October 30, 2018 - 9:10pm EST by
2018 2019
Price: 46.92 EPS 4.25 4.55
Shares Out. (in M): 1,004 P/E 11.0 10.3
Market Cap (in $M): 47,100 P/FCF 11.0 10.3
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0 0

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We like to buy companies from one of two buckets -- first bucket is the high quality business with a wide moat that is likely to be larger and more valuable in ten years.  The second bucket is ridiculously cheap securities that we believe can provide very large returns, but that have more risk (like our AR idea from one year ago that has not yet worked like we expected, but we are patient).  In that first bucket, we like Bank of New York Mellon (BK) at these prices.  We have owned it since 2012.

As most of you know, BK is not really a bank but more of a business process company serving asset management firms.  BK also operates an asset management business.  They have a wide moat built around scale in their servicing business.  The asset management business is also solid, but subject to more competitive threats (in our opinion).  BK reminds me of another investment we made many years ago -- Waste Management.  Wait, what?  We bought WM in 2003 for about $20/share on the thesis that coming out of a recession, with irreplaceable assets in an oligopoly industry structure, WM should have pricing power.  After all, they aren't making new landfills and WM owned key properties near growing urban areas.  The lack of pricing power was frustrating for WM.  We thought the story should evolve more quickly and WM should use their relative power in the industry.  As always, it took more time than we expected, but WM turned out to be a great investment (we no longer own it) with plenty of dividend income and price appreciation along the way at relatively low risk.

BK has been similar.  With STT as the primary competitor for the largest asset managers, it would seem that these two companies should have more pricing power.  Instead, they seem to battle over market share with each company picking off clients from the other each quarter.  While it makes for good headlines, this competition doesn't do much for the profitability of each company.  We get it.  Active asset management is under assault, looking to cut costs in any way possible.  The pressure has been on BK and STT to drop price.  We've been surprised by the intensity of competition, but yet the financials results have been fairly solid. 

Let me demonstrate the financial progress of the two major businesses over the past six years:

                                                     3Q2012                  3Q2018              CAGR

Investment services fees ($M)            $1,678                     $1,964              2.7%     

Investment management fees ($M)     $779                        $922                 2.8%

This isn't exactly FANG-style growth numbers.  Despite growth in assets under custody of 3.6% CAGR (same time period), revenue growth has been slower.  There is compression in fees (a shocking surprise to all on Wall Street).  To be clear, there are a couple of other revenue sources, but they aren't material to the thesis here... just so you don't get confused on how this table doesn't quite equal reported financials.

Revenues aren't the whole story.  Consider expenses for the same time period:

"Normalized" expenses                        $2,705                    $2,738                0.2%

BK management has been able to limit expense growth to a rate below that of revenue growth.  There are two primary reasons for this margin expansion (non-GAAP operating margin has increased from 31% to 33% over this period).  The obvious is higher interest rates.  That has allowed BK to collect fees on money market funds, etc when those fees were waived when interest rates were zero.  The second reason is the constant deflation in technology spending required to provide BK services (automation leads to fewer people as well).  BK has worked hard to simplify their processes after the merger between Bank of New York and Mellon.  This constant grinding out costs is a central part of our thesis.  We think over time, BK (and STT too) will succeed in lowering costs and thus increasing the barriers to entry from other competitors. Currently, and perhaps permanently, those cost savings are being passed on to customers. 

In the meantime, BK generates plenty of free cash flow.  They pay $1.12/share in dividends for a yield of 2.4% on today's share price.  That leaves them with plenty of cash for share repurchases.  They've done just that.  Over the measurement period used above, the sharecount has declined from 1.21B shares to 1.00B shares, or about 1/6th of the sharecount has been retired.  Most of their earnings will be used to retire shares over the next few years.

Given the nature of the industry, and BK's competitive position, we think the shares should trade at a meaningfully higher multiple over time.  We think it is quite possible that BK earns $5.50 per share in 3-4 years.  At a 14x multiple (which seems very reasonable for a business of this quality), the shares would trade for $77.  That represents a 13% annual return over four years, with an additional 2.4% yield.  An expected return of 15% for a business of this quality is tough to find in today's markets, especially with a competitive position like BK.

We had to be patient with our Waste Management shares, but the market eventually figured it out.  We think the same happens with BK.

To paraphrase Jim Grant, 'Value investing is getting investors to agree with you... later.'                                                        

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.



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