Shares of State Street Corporation (STT, Financial) have proved an excellent investment of late. The stock has delivered a total return of roughly 33% over the past year. Despite this move higher, the stock trades at just 10.8x consensus full year 2024 earnings per share and offers a dividend yield of 3.4%. Comparably, the S&P 500 trades at roughly 23x forward earnings while the financial sector, proxied by the Financial Select Sector SPDR ETF (XLF) trades at roughly 17x forward earnings.
While a low valuation and high dividend can indicate an attractive value opportunity, this is not always the case as there is often a good reason why cheap stocks sell at the price they do. Thus, further analysis is typically required to determine if a cheap stock is a value play or value trap. I view State Street as a compelling value play as the company has reasonable growth opportunities and has a fairly wide moat around its business.
Company Overview
State Street is a one of the most important financial services organizations in the world. The company's key businesses are investment servicing and investment management. Investment servicing is the company's most important business accounting for roughly 85% of total revenue.
The investment services business provides services including custody, back office solutions, accounting, regulatory reporting, performance and analytics, collateral services, record keeping, foreign exchange brokerage, and other related functions. The company has a total of approximately $44.3 trillion in assets under custody making it one of the largest custodian banks in the world.
The investment management business provides a broad suite of investment management products and services. The company has a total of $4.4 trillion in assets under management with a focus on passive products including ETFs which account for roughly $1.4 trillion of assets under management.
Wide moat business with limited competition
While the investment services and investment management businesses are highly competitive, State Street has a strong market position and a fairly wide moat around its business. Economies of scale are very important in the investment services business as significant investment is required to build out and maintain the technology systems required to provide complex investment services. During Q2 2024 alone, State Street spent roughly $454 million on information systems and communications initiatives. Additionally, customers tend to prefer using larger banks for custody services as the stability and safety of the custodian bank is perhaps the most important driver of a custody decision. For these reasons, the asset custody business and investment services business more broadly has high barriers to entry. As one of the largest custodian banks in the world, State Street benefits from its size in that clients tend to be more comfortable keeping assets with State Street vs other smaller players. Moreover, clients tend to prefer using the custodian bank for most investment services as there can often be increased efficiency related to doing everything with one provider.
State Street's biggest competitors in the custody business is BNY which has roughly $50 trillion in assets under custody. Together, BNY and State Street tend to dominate the custody business but there are a number of other relevant players including Northern Trust (roughly $15.4 trillion in assets under custody) and Citigroup (roughly $24 trillion in assets under custody.)
In addition to facing fairly limited competition, State Street tends to benefit from the fact that switching costs are fairly high for clients. The reason for this is that State Street services often get integrated with existing client technology and reporting which can make moving custodian banks a fairly cumbersome projects for clients. Overall, State Street has an estimated client retention rate of roughly 97% which suggests a highly sticky client base.
As a result of these factors, State Street has been able to enjoy health profit margins and fairly predictable earnings growth, despite operating in the highly cyclical financial services industry.
Rising asset markets and share repurchases are key earnings growth drivers
Given the fact that State Street operates in a highly mature industry, the primary driver of growth is rising asset prices. In both its investment servicing business and investment management business, the company charges fees as a percentage of assets. Thus, rising asset prices result in higher revenue for the company. However, this is offset by the fact that clients often demand fee reductions after significant increases in asset values and thus fees. State Street CFO Eric Aboaf discussed this phenomenon on the company's Q2 earnings call:
“I think we talked about pricing pressure because just part of the natural course of events, right, we get a market, we get pricing increases from market upticks. And then with clients they ask for a part of that back. That's just how the business has operated, as you say, for the last 30 years. This quarter and last quarter and this year, and for the rest of the year, we expect pricing headwinds to be in-line with the previous years and guidance. We've said pricing headwinds of about 2% per year. We're not seeing any more or any less of that.”
Overall, over the long-term, the impact from rising asset values tends to more than offset pricing headwinds. Over the past 10 years, the company has grown earnings per share (excluding non-recurring items) by an annual rate of roughly 5.2%. In addition to rising asset values, share repurchases are also likely to drive earnings growth over the next few years. The company currently has $4.7 billion remaining on its current repurchase authorization which represents roughly 18% of the company's market cap at current prices.
Currently, consensus estimates call for the company to deliver earnings per share growth of 10% and 12% for FY 2025 and 2026 respectively. I view these estimates as conservative as the share repurchase activity alone is likely to drive mid-single digit earnings growth though the impact is dependent on the timing of the repurchases.
Valuation is compelling
State Street currently trades at 9.8x consensus FY 2025 earnings per share. Comparably, the S&P 500 trades at roughly 23x consensus forward earnings. While State Street trades at a significant discount relative to the broader market, this has also been the case historically as the company has lower growth prospects than the broader market. This is especially true today as the S&P 500 has a path to near term double digit annual earnings growth due to the significant contributions from mega cap technology companies.
State Street's peers represent a more relevant comparison given the similarly of their businesses. State Street's closest peers are BNY and Northern Trust which respectively trade at 11.5x and 12.7x consensus FY 2025 earnings per share. Consensus estimates call for BNY to report earnings per share growth of 11.2% and 11.8% over the next two years while Northern Trust is expected to deliver earnings per share growth of 2% and 4.7% over the same time period. Comparably, State Street is expected to post earnings per share growth rate of 10% and 12% for the next two years. Thus, on a relative basis I do not believe State Street shares are attractive relative to its peers given the lower valuation and similar growth prospects.
Additionally, State Street's valuation is attractive relative to historical norms as the stock has traded at a median price to earnings ratio of 13.6x over the past 10 years. Furthermore, the shares currently trade at a price to tangible book value of 1.98x compared to a median price to tangible book value of 2.13 over the past 10 years.
In addition to trading at an attractive valuation multiple, the stock also offers a compelling dividend yield of 3.4% which compares to a dividend yield of just 1.31% for the S&P 500. I view the stock's dividend as a key positive as historically dividends have tended to contribute a significant portion of the total return for stocks. Recent research suggests 34% of the S&P 500's gain from 1940 to 2023 was attributable to dividends.
Economic slowdown is a key risk to the bull case
The biggest risk to the State Street bull case is a potential economic slowdown. While the company's business model is fairly recession resilient, falling asset prices would almost certainly lead to at least a temporary drop in revenue and net income. Moreover, the company also generates roughly $700 million in net interest income per quarter but would likely experience a decline in net interest income if interest rates were to drop significantly from current levels. Such a scenario is most likely to come as the result of a sharp economic slowdown.
Conclusion
State Street is a leading financial services organization which plays a key role in the global financial system. The company operates in a highly mature industry with limited secular growth opportunities. However, the company enjoys a very strong position in its key asset servicing business as customer retention tends to be very high. Moreover, barriers to new entrants in the business are quite high given the scale required to operate.
Historically, State Street has generated single-digit earnings growth put is poised to generate stronger earnings growth over the next few years due to a massive share repurchase program and a tailwind from rising asset prices. The stock trades at a valuation discount to peers despite having similar growth prospects. Additionally, the stock is trading at an attractive level relative to its own historical valuation range and offers a highly attractive dividend yield.
For these reasons, I believe State Street is a value play and represents an attractive investment opportunity.
