Northern Trust Corp (NTRSO) 2005 Q3 法說會逐字稿

Good day, everyone, and welcome to the Northern Trust Corporation third 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. Please go ahead, Ms. Fleming.

Thank you. Good morning, everyone, and thank you for joining us to review Northern Trust's third 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 might not have received our earnings release or financial trend report via E-mail this morning, they are both available on our website at northerntrust.com. In addition, this October 19th call is being webcast live on northerntrust.com. The only authorized rebroadcast of this call is the replay that will be available through October 26th. 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 for 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.

Similar to last quarter and 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 the Financial Services Group acquisition, or FSG. After I have 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 45 million in revenues during the third quarter of 2005. Note that this figure excludes the funding impact of the acquisition, which equalled 6.3 million during the third quarter. If you include the acquisition funding cost as an interest expense and, therefore, a reduction to revenues, third quarter revenues associated with FSG equalled a net 39 million.

This FSG revenue contribution can be broken down by income statement line item as follows: 30 million in custody and fund administration fees in our corporate and institution services business unit; 6 million in foreign exchange trading profits; 2 million in personal financial services trust fees; 6.1 million in net interest income offset by 6.3 million in acquisition funding cost, as I mentioned earlier; and 1 million in other income.

On the expense side of the income statement, the acquisition added 33 million in expenses during the third quarter. Total expenses associated with the acquisition included approximately 6 million in integration expenses.

Total third quarter FSG expenses break down by line item as follows: 15 million in compensation expense; 4.7 million in employee benefit expense; 3.7 million in occupancy expense; 1 million in equipment expense; and 8.8 million in other operating expense.

On an after-tax basis, the FSG acquisition was accretive to overall corporate earnings in the third quarter by approximately $0.01 per share.

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 third quarter 2005 earnings conference call.

Earlier this morning, Northern Trust reported third quarter 2005 earnings per share of $0.67, up 29% compared to the $0.52 we reported in the third quarter of 2004. Net income equalled $148 million, also up 29% year over year.

On a sequential quarter basis, earnings per share were down 1% from the $0.68 we reported in the second quarter of 2005. Net income was down 2% sequentially.

We are pleased with our results in the third quarter and with the overall momentum that we have seen thus far in 2005. We've organized the balance of today's call to address three basic areas: First, I will outline items that you should be mindful of as you analyze our third quarter results. Second, I will review our financial performance in some level of detail. And finally, I will offer our perspectives on both the FSG integration and on Norther Trust's broader strategies and current market positioning. As always, Bev and I will then be pleased to answer your questions.

As you analyze our results, you'll want to keep in mind four particular items that impacted reported results and year over year comparisons: First, as Bev just outlined for you, our acquisition of the Financial Services Group of Baring Asset Management, or FSG, contributed $45 million in revenues during the quarter and $33 million in expenses. After acquisition funding costs and on an after-tax basis, FSG was slightly accretive for the third quarter. Later in today's conference call, I will provide you with some additional comments on the success of our integration efforts, as well as updated estimates of the impact of FSG for both 2005 and 2006.

Second, our results in the third quarter of 2004 included two items that impacted that quarter's performance. The first was a pretax charge of $17 million or $0.05 per share related to a litigation settlement. The second item was a direct result of that charge. Given the lower third quarter 2004 earnings performance due to the charge, we recorded an accrual adjustment to our ESOP expenses in the third quarter of 2004 which led to lower employee benefit expenses in that quarter.

Lastly, our results in this year's third quarter include a pre-tax gain of $4.7 million related to the sale of a warehouse we owned in Chicago, which was previously used for off-site storage.

With that backdrop, let me review the quarter's financial performance, beginning with our key revenue drivers.

Total revenues equalled $685 million in the third quarter, up 22% or $125 million compared to last year. Excluding the impact of the FSG acquisition, revenue growth was also a very robust 15%.

Trust investment and other servicing fees were the biggest contributor to year over year growth, up $69 million or 21%. Even excluding FSG, trust investment and other servicing fees increased at a double digit rate, up 11%.

Strong year over year fee growth was followed closely by excellent growth in net interest income, up $31 million or 20%.

Corporate and institutional services fees of $220 million increased 33%, or $55 million year over year. Excluding FSG, year over year, C&IS fee growth equalled 15%. C&IS fees were down $7 million, or 3%, on a sequential basis.

The components of C&IS fees performed as follows in the third quarter: Custody and fund administration fees in C&IS increased 58% year over year to $108 million and increased 2.5% sequentially. Included in reported C&IS custody fees were $30 million in FSG fees. Excluding FSG fees, custody and fund administration fees would have increased a strong 14% year over year.

The primary driver of the year over year growth in custody fees was continued strong new business in our international segment. Global custody assets at September 30th equalled $1.2 trillion, an increase of 41% or $343 billion versus one year ago and 9%, or $102 billion, sequentially.

The equity market environment also contributed modestly to the year over year growth. Recall that C&IS custody fees are built primarily on a one quarter lag basis. At June 30th, the S&P500 was up 4.4% versus the prior year.

Securities lending fees equalled $35 million, up 38% versus one year ago and down 25% as compared to the second quarter. The year over year increase was primarily driven by growth in the volume of securities on loan. Securities lending collateral volumes equalled $213 billion at September 30th, up 26%, or $44 billion versus one year ago.

Volume growth this quarter was driven by higher demand in the marketplace for lent securities, due to equity market activities, including M&A and new issuance activity.

The sequential decrease in securities lending fees is not unexpected and represents the traditional second quarter seasonal peak in securities lending business, due to the international dividend season. If you go back five years, the average second quarter to third quarter decline in securities lending was 25.5%, exactly in line with our results this year.

Investment management fees in C&IS of $61 million were up 7.5% versus one year ago and up 3% sequentially. The year over year growth in C&IS investment management fees was driven by our manager of Manager subsidiary, Northern Trust Global Advisors, and by success we are seeing in delivering an array of NTGI investment products internationally.

Assets under custody in C&IS equalled $2.6 trillion at September 30th, up 23% or $497 billion from a year ago, and up 6% or $144 billion versus last quarter. Growth in C&IS custody assets this quarter was driven equally by new assets transitioned and favorable equity markets offset very slightly by the adverse impact of foreign currency translations.

C&IS managed assets of $494 billion were up 15% or $65 billion from last year and 3%, or $15 billion, sequentially. Approximately two-thirds of the year over year increase in C&IS managed assets was the result of outstanding growth in our securities lending business.

Our personal financial services business unit reported third quarter fees of $177 million, an increase of 9% compared to the year-ago quarter.

PFS fees were up 1% on a sequential basis. PFS fees included $2 million in FSG fees in the third quarter. PFS fee growth, excluding FSG, was 8%, year over year.

Total assets under custody in PFS at September 30th equalled $219 billion, up 13% or $25 billion from a year ago, and up 2.5%, or $5 billion, sequentially. Managed assets in PFS equalled $114 billion, up 8% from a year ago, and 2% sequentially.

For those of you who maintain detailed fee map models on PFS fees, recall that all PFS states are on a consistent monthly fee methodology. Using this monthly methodology, the S&P500 was up 3% compared to the month-end values relevant to our second quarter fees.

Our Wealth Management Group, which serves families with assets of $75 million or more, reported third quarter fees of $22 million, up 11% versus one year ago and down 3% sequentially. Similar to C&IS custody fees, wealth management fees are based primarily on a one quarter lag. The year over year results represent both excellent new business in wealth management and a moderately favorable market environment, with the S&P500 up 4% on a year over year one quarter lag basis.

The modest sequential decline primarily represents the revenue sharing arrangements between wealth management and some of our PFS states, where some very large clients and complex family relationships are being serviced, both centrally in wealth management and locally in our PFS offices.

One indication of our continued success in wealth management is the terrific growth we have seen in assets. Assets under custody in wealth management equalled $109 billion, up 20% or $18 billion from one year ago, and up 2% or $3 billion sequentially. Managed assets in wealth management totalled $21 billion at September 30th, up 9% year over year and flat as compared to June 30th.

Foreign exchange trading profits equalled $46 million during the third quarter, up 75% versus last year and down 10% sequentially. The FSG acquisition added $6 million in foreign exchange trading profits during the third quarter. Excluding the impact of FSG, foreign exchange trading profits were up 52% from last year's third quarter.

The primary drivers of the significant year over year increase were higher volatility in the Euro to U.S. dollar relationship and higher client volumes. The weaker sequential performance reflects our strong results in this year's second quarter, coupled with the normal seasonal pattern, which has historically shown a slowdown during the summer months.

Treasury management fees equalled $17 million during the third quarter, down 23% compared to last year and down 6% compared to the second quarter. As interest rates have risen, some clients are now electing to pay for a higher proportion of their treasury management fees via compensating balances.

Other operating income in the third quarter equalled $27 million, up 40% year over year, and up 30% sequentially. Other operating income included $1 million in FSG revenues and the previously mentioned $4.7 million gain on the sale of a warehouse in Chicago. Excluding those revenues, other operating income would have been up 11% year over year and up 8% sequentially.

Net interest income equalled a record $184 million, up 20% or $31 million from a year ago and up 2% or $4 million sequentially. Our net interest margin equalled 1.81% in the third quarter, up 15 basis points from last year and up seven basis points sequentially.

Four primary factors fueled the year over year increase in net interest income. Balance sheet growth was the biggest contributor to the substantial year over year growth in net interest income. Continued success in our global custody business served to again increase foreign office time deposits, which averaged $18 billion during the quarter, up 50% year over year. This growth in foreign office time deposits fueled asset growth in the securities category, which was up 30% year over year.

In addition, we experienced 8% growth in the loan portfolio year over year, primarily as a result of PFS activities and the FSG acquisition.

The growth in our foreign office time deposits has led to a mix shift on the funding side of the balance sheet. Foreign office time deposits now represent a higher percentage of our overall funding base, reducing our relative level of more expensive wholesale funding.

Deposit spreads were the fourth contributor to the year over year growth in net interest income. Similar to recent quarters, deposit spreads have widened to more normalized levels with the rising rate environment from the depressed levels seen when interest rates were very low versus historic norms.

These four factors: balance sheet growth; loan growth; a reduction in our relative level of more expensive wholesale funding; and the industry phenomenon of improved spreads resulting from increased interest rates were the primary contributors to the $31 million increase in net interest income as compared to last year. The $4 million sequential increase in net interest income was generally attributable to the improved spreads earned on foreign office time deposits associated with our global custody business.

Loans during the third quarter averaged $19 billion, up 8% compared with year-ago levels. Loans to individuals were up, with residential mortgages up 3% versus last year to $8.2 billion and personal loans up 5% to $2.8 billion. Residential mortgages represented 44% of our total average loan portfolio.

Commercial loans increased 10% from a year ago, to average $3.6 billion in the quarter. Commercial loan growth was fueled by our middle-market efforts with family-owned businesses, primarily in the Midwest and Northeast, due to rising capital expenditures and the return of M&A activity to the marketplace.

Credit quality at Northern Trust continues to be excellent, reflecting our sound relationship lending practices and conservative credit profile. Nonperforming loans totalled $34 million at September 30th, compared with $64 million one year ago, and $30 million last quarter.

We recorded a loan loss provision for the quarter of $2.5 million, our first provision since the third quarter of 2003. The loan loss provision primarily represents specific reserves established for a loan -- for a personal loan that was classified as nonperforming this quarter.

We recorded $5.3 million in net chargeoffs during the quarter. The chargeoff this quarter primarily represented a nonperforming loan to a Midwest company that emerged from bankruptcy last year. We received some payment upon emergence from bankruptcy and have written off our remaining claim. Note that this loan was nonperforming for four years and was fully reserved for.

Now let me shift my comments to a detailed review of expenses. Expenses during the third quarter of 2005 equalled $442 million, up 17% from the year-ago quarter, and flat sequentially. As Bev mentioned earlier, expenses in the third quarter of 2005 included $33 million related to FSG. Expenses in the third quarter of last year included a $17 million charge related to a litigation settlement. Expense growth excluding both FSG and the litigation settlement charge was 13% year over year and 1% sequentially.

Compensation expense equalled $199 million, up 23% or $37 million year over year and up 1% or $2 million sequentially. Compensation expense included $15 million attributable to FSG. Compensation expense growth excluding FSG was 13.5% year over year.

The year over year increase in compensation expense excluding the FSG impact reflected higher incentive compensation due to improved corporate performance, the April 2005 annual salary merit increases, and additional staff. Staffing levels equalled approximately 9,000 full-time equivalent positions at September 30th, up 13% from last year. 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 $48 million in the third quarter, up 43% or $14 million versus last year, and down 2% or $1 million sequentially. Employee benefit expenses associated with FSG during the quarter equalled $4.7 million. Excluding FSG, employee benefit expenses would have been up 29% year over year. The year over year increase, excluding FSG, is attributable to higher pension, FICA insurance, and medical expenses. In addition, recall my earlier comments about the accrual reduction for ESOP expense in last year's third quarter.

Occupancy expense in the third quarter equalled $33 million, up 9% or $3 million year over year and up 2% or $500,000 sequentially. Occupancy expense associated with the FSG acquisition equalled $3.7 million in the third quarter, accounting for all of the year over year increase.

Other operating expenses of $141 million were up 8% or $10 million year over year, and down $1 million, or 1%, sequentially. FSG added $9 million in expenses to this category during the third quarter, including $4 million in intangible amortization associated with the acquisition.

Last year's third quarter included the previously mentioned $17 million charge from a litigation settlement. Excluding FSG expenses and last year's litigation charge, other operating expenses were up 16% year over year and 2% sequentially.

There were a number of factors that contributed to the year over year increase in Other operating expenses. These included: first, higher technical and consulting services associated with various capability enhancement initiatives, systems development, and other global initiatives. Second, an increase in expenses directly linked to our revenue growth as exemplified, for example, by higher global subcustody fees, asset management subadvisory fees, advertising, employee relocation, and travel associated with servicing our clients.

Northern Trust's effective income tax rate in the third quarter equalled 34.6%, up from 32% in last year's third quarter, yet down from 35.1% in this year's second quarter. Our higher tax rate compared to last year reflects the fact that taxable income has been growing faster than tax exempt income.

We repurchased 861,000 shares of Northern Trust common stock in the third quarter at a cost of $43 million. Diluted shares averaged 221.7 million, up 340,000 from last quarter. We can purchase an additional 4.2 million shares under our buy-back authorization.

In keeping with our practice, we increased average common equity by 10% versus one year ago to a record 3.5 billion at year-end. This represents the 70th consecutive quarter that we have increased common equity.

Let me wrap up by commenting on both the FSG integration and the continued strength of our positioning in the strategic market segments that we serve.

With respect to FSG, as Bill said in our press release earlier today, we are making good progress integrating the new fund administration and related capabilities into our operations. Client migrations to our platform are well underway, as are staff moves and real estate consolidations. Our expanded product breadth is achieving the goal we had set: to make available a broader suite of services to our fund manager clients and to strengthen our position as a leader in the growing global fund manager market place. Our announcement during the quarter that we had earned the $1.2 billion fund to fund business of Swiss Capital is just one visible example of our success to date.

We have provided you with updated FSG financial estimates in the press release. Based on current estimates, we expect that FSG will essentially be neutral to overall corporate net income in 2005. This current estimate takes into account a lower level of expected integration expenses, now estimated to equal 20 to $22 million in 2005 and tight expense control in the core business.

We have also provided updated financial estimates for 2006. We now estimate that FSG will be modestly less accretive to earnings per share in 2006 than our original estimate of $0.08 per share. The primary contributor to this change in the 2006 estimate relates to the timing of our closing of the FSG acquisition. We closed on March 31st, 2005, thereby having only 3/4 of results in 2005 as compared with our original estimate of a full year impact. Shifting one quarter of results into 2006 drives our estimate for that year moderately lower than originally communicated.

An important element of Northern Trust's acquisition strategy as exemplified in this acquisition has been to fully integrate acquired entities into our core businesses, which creates a more seamless service experience for our clients. As we continue the integration, it will become more difficult to provide separate financial estimates for FSG. We currently expect to disclose FSG financial impacts through the first quarter of 2006, at which point year over year financials will be comparable and the majority of our integration efforts will be close to completion.

In closing, let me provide some perspective on our strategies and current market positioning. In PFS, we experienced very solid new business results in the third quarter. New business was particularly strong at the higher end of the wealth spectrum. In addition, we continued to invest in our franchise with the expansion of our geographic footprint in targeted centers of affluence through the opening of our new offices, both in Boston and Minneapolis. In Atlanta, we also upgraded to a new facility located in the Buckhead area. To celebrate this new location, we hosted a grand opening party which was attended by over 600 people.

In C&IS, we also produced strong new business results for the quarter, including several high-profile wins. Our global business continues to lead the way as global custody assets now account for 45% of C&I assets under custody, up from just 9% in 1990. We have achieved a 31% compound annual growth rate in our global custody assets over the past 15 years across a variety of market environments. In fact, during that time period our global custody assets have increased each and every year, including during the 2000 to 2002 period, when many market indexes fell for three consecutive years. During this third quarter, we were gratified to earn yet another powerful endorsement of our capabilities in the Nordic regions, where we were selected as custodian for the $18 billion Fourth Swedish National Pension Fund. Also called AP4, this fund is one of several buffer funds in the Swedish national pension system and will transition to Northern Trust before year-end.

We also achieved a prominent win in the Canadian market place, where we were appointed as custodian for the $20 billion Hospitals of Ontario pension plan, which transitioned during the quarter.

These wins were in addition to a number of other well-publicized successes, including our appointments by Rensselaer Polytechnic Institute, the Weingart Foundation, and Swiss Capital Group, and the expansion of our outsourcing relationship with Julius Baer in the U.S. to support some of their activities in London.

Our investment -- our Northern Trust Global Investments offers a broad product lineup to our core private and institutional clients. During the third quarter we saw particular client demand for our securities lending, manager of manager, and U.S. value equity products.

We also announced several exciting new business wins during the quarter, including Mediolanum Asset Management, which hired Northern Trust to manage 1.2 billion Euro in four new international equity accounts, and Swedish insurer Scandia, which hired Northern Trust to manage 500 million Euro in passive international equity assets.

In terms of trends or tone from our clients, we're hearing a number of recurring themes. First, large funds continue their quest for performance through asset class expansion and the use of enhanced quantitative strategies. Second, disruptions in the hedge fund space are fomenting client concern about transparency at the same time that foundations, endowments, and others are increasing their allocations to this asset class. Third, liability management is growing as a discipline, as pension costs have been outpacing returns. And lastly, open architecture and investment program management continues to gain traction, both in institutional business and in the higher end of our PFS client base.

In sum, we feel very good about our results in the third quarter, including the delivery of positive operating leverage. Double digit revenue growth combined with excellent asset accumulation and attention to expense management led to strong double digit net income and earnings per share growth. New business during the quarter was strong and asset quality continued to be excellent. And lastly, our integration of FSG and the enhanced product capability that it brings to our clients and prospects continues to be well received.

Now Bev and I would be happy to answer your questions. Augusta, please open the call for questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question will come from Mark Fitzgibbon with Sandler O'Neill.

Good afternoon, Steve.

Hi, Mark.

First question I had for you is, I wondered if you'd give us a little progress update on how those offices on the East Coast are doing, maybe in terms of business, one, or total assets in those offices at this point. Because I guess they're kind of lumped into that Other category in your statements.

Sure. Well, we don't break -- as you know, we don't break them out specifically, but I would say that the tone is very, very good. And just to remind everyone what we're talking about, we have an office in Midtown in New York; in Stamford, Connecticut; the Boston office, it's too early to really comment on because it literally just opened; and then a limited purpose office in Delaware.

I would say the overarching themes are terrific client momentum. The pipelines for those offices are strong. And again, I'm really referring more to New York and Connecticut, again, because Boston's a little too early. And Delaware has also been very attractive for us. So that is really more built around a capability that we distribute to our New York and other clients. That has been a very positive surprise.

So, the momentum is good. The receptivity has been good. The prospect pipelines continue to be strong. And I would add that the profile of those clients, in terms of assets, is larger on average than our typical profile. So we continue to be penetrating the high end of the market in the Northeast.

Okay. Second question I had for you, is on a link-quarter basis, there was about a $6.5 million increase in Other operating income. And I'm sorry if I missed it. Did you detail what that increase was a result of?

Remember, the other operating income, we had the gain on the sale of the warehouse here in Chicago, which accounted for $4.7 million of it. So that was the principal driver.

Great. Thank you very much.

You're welcome Mark.

Thank you. Next we'll hear from Mike Mayo with Prudential.

Hey, Steve.

Good morning, Mike.

Question is on the yield on the government securities. Looks like it was up 50 basis points, link-quarter. Just looking to get some color on that.

I don't know that I have any specific color on that, Mike. I think rates have risen, but there's nothing that we have done differently in terms of duration or anything that I think would give you a solid explanation for that.

One more generally on the margin. That was a nice margin improvement. Where do you see that headed? Are you going to be taking any other actions, going ahead?

There's really -- I would say no substantive change in the way that we think about things, Mike, as we have said for a long time, when rates were at a very low absolute levels, that was problematic for us, and it was -- in a sense, undervaluing what we do as rates have risen. That's a positive for us. But I don't see any material change from the levels we're at today.

Just to clarify your FSG comments: so, are you basically going to -- you still plan to get all the benefits, it'll just be one quarter later because the closing was a quarter later.

I think that's a fair way to think about it. Just to remind everyone, we had originally said that FSG would be diluted by $0.04 to $0.06 in 2005 and accretive by $0.08 in 2006. Our new best estimates are that FSG will be neutral in 2005 and modestly less accretive in 2006. And you're right. There's a timing factor because the -- because we had one less quarter in 2005, you in effect get a benefit in 2005, but it just gets plowed into 2006.

And then last question. I always appreciate the update you give us on the retail activity. I think past quarters you've said the very high end, 10 million, $50 million-plus customer looked favorable, where as the lower end wasn't showing quite as much activity. Where does that stand?

You know, I think that would continue to be the case. There doesn't seem to be a slowdown at the top end. The lower end, lower in our context. You know, it's spotty. The pipelines continue to look good, so we feel quite good about that. September was a particularly strong month from a new business perspective. But there are a lot of noisy factors out there still. You've got oil prices and rising interest rates and a little hedge fund scandal, a little Katrina. So, there's noise and I think you get spottiness, depending on which region you're looking at.

But I'd say overall, we continue to feel good about the PFS franchise. The upper end is stronger. But everything that I'm hearing through our sales and relationship people suggests that the pipelines continue to be improved over where they were a year ago.

Thank you.

You're welcome.

Thank you. Next with Banc of America Securities, we'll move to Ken Usdin.

Good morning, Steve.

Hi, Ken.

I was wondering if you could just clarify a little bit more on the FSG side of things. If the Company was a full quarter impact in second quarter, and this was your second full quarter of a full-quarter impact, then what is it that exactly rolls forward in terms of being lower accretion for '06? Is it something relevant to the core business of FSG being lower growth rate or is it something about the integration expenses getting pushed out into '06?

I think it's largely driven, Ken, by the integration expenses being pushed back. I think the other thing is -- that we have seen, and I say this with a pause, but we have seen less -- in terms of 2005, we had a little bit more expectation of some contingencies, the unknowns that didn't happen. But, it's largely the push-out of expenses we would have thought we would have inured in 2005.

Okay. Does that mean that -- is the integration, then, on track, as far as its timing? So relative to -- like your ability to see the synergies side of things? Is the magnitude of that any different or has there been any change as far as the integration plans are concerned?

I think right now the integration plans are still directionally on time, other than this quarter lag. So, no, I wouldn't call that a big change. It's going to be important that we continue to be able to execute on that, because one of the things here that we're excited about is that we have the capabilities that we didn't have before the acquisition. But being able to deliver them seamlessly is predicated on being able to integrate them well from a client perspective. So, I think we still feel good about that but we've got a ways to go, so we'll have to see how we execute there.

Okay. My quick second question was, this quarter you did benefit from, as you mentioned, the 3% lag benefit on the PFS side. And you also mentioned that wealth management did kind of give some back to the PFS business in the other states where it shared revenues. But yet the PFS revenue line was only up about $1 million a quarter. So I was just wondering if you have any more color on the rest of the business there or was it just soft transaction revenues or is there any client defections or the magnitude of new business being lower? Anything of that sort?

Okay. Sure. Let me start with the wealth management and then I'll roll back to an overall perspective on what we're seeing in PFS. When we say wealth management, as you know, that's the $75 million and above. We continue to be very well positioned there. 24% of the Forbes 400 wealthiest clients -- or wealthiest families in the United States are clients. We've seen very strong asset accumulation there, 109 billion, up 20% year over year and up $3 billion sequentially. So our asset accumulation and wealth management is far outstripping the market.

The sequential decline in wealth management is really an internal fee transfer. As you know, our wealth management clients have historically been serviced centrally from the Wealth Management group. And one of the phenomena that we've seen is, in some of our families, some more local support from our local offices, which results in fee transfers. So, for example, just generically, we may have a Florida family in wealth management that is served by the wealth management group here in Chicago. But as that relationship has grown, become more complex and more multi-dimensional, we're now managing money for that client from Florida. And so we have to transfer fees from the Wealth Management Group into Florida.

So, on that front, the Wealth Management dimension, I personally see as quite a positive. It represents an increased level of integration with the broader Northern Trust franchise. So we feel good about that and I don't think there's anything that's nefarious there.

In terms of PFS more broadly, we continue to like our positioning, our physical presence, the local delivery model, the breadth of capability, and the expertise. I think we have a number of initiatives underway in PFS, improved statementing, some sort of changes in our positioning in advertising, PR. The new business was solid. I can't find anything specific that would explain the sequential performance.

The one thing I would say, Ken, is if you think about our historic guidance in relation to the market, we've -- the historic guidance has been for every 10% increase in the markets, that would typically translate into 4% -- a corresponding increase of 4% trust fees and 2% revenue. And PFS does seem to be outperforming that. So I don't know that there's any specific noise I can point to. They're ahead of our guidance. Obviously, we'd like to see that number more in the -- the PFS Trust Investment and other servicing fees, more in the double digit growth. But I think we have to go quarter to quarter and see where that takes us.

Okay. Thanks, Steve.

You're welcome.

Thank you. Next, from Merrill Lynch, we'll hear from Brian Bedell.

Good morning, Steve.

Hi, Brian.

Just a couple of statistical things first. Can you just give me the equities, fixed income and cash segmentation, and managed assets for PFS and C&IS?

Sure.

Brian, I can give that to you. For C&IS, assets under management: 37% equities; 12% fixed income; and 51% short duration.

Okay.

For PFS, the same numbers were 50% equity, 34% fixed income, and 16% short duration.

Great. Great. Thanks.

And then on the integration expenses, you mentioned 20 to 22 million. Are you including the transition expenses in that? So you're basically going from a $34 million total number to 20 to 22?

That's correct.

Okay. Great. And then, just talk about balance sheet a little bit. Just to zero in on foreign deposits. What is your outlook for growth in that over the near term? It looks like it was pretty stable second quarter, third quarter. I imagine that was a seasonal impact. But naturally, you're getting much more substantial growth in Europe. Do you foresee that line increasing substantially in the fourth quarter into the first?

You know, Brian, I wish I could forecast these things. Generally speaking, as you know, the growth in foreign office time deposits is directionally corelated with the growth in global custody assets. So, I really wouldn't have a comment on what it's likely to be. I'd just say -- and it's very hard to predict, quarter to quarter -- I'd just say directionally, to the extent that you believe we will continue to have success in aggregating global custody assets, one would expect that foreign office time deposit number to continue to move up. But beyond that, I don't think I could offer much.

Right, right. And how about any kind of comment on your ability to lag the pricing of that? It looks like you lagged that more this quarter than you did last quarter.

I think there was a benefit this quarter, but I would not anticipate that that would be something that would roll into the future quarter. I think that was quite episodic.

Okay. But in general, you can lag the pricing -- you think you can continue to lag the pricing on those deposits relative to your other -- clearly, relative to wholesale funding. I would imagine.

I don't know that I would call it a lag, per se. I would just say that one tends to be relatively more expensive than the other. And that we talked about that in the conference call itself, where our relative reliance on wholesale funding, which tends to be more expensive, is less because of the growth in foreign office time deposits. So I don't know that I would characterize it using the the terminology "lag," more the relative cost, if you will, one versus the other.

Yes, I think that's right.

Right. Okay. I got it. Then on the -- what portion of your loan portfolio is variable priced?

I don't have that number -- I don't have that number for you, Brian. I'm sorry. We'll have to follow up separately.

Okay. Great. Then, there was one bucket here in the average balance sheet, the Other purchased funds. It went up only about ten basis points in the third quarter versus 30 to 35 basis point increases in the last few quarters. Was there anything unusual in that that caused -- that essentially kept that from going up more?

Nothing that I can think of, Brian.

Okay. And then just if you want to talk about your pipeline in Europe, maybe, versus the U.S. in C&IS. And then if you can just touch on your progress on the Insight middle office outsourcing and Julius Baer?

Sure. Pipeline in Europe continues to be strong. It's sort of a theme that we've had for quite some time. And I would say that it's strong for us across Europe, across client types. As we mentioned, we continue to have particular success in the Nordic region. But it's with insurance companies, it's with pension funds, it's with fund managers. So that continues to be a positive story.

In terms of our progress with Insight and Julius Baer, which are both outsourcing transactions, I'll take Insight first. Insight, that project continues to be on track. You'll recall that we had transitioned additional assets from Insight last quarter. And Insight's assets with us are now order of magnitude, $120 billion. We do expect to move Insight staff to our offices in Canary Wharf late this month or early next month. So that seems to be going well for us. Those staff, when they move, will still be Insight employees. They're -- a characterization of Northern Trust employees will happen sometime next year. So we feel good about that one.

I think in terms of Julius Baer, that's been an excellent relationship. It's a fine firm and they've grown nicely, and our relationship with them -- recall that our relationship with Julius Baer started with them in New York, and that was the totality of the relationship. I think it has worked well for both sides and so they've asked us to be their outsource provider for their fixed income assets managed from London. So, I think that's a good example of if you do well, the ability to migrate and enhance the relationship with the firm, earning it one step at a time. So we feel good about that.

Right.

Did I miss anything else?

No. That was actually really comprehensive. Just on the Julius Baer, did you guys disclose the assets on the fixed income, the London mandate?

I don't believe we did.

Okay. Is it substantially large or is it kind of more modest or something that we should model into our P&L?

I don't believe we disclosed anything. I don't believe it's a major impact, relative to the total corporation.

Right. It's not as large as Insight, for instance?

No.

And then, just on the Insight, the 120 billion, that was basically custody and accounting and then you're doing mid-office. When are you starting the middle office component of that? Is that next year?

Well, we're already working with them, but they'll be fully migrated onto our platform next year.

Next year. Great. Thanks so much.

You're welcome, Brian.

We'll move next to Gerard Cassidy with RBC Capital Markets.

Good afternoon, Steve.

Hi, Gerard.

On the deposit side of your balance sheet, obviously your foreign deposits have moved up nicely and now, according to your numbers, represent about 39% of the funding. Is there any goal of where you think that could reach, or that level could -- where you would be comfortable that would reach to in the future?

No, I don't have a goal that I could give you. I'd say that that has been a pretty stable, steady, predictable march for us. So we haven't had a lot of gyration there. So, no, there's nothing -- there is no target that we have.

What are the risks, if there are any, by having this number approach 40%, possibly if it continues at the pace that you're at over the last eight quarters, it could easily reach 45% by this time next year or into '07? And what are the benefits, I guess, of it reaching that kind of level?

Well, I think, Gerard, this is really client-driven deposit activity. So, I don't think there's -- this is a function of what our clients are doing with us, as opposed to a deep strategy on our part to shift things around. So I don't -- I think we're very comfortable with where we are and that it's part of our process of accommodating and managing our overall client relationships. I don't see anything really beyond that from our perspective.

Okay. Could you give us some color -- I know you don't want to name names. On the chargeoff that you had in the quarter, I know it was fully reserved for. Was that a small -- a business relationship? You may have mentioned it and I didn't hear it.

It was a Midwest company, a family-owned business, well within the sweet spot of what we've tried to do. It just, unfortunately, didn't work out very well for this family.

With the recent announcement of Delphi filing chapter 11 and the well documented problems General Motors and Ford are experiencing at this time, what are your guys down in the trenches telling you about the quality of their loans with maybe some of the Midwest businesses that you do business with?

Well, our credit quality continues to stand up very well. As you would know, Gerard, we don't go name by name, but I can tell you we have no exposure to Delphi. So, you know, I think from our perspective, the record continues to be strong. There was nothing in this quarter that led us to believe that there's a material shift in credit quality.

Another thing I would add to that, Gerard, is there is another statistic that we do talk about, which is our 7 and 8 rated loans, which were 87 million at the end of June and will be 85 million at the end of September. This is the ninth consecutive quarter that that particular category has gone down. So that would be another indication of a positive direction we're seeing in the credit quality of the portfolio.

Yes. The only thing I'd add to that, Gerard, is that we probably are not the best proxy for auto industry and publicly related companies tied to the auto industry. So I'd suggest you keep that in mind.

Oh, no, no. I agree. I was thinking more of the derivatives, not necessarily somebody that's selling Delphi a product, but somebody that might be a small business that is supported by employees that work with those companies, things like that.

Sure. Well, I think, as Bev notes, our loans in our two highest or lowest, however you want to frame it, risk categories continue to trend down, as they have, so, at least at this point in time, we don't see any change. And if there's been a change, it, frankly, continues to be for the better.

Thank you.

You're welcome.

Next we'll go to Andy Collins with Piper Jaffray.

Good afternoon. Just wondering, the pre-tax margins overall have remained pretty stable at the corporate level. I guess the way I calculate it, PFS has been moving up, generally speaking, in terms of pretext profit margins. So I was just wondering how you kind of -- since assets are growing nicely in C&IS, how those two kind of weigh off against each other, if you will.

I don't think I'd have any -- I think I'd have to see your calculations to get there, Andy. But I think what we've said is that our pretax margins on average over time have been quite consistent. As you say, they're steady. I don't think there's any material shift that I could point to that would change that.

Okay. Second kind of question. Outsourcing pipeline. I think you talked about it just a little bit in Europe. Just more broadly, if you could.

Sure. The outsourcing, so-called outsourcing business in C&IS continues to -- continues to grow. The pipelines are thick and probably thicker than is the capacity or appetite for Northern Trust and our competitors to jump into those transactions. So I think that segment of the market is going through a bit of a maturation as all parties get to better understand it. Which is terrific. We think the froth is off that and now it's getting down to a little more strategic, what exactly do you need? How can we serve it? How does that fit with our overall bandwidth? So, we like it.

For Northern Trust specifically, I think we have more of a bias, if you will, toward outsourcing mandates outside the United States because they bring with them a higher proportion of cross-border assets. But we are engaged in a number of dialogues in the United States with firms. So it's clear that the trend is here. It's clearly going to stay, but I think the sales cycle on these things is elongating a bit as everyone tries to digest what they have and make sure what they take on in the future really works, because a couple of these transactions have been unwound and the publicness of that and the lack of successes has been unfortunate.

Yes. So it sounds like demand in general is pretty good. Do you have any specific kind of size parameters that you will kind of walk away from a potential outsourcing contract if it's a certain size? Or is it kind of -- does it run the gamut?

It runs the gamut. For us specifically, we like large but not overwhelming. We generally don't want a single client that can turn into a nemesis, if you will. But I wouldn't want to put a dollar figure on it. These things generally have to be big enough. Because they're complicated, they have to be big enough that with all the resource you're going to pour into it, particularly up front, that it doesn't become a waste of time. On the other hand, we don't want them so big that we have to pull resources from everywhere to make it a success, thereby degrading the service we provide to existing clients. So, it's a balancing act and one that we watch very carefully.

And lastly, kind of a detailed question. I was wondering if FSG changes the way compensation is paid at all. I know the fourth quarter is usually a true up, in terms of variable comp. I'm just wondering if that's going to change at all here this quarter?

No, I don't think there's anything specific to FSG that would change the way we think about things. And we have been trying to insure that we're as close as we can be on our accruals for incentives and that has been driving higher our compensation expense throughout the year because of the improved performance.

Okay. Great. Thank you.

You're welcome, Andy.

Thank you. We'll hear next from Nancy Bush with NAB Research.

Good afternoon, guys.

Hi, Nancy.

Just a quick question on the Atlanta market. Just to make sure I'm clear on this: the office that you've opened in Buckhead; is that a new office or is that a consolidation of existing space there?

I'm sorry. Good question. I probably wasn't that clear. That is -- we have -- that is a new office, having closed the existing office, which -- our lease -- let me rephrase this. Our lease in the old office was expiring. We were growing in Atlanta. We needed a new office and we opted for a different location. So I guess in your terminology it's a consolidation of space.

If you could just comment on how the growth in that market is sort of stacking up, maybe compare it with markets that I think of as sort of historical Northern Trust markets like Florida. Is it among the fastest growing of your markets?

Well, I think -- remember, we're one office in the Atlanta area, so I would be careful about drawing too much from one office relative to our physical positioning in a state like Florida. That said, I will say that this is a relative -- as is our custom with these offices, this is a relatively small office. It's a new market for us. And to have 600 people at our office opening is still making me scratch my head to the positive. So we like the pipeline that we're seeing coming out of Atlanta. We like the opportunity set. And, boy, we like having 600 people at a bank office opening. I think that portends for good things for us.

All right. Thank you very much.

You're welcome.

Thank you. Our final question will come from Tom McCrohan with Janney Montgomery.

Hi, good afternoon.

Hi, Tom.

I had a quick question, Steve, regarding the expense growth rate. You had, during your prepared remarks, said if you strip out, FSG from last year's litigation charge, expenses were up 13%, I believe, year over year.

Yes.

So looking at that more as a core growth rate, how should we be thinking about the growth rate in your expenses? Is that core 13% kind of your target? Is that something that you're going to internally kind of shoot for? Or -- it seems to be higher, vis a vis growth rates from prior years. Just wanted to get your thoughts on that.

Well, I certainly wouldn't say a 13% growth rate of expenses stand alone is where we would want to be or where we typically would be, but I think you also have to remember -- you have to think about the revenue growth rate and what that does to us. What we've always talked about, Tom, is positive operating leverage on average over time. We have a very strong record of that. 13 of the last 16 years.

I think when we have a growing global custody business, when we have a growing manager of manager business, when we have a growing PFS franchise, it does bring with it some expense. So I wouldn't look at that number in isolation and infer much from it. Bev, do you --

Well, the only other thing that I would make sure to add is, don't forget that in the third quarter of last year, our employee benefit expenses were impacted by the accrual adjustment. So, another way to say that would be employee benefit expenses in last year's third quarter were really lower than they would have been if you looked at last year on a quarter average basis across the entire year. So keep that in mind when you're doing the math.

So remember that -- another way of saying that is because of the litigation charge that we took, it degraded our performance in 2004, which meant we took down accruals that we had. So that's a good point.

Okay. Thank you.

You're welcome, Tom.

And it appears we have no questions at this time. I'd like to turn it back over to the presenters for any additional or closing remarks.

Thank you very much for joining us for this third quarter call. We'll look forward to giving you an update in January at the conclusion of the year. Thank you.

Thank you. That does conclude our conference today. We'd like to thank everybody for their participation. Have a good day.