Description
Background:
The merger of Mellon Financial (MEL) and Bank of New York
(BK) was announced in early December of last year and is expected to close on
or about 7/1/07 with the new
company to be called The Bank of New York Mellon Corporation. Both companies are
in the Trust/Custody bank space. Combined, they have five primary business
lines: private wealth management, asset management, custody services to other
asset managers, corporate trust, and issuer services. These businesses exhibit 1)
recurring fees, 2) leverage to appreciating capital markets, 3) leverage to
deepening global capital markets 4) high and intensifying barriers to entry, 5)
consolidating competition, and 5) very high marginal returns on incremental
business growth.
I believe that the earnings power, and future book equity growth
of the new company is very much undervalued.
This write-up will lay out in more detail the 6 catalysts listed below.
The terms of the deal are 1 newco share for each share of MEL and .9493 newco
share for each share of BK – thus I will primarily use MEL stock price and
estimates in the following analysis.
I believe there is minimal downside in the stock and 25%
upside over the next six months, and +50% over the next 12-18 months.
Catalysts for BK:
1 – Short Term (1-2 months) - deal closes removing
uncertainty and arbs
2 – Short Term – the new BK should hold up well if the
market weakens as both constituent stocks have performed poorly since the deal
was announced on 12/6/06.
Since then MEL is up 2%, and BK is up 3% vs. the S&P up 10% and the S&P
Financial Index up 7%. This, despite MEL and BK being ‘market sensitive’.
3 – Medium term (6-7 months) - estimates for the combined
company should rise as both MEL and BK have beaten numbers in 4Q06 and 1Q07 but
estimates have barely budged. Sell side analysts are waiting for the deal to
close prior to updating their models.
4 – Medium Term – expectations for cost cuts are too low at
9% of the combined non-interest expense of the new company. Management has
sandbagged their guidance so as to generate ‘surprises’ vs. the street. These
are firms with significant overlaps in terms of their business lines,
technology platforms and geographic operating offices. Historically, deals in
this space have achieved a much higher amount of expense reductions than
guidance. Also, there are some easily realizable revenue synergies in this deal
which are not yet in estimates.
5 – Longer Term (12-18 months) -The number of large
competitors in this space is rapidly shrinking with this year’s MEL/BK,
STT/IFIN and the 2006 BK/JPM deals. This should alleviate some of the pricing
pressure seen in the last several years and reduce the need to maintain IT
spending at current percentage levels of revenue.
6 – Long Term –This M&A activity has created a few large
players in each subsegment of the trust bank space. Many small regional players
will likely lose business as they are unable to offer the same level and suite
of services and/or keep up with the spending required to stay in the game.
Detail:
1) The deal is expected to close on or about 7/1/07. Both firm’s shareholders
recently approved the deal and it is unlikely at this point that anything will
slow the closing in a material manner. For the last 6 months, BK and MEL have
been seen as ‘deal stocks’ and so have not been receiving as much fundamental
analysis from the Buy & Sell side as usual. Also, many of the recent
holders are arbitrage players who will likely exit upon consummation of the
deal. Many investors have likely been kept away over the uncertainty around the
deal closing as well as anti-trust & regulatory objections. Finally, the
new BK will be an almost $60B market cap company and large cap investors will
not be able to ignore. I expect that the new BK will rally when the deal closes,
the arbs close out their positions and fundamental investors take a look at the
new firm.
2) The last 6 months have been a very good operating
environment for both Trust & Custody banks. Despite this, MEL is up only
2%, and BK 3% vs. the S&P up 10% and the S&P Financial Index up 7%. Also
other competitors have performed much better. The best pure plays competitors –
STT and NTRS are up 6% and 12% respectively and STT was up more prior to paying
up to buy IFIN which is up 48% during this period. While not only in the Trust
& Custody business, C and JPM are the other large competitors in the space
and they are up 11% and 12% as well. Clearly some catch-up may be in order once
the deal closes. If nothing else, the new BK is likely a safe way to invest in
large cap financials if you are concerned that market returns will be
lackluster in 2H07 – after all, if MEL and BK haven’t gone up in this leg of
the bull market, why would they participate in a sell-off?
Between the strong operating backdrop for both companies,
and the poor performance of the two stocks vs. peers, I expect with the removal
of the deal uncertainty we will see 5-10% rise in new BK’s stock price just
from ‘catch up’ over the next 8 weeks.
3) Estimates are likely to rise in the months after the deal
for three primary reasons. First, business has been very good for MEL and BK
over the last 6 months. Both companies beat estimates for 4Q06 as well as 1Q07.
Secondly, State Street and
Investors Financial (two large competitors of MEL and BK) agreed to merge.
Finally the stock market, debt issuance and M&A volumes have been strong
over the last 6 months which is a positive for the EPS for trust, custody and
asset management businesses. Despite these points, estimates have barely budged
upwards for either stock. Once the deal closes, and the company can offer
analysts better guidance as to the composition of the new firm’s balance sheet,
operating outlook, etc. I expect we will see estimates increase.
4) Estimates are also too low at the new BK due to overly
pessimistic cost save assumptions. The companies announced with the deal that
they expected to be able to reduce expenses by $700M, or 8.5% of the combined
companies cost base over the next few years (or the equivalent of about 17% out
of legacy BK). However, more than $400M of those expense reductions were
already expected to take place at BK and MEL over this time due to better use
of technology, ‘offshoring’, etc. Thus, management of the new BK has given us
very conservative assumptions to work with. I have asked both managements on
several occasions and so far they have been sticking to their guns that there
is absolutely no way they will be able to possibly cut more than $700 out of
the cost base. This figure looks to be much too low and I believe management is
sandbagging the street.
Consider the
following: Barclays is currently bidding to take over ABN Amro. Barclays
expects to be able to take more than 8% of the total cost base of that combined
company despite the very limited geographic overlap between the two companies.
In addition, when State Street
bought Dueutsche Bank’s Trust & Custody operations back in 2002, STT was
able to cut out more than 35% of the target’s cost base with almost no customer
attrition compared to the 17% of legacy BK guidance from MEL. STT is planning
to cut more than 55% of the cost base of IFIN. While the business overlaps are
not quite as significant for MEL/BK as they were in the STT/DB transaction, I
expect we will see cost saves at the end of the day in the 10-15% of the
combined company.
Sell side analysts are also not giving any credit to
possible revenue synergies in their models. This is only reasonable as many
deals in the financial services space with promised revenue synergies have
ended up with shrinking top lines instead. However, in the MEL/BK deal there
are some ‘low-hanging fruit’ opportunities that will likely result in at least
some revenue uplift in 2008. A few examples:
a) the
old BK is the world’s largest Corporate Trust provider. However, its cash
management capability is weak. Thus, many $ billions of overnight client cash
management is farmed out to a small number of large asset managers with better
offerings. MEL’s Dreyfus unit is one of the leaders in this space and is
already one of the outside services providers to BK. Post-deal closing, it is
expected that much more of this business will be internalized resulting in
significant asset management fees flowing to the top line with little in the
way of expenses.
b) BK’s
Pershing unit is a top player in providing systems servicing to Independent
Financial Advisors (competing with the likes of SEIC, SCHW and Fidelity). These
providers offer IFA’s a mutual fund supermarket from which to have their
clients assets invested. SCHW, SEIC and Fidelity have strong in-house brands to
offer and capture a significant percentage of total assets invested into the
supermarket. The old BK’s ‘1789 family of funds’ is not a strong competitor and
has a very small market share among these IFAs. With the closing of the merger
it is hoped that in-house wholesalers will be able to get IFAs who use Pershing
to start investing a larger portion of client assets into Mellon, Dreyfus, Newton
and Boston Company funds. The beefed up asset management capability may also
help Pershing in gaining market share.
c) There
will likely be at least some easy opportunities to cross sell between MEL asset
management products and BK private wealth management, as well as MEL’s custody
services and BK corporate trust.
The most historically accurate analyst for MEL on the street
(according to Starmine) is Glen Schorr of UBS. He is the high on the street and
has a $3.10 estimate for 2008. The next most accurate analyst is Betsy Grasek
of Morgan Stanley. She is at $3.06. Consensus is $2.87 (with 17 data points). I
believe that by December of this year consensus will be at (or above) $3.10
after management of the new company will have had a chance to get up at a few
conferences and say, ‘wow, we actually found a bit more in cost savings that we
first announced, and we expect to get a little traction in 1H08 from revenue
synergies.” MEL traded at 17X consensus 2006 in December of 2005 and BK was at
about the same valuation. I see no reason the stock will trade on less than
that P/E by the end of this year on the forward 2008 number as expected EPS
growth could be as high as 25%
$3.10*17X = $52.70
vs. $43 today which would be a 23% return over the next 7 months for an
annualized return in excess of 40% (including the dividend).
5) Longer term, I expect the reduction of the number of
competitors in the Trust and Custody space should lead to higher margins as a)
a smaller number of competitors should allow for a slowdown in the ‘arms race
with no end’ in terms of IT spending as a percent of total revenues, and b)
pricing pressure should alleviate as there are a smaller number of bidders for
new business.
In the last year there has been a significant contraction of
the number of players in the Trust/Custody space.
-
BK/MEL
-
BK buying the global corporate trust business from JPM
-
C buying the hedge fund servicing business of Bisys
-
STT/IFIN
These combinations will result in a few very large players
and a number of much smaller players in each segment of the Trust/Custody
space. Consider the following:
Post the completion of these deals the top global custodians
will be as follows:
New BK New STT JPM C (Top
4)
$16.3Tr $14.1Tr $12.9Tr $9.1Tr
BNP HSBC NTRS UBS SocGen (Next 5)
$4.3Tr $3.9Tr $3.9Tr $2.9Tr $2.5Tr
USB PNC UB FITB CMA (smaller
$1.1Tr $435B $240B $220B $112B players)
(source – globalcustody.net)
This is clearly a scale business and the much higher revenue
base of the top players should allow them to bid the same price and generate
higher returns and/or capture more business by offering more products and
services to customers for higher total fees.
There is even more concentration in the high margin and
sticky ‘middle-office’ investment manager operations outsourcing business:
New STT New BK JPM NTRS Brown Brothers Harriman
$5Tr $1.6Tr $0.6Tr $0.25Tr $0.25Tr (Top 5)
As asset managers become larger, investment products become
more complicated and global regulatory oversight complexity grows, there has
been an increasing to outsource not just back office custody and pricing but ‘middle
office’ trading, FX, reconciliation, etc. to firms such as STT, IFIN, MEL and
BK. Once this business is outsourced to one of the Trust/Custody banks, it is
unlikely to leave the service provider and to date I do not know of any firm
that has moved its business. The new STT clearly has a head start with MLIM,
BGI and PIMCO (among others), but MEL/BK is a strong competitor and one of the
only other players to be able to compete for this high margin business as it
comes up for bid.
As Trust/Custody banks (such as MEL, BK, STT and NTRS) have
grown in size their scale has resulted in some operating leverage as
costs/revenue have declined. One would imagine that the large deals announced
(of which MEL/BK is the largest) will lead to a continuation of this trend.
Non-Interest Expense/Revenues
2006 2005 2004 2003 2002
MEL 63% 65% 67% 69% 66%
BK 50 55 57 56 48
STT 48 54 62 62 58
NTRS 44 49 54 55 50
(of course a generally ‘up’ market over the last 5 years has
helped, but this is partially offset by these firms exiting the traditional
banking business which has much lower costs/revenue ratios.)
Over the next couple of years I would expect these trends to
accelerate with pricing getting a bit more rational as we move more into an oligopolistic
environment, and the ability for the new BK to spread its IT budget over a much
larger revenue base.
All things being equal (assuming no major global bear
markets) this should result in higher net margins for the new BK which means higher
ROE and profit growth which means a higher P/E.
6) Consolidation likely to continue – The large deals of
2006-2007 have created a small number of very large players in the
Trust/Custody space and quite a few smaller competitors who are increasingly
disadvantaged as the business becomes more complicated with more products
(derivatives, commodity contracts, FX, etc) as well as more global with an
increasing number of clients requiring custody and transactions in an ever
larger number of countries. Will USB be able to stay/compete in this business
when it is only 10% of the size of the top 4 players? Will UB or CMA or FITB be
able to when they are each only 3% of the size of the top 4? I doubt it. Over
the next few years many smaller competitors here and overseas will likely exit
the business and or lose significant customers to their larger competitors due
to pricing, product breadth and service capabilities.
Again, all things being equal (assuming no major long term
global bear market) this should result in higher net margins for the new BK
which means higher ROE and profit growth which means a higher P/E. I believe
EPS estimates will be $3.80-$4.00 for 2009 by the end of next year and the
stock will be on at least the same 17X forward P/E. This gets us to $64-$68 for
a +50% return over the next 18 months.
Risks:
1) Major global bear market – simply a flat market would be
good enough for the new BK as it cuts costs, spreads its spending over a larger
revenue base and feeds off of weaker competitors. However a grinding bear
market would be a negative for revenue growth and margins. One would expect
that in such a scenario cost cutting would be more aggressive, and hopefully
some businesses would actually improve. Some examples: Corporate Trust revenues
rise when there are lots of defaults. Hedge fund assets (higher margin custody
business) might grow faster as their returns look better to institutional
investors compared long-only investments, etc. While the new BK has some
defensive characteristics, it is not a stock to own if you think we are in for
a long period of declining share prices.
2) Terrible merger execution – This is a risk but will
hopefully be mitigated by a) a great deal of planning has already taken place
over the last 6 months and management says they are ahead of plan on this
count, b) management plans to integrate the two companies very slowly so as to
not upset the customer base, c) both companies have successfully integrated
several large deals in the last few years.
3) Russian lawsuit – As some of you may have read, the
Russian Customs Service is suing legacy BK for +$20B in connection with money
laundering charges that took place several years ago. BK settled the case with
the US
government, and the statute of limitations has expired here for any claims to
be made. The Customs Service are threatening to sue in Russia
(though for a smaller amount as the +$20B was for treble damages under US law).
If the case moves forward (uncertain), and BK loses in Russian court (a big
if), then the Customs Service will have to try and collect through the US court
system which certainly could throw the claim out as being past the statute of
limitations. I think the most likely worst case scenario is a small settlement
and the worst case result is that the new BK does not end up operating in Russia
- a great growth (though relatively small) market for its services.
Why the new BK deserves a premium to the market P/E.
As VIC is a value stock site where most ideas trade at low
P/Es, I think I should spend a few moments on why a player in the Trust/Custody
business can be a value stock even though it trades at a small premium to the
S&P’s 16X 2008 P/E.
There are a large number of factors that should drive EPS,
ROE and Book Value growth at rates higher than the average stock at the new BK and
its large peers in 2007 over the next few years:
- Hedge Funds (HFs) – Originally, HF’s used ‘Prime Brokers’
such as GS, BSC, or MS as their custodians. As the larger funds have become
multi $B operations they have been splitting their business to multiple Prime
Brokers so as to have better sources of securities borrowing, and to force the
different investment banks to compete on price. This has led to the larger HFs hiring
one of the traditional Trust/Custody banks to provide custody management of its
assets across its multiple prime brokers. The larger HFs are currently
garnering a large majority of inflows in a rapidly growing asset class and many
of them are starting to tap the IPO market to super-charge their growth.
- Baby Boomers in the US
are moving into their prime savings years right now and inflows into mutual
funds, 401(k), 529s variable annuities and IRA have been strong. Also, many $
of savings that traditionally would have gone into the stock market has in more
recent year been going into investment real estate. With the end of the housing
bubble more of these savings assets will likely be directed back into the
capital markets – a very positive trend for the new BK and its peers.
- Private Equity (PE) Funds – have been growing dramatically
in size and sophistication. This represents another new growth channel for Custody
banks. Also, as PE firms take public companies private they load their
portfolio firms up with debt. These new debt issues create significant new business for
Corporate Trust providers. Again, the new BK will be both the world’s largest
custodian and corporate trust provider.
- Securitization – Assets that have traditionally been
securitized in the US
such as mortgages, auto loans and credit card receivables are now starting to
be securitized in earnest in Europe and Asia
as the debt capital markets build out in those regions. In the US,
new assets are starting to be securitized including health care receivables,
CDOs, CLOs, cable TV bills, etc. These trends are creating additional growth in
the Corporate Trust space.
- Emerging Market Growth – The BRIC nations (and other
emerging markets) are seeing a build out of their capital markets and asset
management industries. Their large national reserves of US T-bills are also now
starting to be put to work in more risky assets such as corporate debt,
equities, PE funds, etc. As this trend continues, there are many avenues for
growth for the Trust/Custody Banks.
In conclusion, I believe the earnings power of the new BK is
understated and that the competitive environment in which it operates is
improving. This combined with an operating backdrop of several positive
industry trends should lead to significant risk-adjusted performance for the
stock over the next year and a half.
Catalyst
1 – Short Term (1-2 months) - deal closes removing uncertainty and arbs
2 – Short Term – the new BK should hold up well if the market weakens as both constituent stocks have performed poorly since the deal was announced on 12/6/06. Since then MEL is up 2%, and BK is up 3% vs. the S&P up 10% and the S&P Financial Index up 7%. This, despite MEL and BK being ‘market sensitive’.
3 – Medium term (6-7 months) - estimates for the combined company should rise as both MEL and BK have beaten numbers in 4Q06 and 1Q07 but estimates have barely budged. Sell side analysts are waiting for the deal to close prior to updating their models.
4 – Medium Term – expectations for cost cuts are too low at 9% of the combined non-interest expense of the new company. Management has sandbagged their guidance so as to generate ‘surprises’ vs. the street. These are firms with significant overlaps in terms of their business lines, technology platforms and geographic operating offices. Historically, deals in this space have achieved a much higher amount of expense reductions than guidance. Also, there are some easily realizable revenue synergies in this deal which are not yet in estimates.
5 – Longer Term (12-18 months) -The number of large competitors in this space is rapidly shrinking with this year’s MEL/BK, STT/IFIN and the 2006 BK/JPM deals. This should alleviate some of the pricing pressure seen in the last several years and reduce the need to maintain IT spending at current percentage levels of revenue.
6 – Long Term –This M&A activity has created a few large players in each subsegment of the trust bank space. Many small regional players will likely lose business as they are unable to offer the same level and suite of services and/or keep up with the spending required to stay in the game.