Investments in financial industry companies can perform extremely well over the long term for several reasons.
First, this industry's leading stocks usually trade at lower valuation multiples than the S&P 500 index average, thus offering less downside risk and steady price appreciation opportunity. Second, money has indefinite staying power. We'll always need it, and we'll always need financial companies. Third, because many of America's leading financial institutions have operated for a century or longer, they have their act together. They know what they're doing and they have a giant asset base with which to do it.
For these reasons and others, the Drip Port began to purchase Mellon Financial (NYSE: MEL) in 1998 when it traded near 16 times earnings. Every quarter, Mellon issues a 20-page earnings report and we look at the factors that are most important to us. Following along with us, you can learn what to look for from a financial services company. Is this column going to be boring? Maybe. But nothing is boring when you care to learn something.
Fee revenue is important
Mellon is a financial services company, not a consumer bank. It primarily manages financial doings for institutions and high wealth clients. In its case and others like it, the revenue number that is most important to investors is called fee revenue, or noninterest revenue. At Mellon, this revenue is earned through investment management fees and trust, administration, and custody fees, all of which are services. High noninterest revenue at a financial services firm usually results in a higher return on tangible assets (ROA) than can be achieved at your typical bank. Additionally, recurring fee revenue is more predictable than interest rate revenue, given that interest rates fluctuate.
Mellon's fourth-quarter fee revenue grew 2% from the same quarter last year as lower equity management fees ate into gains. Noninterest revenue for the year totaled $2.65 billion, down reasonably from 2000's $2.85 billion. For the year, total fee revenue grew 4% when excluding equity investment fee revenue. Mellon is lessening its exposure to the equity business pending a sale of its Dreyfus Brokerage Services to Brown & Co, a division of J.P. Morgan (NYSE: JPM).
In 2000, Mellon increased its fee revenue a strong 10%, so 2001 was comparatively disappointing -- but not really when you consider the harsh environment of last year. Long-term, we hope for fee revenue growth to average near double-digits annually. After restructuring the past several years, fee-based businesses accounted for 84% of Mellon's 2001 revenue.
Operating expenses should be near flat
We keep a close eye on operating expenses because an efficiently run financial services company should be able to increase revenue while holding operating expenses quite steady.
In 2001, operating expenses at Mellon rose 3%. Management said costs rose in support of business expansion. For all of 2000, operating expenses rose 5%, so 2001 was an improvement. In the past, we've seen numbers as low as negative 2%, so we know that Mellon can do better, but 2001 was not an easy year and so we're satisifed.
Return on Equity (ROE) from continuing operations rose to 20% in 2001 from 18.3% in 2000. More meaningful is the cash operating return on annualized equity (another form of ROE). However, for some reason Mellon didn't offer this figure this year, and given all the changes in the business (selling and acquisitions) it's a bear to figure it out with any confidence.
In 2000, Mellon's cash operating return on annualized equity was 46.4%, well above the 40% level that we want to see, and up from 45% in 1999. We haven't been able to talk to the right managers at Mellon to ask why this number (and the next one that we'll discuss) was excluded or ask how we can determine it safely ourselves. But we will.
Most relevant is the annualized cash operating return on tangible assets (a form of Return on Assets). Mellon achieved 2.48% ROA on this measure in 2000, up from 2.38% in 1999 and 2.07% in 1998. Seeing this number steadily rise was an excellent sign. Mellon had one of the better ROA numbers in the industry even when it was at 2.0% when we first bought it. Until we talk to management, we don't have 2001's result. (For much more information on simpler forms of ROE, ROA, and valuing stocks, see the suggested links to the top right of the column, especially the Drip Port buy collection on Mellon.)
When analyzing a financial services company, one risk that investors must watch for is the ballooning of nonperforming assets -- mostly loans that aren't being repaid. Mellon ended 1999 with nonperforming assets as a percentage of total loans and net acquired property of just 0.53%, which was very good (just slightly above its 1998 record of 0.44%). In 2000, this figure grew to 1.68% due to a few large defaults. In 2001, nonperforming assets declined as we hoped. The 2001 number was a reasonable 0.72%. As with ROA, Mellon is one of the better companies in the industry on this measure.
When Mellon traded at $31 per share, we said that it was a good company at a good price. The stock has risen about 16% since then. At a recent $36 per share, Mellon trades at 18 times year 2002 earnings estimates and 16 times 2003 estimates. With a book value of $7.80 per common share, the stock trades at 4.6 times book. That's on the high-end of the industry's range, but it's not an unusually high number for Mellon, which has traded above four times book since at least 1998.
Mellon's many prospects for growth at low incremental cost and its experienced management combined with share repurchases and dividends should continue to result in consistent, long-term value appreciation. This is why the Drip Port continues to invest in Mellon's free dividend reinvestment plan.
Well, how boring was that?
Drip Port sold its shares of Campbell Soup (NYSE: CPB), as announced in December, at $28.69 per share on January 28. We also enrolled in Paychex's (Nasdaq: PAYX) direct stock plan (welcome Paychex!) at around $35 per share, awaiting confirmation.
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Jeff Fischer owns the stocks in Drip Port, including Mellon. He's liked financial services since he was 12, when he opened a shoebox bank and forced his parents to deposit money for nominal interest. To see the stocks he owns, visit his profile. The Motley Fool has a rockin' disclosure policy.
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