Investment Thesis
When it comes to investing, learning is earning, and knowledge is power. With that, today’s topic is custodian banks. Back in the old days when stock certificates were issued in paper, custodian banks would literally hold paper certificates. These days the stocks are registered electronically, but the basic job of custodian banks remains the same, namely to provide custody servicing of clients’ assets. With $33 trillion of assets under custody (that’s right trillion with the “T”) the biggest custodian in the world is Bank of New York Mellon (BNY). It is by some measures the oldest bank in the USA, founded in 1784 by one of America’s founding fathers Alexander Hamilton. A more appropriate description of BNY’s business model is a servicing company operating within the bank.
BNY provides the asset servicing services, dividend payment processing, fund accounting, net asset value calculations, which allows it to upsell its corporate clients on a broader range of services such as clearing, cash management or treasury services. The attraction of the business model is apparent at the first glance at the financials. BNY’s franchise generates $11.6 billion of revenue through recurring fees and interest in lieu of fees on the underlying asset base, which grows in line with the stock market value and transactions volume. BNY custody business is enjoying a 33% pre-tax margin and over 20% return on tangible equity, with pre-tax profits of $3.8bln. In addition, BNY operates an investment management business that generates a further $1.1bln of pre-tax profits.
Business is said to possess a moat around it thanks to:
- its large scale benefiting from lower average cost and ability to invest in new technology
- high barriers to entry due to regulatory oversight, high fixed costs of entering, and an entrenched position by incumbents
- customers’ facing switching cost to change custody providers due to onboarding cost, interfaces with back-office technology and processes
- high market share concentration and oligopolistic nature of the competition among the custody banks which include Bank of New York Mello, JP Morgan, State Street, Citibank)
BNY has further differentiated itself thanks to the product breadth, geographic coverage and scale, the unquestioned financial strength and its strong reputation.
Custody business generally involves long sales cycles and typically have multi-year commitments (5 to 7 years deals are common). This is good for BNY in its processing businesses where they are usually the largest incumbent, but it makes it difficult to take share from others. The custody bank knows that if they serve their clients well, clients will not want to take their business elsewhere. Typical client segments are other banks, corporations, insurance companies, and investment managers and hedge funds. BNY is benefiting from an ongoing trend of asset managers to outsource back and middle office functions such as custody and asset services as these are table stakes outside of their core competence and provide little in a way of differentiation.
Asset values and transaction volumes drive the majority of BNY’s revenues. These naturally grow with the economy and the related financial markets growth. BNY also plays a critical role in the capital markets infrastructure providing many services that its clients do not want to – or cannot perform themselves. BNY is well capitalized, has a low-risk balance sheet unlike a typical bank and is viewed as a trusted counterparty. It is our estimate that BNY only generates 2-3 basis points a year on assets under custody, which translates 3 cents a year on $100 of assets.
BNY is well capitalized, has a low-risk balance sheet unlike a typical bank and is viewed as a trusted counterparty. BNY’s balance sheet is primarily driven by client deposits and bank’s assets comprise predominantly high-quality liquid assets and cash. The majority of the securities banks holds are triple-A or double-A rated, and the bank has little term credit exposure. The way the banks earns net interest spread (21% of revenues), is also different from other banks, as a significant portion of the net interest income represents income on deposits that are directly linked to its servicing businesses.
Management believes that bank should be able to grow revenues faster than expenses over time – while continuing to make the necessary investments for the future – and the bank should be able to achieve that growth with very little incremental capital. In 2017, the pre-tax margin was 34% and the return on tangible common equity (ROTCE) was 23%. This allows management to pay out virtually 100% of its profits back to shareholders in form of dividends and share repurchases. Management realizes that it needs to increase the rate of its organic growth so it can still drive more efficiencies across the company. Crucially, management is indicating that the company does not need to increase its risk profile or alter the basic financial profile of the company to accomplish the growth objectives.
Both custody and asset management business generate are annuity-like cash flows whilst not requiring huge amounts of capital to grow. Custody represents an anchor solution for cross-selling opportunities such as cash management solutions, treasury services, accounting, security lending, foreign exchange, collateral management.
Revenue model comprises 75% of fees which are driven by transaction volumes, pricing, and market values. Remaining 25% of revenue is from net interest margin where people can pay with cash balances in lieu of fees, attached to the core services. Cash balances can go up and down with the prevailing interest rates, however, it’s important to note that 80% of net interest is fee like i.e. recurring.
Latest developments
The company has been posting lackluster growth in recent quarters depressing price of the high of $58 to the current level of $52.
BNY posted weak second-quarter EPS of $1.03. The second-quarter had negative operative leverage quarter-on-quarter despite the seasonal benefit to expenses. 2Q results were marked by: 1) decline in asset servicing fees; 2) fall in asset and wealth management fees; 3) lower clearing fees; 4) modest growth in issuer services and treasury services fees; 5) decline in foreign exchange trading revenues; 6) modest decline in net interest income; and 7) some growth in non-interest expenses. Trends in Assets under Management (AUM) and Assets under Custody and Administration (AUCA) were weak, which does not bode well. Core operating margin declined to 34.0% from 35.3% in 1Q18, and up a percent point from 33.1% in 2Q17, despite multiple rate hikes and higher markets. Capital ratios remained strong. For 3Q, BNY lowered its outlook for net interest income growth to mid-to-high single digits year-on-year, a decline from double-digit growth seen in first half of 2018, and lower seasonal quarter-on-quarter increase in Issuer Services – balance sheet is decreasing with deposit outflows. BNY continues to invest in upgrading its technology and has done a good job managing expenses while making these required investments.
Weak trends in Asset Servicing fees, down 0.9% on quarter reported and down 1.4% on quarter excluding securities lending fees. On yearly basis, fees grew 6.6% reported and 5.8% excluding securities lending, benefiting from foreign exchange, new business, and higher markets. Asset under custody and/or administration were flat at $33.6 trillion despite stronger markets, indicating some potential outflows or weak new business.
| Durable Competitive Advantage | Wide |
|---|---|
| Range of Fair Value Estimate | $48 - $63 |
| Stock Price | 52.56 |
| Consider Buying Below | $50.00 |
| 52 Wk range | 58.99- 49.39 |
| Market Cap. | $52.3bln |
| Volatily | Medium |
| Balance Sheet | |
| Shareholder Equity | $41.5bn |
| Adjusted ROE (%) | 11.9% |
| Net Debt (Cash) | N/A (bank institution) |
| Debt/EBITDA | N/A |
| Potential Appreciation | -10% +20% |
| Dividend Yield (%) | 2.1% |
| PE Data | |
| 2017 | 14.8 |
| 2018 | 12.6 |
| 2019 | 11.7 |
| 2020 | 10.7 |
Risks
Whilst custody fees are reasonably steady, the revenues are inherently subject to the market cyclicality and volatility of the underlying asset prices and volumes of transactions. A recession or bear market would cause revenue to decline. The revenue decline would be particularly pronounced in the asset management business.
Custody asset servicing continues to be subject to price deflationary pressures, which means that revenue would grow at less than the underlying assets under custody. The pricing pressure, in turn, puts pressure on BNY management to keep expenses in check and take full advantage of the economies of scale and technology solutions to automate, digitize and reduce cost.
Whilst remote, BNY management may change its position on the risk profile that the bank is prepared to accept fundamentally changing the servicing nature of the business.
BNY has been acquisitive in the past and there remains a risk that management would overpay for an acquisition.
long-term BUSINESS QUESTIONS & DYNAMICS
- Q: Will BNY maintain its preeminence in the custody asset servicing? A: We believe so as business model inherently favors incumbents, barriers to entry are high, scale, ability to invest and service clients at low cost matter.
- Q: Will BNY be able to offset deflationary pressures? A: Partially yes, BNY will be able to leverage technology to reduce the cost of transactions processes per $1 of AUC, however so will others, therefore, we expect the company revenue growth to fall short of the underlying market price increases.
- Q: Will management change its attitude to the risk profile? A: Management reiterated its view that BNY’s business model is about providing services, rather than engage in traditional lending. We, therefore, believe that this is unlikely in the short to medium term.
- Q: Will BNY business model become obsolete through technology. A: This is always possible as technologies such as blockchain allow for much simple tracking of large volumes of transactions, however, presently there are no fin-tech challenges with a market ready product. Custody banks are also subject to various government regulation and we don’t see an easy path for incuments to be displaced.
Valuation
Business doesn’t need much capital to grow and throws off large amounts of cash back to shareholders. The profit payout in 2017 was 92%, and over the past 3 years, the company has returned a combined $10.4 billion, some 20% of the company market cap bank to the shareholders, whilst still managing to grow revenues.
On the price-to-earnings basis, Bank of New York Mellon isn’t expensive with 2018 PE of 12.6, projected to fall to 11.7 in 2019, and to 10.7 in 2020. The company intends to pay out all of its profits creating annuity-like yield of 8.5% which growth between 1% to 3% a year, thus yielding a total return of between 9.5% to 11.5%.
It should be noted that Buffett has added 4% to his Bank of New York Mellon position in the second quarter of 2018 at between $50 to $55 a year, which is the current level at $52.56.
The margin is safety is arguably in the strength of the BNY’s franchise rather than heavy discount in the price. Assuming the company will continue to generate annuity stream and grow its revenue in low single digit, the return should be satisfactory.
Bottom line is that BNY is an inexpensively priced, high-quality franchise with rational management.
Disclosure: The author is long Bank of New York Mellon shares
Bulls Say
- Business with a wide moat and sticky customer base. Highly concentrated market share by the top custodians.
- Attractive business model with high margins, little capital requirements, high return on capital and inflation proof revenues linked to market values and volumes growth
- Rising interest rates, broader product portfoilo, and international expansion should help to increase sluggish growth rates
Bears Say
- Business is inherently subject to cyclical swings such as changes in interest rates and market values
- Constant pricing pressures will limit the margin and earnings growths
- US custody is a mature industry with little growth and limited opportunities to win market share
For those who want to find out more about Bank of New York Mellon, below is the link to the company’s 2018 Investor Day presentation that further elaborate on the business model, performance measures, and management plans for the future.
