"Men and melons are hard to know." - Ben Franklin
Bank stocks are out-of-favor, perhaps deservedly so. But I believe that the financial crisis is likely to create clear winners and losers with the benefit of hindsight. I've grown increasingly interested in "bank-like" businesses which are discarded as banks, but have significantly different credit risks and drivers of earnings. The trust banks are such an example.
I believe I have found a good melon for a cheap price with Bank of New York. It is an above average business in an improving industry, which happens to be trading at a below average multiple on depressed earnings. I hope that I can double my money in the stock over the next few years, with limited risk of losing my money. In 2014, I believe the company will have $3.50+ per share in earnings power and be worth $50-55 a share, capitalizing those earnings at 15x.
My thinking is simple. In June 2008, with the benefit of one-year of the Mellon merger behind them (~$1B in synergies 25% achieved in 2008) and robust financial market activity, management presented aggressive earnings goals which implied $10B+ in operating earnings by 2014 extrapolating forward. Instead, the financial crisis and related events significantly dampened the earnings of the business, so that the business generated only $4.2B in recurring operating income in 2010.
In 2014, assuming that interest rates rise and financial market activity and asset prices drift upward (while holding Fx and issuer services basically stagnant from depressed levels today), I believe the business can earn $6B in operating income, which corresponds with the $3.50 in EPS mentioned above.
Management is above average, appearing to deserve their positive reputation in the industry. Further, Bank of New York's financial position appears strong. I believe the combination of a large amount of assets being short duration US government guaranteed securities and similar, 6:1 ratio of "risk" assets to capital (much of which appears to in fact have very little credit risk), and the creation of $3B of capital each year from earnings, provides a strong financial position which will survive a second recession unimpaired. The CEO Bob Kelly recently said, "All of our analysis seem to indicate that we do not need much more capital in any circumstance higher than today."
Lastly, I believe there is a possibility that the trust banking business may be going through a positive change. It is an oligopoly industry with high barriers which has lost some of its most lucrative add-on services, mainly indirect Fx trading and securities lending. Industry participants believe this and seem committed to improving margins nonetheless (as example, read Mike Cavanagh's goals in JPM's annual letter). I believe this may drive much firmer pricing by the industry participants (switching costs are very high, so a modicum of industry discipline could lead to much improved pricing). Also, aspects of the business are more analogous to IT consulting and software-as-a-service, with high technology fixed costs which drive higher margins with throughput and the ability to reduce costs through consolidation and off-shoring. This possibility has not come through in the numbers yet due to the recession, but remains a reasonable and exciting possibility.
Below is a general description of the business and some key details, relevant for only those interested in reading further:
Bank of New York is a put together company. The most important transaction was the merger with Mellon in July 2007, after a decade of sporadic courting.
Roughly ? of the revenue and operating income comes from traditional custody business, called asset servicing. Bank of New York is the #1 in the world with ~24% of assets under custody; #2 is JPM with 17%, #3 is State Street with 16%, and #4 is Citi. Top 5 in the world have ~67% of assets under custody. This is a "plain vanilla," back-office service of holding someone else's assets on their behalf and managing all the associated paperwork (increasingly electronic). In spite the commodity-like nature of the business, management says it generates high returns and has high growth potential. The high returns appear to come from the high fixed cost and scale-driven nature of the business. High growth comes from asset valuation inflation over time and world-wide consolidation. This business also includes securities lending, which I think of in its simplest form as a way for the owner of a security to skim a little yield off lending its assets out, but a practice that can lead to out-sized losses if one reaches for yield. Low interest rates hurt earnings of securities lending. Around ¼ of this businesses revenue and perhaps ? of its operating earnings comes from foreign exchange trading, discussed in more detail below.
Another ½ of the revenue and operating income come from issuer services, clearing services and treasury services. Management has described these businesses as being average in growth outlook and returns. The issuer services is managing the flow of funds through corporate trusts, ADRs, and cross-border M&A and other corporate activities. This business was somewhat impaired after the collapse of the securitization market, but should grow modestly from a new base due to increased cross-border activity. Clearing services (Pershing) is a global execution and clearing business targeting smaller broker dealers and managed accounts, and appears to be an average business. Lastly, there is a treasury services business, which involves processing payments. This is a high margin business with modest growth potential.
All of the above businesses rely on interest rates to generate income. As securities are purchased, sold, and distribute dividend and interest payments, deposits are created ($145B as of year end 2010). Bank of New York earns a net interest on these deposits, primarily through purchasing securities. Securities lending and margin loans likewise rely on interest rates to generate income. To the extent current short-term interest rates are below normal, earnings are dampened.
Lastly, the remaining ? of the business is asset management and a smaller wealth management business. This is a high return business with attractive long-term growth prospects. Bank of New York has $1.1T of assets under management, including cash, index funds, fixed income and currencies. Most of this business is legacy Mellon and is described as a "class of its own" by sell-side analysts.
Roughly ? of the company's revenues are outside the US, and this will increase over time, partially due to foreign acquisitions.
There is a lot of concern with the capital position of banks and the future requirements of large financial institutions (Bank of New York will be a global SIFI).
I believe the combination of rapid capital generation, a high return on tangible capital business, and a highly liquid and apparently safe balance sheet makes the financial position sufficiently strong and the increased capital required to support the business more than already priced in the stock price.
Bank of New York has $225B in tangible assets and only $9B in hard book. Of the assets, however, $120B are US government guaranteed securities and short-term deposits at banks, which I view as basically "riskless," setting aside interest rate sensitivities. "Risk" assets are as follows: $19.1B in securities, $11.3B in margin and overdraft loans, and $26.0B in other loan. Assets are funded with $145B in deposits, $35B in loans, trading liabilities and similar. There is $9.4B in hard equity, so that the ratio of "risk" assets as defined to hard equity is 6-to-1.
According to Bob Kelly, the capital ratios are improved by 25% each year after dividends. Therefore, the company should be able to generate more than enough capital to meet any increased regulatory requirement.
MBS and Fx liabilities
There are two major concerns with ongoing liabilities with Bank of New York: MBS exposures and indirect Fx trading.
The MBS securities concerns relate to potential liability from serving as the trustee on MBS securities that went bad. According to p. 25 of the 10-K, "As trustee or custodian, we have no responsibility or liability for the quality of the portfolio; we are liable only for performance of the limited duties as described above and in the trust document." It appears that if Bank of New York made errors in keeping track of documents, it may have some exposure. But the prospect of material losses from mishandling paperwork, as opposed to bad underwriting, seems exceedingly remote, in my view.
Bank of New York makes money by providing indirect foreign exchange to clients. As dividends and other flows "drip" from securities in multiple currencies held in custody, Bank of New York nets these flows on behalf of clients and then executes foreign exchange transaction on their behalf for any outstanding amounts. In doing so, it acts as a market maker taking the opposite side of the transaction and not as an agent. There are numerous potential principle-agent problems with this service. The trust bank can somewhat arbitrarily choose advantageous Fx prices for themselves (it is a highly liquid market, but there is no "print" to determine the correct price at any given moment). The trust bank could manipulate prices with their large flows, functionally front-running their clients. The trust bank could perform sloppy execution with other people's money.
The indirect Fx business has generated numerous news stories, litigation suits by "whistleblowers," and investigations by state attorney generals. The presence of Harry Markopolos leading whistleblower suits and numerous WSJ cover stories with "proprietary research" appear to add gravitas to the perceived impropriety. The news story graphs make this appear to be as rotten as stock option backdating. Many more suits are being considered but not announced. More negative news stories and further litigation are a certainty.
I believe that the final result of this ballyhoo will not result in material liabilities or impairments in the earnings power of the business. In my view, a better analogy than stock option backdating is 'soft dollars" and the sell-side research suits. Custodians need to get paid for their services. Analogous to higher commissions accompanied with soft dollars, an asset manager can "pay" its custodian by using indirect FX services. This has the additional benefit for the manager of not appearing in their expenses. Sophisticated parties knew what they were doing, or most definitely should of. The settlement of trailing liabilities will take time, but is unlikely to involve significant dollar values. For instance, the State of Washington recently settled their Fx related suit with State Street for $7MM. The go forward earnings of the business will be corrected by careful adjustments to the legal language and frank conversations with clients holistically about "the relationship."
I will attempt to answer further questions in the message thread. I am particularly interested in those of you who take a divergent view with elements or all of my analysis.
|Subject||Return of Capital|
|Entry||06/13/2011 05:56 PM|
Given the increasing capital requirements, is there a possibility that BK will be forced to retain all earnings going forworad? or will they possibly still have excess capital for buybacks or increased dividends?
Also, can you roughly quantify BK's leverage to higher short term interest rates? Seems like a free option.
|Subject||RE: Bear case|
|Entry||10/03/2011 03:46 PM|
I think the quickest way to get up to speed on the business is review Brad Hintz's research on the custodial banks.
|Subject||RE: RE: RE: Bear case|
|Entry||10/05/2011 03:28 PM|
There are others who will have a better view of current pricing negotiations. I summarize my view on the broader dynamics as follows:
1) there are four players of size in a scale game which has costs which have elements which are akin to software-as-a-service and are inherently deflationary.
2) over a period of half a decade, prices for the core custody product were deflationary as well as the entities were able to make ample profits from the add-ons, mainly Fx and securities lending, often in ways the client didn't "feel." With the addition of low interest rates and little appetite for asset risk, and low expectations for the future of all of the add-ons, and management's stated profit goal expectations (see the JPM subset of annual letter), there will be a lot of pressure on management's to maintain profitability through being firm on pricing and cutting costs.
3) if State Street management is right, there will be ample opportunities for growth through international consolidation as the subscale European national champions shed custody businesses, which should relieve competitive intensity.
4) this is a price discussion between a sophisticated client and a sophisticated, wholistic view of client-level profitability custodian. and switching costs are ridiculously high.
5) there is no obvious player who has an incentive to be the price aggressor.
These dynamics lead me to believe the following: 1) it is unlikely to go back to the good old days of the 2000s, these businesses are permanently worse than before, 2) the custody businesses need to hold price and let the deflationary dynamics of costs (relative to AUM) play out over time to recapture some of the lost margin. This can be an OK business again, but not a stellar one.
In summary, I think an improving pricing environment is more likely than a deteriorating one.
If there are others who disagree, please share.
My concerns relate to the balance sheets and the off-balance sheet contingent liabilities, such as a soft obligation to "make whole" money market funds and securities lending portfolios.