Considering how hard the financial sector has been hit this year by the one-two punch of the COVID-19 pandemic and the Fed lowering prime interest rates to near 0%, State Street (STT -3.42%) has fared relatively well in the first quarter.
The asset manager/custody bank reported a 25% increase in first-quarter earnings compared to the same period last year, topping analysts' estimates. The company benefited from a complementary mix of revenue streams that enabled it to navigate the rapids in Q1.
But where does it go from here? Is State Street stock worth owning?
Buoyed by volatility
What makes State Street unique is its market-leading position in two areas of financial services -- custody and asset management. It is the second-largest custody bank in the world, with about $31.8 trillion in assets under custody, behind only Bank of New York Mellon (with $35.2 trillion).
In this business, State Street earns revenue from fees for holding and serving assets of large institutional investors, like pensions and mutual funds. Assets under custody decreased 2% in the quarter, but revenue from servicing fees was up 3% year over year, driven in part by an increase in new business. As their main source of revenue comes from fees, custody banks are less affected by interest rate changes than other banks.
On the other side of the business, State Street Global Advisors is one of the five largest asset management firms in the world, with about $2.8 trillion in assets under management (AUM). State Street had net inflows of $39 billion in the quarter, driven by increases in cash and institutional flows, but AUM dropped 4% due to a 1% decline in net interest income and lower equity market levels. As its assets are predominantly with institutional investors, the assets are stickier and less prone to volatile swings in fund flows.
What helped buoy State Street in the quarter was a 64% increase in revenue to $459 million in foreign exchange trading services. The boost was due to higher foreign exchange trading volume caused by significant market volatility, particularly in March.
State Street has built a pretty all-weather business model that proved itself durable in the volatile first quarter. Furthermore, the company has a strong balance sheet to help it navigate the storm. Expenses and debt have been kept low, and the company has strong liquidity with a liquidity coverage ratio of 109%, virtually unchanged from a year ago. The common equity tier 1 ratio, which measures a bank's capital strength, was 10.7% at the end of the quarter, down from 11.5% in the first quarter of 2019 but well above the minimum standard.
While State Street is priced attractively with a price-to-earnings (P/E) ratio under 10, it will face some earnings headwinds, as will most of the financial sector in this low-interest-rate environment. A new report by the International Monetary Fund expects bank profitability to be challenged for the next five years due to loan losses and low interest rates. With its diversified business mix and market-leading positions, State Street may be as well-positioned as any to buck the trends, as it is not a traditional bank. It also pays out a solid $0.52 per share quarterly dividend at a 3.4% yield.
While the stock has come back nicely at the end of May on optimism surrounding the slow reopening of state economies, the outlook for the next few quarters is muddled. State Street should hold up better than both traditional banks and most pure-play asset managers, but if you are hungry for growth, this might not be the stock to provide it.