Northern Trust Corp (NTRSO) 2005 Q2 法說會逐字稿

Good day, everyone and welcome to the Northern Trust corporation second quarter 2005 earnings conference call. Today's call is being recorded.

At this time I would like to turn the call over to the Director of Investor Relations, Beverly Fleming, for opening remarks and introductions. Please go ahead, ma'am.

Thank you, Tracy. Good morning and thank you for joining us to review Northern Trust's second quarter 2005 financial results. Joining me this morning are Steve Fradkin, our Chief Financial Officer; Aileen Blake, Controller; and Mark Bette from our Investor Relations team.

For those of you who may not have received our earnings release or financial trend report by e-mail this morning, they are both available on our website at northerntrust.com. In addition this July 20th call is being webcast live on northerntrust.com. The only authorized rebroadcast of this call is the replay that will be available through July 27th. Northern Trust disclaims any continuing accuracy of the information provided in this call after today.

Now for our Safe Harbor statement. What we say during today's conference call may include forward-looking statements, which are Northern Trust's current estimates or expectations of future events or future results. Actual results, of course, could differ materially from those indicated by these statements, because the realization of those results is subject to many risks and uncertainties. I urge you to read our 2004 annual report and our periodic reports to the SEC for detailed information about factors that could affect actual results.

The second quarter of 2005 is our first quarter to include full results from the acquisition of the financial services group of Baring Asset Management. Many of you will recall that this acquisition closed on March 31st, 2005, the last day of this year's first quarter. To assist you in your analysis of our quarterly performance, let me quickly review the line items on our income statement that were impacted by this acquisition. After I've given you those figures I'll hand the call over to Steve Fradkin, Northern Trust's Chief Financial Officer.

On the revenue side of the income statement, the FSG acquisition added $43 million in revenues during the second quarter of 2005. Note that this figure excludes the funding impact of the acquisition, which equalled $6.7 million during the quarter. When you include the acquisition funding costs as an interest expense and therefore a reduction to revenues, second quarter revenues associated with FSG equalled a net $36.3 million. This FSG revenue contribution can be broken down by income statement line item as follows -- $28.5 million in custody and fund administration fees in our Corporate and Institutional Services business unit; $5 million in foreign exchange trading profits: $2.1 million in other trustees in our Personal Financial Services business unit; $6.3 million in net interest income, offset by $6.7 million in acquisition funding costs, as I mentioned earlier; and $1.1 million in other income.

On the expense side of the income statement, the acquisition added $36.1 million in expenses during the second quarter. Total expenses associated with the acquisition included $6.6 million in integration and transitional expenses. Total second quarter FSG expenses break down by line item as follows -- $14.8 million in compensation expense; $4.4 million in employee benefit expense; $3.6 million in occupancy expense; $0.7 million in equipment expense; and $12.6 million in other operating expense. On an after tax basis, the FSG acquisition was slightly dilutive to overall corporate earnings.

With those details behind us, let me now hand the call over to Steve Fradkin.

Thank you, Bev, and good morning, everyone. Let me extend my welcome to all of you listening to Northern Trust's second quarter 2005 earnings conference call.

Earlier this morning Northern Trust reported record second quarter 2005 earnings per share of $0.68, up 15% compared to the $0.59 we reported in the second quarter of 2004 and up 8% from the $0.63 we reported in the first quarter of 2005. Net income equalled a record $150 million, up 15% year-over-year and up 8% sequentially.

As Bev just outlined for you, our acquisition of the financial services group of Baring Asset Management -- or FSG -- contributed $43 million in revenues during the quarter and $36.1 million in expenses. After acquisition funding costs and on an after tax basis, FSG was modestly dilutive. Later in today's call, I will provide some additional comments on the progress of our integration efforts.

As we have done in recent quarters, we'll be dividing today's call into several sections. First, I'll highlight some of the key financial items contributing to our second quarter results. Second, I'll review our second quarter numbers in some detail, providing you with our perspective on the specific performance achieved on each of the major line items, including FSG impacts. And finally, I'll share some observations on recent developments in each of our businesses. Bev and I will then be pleased to take your questions.

We are extremely pleased with our results in the second quarter. Let me highlight for you four key factors that influenced our outstanding financial performance.

First, excellent revenue momentum experienced in 2004 and in the first quarter of 2005 continued in the second quarter. We experienced strong growth in trust investment and other servicing fees. Fee growth was evident both with and without the acquired FSG fees. Foreign exchange trading profits were also very robust. Again, both with and without the positive impact of the acquisition. Lastly, on the revenue front was net interest income, which continued its recent trend of very strong growth. As interest rates have continued to rise to more normalized historic levels, we have seen a steady positive trend in net interest income for four consecutive quarters.

Second, expenses were well managed. This combination of excellent revenue growth and disciplined cost management resulted in modest positive operating leverage for the quarter even when including FSG and related integration expenses.

Third, while the equity market environment was modestly positive on a year-over-year basis, the markets placed a drag on asset based fees on a sequential basis. Our institutional custody business and our PFS wealth management business are both impacted by quarter lag markets which were down. Our PFS private client business operates primarily on a one-month lag basis, likewise using that methodology, the markets were down.

Fourth, credit quality, again, remained very good resulting in no loan loss provision being recorded in the second quarter.

With that backdrop, let me review our key revenue drivers in the quarter. Total revenues of $687 million were at record levels in the second quarter, up 17% or $102 million compared to last year. Excluding the impact of the FSG acquisition, revenue growth was also a very robust 11%. Trust investment and other servicing fees were the biggest contributor to year-over-year growth, up $66 million or 20%. Excluding FSG, trust investment and other servicing fees increased at a double digit rate, up a strong 10%. Excellent year-over-year fee growth was followed closely by growth in net interest income, up $33 million or 23%. On a sequential basis, revenues were up 11% or $66 million versus the first quarter of 2005 with institutional fees, personal fees, foreign exchange, and net interest income all contributing to the solid sequential growth. Sequential revenue growth excluding FSG was also up a very solid 5%.

Corporate & International Services fees of $227 million increased 29% or $51 million year-over-year. Excluding FSG, year-over-year C&IS fee growth equalled 13%. C&IS fees were also up $42 million or 23% on a sequential basis and up a very healthy 8% excluding FSG. The components of C&IS fees performed as follows --

Custody and fund administration fees in C&IS increased 53% year-over-year to $105 million and increased 39% sequentially. Included in reported C&IS custody fees were $28.5 million in FSG fees. Excluding FSG fees, custody and fund administration fees would have increased 11% year-over-year and 1% sequentially. Recall that C&IS custody fees are billed primarily on a one quarter lag. At March 31st, the S&P was down 2.6% for the quarter while the Nasdaq was down 8% and the EFA index was down 2%, all combining to place a drag on sequential custody fee growth.

The strength of our global business continued to fuel the growth in our custody fee line. Global custody assets at June 30th equalled $1.1 trillion, an increase of 35% or $281 billion versus one year ago and 5% or $56 billion sequentially. Global custody assets now represent 43% of total C&IS assets -- C&IS assets under custody, up from just 15% one decade ago.

Securities lending fees equalled $47 million, up 29% versus one year ago and up 38% compared to the first quarter. The year-over-year increase was primarily driven by growth in the volume of securities on loan. Securities lending collateral volumes equalled $206 billion at June 30th, up 28% or $45 billion versus one year ago. Volume growth this quarter was driven by higher demand in the marketplace for leant securities due to improvement in the overall economy and renewed M&A and IPO activity. The 38% sequential increase in security lending fees represents the traditional seasonal peak in the securities lending business due to the international dividend season. FSG was not a material factor in the year-over-year or sequential performance of securities lending fees.

Investment management fees in C&IS of $60 million were up 6% versus one year ago and up 1% sequentially. As of June 30th, approximately 37% of our C&IS managed assets were equities with the remainder representing short duration, fixed income and other alternative asset classes. Within the C&IS investment management fee line, we saw strong growth in manager of manager, quantitative, equity, mutual fund fees, and custom cash management assignments. Offsetting strong growth in each of these areas was a reduction in fees earned on residual cash suite products.

Assets under custody in C&IS equalled $2.5 trillion at June 30th, up 23% or $460 billion from a year ago and up 3% or $78 billion versus last quarter. Growth in C&IS custody assets this quarter was driven by new asset transitions which more than offset the adverse impact that foreign currency translations had on our sequential growth in assets under custody.

During the second quarter, we concluded negotiations and signed contracts with Insight Investment Management for the complete outsourcing of their back and middle office investment operations. This is a very exciting opportunity for Northern Trust as it expands an already significant client relationship with this prominent London based fund manager. The relationship also enhances the capabilities and intellectual capital to support our growing outsourcing business. Migration of Insight's investment operations to Northern Trust's platform will occur between now and April 2006. In addition, Insight transitioned to Northern Trust approximately $44 billion in additional custody assets during the second quarter. The incremental Insight custody assets represented approximately half of the sequential increase in C&IS assets under custody. The remainder of the sequential increase represents new clients transition during the quarter, as well as new assets from existing clients, supported by some growth due to markets, yet offset by currency translations due to the strengthening U.S. dollar.

C&IS managed assets of $478 billion were up 13% or $56 billion from last year and were flat sequentially. Over 80% of the year-over-year increase in C&IS managed assets was the result of outstanding growth in our securities lending business. The second largest contributor was Northern Trust Global Advisors, our manager of managers subsidiary, which has experienced outstanding new business growth of late.

Our Personal Financial Services business unit reported second quarter fees of $175 million, an increase of 9% compared to the year ago quarter. PFS fees were up 1% on a sequential basis. PSF fees included $2 million in FSG fees in the quarter. PSF fee growth excluding FSG was 8% year-over-year and flat sequentially. Total assets under custody in PSF at June 30 equalled $214 billion, up 10% or $20 billion from a year ago and up 2% or $4 billion sequentially. Managed assets in PSF equalled $111.5 billion, up 6% from a year ago and flat sequentially.

For those of you who maintain detailed fee models on PSF fees, recall that all PSF states are on a consistent monthly fee methodology. Using this monthly fee methodology, the S&P 500 was down 2% compared to the month-end values relevant to our first quarter fees.

The only exception to this approach is our wealth management group, which serves families with assets of $75 million or more. Similar to C&IS custody fees, wealth management fees are based primarily on a one-quarter lag. Recall that the major equity market indexes were down as of March 31st, with the S&P 500 down 2.6%. Wealth management fees equalled $23 million in the second quarter, up 20% versus a year ago and up 5% sequentially. Excellent new business in wealth management offset the negative equity market environment. Assets under custody in wealth management equalled $106 billion, up 18% or $16 billion from one year ago and up 5% or $5 billion sequentially. Managed assets in wealth management totaled $21 billion at June 30th, up 16% year-over-year and up 1% as compared to March 31st. Our wealth management group has experienced very strong growth in recent years, indicative of our unique leadership position at the ultra high end of the affluent market. Over the past five years, wealth management custody assets have grown at a compound annual growth rate of 13%. This compares quite favorably to the overall downdraft in the equity markets during that same time period, with the S&P 500 down 4% on a compound annual growth basis and the Nasdaq down 12%. Northern Trust currently enjoys a relationship with 24% of the Forbes 400 richest Americans.

Foreign exchange trading profits equalled a record $51.6 million during the second quarter, up 9% versus last year and up 35% sequentially. The FSG acquisition added $5 million in foreign exchange trading profits during the quarter. Excluding the impact of FSG, foreign exchange trading profits were down 2% from the previous record of $47.5 million in last year's second quarter and up 22% sequentially. The primary driver of the modest year-over-year decline was lower volatility in the major currencies. The higher sequential performance is attributable to a steady strengthening trend throughout the second quarter in the U.S. dollar against the Euro and British pound sterling. Treasury management fees equalled $18 million during the second quarter, down 19% compared to last year and down 7% compared to the first quarter. As interest rates have risen, some clients are now electing to pay for a higher proportion of their treasury management services via compensating balances.

Securities commissions and trading income in the second quarter equalled $14 million, up 11% year-over-year and up 1.5% sequentially. Other operating income in the second quarter equalled $21 million, up 10% year-over-year and 5% sequentially. Other operating income included $1 million in FSG revenues. Excluding those revenues, other operating income would have been up 4% year-over-year and flat sequentially. Net interest income equalled a record $180 million, up 23% or $33 million from a year ago and up 5% or $8 million sequentially.

Three primary factors fueled the year-over-year increase in net interest income. Similar to recent quarters, we continue to benefit from the higher absolute level of interest rates. Higher rates benefited deposit spreads in two ways. First, deposit spreads are returning to a more normalized level from the depressed levels seen when rates were very low versus historic norms. Second, the industry has lagged increases in retail deposit rates, albeit at a slower rate in the second quarter than in prior quarters. Given that Northern has a $9 billion private client interest bearing deposit base, our year-over-year comparison benefits from the impact of the rising rate environment on deposit spreads.

Second, the year-over-year comparison benefited from loan growth. Specifically, average loans increased 9% in the second quarter fueled by our middle market client group, private client lending, and FSG.

Finally, continued growth in our global custody business provided a corresponding increase in foreign office time deposits, which averaged $18 billion during the quarter, up 50% year-over-year. This growth in foreign office deposits can be seen in part on the asset side of the balance sheet in the money market asset category which was up 17% year-over-year and in the securities portfolio which was up 14% year-over-year.

The sequential increase in net interest income was driven almost entirely by growth in earning assets as I just described. Our net interest margin equalled 1.74% in the second quarter, up 14 basis points from last year and down 5 basis points sequentially. The year-over-year increase of 14 basis points reflects both the deposit spread phenomenon that I described earlier, and the outstanding growth in foreign office time deposits, which has reduced our reliance on more expensive wholesale funding. The sequential decline of 5 basis points in the net interest margin reflects a decline in non-interest related funds due to the FSG acquisition. Specifically, average net non-interest related funds were down $277 million from the second quarter primarily due to the addition of goodwill and other intangibles associated with the FSG acquisition.

Loans during the second quarter averaged $19 billion, up 9% compared with year ago levels. Loans to individuals were up with residential mortgages up 3% versus last year to $8.1 billion and personal loans up 10% to $2.8 billion. Residential mortgages represented 43% of our total average loan portfolio. Commercial loans increased 7% from a year ago to average $3.6 billion in the quarter and represented 19% of our total average loan portfolio for the second quarter.

As I mentioned at the outset of this call, credit quality continues to be very strong. Nonperforming loans totaled $30 million, down from $68 million one year ago and down from $34 million sequentially. We experienced net charge-offs during the quarter of $800,000 and recorded no loan loss provision. Our loan loss reserve of $130 million covered total nonperforming loans over 4 to 1 as of June 30th.

Now let me shift my comments to a detailed review of expenses. Expenses during the second quarter of 2005 equalled $442 million, up 17% from the year ago quarter and up 12% sequentially. As Bev mentioned earlier, expenses included $36 million related to FSG. Expense growth excluding FSG was 7.5% year-over-year and 3% sequentially. Compensation expense equalled $197 million, up 18% or $30 million year-over-year, and up 10.5% or $19 million sequentially. Compensation expense included $15 million attributable to FSG. Compensation expense growth excluding FSG was 9% year-over-year and 2% sequentially. The year-over-year and sequential increases in compensation expense, excluding the impact of FSG, reflected higher incentive compensation due to improved corporate performance, the April 2005 annual salary merit increases, and additional staff.

Staffing levels equalled 8,959 full-time equivalent positions at June 30th, up 929 positions from last year, and up 115 positions from last quarter. The increase from last year reflects the addition of approximately 800 staff related to the FSG acquisition. The remaining hires relate primarily to the outstanding growth in our global business. Employee benefit expenses equalled $49 million in the second quarter, up 14% or $6 million versus last year and up 5.5% or $2.5 million sequentially. Employee benefit expenses associated with FSG during the quarter equalled $4 million. Excluding FSG, employee benefit expenses would have been up 4% year-over-year and down 4% sequentially. The sequential decline represents a defined contribution plan true up that was taken during the first -- this year's first quarter. The year-over-year increase in employee benefit expense is attributable to higher pension, FICA insurance and medical expenses.

Occupancy expense in the second quarter equalled $33 million, up 6% or $2 million year-over-year and up 8% or $2.5 million sequentially. The increase in occupancy expense relates primarily to the FSG acquisition.

Equipment related expense equalled $21 million in the second quarter, up 1% year-over-year and up 7% sequentially. Again, FSG was the primary contributor to the increase in equipment related expenses.

Other operating expenses of $142 million were up 23% or $26 million year-over-year and up $21 million or 18% sequentially. FSG added $13 million in expenses to this category during the second quarter. Excluding FSG expenses, other operating expenses were up 12% or $14 million year-over-year and 9% or $11 million sequentially. Note that second quarter 2005 -- note that second quarter 2005 other operating expenses includes $4 million in intangibles amortization associated with the FSG acquisition. The year-over-year increase in other operating expenses, excluding FSG, was driven by higher advertising, travel, employee relocation and hiring costs, and new business growth which resulted in higher global sub-custodian and asset management sub-advisor costs. The sequential increase, excluding FSG, was driven by many of the same factors.

Northern Trust's effective income tax rate in the second quarter equalled 35.1%, up from 32.7% in last year's second quarter and up from 34.3% in this year's first quarter. Recall that during last year's second quarter, we successfully settled several state income tax matters. As a result, income tax benefits of $2.2 million were recorded last year due to reductions in previously accrued income taxes, thus impacting the year-over-year tax rate comparison. Our higher tax rate in the second quarter of 2005 also reflects the fact that taxable income has been growing faster than tax exempt income.

We repurchased 911,000 shares of Northern Trust common stock in the second quarter at a cost of $41.5 million. Diluted shares averaged 221 million, down 329,000 from last quarter. We can purchase an additional 5 million shares under our buyback authorization. In keeping with our practice, we increased average common equity by 8% versus one year ago to a record $3.4 billion at year end. This represents the 69th consecutive quarter that we have increased common equity.

Let me wrap up by commenting on the momentum we have recently seen in each of our businesses. In C&IS, our global business continues to perform very well. Within that segment, our business and fund managers has been -- our business with fund managers has been particularly strong. Integration of the FSG acquisition is progressing well. The additional capabilities that this acquisition brings to our fund manager's suite of services are in demand in the marketplace and we are now better positioned to meet the expanding needs of both existing and prospective clients. New business momentum in C&IS was excellent in the second quarter. Our pipelines are solid and we are seeing considerable interest in a number of exciting product areas, such as outsourcing, cross porter pooling mandates and fund administration services.

Also during the second quarter, we celebrated the grand opening of our representative office in Beijing, China. While China is a market in the early stages of development for the services that we offer, we are excited by the pace of change developing in this market.

In PFS, our new offices in both Boston and Minneapolis are opening this month. In addition, our Atlanta partners have moved into a beautiful new building located in the Buckhead area and are planning a late September grand opening celebration.

The strength of the Northern Trust brand is a considerable asset for our private client business and we have been implementing a number of new initiatives in 2005 to leverage the brand on a national basis. During the second quarter we launched a new advertising campaign. At the center of this effort are many prestigious business publications with a combined circulation of 7.6 million readers. Our advertisements are now being regularly featured in the Wall Street Journal, the New York Times, Forbes, Fortune, Worth and other publications. We also stepped up our sponsorship of prominent events that attract our targeted market segments, including the King Tut exhibit, the spring season of the American Ballet Theater in Manhattan, the Jimmy Fund Regatta in Newport, Rhode Island and the upcoming Andy Warhol exhibition.

And lastly, on the -- on the business front, a comment on our investment, our Northern Trust Global Investments. As I noted last quarter, we are the ninth largest asset manager as ranked by Global Investor Magazine, offering a broad product lineup to our core private and institutional clients. Products that exhibited particular strength during the second quarter of 2005 included securities lending, manager of manager, and quantitative management. We continue to be very well positioned to serve the investment needs of our targeted markets, private clients in the United States, and institutional investors worldwide.

Now, before I wrap up my remarks, I'd like to make a special acknowledgement of a respected colleague and friend for many of us at Northern Trust, Mr. Perry Pero. Perry is well known to many of you, having preceded me as Chief Financial Officer for 15 years before moving to head up our corporate risk management function. During the second quarter, we announced that Jana Schreuder, who is an Executive Vice President of the company would be joining Northern Trust's Management Committee and succeeding Perry as head of Risk Management, facilitating a smooth transition consisted with Perry's plans to retire after 41 years at Northern Trust. During the third quarter, Perry will complete his tenure at Northern Trust, capping off a remarkable career. Perry's integrity, work ethic and stewardship have provided a wonderful example for future generations of leaders at Northern Trust and on behalf of his many friends here, I wish him all the best, for good health and happiness as he goes forward into retirement.

Let me close by saying that we are extremely pleased with this quarter's outstanding financial performance. These results are a testament to the excellent balance and strategic positioning of our businesses and to our ability to execute on our strategies to serve clients exceptionally well, which can then translate into strong growth in the marketplace.

And now, Bev and I would be pleased to answer any questions you might have. Tracy? Please open the call for questions.

Thank you.

[OPERATOR INSTRUCTIONS]

We'll go first to Andy Collins with Piper Jaffray.

Good afternoon. Or good morning there. I'm just wondering, on the net interest margin, you know, you had talked about potentially getting to 2%. I was wondering what that might be adjusted for FSG? And then also, unrelated, what was FSG's foreign exchange before it was rolled in?

Thanks for your question, Andy. On the net interest margin, we didn't really talk about 2%, though 2% historically on a pretty long-term basis was a level that we were -- were -- have been around. So we don't have that as a target and we -- we can't affirm that that's where we'll get. That's just -- that's just a number that many people refer to as something that we've been at in the past.

Okay. So you wouldn't think that the FSG is going to weigh down too much then going forward on the margin? What about -- what about the foreign exchange? What was their run rate before they were acquired? Is the $5 million where they were before or was that more of a cross-sell opportunity for the new Northern?

I don't have the run rate on FSG pre-Northern, so I wouldn't want to comment on where they've been historically and whether this is a material variance.

Okay. And then just lastly, on the tax rate, wondering what we might expect going forward given that it's been bouncing around here a little bit.

I think the tax rate that you saw in this quarter should be representative of the -- of the -- of future expectation for you.

Great. Thank you.

Okay. Thank you, Andy.

We'll go next to Joel Gomberg with William Blair.

Thanks. Steve, Could you at least outline over the next few quarters what you're expecting on expense saves out of FSG and then what you expect in terms of additional charges? Thanks.

Sure, Joel. You know, we have not changed any of our prior statements on FSG. The $25 million in integration expenses and then $9 million in transitional expenses. We had about -- just a little over $2 million in the first quarter and then $6.6 million in the second quarter of which $4.4 million was integration expenses and $2.2 million was transitional expenses, so we will continue to see expenses associated with integrating that business and we're not changing our statements in that regard.

And then in terms of the fee growth in Illinois last year, there was some decline sequentially. Is there -- is there some tax -- you mentioned a tax reason, sequentially with the tax season? Is that the same occurrence here or is it more market related?

Well, we have -- we have both. The markets did have an adverse impact based on the -- either the way that we calculate fees, but you are correct. Another factor for the state of Illinois was that we have a significant impact from the tax preparation fees where we get those fees in the first quarter but not in the second quarter so it's both those factors.

Okay. Thank you.

You're welcome.

Moving on to Glenn Schorr with UBS.

Hey, Steve, thanks. Staying in the state by state stuff, if you look at the PSF fees other line, it by far had the best sequential and year-over-year growth. Is that as simple as function of the new offices growing a small base and is that particular the New York metropolitan area this quarter?

Thanks, Glenn. I think, you know, one thing to remember is that the $2 million from FSG is in that -- in the other line.

Okay.

So that's a -- that's a big part of the factor, but we are continuing to see growth from around the system, New York included.

Fair enough. You also mentioned in your prepared that some treasury customers are choosing to pay via compensating balances. Is that a meaningful shift and does that mean we'll see a little more net interest income and little bit less on the fee line? Just a geography thing?

It historically has been a meaningful shift. I'm a little hesitant to offer any real thoughts on what the -- how those clients will elect to do it. So I'm a bit guarded there.

But you're indifferent is I guess a part of the question.

Glenn, one thing that I would add to that, in the press release there was a sentence that said approximately 60% of that decline year-over-year was offset by improved net interest income. So that's something to keep in mind as well. So I would say that to some extent we are indifferent to which revenue line it falls into.

Okay. And then the last one you also mentioned the assets on the custody is somewhat impacted by currency. Assets under custody are just maybe a memo item on the currency impact, but can you just remind us, Steve, on how you -- the franchise in general is impacted overall as you have stronger moves in the dollar?

Well, I think in terms of -- in terms of our overall results, I would say that it's -- it's been a de minimus factor. What we're talking about here is that -- when you take those total assets under custody and translate them back, it was -- it was a meaningful factor in diminishing that overall custody fee growth. But in terms of financial results it was not meaningful.

Okay. That's all.

On the income statement.

Thank you both.

You're welcome.

We'll take your next question from Tom Mccrohan with Janney Montgomery Scott.

Good morning.

Hi, Tom.

Just two quick questions -- the first on the dilution and the second on the deposit spreads. For the dilution analysis, can you just walk us through quickly how you get to the guidance for this year for dilution, simply just back of the envelope analysis? I just get a lower dilution number.

And Tom, you're referring to the $0.04 to $0.06?

Yeah. The $0.04 to $0.06. Real quick, back in the envelope, if you back out the $6.6 million this quarter of integration and the transition costs, you can, you know, get a -- kind of a quarterly pretax profit for FS and G of about say $13.5. Just call it $15 million. So if you just kind of go with current run rates, you've got $45 million of operating profits for the next nine months and if you include the guidance of $25 million integration, $9 million in transition costs for this year, plus the run rate funding costs, you get about $10 million dilution pretax. Tax effect is like $0.02 cents or something. So I'm leaving something out. I'm just not sure how you're getting to the $0.04 to $0.06. It could just be the share count or maybe you're just assuming different kind of growth assumptions in margins and FSG.

Tom, I'm not sure. I can't tell from the quick run through that you gave here, whether you were incorporating all the figures that are relevant here, but you've got the integration expenses, the transitional expenses --

And then funding. Right?

Funding and then the intangibles amortization.

That's my problem. I'm leaving out that.

You kind of ran through your numbers real quick and I'm not sure exactly which of those you might not have included in their entirety.

Okay. I'll follow up with you then. Just so I don't tie you up on that. But it will be helpful to walk through that.

To the deposit spreads, Steve, could you point me to where on your average balance sheet what items you're talking about? You're talking about the deposit spread? For example, are you just simply looking at the spread between the yields on your interest bearing deposits and your money market assets?

We'd be talking about the private client deposit base.

The $9 billion.

The private client interest bearing deposit base.

Yes. Okay. So you're basically saying it's getting a better yield on your interest free deposits?

We're saying we're getting a better spread on the private client deposits of $9 billion.

Okay.

All right.

Thanks.

Okay. You're welcome.

We'll hear next from Brian Harvey with Fox-Pitt Kelton.

Thank you. Just a couple of questions here on the balance sheet. Steve, can you just talk about the size of the balance sheet. It looks like it fell a little bit at quarter end relative to some of the averages. Just wondering if that was client driven deposits or not. And then the second question is just on the funding mix, it looks like foreign office time deposits as a percentage has really increased significantly while some of the other purchase funding has come down which has helped out the mix in terms of funding. Can you just talk about that relationship and what you're doing with that?

Yes, Brian, I don't think there was anything that I can think of in terms of the overall size of the balance sheet. And similarly with foreign office time deposits, that really is a function of our client activity. You're right, that moved up substantially year-over-year, but there's nothing that -- that comes to my mind that is, you know, a material change in our business, you know, other than we had FSG as a client, but I don't think there's anything beyond that that comes to my mind that would drive that.

Okay. It just seems as though the foreign time deposits are sort of a cost advantage relative to some of the other purchase funds and if that growth continues it seems to be a nice sort of head wind -- I mean tail wind for you.

That's correct and as you -- as you know, the growth in our overall global custody business has driven the foreign office time deposits up. So you're -- you're right.

Okay. Just lastly, sort of unrelated question, can you give any color on the transition management business this quarter, any strength that you're seeing?

Transition management, you know it's episodic as we've talked about in the past quarters. We've -- we recently won some awards in the transition management business for quality, but I'd say that number jumps around. I don't -- I can't remember it. Our internal number off the top of my head, but I don't think there was anything magic this quarter positive or negative on that front.

Okay. Thank you.

You're welcome.

And moving on to Ken Usdin with Banc of America Securities.

Thanks. Steve, would you be able to reconcile for us the difference between kind of the pretax add from FSG which was about like 0.2 and then the after tax effect which was closer to minus a million?

Sure, Ken. While the acquired FSG legal entities on a combined basis did operate at a profit at the second quarter, we had certain subsidiaries that incurred operating losses and what we've done is take a conservative position which meant that we did not record a tax benefit for U.S. tax purposes on these losses, since it wasn't certain that the losses would be realizable until the subsidiaries rather are profitable. So once these subsidiaries generate profits, the preferred tax benefits can be recognized in our financial statements, but we just took a conservative view at this point in time.

So that -- Okay. So that could actually be a benefit in the future?

It could be, but remember we're in the first quarter of this. There are a lot of new entities and structures and we just wanted to be careful about that.

Okay. Great. And then back -- back on the -- the margin question, Steve, I just wanted to make sure, what -- the reason then that the margin was down this quarter even though you made some comments on the fact that short term interest rates usually do help. How much of that is related to the acquisition and the mix shift related to FSG and just directionally, can the margins start to move back up again going forward?

Well, you know, as I mentioned in the -- in the remarks on the sequential decline, we had non-interest related funds that were down $277 million and that was primarily the addition of goodwill and other intangibles. I'm not a great predictor of markets and I think in the only quarter we did it a couple quarters ago to try and give you help, we were wrong. So I would be hesitant. 2% has been the historic net interest margin. We talked that that may not be a margin that is easily achievable and something we'll come back to, but we really don't know. We're going to have to wait and see.

Okay. Then lastly, can you just comment on the -- the kind of the core PSF business and just business trends there, any directional improvement at all in -- as far as new relationships this quarter?

Sure. You know, I -- I think what I'd say is the year-over-year results show a steady -- steady and continued improvement and kind of the way I would think about it, Ken, is we are clearly showing continued strength at the top end of the market, the wealth management business, you know, assets under custody, $106 billion, up 18% and 5% sequentially, fees up 20% year-over-year and 5% sequentially, and that -- that sequential performance is in the face of down markets for fee calculation purposes.

In the middle of the market, the market that we call $25 to $75 million, which is the open architecture space, we're seeing very strong growth in pipelines. That's a relatively newer market for us, so you don't want to overemphasize it, but certainly what we've seen in terms of percentage growth rates and the strength of the pipeline and ability to compete there looks very, very good.

As for the broader PSF franchise, the 84 offices in 15 states, we continue to see broad-based improvement year-over-year. We talked last quarter, we had a very strong net new business quarter. This quarter new business was softer. I don't know if that's a trend or if that's a function of -- of more things closing in the first quarter, so I'd say, you know, we're clearly seeing progress on that front and we'll just have to wait and see how it -- how things play out over the next couple of quarters to see how strong that trend will be. But overall, we're pleased with the direction we've headed in PSF and it's sort of a gradation, from the top end of the market being the strongest, down to the more traditional business, moving up, but still not moving up in the -- you know, leaps and bounds.

Okay. Thanks a lot, Steve.

You're welcome.

And Ryan Medalle with Merrill Lynch has our next question.

Good morning, Steve. Just to ask this another way without you trying -- getting you to try to predict a net interest margin, how comfortable are you that you will be able to continue to grow foreign office time deposits in the second half and also continue to lag DTFS deposit pricing and how would you feel if the yield curve got considerably flatter in relation to those two factors?

Well, I think what we -- let me start with the industry lag effect on the -- the retail deposits first, and I think what we saw in the second quarter was that the strength of that phenomenon was diminishing. Rates were starting -- the deposit lag was not as great in the second quarter as it was in the first quarter. I don't know where that will take it, but directionally I will assume that that will not be as strong a phenomenon as it was.

In terms of foreign office time deposits, again, I'd be loathe to predict. All I could point you to is that there is a broad correlation between, on average over time, between the growth in our foreign office time deposits and the growth in our global custody assets and we have a pretty good track record over -- over a very extended period of aggregating additional assets. So my hope would be that that trend would continue though I'm not sure I would -- I would project 50% year-over-year increases every quarter. But I think directionally, that phenomenon should continue to exist to the extent that we can continue to grow our global custody assets.

And then how much would a flatter curve get in the way of this dynamic if we -- say the curve today and flattened it by another 2 to 5 year curve, I don't know, another 25 to 30 basis points.

Brian, this is Bev. Obviously a steeper yield curve, we would prefer that, but given that we are a company is -- that does and has always had a very conservative approach to interest rate risk management and given the fact that our -- for example, our securities portfolio is a very short duration, it probably doesn't have as big of an impact on us as it does on others. With that being said, clearly it would be our preference for there to be -- to have it a little bit steeper.

Right. Even on the shorter end? Naturally?

Sure.

Right. Of course. Okay. Just a couple of other questions. Any out -- any way to outline what you think could be cost saves in '06 from that $36 million quarterly cost run rate at FSG or is that -- is that too tough to decipher?

Brian, we actually gave some guidance on that on our investor day which we haven't updated, but I can give you that. We did estimate that in 2006 there would be $16 million in expense -- wait, is that right, Steve?

I can just refer back.

Yeah, if you refer back, there's a slide in our investor day presentation from May 25th titled expense factors for 2005 and 2006.

And you're still on target for that after this quarter?

Yes.

And then just on the Insight deal, you said you're bringing $44 billion of custody assets in relation to that on your books. What is the level of assets that you're servicing in the middle office from Insight?

A couple of points there, Brian. One it is $44 billion of additional assets, so this is providing outsourcing, in fact middle office outsourcing to an already important client and expanding that relationship not only in -- with outsourcing services, but with additional assets that they're moving to us. I don't -- I don't want to release their -- the asset number with us, because, frankly, I'm not sure if they want us to do that. But I would say it has been a substantial relationship and -- I'll just say it's a substantial relationship and you could probably discern that by someone moving -- by an organization moving $44 billion in additional assets.

Right. Would you characterize this mandate as considerably bigger than the Julius Baer mandate?

I -- yes. It's bigger.

Okay. And then just going forward as you go into '06, what should we think about expenses that are associated with building out the middle office for this deal and for other -- other mandates that you might be targeting in this regard?

Well, as -- as we've talked about with the outsourcing business, there is some upfront costs to supporting some clients and we expect it will have some of that head wind in 2005. The transition and migration process is happening now, and we already have people in their office and their people will be moving to our office so we'll feel some of that as we go through the end -- the second half of the year and into 2006. But you know, this is not a major line item head wind for you, but there will be expense associated with it, but it's not a -- it's not going to be a major thing for us.

And you're still sticking with your goal of neutral to positive operating leverage on a year-over-year basis for 2005? Correct?

Yes.

Great. Thanks very much.

You're welcome.

We'll go next to Jeff Steinberg with JLF Asset Management.

Thanks very much. Congratulations on the great results, guys.

Thanks, Jeff.

Just a quick follow up with regard to the acquisition. I know you said $0.04 to $0.06 negative impact this year. In terms of the impact for next year, what have you said?

Accretive by approximately $0.08.

So is the way to think about that in terms of looking at '06 versus '05 that it's actually a roughly $0.13 swing going from a midpoint negative $0.05 this year to plus $0.08 next year?

Yes. That's right.

Okay. So I think I'm -- just to make sure whatever we end up doing this year in earnings we actually add $0.13 to that just for that factor?

Correct.

Okay. And then obviously we would hope to continue to grow the business beyond that just in the core of Northern Trust?

That's right.

Okay. Thank you very much.

And we now have a follow up question from Andy Collins with Piper Jaffray.

Yes. I was just wondering if you could give us a little more color on the strong C&IS pipeline?

Sure. I think our view on the C&IS business would be that we continue to have a strong and very competitive positioning. In that business, we've had particular strength internationally and especially in Europe, although I think the strength has been global, but the opportunities have been a little bit bigger in Europe. You know, I would say in terms of the -- the performance this quarter in terms of new business performance, it was -- it was very strong, not at -- not at record levels but strong, and our pipeline continues to be strong.

The -- the one thing I would add to that, Andy, is that we -- there is an increasing overall complexity that we're seeing in the C&IS business which is both an opportunity and a challenge and you see that in the complexity associated with outsourcing mandates, you see that in the complexity associated with things like cross border pooling and you see that in the complexity associated with the sophistication of some investment strategies that our clients are undertaking and that's both a challenge and an opportunity. It's a challenge in that it requires more expertise and technology and so forth on our end. It's an opportunity in that you can differentiate yourself in terms of delivery with the sophisticated clients.

So we continue to feel good about the C&IS business, and feel that we're nicely positioned in that business.

The pipeline, is it mostly international or is it split 50/50 or kind of -- how's it cut geographically?

I don't know that I'd put a percentage on it. I would say there's definitely a pipeline of opportunity that is existing in the United States. We just announced a week or so ago the win of Worcester Polytech, but there's -- there's also a strong growth opportunity that continues internationally. So I don't think I'd put a percentage on it, but we're seeing opportunities in both.

Great. Thank you.

You're welcome.

We have a question from Nancy Bush with NAB Research LLC.

Good afternoon, guys.

Hi, Nancy.

Just a quick issue on this issue of deposit lag. You're not only getting better deposit spreads, but you mentioned that you're continuing to be able to lag deposit pricing. Is there a formula that goes through into that and are you seeing any sort of, you know, price elasticity at this point from this deposit lag? I mean, is there just -- is there sort of a barrier beyond which you cannot go in lagging deposit pricing?

Good question, Nancy. No, I don't think there's a formula. I think the formula and then as we've talked about with people, the formula seems to be what the rest of the market is doing. As you know, our -- our $9 billion in private client deposits is -- is very attractive to us, but pretty small potatoes relative to what the other banks are doing and so we're kind of a tree amongst the forest and kind of where they go is -- and what the market bears is -- is kind of where we're going to end up. My sense was that -- or our sense rather, was that that elasticity had been stretched and it was diminishing, but I don't think I could give you any mathematical guidance beyond that.

Okay. Thank you.

You're welcome.

We'll now take a question from Mike Mayo with Prudential equity group.

Hi, good afternoon.

Hi, Mike.

Just want to understand the dilution from the acquisition. I guess it hurt earnings by a half a cent this quarter and you're expecting it to hurt -- what? $0.04 or so this year? So I'm wondering why we wouldn't have seen the worst of the dilution already and how you expect that to play out this year? Thanks.

Sure. You're correct. As we've talked about with -- with integrating the -- the FSG transaction, we had a full plan down to a very granular level.

Recall that the acquisition was announced in November of last year and it closed on March 31st, so we had a good opportunity to put our plan together, but equally, we were very sensitized to ensuring that our plan was the right plan and that we executed around it carefully. So we did not come in on April 1st, the day after the close and immediately start moving the pieces. We wanted to sit down with the people, we wanted to make sure that our understanding of the business and the -- the verbage and so forth that we use is consistent with what they use and so we've been working very much in partnership with our new employees to make sure we get that right and so that's the other reason, Mike, that we were very deliberate in not -- not staging out the guidance as to the timing, because I think we -- we very much know what we want to do and a lot of what we've been -- had in the plan has been validated, but we've been careful about making sure we get this right.

So that's the rationale, nothing more beyond that.

Do you want to brace us for I guess for an increase in expenses or a loss of revenues or how should we think about the next couple quarters?

I don't know that I'd use the word "brace", but I think that we are not changing the guidance that we've given, that we expect $25 million in integration expenses and we've -- we've spent whatever 6 -- $4.4 in this quarter and then approximately $2 in the first quarter, and we expect, you know, order of magnitude to continue down that trend. And in terms of the revenue side, you know, it's going to take us time to get it kicked up and fully integrated and optimize that and we'll just have to see how that goes, but no, there's no change to the guidance that we've provided previously.

Okay. If I could have one more question.

Sure.

Hey, it's Rob Rutschow. I'm just wondering if the pricing lag and the benefit that you get on the deposits, if you're going to end up giving that back when interest rates stop rising?

Well, I think the -- you know, the phenomenon, Rob, that we've talked about in the past was that when interest rates got to an absolutely low -- to such an absolutely low level, there was no spread. The phenomenon that we're talking about now is that as interest rates rise, we do get a deposit lag benefit, if you want to term it that, but at a higher absolute level of interest rates, there is a spread where there was no spread before. So I don't know if you call that giving it back, but I -- you know, we would expect to have a spread at a higher absolute level of rates, where as before we did not.

Okay.

All right. Thank you.

And there are no further questions at this time, Mr. Fradkin. I'll turn it back to you for any closing comments.

Thank you, Tracy. And thank you to everyone for joining us. We'll look forward to giving you an update at our third quarter call. Have a great day.

Thank you. That does conclude today's conference. Thank you for joining.