Massive Scale Benefits State Street

The company's asset management business, about 15% of group profits, is floundering despite positive trends in passive investments, a market where it is a major player. State Street, which focuses on institutional investors and charges premium pricing, has struggled to adjust strategically as industry pricing has marched ever lower. Moreover, it is heavily concentrated in products, like its S&P 500 index, which are easily copied and vulnerable to swings in investor preferences. Recent moves, such as price cuts and acquisitions aimed at building out its portfolio of offerings, may help stem the bleeding, but we think the firm may continue to lose market share.

Post-crisis, State Street was ahead of the curve in cutting costs, but margins have suffered as regulatory costs have piled up and rival Bank of New York Mellon BK ramped up cost-cutting efforts. Although State Street's current cost-cutting measures will fall short of fully restoring its profitability, we think the firm will continue outearn its cost of equity even if interest rates remain flat.

Economies of Scale, Switching Costs Dig Wide Moat State Street benefits from a wide moat, in our opinion, built on economies of scale and switching costs in its largest business, custodial banking.

Custodial banking tends to be a moaty business, as only large players like State Street, one of the top three custody banks in the U.S. with about $28 trillion in client assets, can compete effectively on price. Moreover, asset custody (taking possession of and providing safekeeping for financial assets) and asset servicing (providing back-office support such as collecting dividends and recording asset values) is a business with naturally sticky customers who are loath to risk changing providers and who value the one-stop shopping that State Street can provide. As such, it is a naturally high-return and highly scalable business.

State Street's scale and stability in custody are increasingly attractive as more potential customers seek to outsource their back-office operations, and it becomes increasingly unlikely that new competitors could build enough scale to effectively compete. Clients are becoming more cost-conscious, especially in this low-yield environment, but this is balanced by increased regulatory compliance costs, which are increasing the importance of economies of scale.

State Street's $2 trillion asset management business, which contributes about 15% of the firm's operating income, has some, but fewer, moaty characteristics, in our opinion. While barriers to entry are low, it is difficult for competitors to build the scale and intangible assets necessary to compete in this business. We think State Street benefits from some cost advantages built on scale, but it has lost share to lower-priced rivals like Vanguard. Margins remain attractive, however, and State Street's recent efforts to increase the scope of its investment offerings will help to improve the package it can offer to institutional investors. We think State Street will continue to lose share among investors to whom price is paramount but should stem outflows from investors willing to pay a premium for liquidity and breadth of offerings.

Market and Currency Movements Are Risks State Street faces a number of risks. Adverse market movements or client outflows could reduce the value of client assets, lowering fee revenue. Cash flows are subject to currency movements that may not be effectively hedged, because the firm conducts significant foreign operations. State Street invests customer deposits in fixed-income securities, and an unexpectedly sharp increase in interest rates could reduce the value of State Street's securities and cause significant balance sheet losses. Customers are paying increasing attention to custody fees, which has led to lower fees and average assets under custody in general and to expensive lawsuits (like CalPERS and CalSTRS versus State Street in 2009) in extreme examples. Increased attention and transparency could cause fees to continue to creep downward.

State Street is in good financial health. As of year-end 2015, it had an 11.2% fully phased Tier 1 common equity ratio, comfortably exceeding regulatory minimums. State Street's common tangible equity ratio is also reasonable, at 4.6% as we calculate it. While State Street exceeds the proposed supplementary leverage ratio at the bank holding company level, it does not at the bank level--its 5.7% ratio as of Dec. 31 is below the 6.0% minimum. We think State Street has plenty of time to build up a bigger cushion, as the rules are not set to be implemented until 2018. Moreover, we think the somewhat low ratio is driven by the bank's reputation as one of the country's safest banks and recent strong deposit levels. State Street has already made some progress at reducing its levels of excess deposits--deposits fell 8% in 2015--and more of these deposits are likely to flow off as the economy improves. As a result, the leverage ratio would improve without a material change to the bank's business model.