State Street (NYSE:STT), which provides services for institutional investors, is finding it tough to continue its growth path. To keep growing, the company has agreed to purchase Investors Financial Services (NASDAQ:IFIN) for $4.5 billion. The deal should let State Street will tap into the lucrative hedge fund market -- but its high price is likely to drag the stock down.
State Street, founded in 1792, has a global platform that helps provide custodian services -- such as accounting, pricing, and administration -- for large pools of investment capital, like mutual funds, pension funds, and hedge funds.
To date, State Street has been a steady growth business, with uninterrupted earnings-per-share (EPS) growth since 1980. In the fourth quarter, EPS grew 16% to $0.86 per share; for the full year, earnings grew 15%. Investors Financial is a much younger firm, but though it was only founded 17 years ago, its growth rate has been similarly strong. For the past three years, revenues have posted a compounded average growth rate of 18%.
State Street is a top servicer for the hedge fund industry, which continues to accumulate assets. But the space still has its risks, as the implosion of the Amaranth hedge fund shows. In addition, Investors Financial gets about 18% of its revenues from one client, Barclays (NYSE:BCS), one of State Street's fiercest competitors in the ETF market.
Why do the deal?
State Street has several successful acquisitions under its belt, including 2003's $1.5 billion deal for Deutsche Bank AG's global securities business. By all accounts, the process seemed fairly smooth, and the company hit its goals.
The integration risks for the Investors Financial deal look less daunting. There will be no need to consolidate global operations, and both companies are based in the same city (Boston). The plan includes major cost reduction opportunities as the firms consolidate and pare back technology systems, office space, and head count, which should save an estimated $345 million to $365 million.
The deal will also boost State Street's market positioning, making it the No. 2 custodian ($14 trillion in assets) and the No. 1 administrator of hedge funds ($340 billion in assets).
The price to pay
Growth is rarely cheap, but the valuation for the Investors Financial deal is particularly steep. The new addition won't be accretive to operating profits until 2009. However, the scarcity of properties like Investors Financial adds to its value. Bank of New York (NYSE:BK) recently took another prospective target off the market by agreeing to purchase Mellon Financial (NYSE:MEL).
In light of the deal's price tag, it's not surprising that investors dropped State Street's stock by about 6%. This is a big shock for the company's shareholders, who have been accustomed to stability, and it's a good bet they'll be gun-shy with the stock for awhile.
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Fool contributor Tom Taulli does not own shares mentioned in this article. He is currently ranked 1,623 out of more than 21,000 players in CAPS. The Fool has a disclosure policy.
