With Activist Investors Circling, Is The Bank of New York Mellon a Buy?

Over the next month, banks will be releasing results for the second quarter. In advance of these releases, let's take a moment to review the state of some of these banks as of the end of Q1.

In this post, we'll look at The Bank of New York Mellon Corporation (NYSE: BK  ) , a $368.2 billion custodian bank headquartered in New York City. You can find information on other banks at my Motley Fool article feed, available here. All data in this analysis was sourced from the FDIC's Quarterly Banking Profile and S&P Capital IQ.

When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: soundness, profitability, and growth. As investors, we then look at valuation and the potential for investment after gaining a better understanding for each bank.

Soundness

Soundness refers to the bank's asset quality. Generally speaking, this means loans.

If a bank makes loans that are never repaid, that bank will fail, and fail quickly. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.

To measure this, we'll look at both non-performing assets and Bank of New York Mellon's provision for loan and lease losses. A simplified definition of non-performing assets is loans or other assets that have fallen seriously delinquent or are in foreclosure.

The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio.

Banks are required by regulation to maintain certain levels of reserves, but within that, management has plenty of wiggle room to over- or under-reserve. Over-reserving increases protection but hurts net income; under-reserving increases risk but keeps net income high.

For the quarter ending on March 31, Bank of New York Mellon had 0.04% non-performing assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.5% non-performing assets as a percentage of total assets.

Bank of New York Mellon released $18 million from its reserves in the first quarter, which represented a 4.9% boost to operating revenue. That compares with new reserves of 5% for the $10 billion-plus peer group, according to the FDIC.

Bank of New York Mellon's primary businesses are, generally, service related.

In this way, and as we'll see further in the next section, this distinction makes the bank's soundness profile slightly different from your standard bank's.

In this case, New York Mellon has no real problem assets to speak of and this reserve release is a drop in the bucket compared to the company’s fee related income. 

Profitability
After establishing an understanding of a bank's risk culture and soundness, next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.

The first question, perhaps most obviously, is whether the bank generates a profit at all.

According to data from the FDIC, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!

For Bank of New York Mellon, the first calendar quarter of 2014 fortunately wasn't that bad. The company generated total net revenues of $3.6 billion for the quarter -- that's total interest income plus non-interest income minus interest expense.

BK Net Income (Quarterly) Chart

Over the past 12 months, Bank of New York Mellon has generated $15.0 billion in total net revenue. Of that revenue, 20% was attributable to net interest income, the difference between interest earned on loans and paid out to depositors. The remaining 80% was through fees, trading, or other non-interest revenue sources.

Again, this split is a result of Bank of New York Mellon's status as a custodian bank, with its primary revenues coming from services, not loans. The bank was able to turn a profit margin of 20% on that revenue.

For the first quarter, the company reported return on equity of 7.2%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.

With such a heavy reliance on fee-based income, instead of the reliable monthly payments of loan income, the bank's revenues would at first seem more vulnerable than a traditional bank's.

However, Bank of New York Mellon is the world's largest custodian bank, providing a steady opportunity to charge fees to its extremely large and affluent customer base.

BK Return on Equity (TTM) Chart

Leverage
Leverage is a double-edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.

Leverage is just part of the game with banks, so if you're a conservative investor who really focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is, generally speaking, a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.

The result is a higher numerator, a constant denominator, and a larger return-on equity number. The math does the heavy lifting for you.

On the flip side, too much leverage can put the bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and downright terrible for shareholders.

Banks use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old-fashioned assets-to-equity ratio. The lower the number, the less levered (and more conservative) the bank.

BK Assets To Shareholder Equity (Quarterly) Chart

Bank of New York Mellon Corp.'s assets-to-equity ratio comes in at 9.4. The average of the 62 banks analyzed in this series of articles was 9.1.

At this level, investors would hope for higher return-on-equity figures; with above-peer-average leverage, Bank of New York Mellon trails its peers in ROE. That said, in this case it's a conservative play to maintain leverage in this range while the bank continues to clean up its problem assets.

Growth and valuation
Bank of New York Mellon saw its revenues change by 2.6% over the past 12 months. That compares with the 5.7% average of the 62 banks analyzed.

This change in revenue corresponded with a 93% drop in net income over the same period because of an abnormally poor quarter last year. (See the preceding chart for a better picture of the long-term trend.) The peer set averaged 14.1%.

Fifty-four percent of all U.S. banks saw year-over-year earnings growth in the first quarter.

Moving now to valuation, The Bank of New York Mellon Corp. traded at a forward price-to-earnings ratio of 15.1 according to data form Capital IQ. That compares with the peer set average of 16.7.

Bank of New York Mellon's market cap is, at the time of this writing, 3.2 times its tangible book value. The peer set average was 1.9.

In this case, a more specific peer set is justified for the comparison, given the unique custodial nature of New York Mellon's operations. Competitors State Street (NYSE: STT  ) and Northern Trust (NASDAQ: NTRS  ) trade at 13 and 19 times forward earnings, respectively.

Recently, activist investor Nelson Peltz announced a 2.5% equity stake in the company and said he's in talks with management and the board of directors to shake things up at the bank. Why? Because he and the board agree that Bank of New York Mellon is undervalued.

In this case I tend to agree. Given the bank's unique business model and focus on services over loans, the company can afford to restructure its capital base, handle more leverage, and generally create more shareholder value through financial engineering alone.

We'll leave the financial engineering to the activists. In the meantime, we can use these changes at the company as a chance to buy a world-class financial institution at a fair price. Bank of New York Mellon has a massive deposit base and banking relationships with some of the largest and most affluent customers in the world. It offers a huge variety of in-demand products; the bank is kind of boring in this way.

And when it comes to banks, I value boring. While not hugely discounted, this bank does represent a value at today's prices.

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