The Virtues of Slow and Sturdy
By ANDREW BARY / Barrons April 17, 2010
Bank of New York Mellon and State Street have dominant franchises with better-than-average growth prospects. Higher rates? Yes, please!
TWO LAGGARDS IN THE SURGING BANKING sector, Bank of New York Mellon and State Street, have some of the industry's best franchises, and should benefit from the inevitable rise in short-term interest rates.
Both look reasonably priced. BNY Mellon (ticker: BK), at 32, trades for 14 times projected 2010 profits of $2.34 a share while State Street (STT), at 48, commands 14 times estimated 2010 profits of $3.37 share. Both stocks trade for about 12 times projected 2011 earnings, well below their historic price/earnings ratios in the mid- to high teens.
Bulls argue that the stocks look appealing at a time when institutional investors are shunning defensive names in favor of more direct beneficiaries of a stronger economy. In the banking sector, turnaround stories are in vogue, including giants Citigroup (C), Bank of America (BAC), and regionals like Zions Bancorporation (ZION), SunTrust Banks (STI) and Regions Financial (RF), all of which were struggling with loan problems a year ago.
Financial stocks often face headwinds when rates rise, but BNY Mellon and State Street are part of a group of financials -- including discount brokers like Charles Schwab (SCHW) and TD Ameritrade (AMTD) -- that should get a boost from higher rates. BNY Mellon has estimated that a one-point rise in short rates would boost pretax profits by $500 million annually, or about 30 cents a share.
With the economy recovering and the stock market rallying, the Federal Reserve may start increasing short rates sooner rather than later this year. Near-zero short rates, for instance, have depressed profits in such areas as asset management and securities lending. BNY Mellon has been giving fee rebates to investors in short-term money-market funds that now yield next to nothing. Those rebates would decline as short rates rise.
"There aren't many dominant international companies that you can buy at these valuations," says analyst Eric Goldberg of Basswood Partners, a New York investment firm that owns BNY Mellon and State Street shares. "These are some of the highest-return businesses in banking, and their growth prospects are better than that of the typical commercial bank. It's almost unfair to compare them to banks." He puts fair value for BNY Mellon at about $52 a share and $80 for State Street.
![](http://<br><br>The banks engage in similar businesses, as securities servicers and asset managers. BNY Mellon is the top global custodian, with $22 trillion of assets under administration. State Street is the No. 2 custodian, and its State Street Global Advisors is a leading investment manager, with $1.9 trillion in assets, including a strong position in exchange-traded funds. These custody businesses may not be exciting, but they benefit from oligopolistic market structures and prohibitive barriers to entry.<br><br>What both lack are large loan portfolios. State Street's loan book of $10 billion is equal to just 7% of assets. BNY's $32 billion loan book is 15% of assets.<br><br>Their focus on stable fee-based services was long rewarded on Wall Street with some of the loftiest valuations in the banking sector, but the past decade hasn't been kind to their stocks; the P/E on both has fallen sharply. BNY Mellon shares are below where they stood in 2000, while State Street is little changed.<br><br>Ken Charles Feinberg, a co-manager of the Davis New York Venture Fund, calls BNY Mellon a "great bargain," and lauds BNY Mellon CEO Robert Kelly and his team. "They did a great job integrating in merging Bank of New York and Mellon." The two combined in 2007. Kelly is one of the industry's top executives, and BNY Mellon investors were happy that he turned down a reported offer to become CEO of Bank of America last year. (Davis Selected Advisers was the largest shareholder in BNY Mellon at year-end '09.) BNY Mellon yields 1%, and State Street next to nothing, but dividend increases are likely in the coming year.<br><br>BOTH BANKS MAY PRODUCE RETURNS on tangible equity of more than 20% this year, and their custody and investment-management businesses make them similar to asset managers, but with lower P/E ratios. State Street's new CEO Jay Hooley is targeting growth of 10% to 15% annually in profits per share. BNY Mellon has no stated earnings target, but investors see similar potential.<br><br>Both took stinging losses on mortgage and other bond holdings in '09. State Street, however, expects to recoup the bulk of a $6 billion write-down it took last year.<br><br>The chief investor concerns about the two stem from fee pressures in custody and administration, depressed conditions in securities lending, and declining profits in foreign-exchange trading. The fee issue appears manageable. BNY Mellon, for instance, gets paid just 1/100th of a percentage point for acting as custodian for $22 trillion of assets, mostly bonds. Both companies bundle custody and administrative functions with other services for big institutional investors, including foreign exchange and securities lending. Both banks are acquisitive, and arguably have overpaid in some deals.<br>The Bottom Line<br><br>One analyst thinks BNY Mellon is worth about $52 per share, and State Street, $80 -- way above their current prices.<br><br>Investor sentiment wasn't helped when rival JPMorgan last Wednesday reported lower first-quarter profits in its Treasury and Securities Services division relative to the year-ago period. That may not bode well for State Street and BNY Mellon, which are due to report first-quarter profit reports on Tuesday -- but bulls say mediocre results already are discounted in the stocks.<br><br>BNY Mellon and State Street have dominant businesses with high returns and limited competition that ought to benefit from stronger markets and higher rates. With investors now favoring weaker banks, buyers can get these durable franchises at attractive prices.</span></td></tr></table></div></tr></td><tr><td colspan=99 class=) |
