State Street Corporation (NYSE:STT) Q2 2023 Earnings Call Transcript

State Street Corporation (NYSE:STT) Q2 2023 Earnings Call Transcript July 14, 2023

State Street Corporation beats earnings expectations. Reported EPS is $2.17, expectations were $2.1.

Operator: 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.

Ilene Fiszel Bieler: 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.

Ronald P. O’Hanley: 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 is 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 market sell as investors had to contend was 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 — US 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 on-boardings 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 ETF 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 ETFs 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 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 as 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 meaningfully 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. We need to demonstrate that 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 realized 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’ll take you through the quarter in more detail.

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Eric Aboaf: Thank you, Ron, and good morning, everyone. I’ll begin my review of our second quarter results on slide four. We reported EPS of $2.17 for the quarter, an increase of 14% relative to the second quarter a year ago. As you can see on the left panel of this slide, revenue grew by 5% year-on-year, driven by the expansion in our front-office solutions area, where we are an industry leader, continued momentum in securities finance business as well as strong growth in net interest income. This growth enabled us to offset some of the headwinds we saw in other fee areas given the relatively mixed macroeconomic backdrop. We also had the benefit of an accounting change for tax credit investments, which simplifies our reporting going forward.

While our overall year-on-year fee growth was less than we would have liked to deliver, we did see sequential quarter revenue momentum and a step up in the sales pipeline, which we expect to build upon in the coming quarters and which I’ll discuss later in today’s presentation. As we drive growth, we continue to prudently invest in the business while remaining focused on managing costs given the current operating environment, and we stand ready to further intervene on expenses should the softness in the global environment persists. Turning now to slide five. We saw period-end AUC/A increased by 4% on a year-on-year basis and 5% sequentially. Year-on-year, the increase in AUC/A was largely driven by higher period-end equity market levels and client net inflows.

Quarter-on-quarter, AUC/A increased as a result of the significant trillion-dollar Alpha installation and higher period-end market levels. At Global Advisors, we saw similar positive dynamics play out in the quarter. Period-end AUM increased 9% year-on-year and 5% sequentially. The year-on-year increase in AUM was largely driven by higher period-end market levels. Quarter-on-quarter, the increase in AUM was also due to higher period-end market levels as well as strong sequential net inflows. Turning to slide six. On the left side of the page, you’ll see second quarter total servicing fees down 3% year-on-year as net-new business in the quarter was more than offset by lower client activities and adjustments largely due to lower custody and transaction volume and better than usual pricing headwinds.

Positive year-on-year equity markets were offset by the negative impact of fixed-income markets. Sequentially, total servicing fees were up 3% primarily as a result of higher average market levels and net-new business slightly offset by better-than-usual pricing headwinds this quarter. We had a more constructive market environment relative to the first quarter as well as a significant onboarding of $1.2 trillion of AUC/A related to an Alpha client in the asset manager client segment, which comes at a modest fee rate, but with services are expected to be added in the coming years. Within servicing fees, back-office servicing fees were generally consistent with total servicing fees and largely driven by the factors I just described. Middle office services fees performance was meaningfully more positive for the quarter.

On a year-on-year basis, fees were up 3% primarily reflecting net-new business and up 10% sequentially, largely driven by the installation that I just mentioned. On the bottom panel of this page, we’ve again included some sales performance indicators which highlight the business momentum we saw in the quarter. While total AUC/A wins in the second quarter were not as robust in volume terms, client engagement remained healthy and we saw wins across strategic segments, including mandates and asset owners, official institutions and alternatives, which are key growth areas for us as we previously mentioned. The wins including those in the alternatives segment, which are more complex to service come with above-average fee rates. We have also seen a healthy uptick in our pipeline this quarter.

Turning to slide seven. Second quarter management fees were $461 million, down 6% year-on-year, primarily reflecting the impact of net outflows from prior periods, a shift of certain management fees into NII as previously described and some pricing headwinds, partially offset by higher average market levels. Quarter-on-quarter, management fees were up 1% as a result of higher market levels and cash net inflows. As you can see on the bottom-right of the slide, our investment management franchise remains well-positioned with very strong and broad-based business momentum across each of our three lines of business. In ETFs, we saw very strong net inflows of $27 billion into SPY and our sector suite of ETFs as well as our SPDR portfolio low-cost suite.

In our institutional business, we saw net inflows with continued momentum in our well-established index fixed-income and defined contribution franchises. Across our cash franchise, we continue to see strong demand for our money market funds. We recorded net inflows of $10 billion. Turning to slide eight. Relative to the period a year ago, second quarter FX trading services revenue was down 8% year-on-year and 11% sequentially, primarily reflecting lower client FX volumes and lower industry FX volatility. Relative to the period a year-ago, both volumes and volatility were more muted as the start of the war in Europe last year caused unusually high FX trading activity in the first half of 2022. Many clients were also risk-off during the debt ceiling discussions in April and May, with a rebound in June and client volumes falling its resolution.

Altogether 2Q is muted. We are optimistic about 3Q, but it’s hard to predict. Securities finance performed well in the second quarter with revenues up 9% year-on-year, driven by higher agency spreads. Sequentially, revenues were up 7%, again mainly driven by higher agency spreads as well as higher prime services or enhanced custody revenues from deeper client engagement and specials activity, partially offset by lower balances. Moving on to software and processing fees. Second quarter software and processing fees were up 18% year-on-year and 34% sequentially, primarily driven by higher front office software and data revenue associated with CRD which I will turn to shortly. Lending fees for the quarter were down 5% year-on-year, primarily due to changes in product mix, but up 5% sequentially, mainly driven by strong client demand for lines of credit.

Finally, other fee revenue increased $101 million year-on-year, primarily due to a tax credit investment accounting change and the absence of negative market-related adjustments. This includes the impact of the new accounting adoption. Moving to slide nine, you’ll see on the left panel that front office software and data revenue increased 29% year-on-year, primarily as a result of higher on-premise renewals and continued growth in our more durable software-enabled and professional services revenue as we continue to convert and implant more clients over to our SaaS environment. About 60% of our clients are now on our SaaS platform. Sequentially, front office software and data revenue was up nearly 50%. About two-thirds of this uptick was driven by wealth management mandates that are becoming an increasingly important growth segment for us.

Our sales pipeline continues to grow and remains strong for our Charles River development front office solutions products. Turning to some of the other Alpha business metrics on the right panel, we were pleased, we had three more Alpha mandates go live, which brings our total live Alpha clients to 15, and as I previously mentioned, we installed a significant portion of assets related to Alpha this quarter. We expect to provide more services related to these assets in the future, helping us increase the share of our client’s wallet. Now turning to slide 10. Second quarter NII increased 18% year-on-year, but declined 10% sequentially to $691 million. The year-on-year increase was largely due to higher short-term rates and increase in long-term rates and proactive balance sheet positioning, partially offset by lower average deposits.

Sequentially, the decline in NII performance was primarily driven by our continued rotation of non-interest-bearing deposit balances and rate pressure in the US back-book, partially offset by higher short-term market rates from international central bank hikes. On the right side of the slide, we show our average balance sheet during the second quarter. Average deposits declined 2% quarter-on-quarter in line with industry total deposit trends, which also fell by 2% in the second quarter and reflect client preferences to shift some cash to other products during periods of rising rates. Our operational deposits as a percentage of total deposits remained consistent at approximately 75%. Our global floating-rate loan book provides upside at this stage in the cycle and our investment portfolio positioning provides a tailwind as long rates roll through.

We now also have the opportunity to selectively add some duration across the curve, as we see good entry points, which could enhance NII over time. Sequentially, US dollar client deposit betas were 100% during the second quarter, leading again to some sequential NII compression. We are now at the point in the US rate cycle where we expect to adjust back-book pricing to accommodate our larger clients, but do so in a disciplined manner and usually as part of a broader relationship discussion, a balancing trade for fee opportunities. Foreign currency deposit betas for the quarter continued to be much lower in the 45% to 50% range. We’ve also included a new slide in the appendix, page 16 that shows our NII trends over the past few rate cycles. I think it will be — it will put the larger NII increases and decreases in context, which are driven by many factors, including changes in interest rates, the pacing of hikes, deposit levels and mix, Fed balance sheet changes as well as equity markets.

You can see from that page that our recent quarters have come with a much higher than usual level of NII and we are now normalizing to a more typical level of NII that is inherent in our business activities. Turning to slide 11. Second quarter expenses excluding notable items increased 6% year-on-year. Sequentially, excluding seasonal expenses, second quarter expenses increased just over 1% as we actively manage the expenses and continued our productivity and optimization savings efforts, all while carefully investing in strategic elements of the company, including Alpha, private markets, technology and operations, automation. On a line-by-line basis year-on-year, compensation employee benefits increased 7%, primarily driven by salary increases associated with wage inflation and higher headcount attributable primarily to operational staff for growth areas, technology staff, insourcing and some lower attrition, lower than expected attrition rate.

Sequentially, however, we have managed the headcount to be flat. Information systems and communications expenses increased 3%, mainly due to higher technology and infrastructure investments, partially offset by benefits from ongoing optimization efforts in sourcing and credits related to vendor savings initiative. Transaction processing decreased 2%, mainly reflecting lower sub-custody costs from vendor credits. Occupancy increased 7% as we relocated our headquarters building temporarily resulting in overlapping costs and other expenses were up 7%, mainly reflecting higher professional fees. Moving to slide 12. On the left side of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios, followed by our capital trends on the right side of the slide.

As you can see, we continue to navigate our operating environment with very strong capital levels, which remained well above both our internal targets and the regulatory minimums. As of quarter end, our standardized CET1 ratio of 11.8% was down 30 basis points quarter-on-quarter, largely driven by the continuation of our share repurchases and modestly higher RWA, partially offset by retained earnings. Our LCR for State Street Corporation was flat quarter-on-quarter at 108% and decreased four percentage points quarter-on-quarter, but still quite high at 120% for State Street Bank and Trust. We’re also very happy with our performance on this year’s CCAR with the calculated stress capital buffer well above the 2.5% minimum, resulting in a continued preliminary SCB at the floor.

This demonstrates we have one of the strongest balance sheets in the industry. In keeping with our results, in June, we announced the planned 10% increase for our 3Q ’23 quarterly common stock dividend, subject to Board approval and it remains our intention to continue common share repurchases under our current authorization of up to a total of $4.5 billion in 2023, subject to market conditions and other factors. We plan another $1 billion buyback in third quarter. Lastly, we are quite pleased to return roughly $1.3 billion to shareholders in the second quarter ’23, consisting of just over $1 billion of common share repurchases and over $200 million in common stock dividends. Turning to slide 13, which provides the summary of our second quarter results.

While there is certainly still work to do, we are pleased with the durability of our business this quarter against a mixed and divergent backdrop. Robust expansion of our front office solutions area and continued momentum in securities finance as well as strong growth in net interest income enables us to offset some of the headwinds we saw in the other fee areas highlighting the resiliency of the franchise. Next I’d like to provide our current thinking regarding our third quarter. At a macro-level, while we know that rate expectations have been moving, our rate outlook is broadly in line with the current forwards, which suggest that the Fed, the ECB and the BOE will all continue to hike in 3Q to varying degrees. In terms of average equity markets, we currently expect US equity markets to be up about 5% quarter-on-quarter as we are expecting equity markets to remain flat from now to quarter-end, and we expect international equity markets to be flattish on average.

Regarding fee revenue in 3Q, on a sequential-quarter basis, we expect overall fee revenue to be down approximately 1% to 1.5%, with servicing fees down 1% to 2% as the below-average fee repricing headwinds we saw this past quarter is expected to normalize in 3Q. This will also include a revenue headwind from the previously disclosed client exit. We expect management fees to be up around 0.5% to 1.5%. We expect front office software and data quarter-on-quarter to be down 7%, as we do not expect the level of on-premise renewals in 3Q that we saw this quarter. We expect the other fee revenue line to come in around $30 million to $35 million in 3Q which is higher than prior years but down post the accounting change impact in 2Q. Regarding NII, after three double-digit sequential increases in NII last year, we now expect NII to decrease 12% to 18% on a sequential-quarter basis, driven by lower deposit levels and continued rotation as rate hikes continue into 3Q.

Our outlook assumes that average non-interest-bearing deposits declined by approximately $5 billion from 2Q to 3Q. As we look forward to 4Q, we do expect to see some moderation to the amount of deposit rotation as we work through most of our back-book and most central banks begin to pause. With that context, we expect that 4Q NII decline to be much less somewhere in the range of down 2% to 6% versus 3Q, and we expect NII to then stabilize around those levels, but it will depend on market conditions. And our expectation is that 4Q declines in non-interest-bearing deposits will be small as well likely in the down to a $3 billion range versus 3Q. Turning to expenses, we remain focused on controlling costs in this environment, and we expect to take action in 3Q to bend the cost curve.

As such, we expect that expenses will be down 0.5% to 1% on a sequential-quarter basis and intend to continue to actively manage expenses. As always, this is on an ex-notables basis and we’re keeping an eye on the FDIC assessment, which could be a 3Q notable item. And as I noted previously, given the accounting changes we adopted this quarter, we expect our effective tax rate to be between 21% and 22% for third quarter. With that let me hand the call back to Ron.

Ronald P. O’Hanley: Thanks, Eric. Operator, we can now open the call for questions.

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Q&A Session

Operator: 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.

Brennan Hawken: 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?

Eric Aboaf: Brennan, sure. Let me start on the on the betas that we saw in particularly on the US book because we are at a period in the interest-rate cycle where we’ve now had multiple 50 basis points moved. It’s been a very strong signal to our clients that rates are much, much higher and much more quickly and much more visibly. And at the same time, they now have because of that highly inverted yield curve, they have real substitute alternatives that they used to not have in the past, whether it’s treasuries, whether it’s money market, whether it’s repo. There’s a range of what they can invest in. And what we found is that our larger clients and you know we primarily have large sophisticated clients are quite active and thinking about their alternatives and then that has been accelerated by the swiftness of this cycle and the place that we’ve come to and the speed.

If we think about the US deposit betas, they were in the 80% to 90% range last couple of quarters. This quarter we saw 100% and, yes, we expect next quarter we’ll be well over 100% and what’s driving that is really a catch-up in the back-book. We have clients coming to us as you’d expect, just like it happens with retail deposits for retail banks, but we have sophisticated large clients coming back and saying, look, some of our lower transactional rate levels or mid-tier rate levels are something that they like us to adjust. And in a way, what I think we — has played out is that while spreads widened for us on the deposit, but for some period of time, we’re now seeing a convergence back to where they would have been. And that’s coming through and so what we have in the cycle is actually a number of quarters of below 100% betas, then we get to a 100% beta and then we are going to have a quarter where betas are well-above that 100% level.

And it’s really a catch-up in the back-book and that’s what’s playing through. It is what is beginning to drive this higher reduction in NII this quarter, the 10% quarter-on-quarter that you saw. You saw in my outlook, we are expecting 12% to 18% reduction in NII this coming quarter. And if you peel that apart, some of that is the continued rotation out of non-interest-bearing, but some of it and in good part of it is this catch-up in the back-book that’s playing through. We do think that over time, we’ve seen the bulk of that and that will begin to moderate and I’m certainly happy to go into that and some of our perspective as we drill down deeply into our areas, but that’s the context. On your other question on euros, we should probably follow up.

I think we see betas quarter-on-quarter of about 50%, but we should probably just follow up offline because I think that’s deep in the supplement and probably do that with you and the IR team.