making substantial progress. We now have team members dedicated to both operations reengineering and technology who are actively working on this. This effort has impacted our results; as you can see from our expenses, we've managed to invest more in the business than we would have otherwise. We believe there is still much more to accomplish, and we will continue to provide updates on this each quarter. Additionally, we've discussed some tactical actions we can take, which are more about short-term considerations like consensus rather than extensive reengineering.

To summarize, we are committed to performance-based pay. When our sales are higher, we will reward that, and conversely, we will adjust when sales are lower. As you've noticed, we are controlling expenses as part of our execution strategy. Additionally, we've introduced updates regarding salary increases that we've reviewed over the past few quarters. At this point, we believe we have sufficient staff, which is why we've implemented a hiring freeze to manage our staffing costs. Our goal is to ensure that as we restructure, we effectively reassign employees to new or growing business areas while reducing staff in others. To achieve this in a calculated manner, we are maintaining strict control over hiring. Given our current performance, these measures reflect our commitment to managing costs.

There are no further questions at this time. I would like to turn the call back over to Ron O'Hanley for closing remarks.

Thanks, operator, and thanks to all on the call for joining us.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for your participation. You may now disconnect at this time.