State Street Earnings: Lower Deposits and Higher Funding Costs Weigh on Net Interest Income

Wide moat-rated State Street STT reported an OK second quarter, with revenue of $3.11 billion and adjusted EPS of $2.17 compared with the FactSet consensus of $3.14 billion and $2.10 respectively. Net interest income was down 10% sequentially, which was on the low end of the firm’s 5%-10% outlook. The culprit was primarily higher funding costs on deposits, though average deposits also declined 1% sequentially. These trends show no signs of slowing down and, as a result, State Street expects net interest income to decline 12%-18% sequentially in the third quarter and then another sequential decline of 2%-6% in the fourth quarter.

This suggests that net interest income could range from flat to up slightly for the full year, a stark contrast to the firm’s initial full-year outlook of 20% growth. We believe State Street’s difficulty with growing net interest income reflects the firm’s sophisticated institutional client base. While net interest income is only about a fifth of State Street’s total revenue, it is highly incremental to the bottom line and, as a result, tends to have a disproportionate effect on the firm’s profits. As we update our model and trim our net interest income forecasts, we expect to lower our fair value estimate by a single-digit percentage.

State Street’s fee revenue was up 4% sequentially. Servicing fees and investment management benefited from higher market values. Software revenue continues to be bright spot as the firm’s State Street Alpha offering continues to perform well. Looking ahead, fee revenue will face headwinds from pricing negotiations and BlackRock exiting some of its custody contracts with State Street. Expenses were up 6% from the year-ago period primarily related to higher compensation costs.