While equity markets finished 2013 on a strong note, interest rate headwinds continue to plague the custody / trust bank sector and mask core franchise growth, says a note from Credit Suisse’s equity research team. Securities lending remains weak and FX revenues should take a step back on the heels of softer FX volatility, it adds.
The research team, which covers BNY Mellon, Northern Trust and State Street, continues to prefer State Street. “We expect State Street to stand out and reiterate its desire to deliver positive operating leverage and maximize capital returns for shareholders, and we believe sets up best in the group for 2014 on a relative basis,” says the team’s note. “Bank of New York Mellon should experience a noisy quarter on the expense front with elevated legal and litigation expenses. Northern Trust should continue to see top-line growth given various investments in the franchise, but in this tough operating environment the focus will be on expenses – and we see most negative estimate revision risk here.
“We expect the fourth quarter to be a critical juncture for putting a fine point on 2014 earnings expectations as we expect to gain a better sense of Net Interest Margin (NIM) and expense trajectory for the group.”
Presenting its Q4 2013 expectations for the three banks (vs. Q32013), Credit Suisse estimates that asset servicing fee revenue to be down for BNY Mellon and up for Northern Trust and State Street, foreign exchange fee revenues down for all three banks, while securities lending revenue is expected to be down for BNY Mellon, flat for Northern Trust and down for State Street.
Credit Suisse expects Q4 fee revenues for Asset Servicing, Custody & Trust at BNY $1,19 billion (-6%), Northern Trust $278 million (up 7%) State Street $1,23 billion (up 1%) and for the industry $2,7 billion (down -1%).
Credit Suisse has raised its estimate for State Street to $1.20 (old: $1.17). “We are now a penny above the street ($1.19). We expect this quarter to be characterized by higher custodial and asset management fees as the franchise benefits from equity market tailwinds but softer FX and securities lending revenue. All in, we expect to hear a message of consistency – aggressively controlling what can be controlled namely expenses and share count (est: $560 million) to drive positive operating leverage (we are looking for 20 bps yr/yr) while continuing to grow the core franchise. With respect to potential negatives, while we think investors have largely grown comfortable with the notion that NIMs will fall next year (we are looking for 6-7 bps of compression).”
In relation to net interest income, Credit Suisse expects spread income at State Street to increase 1% sequentially driven by lower premium amortization and a slightly bigger balance sheet (+1%).
Credit Suisse says tailwinds from equity prices and dollar depreciation should drive revenues in custody and asset management at State Street higher. The research team says it is looking for a 12% decline in foreign exchange fees as FX volatility and volumes were both weaker in Q4. Not much has changed in securities lending, notes the team, adding that trends have become more challenging at the short-end of the curve.
For BNY Mellon, the research team has reduced its Q42013 EPS estimate to $0.48 (old: $0.54). “We are seven cents below the street ($0.55) as we believe a multitude of headwinds will take their toll on earnings this quarter including seasonally weaker high margin issuer services fees and softer high margin FX revenues. We expect these trends will be exacerbated by higher consulting/legal fees, higher litigation charges (-$0.03) and higher preferred dividends (-$0.02 vs 3Q). Of note, we consider litigation as a cost of doing business–especially since the settlements involve previously booked FX revenues being returned to clients. Some offsets to consider include a weaker dollar and seasonally higher incentive fees. We expect repurchase activity to rebound to ~$350 million this quarter as we believe the firm is more comfortable with AOCI fluctuations from a steeper yield curve.”
Credit Suisse says it will be looking at BNY Mellon’s ability to control expenses and deliver positive operating leverage in 2014 from continued process automation (sizing the opportunity here would be an incremental positive), as well as a potential sale and relocation of NYC headquarters and lower pension expenses.
Commenting on the revenue outlook for BNY Mellon, Credit Suisse expects a seasonal decline in issuer services to trump market tailwinds. In terms of NII, it expects spread income to decline 3% sequentially, as discount accretion continues to fade (a $55 million benefit last quarter) and yields get squeezed further by the low rate environment. In securities servicing, it expects issuer service seasonality to dampen revenue generation this quarter–“we are modeling in an $80 million negative impact. We anticipate weakness here will be partially offset by higher asset servicing fees as we expect the tailwinds from equity markets to help but to a lesser extent than peers given that given that 64% of AUC is concentrated in fixed income.” The research team is also looking for a 12% decline in foreign exchange fees as FX volatility and volumes were both weaker in Q4.
“We expect expenses to be elevated this quarter driven by seasonally higher items such as business development (the company has started advertising on CNBC), consulting and elevated legal expenses following litigation settlements totaling ~$45 million (Massachusetts and Florida FX cases). Besides this, with the company’s “Operational Excellence” program now over we don’t see much in incremental offsets this quarter.”
For Northern Trust, Credit Suisse retains its $0.72 Q42013 EPS estimate–“this puts us four cents below the street ($0.76). We expect this quarter to exhibit the bank’s unwavering philosophy of using the down-cycle to make investments to drive EPS higher longer-term. While investments are likely to pay-off in higher revenues this quarter, benefits here a likely to be offset by higher consulting and technology expenses and seasonally higher other expenses. All in, we see nothing wrong with the firm’ strategy given the abnormal operating environment (highlighted by near-zero interest rates) that has taken its toll on franchise earnings and expect the firm to post outsized and arguably best-in-class EPS growth once rates rise. When rates rise is up for debate, hence, in the mean-time we favor those franchises that are able to drive outsized operational leverage in this tough environment and complement efforts with aggressive capital return programs.”
Tailwinds from equity prices, dollar depreciation and on-boarding of ATP should drive revenues at Northern Trust higher, says Credit Suisse. Money market fee waivers will remain elevated ($15 million drag in 3Q). Securities lending is likely to remain soft too while the research team is looking for a 12% decline in foreign exchange fees as FX volatility and volumes were both weaker in Q4. It also expects Northern Trust to buy back $100 million.
Interest Rate Headwinds Continue to Plague Custody Banks, Say Equity Analysts
Going forward all eyes will be on expenses and capital, says a note from Credit Suisse's equity research team, which continues to prefer State Street.