(STT) State Street Beats Earnings on Lower Costs

State Street Corporation (STT) reported third quarter 2011 operating earnings of 96 cents per share, which were significantly ahead of the Zacks Consensus Estimate of 88 cents. However, the results were flat sequentially and favorable with the prior-year quarter earnings of 86 cents.

State Street’s operating results, however, exclude certain discount accretion related to former conduit assets, restructuring charges related to reduction in staff and merger and integration costs.

On a GAAP basis, earnings for the quarter came in at $1.10 per share compared with earnings of $1.00 in the prior quarter and $1.08 in the year-ago quarter.

Better-than expected results in the quarter were mainly due State Street’s initiatives to lower expenses and rise in net interest income. Also, the company reported strong capital ratios. However, lower non-interest income was the negative for the company.

Quarter in Detail

State Street reported revenues of $2.43 billion in the quarter, down 2.5% sequentially but up 5% year over year. Operating revenues of $2.41 billion fell 2.4% from $2.47 billion in the prior quarter but rose 12.0% from $2.16 billion in the year-ago quarter. The company’s operating revenues were in line with the Zacks Consensus Estimate of $2.41 billion.

For the reported quarter, net interest income on an operating basis increased 1.8% sequentially but decreased 0.7% year over year to $564 million. This sequential rise was mainly attributable to an increase in earning assets driven by an increase in client deposits.

Net interest margin (NIM) on an operating basis (excluding the excess deposits) was 1.57% in the quarter, down 20 basis points (bps) year over year.

In the quarter, State Street reported 2.5% decline in fee revenues compared with the prior quarter but showed a growth of 17.5% from prior-year quarter to $1.84 billion. The sequential drop in non-interest income was mainly due to substantial fall in securities finance revenue.

In the reported quarter, the net after-tax unrealized mark-to-market losses in the investment portfolio were $259 million, up from net unrealized mark-to-market losses of $94 million in the prior quarter but down from $281 million in the year-ago quarter.

On an operating basis, expenses fell 2.5% sequentially but increased 12.8% year over year to $1.71 billion in the quarter. The decline was mainly due to lower salaries and employee benefits expenses, information systems and communications expenses and transaction processing services expenses.

Total assets under custody and administration were $21.51 trillion as of September 30, 2011, up 6.3% year over year. Total assets under management as of September 30, 2011 totaled $1.87 trillion, down 4.2% year over year.

Profitability Ratios

State Street’s capital ratios continue to remain strong. As of September 30, 2011, Tier 1 capital ratio was 18.0%, down from 18.9% as of June 30, 2011 but up from 15.8% as of September 30, 2010. Similarly, Tier 1 common ratio fell to 16.0% as of September 30, 2011 from 16.9% as of June 30, 2011 but improved from 13.9% as of September 30, 2010.

For the reported quarter, return on common equity (on an operating basis) came in at 9.8% compared with 10.2% in both the prior quarter and the prior-year quarter.

Share Repurchase

During the quarter, State Street repurchased 5.8 million shares, bringing the total shares repurchased in the last nine months to 10.7 million shares. This is the part of share buyback program that was announced by the company in the first quarter under which the company can repurchase $675 million worth of common stock in 2011.

Our Viewpoint

We expect that the company’s restructuring programs, strong capital ratios, as well as well-off core servicing and investment management franchises, will help offset the financial weakness caused by the sluggish economic recovery, thereby supporting growth in the near future. However, given the ongoing weakness in the mortgage market, we remain concerned about the sizable amount of mortgage-backed and asset-backed securities in State Street’s investment portfolio.

State Street’s close competitors, KeyCorp (KEY) and BB & T Corp. (BBT) are scheduled to report third quarter earnings on October 20 while SunTrust Banks Inc. (STI) is expected to report on October 21.

State Street currently retains a Zacks #4 Rank, which translates into a short-term Sell rating. However, considering the fundamentals, we are maintaining our long-term Neutral recommendation on the shares.

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