Based in Boston, State Street Corp. (STT) — a new addition to our growth & income portfolio — is the world’s largest custodian bank, with $38 trillion in assets under custody/administration, suggests Bruce Kaser, editor of Cabot Undervalued Stocks Advisor.
In its early days, State Street provided back-office services for investment managers, including holding securities for safekeeping and processing of investment fund transactions. Over time, the bank added middle-office and front-office services, including client reporting, electronic trading and full enterprise solutions for investment managers. Today, all of these services comprise about 56% of the bank’s revenues.
The industry has consolidated into four dominant firms, including #2 Bank of New York Mellon (BK), and JPMorgan (JPM) and Citigroup (C), due to the economies of scale that allow larger firms to offer more and better services at lower costs.
A recent indicator of these economies is that State Street acquired the back-office operations of Brown Brothers Harriman (BBH), adding $5.4 trillion in assets under custody/administration, as BBH wanted to focus on its core investment management activities.
The bank’s State Street Global Advisors subsidiary is a major issuer of index exchange traded funds, with $3.5 trillion in assets under management. The division produces about 17% of total revenues. In addition, the bank earns interest income on its portfolio of investments, which contribute about 16% of total revenues. The balance of revenues is produced from foreign currency transactions.
Shares of this well-managed, high-quality bank are out of favor with investors. Since reaching 104 in January, the shares have declined about 30% and are essentially unchanged since 2007.
Near-term concerns include the bank’s fee sensitivity to stock and bond markets, cost pressures from wages (about half of total expenses), travel and other expenses, the likely loss of some cash deposits as customers shop around for higher returns on their short-term cash balances, and potential integration issues with the BBH combination. Longer-term concerns include slow industry revenue growth along with steady pricing pressure from competitors.
While we acknowledge these issues, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive 8.6x estimated 2023 earnings. This is below what we believe is a fair valuation at about 11x.
The valuation on tangible book value (TBV), at about 1.9x, is also at the low end of its post-financial crisis valuation range. We place a more appropriate valuation at about 2.1x TBV based on likely 2023 tangible book value. We also find the 3.4% dividend yield appealing. For STT shares, we have a $94 price target.
