State Street Corporation Strategy in Investment Outsourcing
State Street Corporation Strategy in Investment OutsourcingState Street Corporation at Lehman Brothers 10th Annual Financial Services Conference
JASON GOLDBERG, ANALYST, LEHMAN BROTHERS: Moving right along, next up we're very pleased to have State Street. State Street is one of the largest custodians in the world, one of the largest asset managers in the world and very well positioned in higher growth businesses where it is actually outgrowing its peers. It is a name that has put down extraordinary revenue growth over the last decades and more recently a key focus on expenses as well as managing net interest margin, has also helped to double-digit earnings growth, a trend we expect to continue, aided over time by its pending acquisition of Investors Financial. From the Company we're very pleased to have Ron Logue, Chairman and CEO; Ed Resch, Chief Financial Officer and Kelly MacDonald, Director of Investor Relations. With that, we'll turn it over to Ron.
RON LOGUE, CHAIRMAN & CEO, STATE STREET CORPORATION: Jason, thank you. Thank you very much. As Jason said, our CFO Ed Resch, is here as well and Kelly MacDonald in the audience if anybody wanted to direct any questions to Kelly as well. So why is this title called "setting the standard". We think that for the market to continue rewarding us the way they have in the most recent past, that we're going to need to continue to set the standard for our particular industry, and that standard is what I would like to talk about with you this morning.
We believe in four things. I'm going to talk about how we performed against our goals in 2006, how we're going to build on that success in 2007, why it is so important for us for our success to extend our global reach, and then I will summarize and talk about how we continue to deliver that financial performance. Obviously I have to show you this slide again. I am sure you've seen it many times. I have to remind you that I may make forward-looking statements and that actual results may differ materially. So let's talk first about 2006, just recap what happened.
We have three financial goals. We express those goals in terms of ranges, because we realize that we're going to be operating in different economic climates. The first goal is to be a consistent earner. We define that as operating EPS growth of 10% to 15%; in the last year we grew operating EPS almost 23%. If we are going to be considered a growth company we're going to have to grow topline revenue consistently. We have a goal of growing topline revenue 8% to 12%. Last year again exceeded that goal in good markets, growing topline revenue growth 15%.
And our third goal is to be a prudent allocator of capital, defining that in terms of operating return on equity of between 14% and 17%, and again exceeding the high mark of that last year at 17.1%.
So let's review what's happened so far in 2007. At the beginning of the year we announced that our acquisition of Investors Financial, which is a $2.2 trillion trust bank based in Boston. Prior to that announcement, however, we said that we thought we would expect to operate in the top half of what our goals were, hence the 10 to 12% growth in revenue, 12.5 to 15% growth in earnings per share, 15.5 to 17% operating return on equity.
As a result of that acquisition, we adjusted those goals for 2007, and obviously increasing revenue 16 to 18%, reducing growth and operating EPS 8 to 10% and operating return on equity 12 to 15%. We are off to a pretty good start in the first quarter of 2007; revenues were up a little over 11%. Expenses up a little less than 11%, generating 60 basis points of positive operating leverage, the 10th consecutive quarter in a row where we have been able to do that and growing earnings about 11%, return on equity 17%, as well.
In the fourth quarter we made two acquisitions. The first acquisition was the foreign exchange trading platform, a company called Currenex. What Currenex does for us, and you will see in a few minutes why it is also important in terms of some our other acquisitions, it really accelerates our participation in the growing electronic foreign exchange market. It is going to be neutral to earnings in 2007; slightly accretive in 2008. What it really does it provides for us a very high-speed technology solution for very sophisticated traders who truly demand fast execution.
Let me just break that down a little bit. It is very complimentary to a platform that we have -- some of you may know as FX Connect. It serves a very different constituency as you can see here. Between the two we believe that what we will have is the real-time, transparent, streaming price capability that really is going to marry liquidity and technology for tomorrow's foreign exchange world. Why is that important to us? As you will see in a minute, 43% of our revenue comes from outside of the United States. As we acquire a win, large pieces of non US assets this capability becomes an ever-increasing more important capability for us.
We made another acquisition which probably has received much more press than Currenex. The acquisition of Investors Financial. Let me focus on the first three points that you see here. I am going to show -- I am going to drill down a little bit and talk a little detail on what this transaction really does do for us. It truly accelerates our leadership in high growth areas, mutual fund custody, administration, but also hedge funds, offshore funds. Yes, it adds $2.2 trillion in assets under custody, and more than $800 million in revenue, and it truly extends our leadership in this new business that is called middle office outsourcing or investment managing operations outsourcing.
Given us a very good client base. Many customers that we did not have in the past. I said it added $2.2 trillion of assets under custody, and on a pro forma basis that is going to make us the second largest custodian in the world behind the combination of Bank of New York and Mellon once that transaction is consummated, as well. That is nice. That may sell a lot of newspapers, but that's not what really pays the rent. We pay the rent -- on the next three or four slides -- and I'm going to show you. I am going to start with the US mutual fund marketplace.
People have been telling us for years that the US mutual fund marketplace is a mature market.
We don't necessarily believe that's true. As you can see here is the total market about $10.3 trillion of assets under management, and in the last two years it has grown faster than it has previously, [50.5]% versus 11.5%. So if you take a look at the US mutual fund assets that we have about, $4 trillion worth, I show you the pro forma after IFIN and before IFIN. You can see that that is significant more than the -- in terms of assets under custody -- significantly more than the number two player, number two player here being JPMorgan Chase. And you can see the lineup in terms of assets under custody.
The right-hand side of the screen that is for us much more important and very relevant in terms of the acquisition. Of that $3.97 trillion in assets under custody we do the accounting evaluations for the greater majority of those assets. You can see again pro forma after IFIN. And I think what you can see from this screen is how quickly that drops in terms of the accounting and valuation of in essence daily price collective [clones]. Very fragmented, very few number of players and those traditional large custodians that you know of as having trillions of dollars of assets under custody, for the most part really aren't in this business. So I think you can begin to see the relevance of the acquisition of IFIN.
Another business that we haven't talked a lot about in terms of our acquisition of IFIN but the hedge fund administration business today, fastest-growing business or service business anyway is State Street; a $1.4 trillion marketplace. You can see the market's growth over the last three years, 21%; we growing almost twice as fast as that through the acquisition we made almost five years ago now, International Financial Services are doubling (inaudible) base, hedge fund administrative. Again I show you the pro forma numbers here.
After adding IFIN's numbers in their own right a very significant hedge fund administrator, large operations in Dublin, which also will be integrated. Again because of this acquisition we can see us now becoming the number one hedge fund administrator in the world, leapfrogging Citco Fund Services and again you can see the order in terms of who the other competitors are and relative size and scale of those, as well.
Let's talk about another fast-growing market, the offshore funds market, based for the most part Dublin and Luxembourg. $2.7 trillion market. Market growth again, very strong 29%, again our growth extremely strong, very large operations in both Luxembourg and Dublin that we've had for sometime going back to the early 1990s, actually 1990 itself. Again, you can see the acquisition of IFIN extending our already first-place lead in this business again determined by assets under custody, almost $300 billion of assets under custody after the IFIN transaction here as well. Again, you can take a look at the other providers.
The newest business, investment manager outsourcing, taking the investment operations of large global asset managers, rationalizing those operations literally, lifting out many of those employees, the first transaction was and many of you may remember one we did now almost seven years ago with PIMCO. And then after PIMCO the Allianz (inaudible) business that PIMCO took over, at least on the fixed income side. What we are targeting here are the top 500 investment managers worldwide, a very large market here.
The original global demand for this type of product, again if you take a look at the market growth here and our growth, (inaudible) has been the leader for sometime with the number of the mandates that we have won in Europe. Some of the most notable, AXA, ABN Amro asset management, Investec in the United States the most recently. Putnam and the Evergreen funds. IFIN as you know also in its own right a large customer in BGI. So you can see the lead that we have in this business, fast emerging as a growing business, one that truly captures the relationship. This type of business is really the creation of annuity streams, large long-term contracts usually 8 or 7 or 10 years, sometimes 12 year contracts. So a business that really captures the relationship and creates annuity streams of revenue. If you can do it and if you do it well.
So what else have we been doing as well as extending our lead or taking the lead in some of the faster growing product segments? As well as being a market leader in those product segments we also need to be a market leader in the geographies that are growing faster than other geographies. Our global imprint is very important. Let's talk about that just for a second. Let's go back five years, what we had found and had been saying for some time, is our non US business is growing 2 to 2.5 times faster than our US business. If you look at the CAGRs in terms of non US revenue versus company revenue, the absolute numbers 2001 versus 2006. I think what is important however, is the percentage of growth of non US revenue growing from 27% to 43% pre IFIN. After IFIN it will drop to 37% given the fact that a majority of IFIN's assets under custody are US based.
And the other thing that is important in telling the number of employees and the number of non US employees more than doubled. We have 8600 people on the ground outside the United States, twice as much as we had five years ago, 40% of the total staffing. If you take a look at the total staffing it is clear that total staffing is not grown as much as non US staffing. We are extracting productivity out of I guess what you would say some more mature markets and I believe we have begun to bring that down to the bottom line as well.
Let's drill down a little further and talk about peer comparisons. Non US revenue, pre-tax income non US employees. As I said in terms of non US revenue (inaudible) pro forma after IFIN down to 39%. You can take a look at that, I guess what you call the near term competitors, (inaudible) the Morgan trusts, many of you could walk in the Mellons, and again showing here Bank of New York Mellon pro forma after the (inaudible) was consummated in terms percentage of non US revenue versus total revenue. Same thing on pre-tax income, significantly more pre-tax income as I said again in terms of numbers of employees, people on the ground.
So let's take a look at the opportunity and let me first focus on Europe. We target the seven largest markets in Europe, you can see them here. Break it down by collective funds, pensions funds and insurance funds so a $21 trillion opportunity. Offshore market as you can see here, the largest market for collected funds, UK the largest market for pension and insurance funds.
Market grew 12% in the last three years and we've grown almost 30% in that period of time, a lot of that arguably because of the Deutsche Bank acquisition we made about three years ago now. Talk about Asia Pacific a littler over $12 trillion market, again broken down, collected funds, pension funds, what we'll call government related. Again, looking at the seven largest markets I think it is obvious with Japan dominating all of those three segments.
Again here that market growing 14% again as in many cases we almost growing twice as fast as that market as well. So ask the question really is should you invest in a growth company like ourselves positioned where we are in those markets. And I guess what I would say is three things. First of all, what we are really doing is establishing a very strong position in fast-growing markets and trying to grow faster than our competitors; hedge funds, private equity, offshore funds, increasing the non US revenue, twice the US growth. That is what has been fueling our topline growth, I'd say for the last three or four years.
Investment servicing, solidifying our leadership in mutual funds. That is what IFIN does for us. You can tell from that slide I showed you the tremendous need we have in terms of accounting in administration for US mutual funds. Positioning foreign exchange for the change that will take place in that business, going truly to an electronic real-time streaming priced type of function that's going to be necessary, especially if you have as a goal as we have to eventually get 50% of our revenue from outside the United States, a real opportunity foreign exchange as long as you have the capability for today's world markets. And continuing to lead in investment manager operations, outsourcing, creating those annuity streams, those 7, 10, 12 year contracts with large, complex, global investment managers around the world.
We do talk a lot about investment management. But our investment management on global advisors has significantly increased its profitability over the last two or three years growing to 25% of our bottom line contribution, a goal that we gave them just a little over two years ago, growing from somewhere around 13, 14% profit contribution. Have done an extremely good job in terms of extracting more profitability out of that business.
So we have a simple formula for success. What we need to do is strengthen our foundation, our foundation, our franchise was built in the US as you might imagine, it was built on the back of the US mutual fund business in the 1970s, we need to protect that strong franchise. Again, IFIN has a lot to do with that. (inaudible) relationships with our customers; you can measure market share in many ways; the traditional way obviously is assets under custody. I like to measure it in terms of how deep our relationships with those top 500 financial institutions in the world. It goes without saying we have to deliver superior service levels. It is not necessarily a differentiator any more. It is something that you have to do and obviously we need to continue to seek operational efficiencies. If we add to that, building market share, growing in those new markets that are growing faster than others, creating critical mass. If we continue to develop new products and services continue to take the lead, one of the things that we didn't talk about, IFIN is, IFIN gives us the capability we did not have and that is the servicing of private equity funds. Granted a relatively small business today, a business that we were going to invest in. (inaudible) we have to but probably a business that is going to grow pretty quickly. We're going to keep winning competitively. We've got to win our share and obviously add quantitative active management capabilities to our already very large passive asset management capabilities.
We do that, what we're trying to seek is sustainable growth, meeting the benchmarks, making sure our revenue is growing faster than our competitors in strong markets and in not so strong markets. To continue to increase profitability; achieving operating leverage. An annual goal of achieving operating leverage, maybe not every quarter but at least at the end of the year revenue has to grow faster than expenses. We've been able to do it 10 consecutive quarters and it continues to be a very strong goal. (inaudible) discipline has been inculcated in the Company that I think allows us to do that much better than we have in the past and if we do that then we're going to deliver consistent results. Because I think what the market place seeks is that consistency quarter after quarter after quarter, and that is what we're seeking to do. So with that, I'll stop I will stop my formal remarks and be happy to answer any questions that anyone has.
UNIDENTIFIED AUDIENCE MEMBER: What are the major cost opportunities related to the acquisition?
RON LOGUE: I'm sorry, the major what?
UNIDENTIFIED AUDIENCE MEMBER: Cost opportunities, taking out costs.
RON LOGUE: The IFIN acquisition, IFIN is a mirror image of State Street. You can basically say it is a miniature State Street. It is organized, and I mean this literally, exactly the way the State Street servicing organization is organized, it is physically in the same city. The degree of difficulty is nowhere near with the degree of difficulty Deutsche Bank was, which was multijurisdictional. Obviously it is a legal organization itself, so all the corporate staff, US will be eliminated. We've publicly stated reduction of 1700 staff. On Friday we announced the severance of about 550 individuals on the day that we will close. We've actually identified those.
Most importantly we've also identified the key managers that we want to keep. Because the way you retain the business is by retaining the people who service the business. We've also notified those individuals, as well. Happy to report that most of the customer facing management beginning at the Chief Operating Officer are staying. We called on most of those customers already. No one has said they are leaving; as you know as I am sure that you've seen other acquisitions, these things have long tails. It will take some time. We're very confident we're going to be able to get those cost savings. We've known this organization for a long time, and it truly is the mirror image of State Street, just smaller. So we're extremely confident we'll be able to get those kind of cost savings that we publicly stated. Hopefully that answers your question.
UNIDENTIFIED AUDIENCE MEMBER: Ron, you just mentioned at the end there that on a go forward basis you were hoping to win your share of competitive bids. And maybe just a comment about the competition in the states you see and maybe the pro forma Bank New York Mellon but over here who you are up against and who you expect to be competing against.
RON LOGUE: Over here the traditional American banks are obviously but also Hong Kong Shanghai, BNP Paribas, and Societe Generale probably the larger players still here. Obviously as consolidation is going to continue you are going to see that there is going to be some dislocation, there is a differentiation of I don't know how many people appreciate between the consolidation of State Street and IFIN and the consolidation of the Bank of New York and Mellon. The content of customers at Bank of New York Mellon for the most part are US based, defined benefit plans.
The content that IFIN for the most part are US, in this case, (inaudible) mutual fund managers. When we talk about price competition you cannot generalize and say there is price competition in the custody business. There is price competition in segments of the custody business and where there is the most intense price competition is in the pension world, defined benefit defined contribution US and non US. Not so much in the collective fund world. Why? I take you back to that chart. There are not many people who do it, so there aren't many people who compete. All of us custodian banks can compete the defined pension business. For most of us who are custodian banks cannot compete at scale for collective funds business, especially in the United States. And that is, it remains to be seen what happens in consolidation as I said before these things have long tails. We are really not going to know how that is going to work out probably until first and second quarter next year and the telltale sign in my view is going to be topline revenue growth, all other things remaining equal, so we will see.
UNIDENTIFIED AUDIENCE MEMBER: If I could tag onto that just briefly if you can provide a little bit more granularity on the Bank of New York Mellon; do you see any fallout on that side. Is it easy to pick up contracts?
RON LOGUE: It is too early to tell, is the honest answer. It is clear just as all of the other custodian banks went after the Deutsche Bank or bank of trust book of business when we acquired that that we and everyone else is calling on all those customers. It is really going to depend not necessarily so much on price, but although it will to some extent. But how much dislocation is going to take place at in this case Bank of New York Mellon versus if one has to go through that dislocation anyways, is it worth, can you get more value somewhere else? My sense is a lot of those decisions will be made in the third and fourth quarter, probably closer to the fourth quarter of this year. Then you won't be seeing announcements of those things probably until the first quarter of next year. If in fact that happens and probably begin to see some of that reflected, I would think in topline revenue in first, second, third quarter of next year. It just takes a long time for that to happen. I'm sure you will hear from time to time names here or there; personally I don't think it is very constructive to talk about this name or that name. You will hear that from time to time. It may or may not be meaningful. It is really in the aggregate, and it is really usually at least three quarters after a close, at least that has been our experience and that is where you're going to be able to tell. At least that is where I would look to see.
UNIDENTIFIED AUDIENCE MEMBER: Ron, you talked about (inaudible) outsourcing opportunities (inaudible) Europe, and I guess you know a lot of big contracts but I think it is our understanding those are still not I guess converted onto your platform. Can you just talk to (inaudible) on building on your own platform and the process (inaudible).
RON LOGUE: Sure. What is happening with this business -- I have to go back for a minute -- is that the degree of difficulty of processing has continued to escalate. There was a time we were all custodian banks and that is all we did. We settled trades, and then some of us went to do accounting and some of us went to do trusteeship or fund administration, as we call it. And now some of us are trying to increase that degree of difficulty and literally take over the investment operations of large, global asset managers.
The key here is it is not about building a system to do that. It is about finding a way to integrate various functions and we've identified I think it is fourteen different functions that take place within the investment operations. They are small functions but fourteen very important functions; some of which organizations are emotionally attached to, want to do it themselves, some of which they don't care about. And they'll let others do it. It is a question of integrating that and creating a platform. It is not about building a whole new system.
So what we've done is we've taken over those operations as is and over time begun to develop a process that integrates systems that asset managers are using today with some of our systems and mixing and matching. And that is what the investment manager operations outsourcing is about. It is not about waiting for a system to be delivered. So we have something called the enterprise platform. We are at the point where we are installing pieces of that in different non US actually organizations, Investec, Scottish Widows, Axa, ABN Amro asset management. What we've said is that most of that will be done by the middle of 2008, and we will be on our platforms.
Until that time we basically literally take the people, put them on our payroll. That is a good thing, by the way, not a bad thing. A number of people said that is a bad thing. Why is it a good thing? It is a good thing because custodian banks don't necessarily know how to operate in the middle office. That is not what they've done all their life. Acquiring intellectual capital who knows how to do that is very important. And so we've probably acquired some lift outs of maybe over 1000 people who have done that. So today as I am speaking to you there are people who used to and still do work for PIMCO in Newport Beach, California, Citi in Paris, France and Amsterdam; and here in London helping those organizations convert, if you will, or integrate their operations. We have been able to take that intellectual capital and spread it around the world.
So at the end of the day what happens is Axa will do some things themselves, and we will do some things. ABN Amro asset management may do a totally different set of things. They will use the same underlying integrated platform to do that. It is not like you are bringing in a system and you are plugging it in and it's working. And I think that is a something that is not well understood in this newly emerging business.
UNIDENTIFIED AUDIENCE MEMBER: (inaudible -- microphone inaccessible) competition between State Street's own asset management group and what BGI group does. Is that an issue in moving that contract over?
RON LOGUE: No. First of all, it is not BGI business that is here. It is all BGI business that is in the United States currently serviced by IFIN in Sacramento, California. I think there has been more hype about that then reality, honestly. When we look at BGI as any other customer, we have to prove our worth to them. The way we are organized again just the same way IFIN is organized, it is around individual customers. It is not a large factory. So the ring fencing of BGI is the same as the ring fencing that we do for Fidelity. We are in another group we're doing work for Putnam. It is very similar. We are used to that. We've been doing that for years and years and years. When you are looking at that from the outside it looks like it is one large homogenous factory and the things can get intermixed, but that's not the way things work. So that is why we feel pretty good about our ability to do that. We've been working that way literally since the 1970s, with all of those competitors in the US mutual funds business. This is no different.
UNIDENTIFIED AUDIENCE MEMBER: Can you comment on some M&A opportunities in Europe? We seem to have Bisys being acquired by Citi. Any comments that would be useful for the group.
RON LOGUE: Bisys was a book of business that didn't have the same kind of interest, at least not in the US mutual fund side, very small number of customers. The one piece of value that we saw there was the hedge fund piece, a company called Hemisphere that they had purchased. But we already have that now in terms of our own business with IFS and now with IFIN. So I don't see that as a major issue at all. I think there will over time continue to be opportunities here in New York for more consolidation. I don't think it is going to happen in the near future. Things are going pretty well for everybody now. If you go back in time and look at when acquisitions take place, they usually during or just after down economic times when certain organizations no longer want to invest in this business. I would anticipate that at or slightly after the next down economic cycle there will be organizations who will rethink and potentially get out of that business. At that time we, as we have in the past will look long and hard at being able to do that. I think hopefully time will be such that we will be able to finish with the IFIN transaction this year, and if that were to happen in the next one or two years we would be in a position to do something again, and we would very proactively seek to do that.
UNIDENTIFIED PARTICIPANT: Please join me in thanking Ron for the presentation.
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investment management, business process outsourcing, state street, hedge fund, mutual fund
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