Author: Gabriel Grego, Zanshin Capital
Covestor model: Buffettian Value
Disclosure: No position in Covestor portfolio, but long BK in other accounts
We find BNY Mellon (BK) stock attractive currently. This 200-year old bank is the market leader in the custody business and an important player in wealth management and issuer’s services. We believe the company benefits from a durable moat thanks to its scale, brand equity and the stickiness of its client base. BNY Mellon is also likely to benefit from numerous long term trends which should constitute important tailwinds for its future profitability.
At the moment, the stock can be acquired at a very attractive price relative to its intrinsic value due to a combination of short/medium term factors which we believe are inherently temporary and unlikely to affect the long term profitability of the franchise.
I. Industry Overview
Macroeconomic outlook
Bank of New York Mellon operates primarily in the asset management and asset services segments.
Both segments suffered significant headwinds since the latest financial crisis as investors fled the market or scaled down their commitment to riskier securities. High unemployment rate also forced many individuals to tap into their savings in order to meet day-to-day expenses, thereby reducing funds available for investment. The situation recovered somewhat in 2010, but trouble in Europe and a threatened global slowdown are not helping.
The current state of affairs is unlikely to endure. As the US real estate sector starts to gain traction, unemployment is bound to fall and sustained growth is likely to resume together with risk appetite and demand for financial services.
Furthermore, this industry is also likely to benefit from significant long-term demographic trends:
(1) Aging population in wealthy countries is likely to increase demand for financial services (as older people tend to hold more savings).
(2) Globalization increases the need for players with strong international capabilities, providing administration services in multiple currencies, languages, jurisdictions.
(3) New government regulations are making it harder for asset managers to administer assets in-house.
Asset managers and asset servicers are likely to enjoy increased profits during the next five years and top players will probably reap most of the gains.
Industry Dynamics
The global custody is concentrated within the hands of six firms, BNY Mellon being the largest, which administers more than 75% of all financial assets. In the issuer services segment, BNY Mellon is the dominant player, with no contenders in sight.
Existing firms compete in a rather disciplined fashion. A porter 5-Forces analysis confirms that most of the significant profits generated by this industry tend to remain concentrated in the top firms. High entry barriers, low customer and supplier bargaining power and absence of substitute products suggest a significantly remunerative environment.
Competition
In the asset servicing segment, BNY Mellon competes primarily with JPM Chase (JPM), State Street (STT) and Citigroup (C). The wealth management industry is significantly more fragmented, with no single player enjoying a dominant position.
In the asset servicing segment, key success factors are: scale, efficiency, brand, and cross-country capabilities. In wealth management, track record and reputation are dominant.
II. Business Model
BNY Mellon operates in three main segments with as many business models. In the asset servicing business, the bank essentially provides back office services for other financial institutions, including custody, administration, money transfers, forex, etc. The compensation charged by the bank is a function of assets under management and product complexity.
In wealth management, the bank simply receives funds from other private or institutional entities and invests them in various vehicles, receiving a fee based on overall asset size. In issuer services, BNY assists clients in new securities issues.
BNY Mellon also earns significant income on interest payments received on assets deriving from its funding sources. Clearly, this line of income is suffering from the low interest rates prevailing at the moment. Finally, the bank engages in clearing and treasury services.
III. Competitive Advantages
The BNY Mellon investment case relies on the existence of powerful competitive advantages which combine to make this bank’s position almost unassailable.
1. Scale
Banking business in general, and custody and wealth management in particular, are characterized by the presence of high fixed costs relative to the overall cost base. Manpower, IT and marketing expenses do not increase proportionally with the amounts of assets under management and, therefore, institutions in this industry benefit from a decreasing per-unit cost as scale increases. BNY Mellon being a top player in most of its business segments, enjoys a significant cost advantage thanks to its economies of scale.
2. Economies of Scope
An increasing number of clients are finding it convenient to use BNY Mellon as a one-stop shop for most of their asset servicing (and other) needs. This approach is significantly more convenient than shopping for multiple financial products across multiple providers. Again, this tends to benefit BNY Mellon vis-à-vis competitors that cannot provide a full service portfolio.
Also, as the financial services sector becomes ever more globalized, clients prefer companies that can operate in multiple countries and this benefits truly international players like BNY, penalizing smaller local companies.
3. Customer Captivity
Once a client selects their custodian or asset servicer, the resulting relationship might well last for decades as powerful forces keep clients from switching providers frequently. First, selecting and initiating the relationship with a new provider requires a significant sunk cost investment in time and effort. Second, changing providers can lead to costly disruptions and is in itself a hard process, especially considering that over time, much like for one’s lawyer or accountant, the value of the relationship increases over time as the service provider provides tailor-made solutions for its clients. Third, in general, asset servicing costs tend to be a relatively low portion of clients overall cost base and, thus, there is little scope for changing providers for a small monetary gain.
4. Barriers to entry
Opening a bank requires significant capital investments as well as a heavy regulatory burden. And this is particularly true for global players like BNY Mellon. Additionally, given the latest uncertainty existing in the industry, clients tend to favor safer institutions with negligible credit risk like BNY which, unlike traditional banks, derives most of its revenue from managements fees rather than loans and trading.
IV. Financial Health
BNY Mellon is in excellent financial condition. As a matter of fact, it is the highest rated US bank and one of the highest rated financial institutions in the world with a AA- rating from S&P.
BNY Mellon’s financial solidity is mostly a result of its business model which generates recurrent fee-income from services rather than interests from loans and trading activity. In addition to this, the management has been doing a good job in keeping a conservative financial profile, with little net exposure, adequate equity capital, and plenty of cash on its balance sheet.
We believe that the bank would prove resilient to most adverse economic scenarios from both a liquidity and solvency point of view.
V. Management
The company has recently changed CEOs, an existing veteran from the same institution: Mr. Gerald Hassel, and given his long tenure at the bank, he should have no difficulty in his new role.
The former CEO has been blamed for taking excessive risks and reducing the bank’s financial solidity prior to the financial crisis. The board fortunately realized such mistakes in time and took steps to correct the situation, hence, the stronger profile for the bank today. We believe the latest leadership change is a further step in the right direction.
A look at BNY Mellon’s capital allocation suggests that the company has been returning about 25% of cash flows to shareholders and about 40% to new investments such as acquisition. The rest has been used mostly to acquire securities of various nature. The Return on Invested Capital (excluding securities) over ten years has averaged about 20%, which is excellent for an institution of this kind and confirms the management’s decent stewardship.
VI. Risks
Economic/Financial Shocks
Despite its relatively good credit standing, BNY Mellon is still exposed to the health of the financial sector as a whole. Because most of its revenues depends on the level of assets under management, custody and trading, major negative market swings can significantly affect the bank’s profitability.
Changes in interest rates
BNY Mellon’s income is also partially dependent on the level of interest rates and spreads. Adverse swings can have an effect on the bottom line of the company (although interest rates are so low at the moment that the future probably holds positive surprise from here onwards).
Acquisitions
Management has stated its intention of pursuing acquisition activity in the future with the purpose of increasing the company’s scale and geographic reach. We do not think this is necessarily a bad idea (and the track record seems good so far), but there is a risk of overpaying or failing to integrate successfully.
VII. Valuation
Asset Approach
A look at BNY Mellon’s balance sheet suggests the company is significantly undervalued: the company’s market capitalization is 73% of its book value. This is not justified in our opinion as the balance sheet is mostly high quality and this kind of discounts are usually found in institutions holding potentially toxic assets, overleveraged or on the verge of a market recapitalization – none of which seems to be the case here.
The company’s valuation relative to its book value has ranged between 4.7x and 1.15x in the past (suggesting significant potential upside).
Earnings Power Value Approach
A conservative estimation about BNY’s normalized cash flows gives us approximately a $3bn figure. The last 12 months’ earnings were about $2.6 billion and we can safely add another $400m due to goodwill amortization and the fact that the current period should not reflect the full earning power of the company due to a number of contingent factors (low interest rates, stagnant economy, risk aversion, etc.). If we discount $3bn at an 8% interest rate we get an earnings power value of about $36.7bn or $30 per share. That is equal to a 12.5% earnings yield.
The stock is currently (as of 11/28) trading at about $18.30 so the margin of safety is over 30% for those who buy at this point. Of course, the value of $30 excludes any future growth.
Expected IRR including growth
If growth becomes part of the equation, BNY Mellon may be worth considerably more. Of the existing 12.5% earnings yield, about 35% will likely be reinvested at a return on capital of at least 15% (as stated by management and evident from past activity). That is at least twice the company’s cost of capital and, along with organic growth, should generate long term earnings increases of about 11% per annum. If we add 7.7% of redistributable earnings, it follows that an investment in BK at 20$/per share should generate approximately 18% of IRR.
Considering that long term equity returns average about 10% per year, it follows that BK is strongly undervalued and should be trading at about $40.
VIII. Current Status
BNY Mellon shares are clearly under pressure due to a number of contingent factors making the markets uneasy with the stock.
1. BNY Mellon is seen as a somewhat leveraged play to the performance of the US equity markets at a time of great uncertainty.
2. Just as with any other bank, there is widespread concern about possible repercussions of the European sovereign debt crisis.
3. There is a lawsuit outstanding against the bank due to its handling of foreign currencies transactions. The total claimed amount is in the order of $2bn (about 8% of market cap): significant, but not life threatening. Due to our analysis of the situation, we believe the issue will be solved with a settlement equal to a fraction of the amount mentioned.
4. Uncertainty due to the recent change in management. In our opinion this is not justified as the chosen figure seems competent and is likely to prove an improvement over his predecessor.
5. Some concerns about escalating costs (relative to revenue). It seems however, that the issue has been well understood by management which has recently embarked in a set of actions with the long term effect of cutting costs in the order of $700m in 2/3 years.
In short, there is no shortage of issues outstanding for the bank. However, I believe that none of these are threatening the existence or the privileged competitive position of the company. It is routine business in value investing to snatch shares of great franchises when prices are affordable due to short term concerns about companies with a likely bright long term future. We believe this is the case here.
