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By Erik Kobayashi-Solomon | 04-10-2012 11:00 AM

Can BoNY Become a Nimble Giant?

The world's largest custodial bank is fighting to make itself more efficient.

Erik Kobayashi-Solomon: Hi. I'm Erik Kobayashi-Solomon for Morningstar OptionInvestor. Today, it's my great pleasure to welcome Michael Kon, who is a senior analyst on Morningstar's financials team, to talk about Bank of New York Mellon.

Michael, thanks for coming.

Michael Kon: My pleasure.

Kobayashi-Solomon: So, not long ago, I recommended a covered call investment on this company that you cover, Bank of New York Mellon, and it's done really well. But when people hear the name 'bank' they usually think of deposit slips, ATMs, and so forth. Bank of New York is a little bit different from that. Can you explain what Bank of New York does?

Kon: Sure. A typical bank will take deposits from its clients and lend them out to other customers and will earn the spread income from this activity. Bank of New York has two substantially different business segments that a typical bank won't have. The first segment is investment services, and other segment is investment management.

Kobayashi-Solomon: These are really businesses focused on institutions, not mom-and-pop clients, right?

Kon: That's right. Most of its clients are institutional money managers, broker-dealers, and large pension funds that look for an asset manager for their portfolios.

Kobayashi-Solomon: What is it about Bank of New York's business that's, let's say, attractive especially vis-à-vis a regular deposit bank?

Kon: Unlike a regular deposit bank that takes credit risk, Bank of New York doesn't have to find individuals and companies to lend its money to and underwrite loans to make a profit. Instead, Bank of New York takes financial assets of asset managers and other institutional investors and provide them with back-office services, and the firm charges a fee for those services. In the investment management segment, the bank actually manages financial assets for its clients, for institutional investors.

Kobayashi-Solomon: And it receives a fee for that too?

Kon: That's right. That's another fee business for the firm.

Kobayashi-Solomon: So, it's basically a fee-based business model?

Kon: That's correct.

Kobayashi-Solomon: That is attractive. Now when I wrote the original article, the stock was trading about 10% lower than it is now, so that covered call strategy has been a big success. However, the stock still has a ways to go before it hits your fair value estimate. What has to happen in your opinion for the market to kind of fully value this stock?

Kon: Well, there are several things that weigh on the stock right now. There are legal problems with pension funds regarding foreign exchange transactions; obviously, that created a lot of negative headlines. Low interest rates are a problem for Bank of New York because the firm does have a sizable investment portfolio, and its spread shrinks when interest rates decline. In addition, it has to waive money market fees not to break the buck in those funds because those funds are not earning much.

Kobayashi-Solomon: So, basically with these money market funds that the firm would have normally charged a fee for, now because the interest rate is so low, the bank has to waive those fees.

Kon: That's correct.

Kobayashi-Solomon: I see.

Kon: So, those concerns weigh on the stock, but I think those are short-term headwinds, and then in the long-run the business remains solid.

Kobayashi-Solomon: Well, it's a really interesting story. Thanks a lot for coming in and talking about it.

Kon: Thank you.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor website, where you'll find many more option ideas based on Morningstar's fundamental research.

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