道富銀行 (STT) 2002 Q2 法說會逐字稿

Please stand by. Good day, everyone. Welcome to the Investors Financial Services Corporation second quarter earnings release conference call. Today's call is being recorded. At this time for opening remarks and introductions, I'd like to turn the call over to Mr. Joe DeChristofero (phonetic).

Thank you, operator. Thanks for joining us on today's call. We'll be making a number of forward-looking statements which are based on management's assumptions as of today. The company's actual results may differ materially from our current predictions due to any one of a number of factors. Information regarding the factors that may affect our actual results is set forth in the MBNA section of the most recent 10-Q and 10-K. I recommend that anyone listening to this call review those reports carefully.

Because this call will be archived on our website, I want to emphasize again for anyone listening at a later date that the statements made today are based on our assumptions today, July 11th, 2002. These assumptions may change, but the recording of this call will not be updated. Joining us on today's call are Kevin Sheehan, Chairman and Chief Executive Officer, Mike Rogers, President, and John Spinney, Chief Financial Officer. I'll now turn the call over to Kevin Sheehan.

Good morning. I'll begin by reviewing some key points from the second quarter and then John Spinney will discuss our financial results in more detail and update our guidance on our models. The diluted EPS for the second quarter came in at 26 cents up two cents or eight fence link quarter and up eight cents 44 quarter two of last year.

As of June 30th we processed approximately $835 billion of assets for our clients, up approximately $4 billion from March 31st, 2002, and $21 billion from the year ended 2001. During the quarter the S and P 500 index declined approximately 14 percent and NASDAQ declined approximately 21 percent. We converted approximately $19 billion in assets from new clients during the quarter and added an additional $11 billion in assets from existing clients.

Finally, market depreciation and client fund flows reported from a $26 billion decrease in our assets processed during the quarter. During the quarter we converted new business we announced on last quarter's call. This new business included Oak Mark Funds, CDC Invest Funds, Agone TransAmerica Funds, and BGI Global ETF Product, MFCI I-shares (phonetic).

In addition, we expanded our relationship with BGI by winning the processing mandate for I-shares. Some of which are expected to commence trading in July. The pipeline for new business remains at $40 million in annualized revenue. We define pipeline as the actualized revenue on outstanding bids where we believe we have a 50 percent greater likelihood or greater of winning the new business. The BGI conversion is on track for completion by October 31st, 2002, and the second quarter 2002 represents another solid top line and bottom line performance for our company in a difficult market environment. These results have been driven by our ability to sell new business in a declining market and a continued favorable interest rate environment. Now I'd like to turn the call over to John Spinney, who will review the quarter's results in more detail.

Good morning. As Kevin mentioned, second quarter diluted EPS came in at 26 cents a share and 8 percent linked quarter increase. Our diluted EPS of 26 cents represents a 44 increase over the second quarter of 2001 EPS of 18 cents. Diluted EPS in net income for 2002 both exclude the amortization of good will in the accordance with provisions HASBY-142 (phonetic).

Revenue growth remains a key driver of the company's EPS growth. That off burning revenue which is made up of net interest income and fee income increased 4 percent link quarter and 22 percent over the same quarter of last year. The two components of our revenue, net income are reported separately financial statement for presentation purposes, but these two revenue sources are derived from the same core securities processing business as clients use the company's balance sheet as a convenient way to invest their excess cash, thus generating net income for us.

I'll now walk through the significant income and expense components in more detail. Debt income decreased 4 percent link quarter primarily due to three factors. Interest rate resets on our variable rate investments, 2Q having 91 days versus 89 in Q1 in an asset liability strategy to prepay high rate FHLB advance and replace it with one at a lower rate.

Despite these factors we maintained healthy net interest margin and spread percentages as the yield curve remained steep during the second quarter. The link quarter interest rates spread contracted by 33 basis points to 2.26 percent while net interest margin contracted by 35 basis points to 2.45 percent. Compared to the same quarter of last year, net interest income was up 28 percent both due to a steep EPO (phonetic) curb and the increase side of our balance sheet.

Fee income increased 8 percent link quarter due primarily to additional client fund flows in higher income from our securities lending and foreign exchange services. On a year over year basis fee income increased 20 percent due to higher asset levels in 2002 versus 2001 and higher ancillary revenues in 2002 versus 2001 all achieved during challenging equity marketing conditions.

Operating expenses increased 3 percent link quarter an increase in transaction processing fees accounted for the majority of the increase in operating expenses. Transaction processing fees were up link quarter as a result of higher transaction volumes in Q2 versus Q1. Comp and benefits, our largest operating expense, declined on a link quarter basis by approximately $1 million. The decrease in compensation and benefits link quarter as a result of lower bonus and payroll tax accruals in Q2 versus Q1. Both of which were partially offset by additional head count added in Q2 to service new business. We continue to maintain strict cost controls especially in the face of weaker equity markets.

I'd also like to address an issue that some of you may have seen in last month's American Banker, that we will disclose in our second quarter Q. Like many other financial institutions in Massachusetts, we recently received from the Mass DOR, Department of Revenue, a notice of intent to asset state excise taxes for tax years 1999 and 2000, 6.2 million including interest. The notice claims that the bank was not eligible to receive a 95 percent dividends received deduction on dividends it received from Investors Funding Corps, the bank's majority owned REET (phonetic. After consultation with our tax accountants and legal counsel, we believe strongly in a technical merits of our case and at this time feel comfortable with our 1999 and 2000 tax provisions. As always, we are reviewing a number of business strategies that may also minimize our tax exposure. Prospectively we remain comfortable with our current effective tax rate.

In addition, I received several inquiries regarding our option dilution disclosure in our annual report. After reviewing financial accounting standards 123 and consulting with our independent accountants, it was fair to say we have been extremely conservative in our disclosure. The key drivers of the dilution calculation are the expected life of the option, the volatility of the underlying stock, and the effective tax rate used in the pro forma calculation. Our 2001 FAS-123 option dilution disclosure was based upon an expected option life of ten years, a volatility percentage of 57 percent, and a 30 percent effective tax rate.

Under these variables the resulting dilution as disclosed in the annual report was 37 percent. Utilizing the annual expected life of 40 years volatility over these years of 55.3 percent, an effective tax rate of 27.3, reflecting the tax benefit of the compensation deduction, the actual dilution would have been 18 percent.

I hope this clarifies our disclosure. We plan to update our FAS-123 disclosure for 2001 in our 2002 annual report. Given our continued strong top and bottom performance during the second quarter the continued favorable interest rates environment and client wins and conversions, we are raising our 2002 EPS guidance to 101 to 103, from a dollar to 102. We remain comfortable with our long term growth rate of 25 percent in EPS. I'd now like to open up the call to your questions.

Thank you. The question-and-answer session will be conducted electronically. Any participant wishing to ask a question, please press star one on your touch tone telephone. We'll take your calls in the order that you signal and as many as time permits. Again, that is star one to ask a question.

We'll first hear from Jon Afrstrom of RBC Capital Markets.

Good morning guys. Pretty good quarter. Can you give us an update on how much of the new business from last quarter is already on the books and how much is left to go on Q3?

Pretty much all the business we announced last quarter we talked about in this call has been converted in this call. The last piece converted on July 1, Jon, so that will be in place for the full Q3.

And then can you talk a little bit about value added, what drove some of the results there.

I think on the value added side, security funding, we were in a traditional foreign dividend season, we got a little bit of benefit from that. We also on the effect side had good transaction volume and substantive favorable spread over the period.

And then on the new guidance are you still saying the 25 percent long term growth rate should be listed in '03?

Yes.

Thank you.

Moving on, we'll next hear from Joel Gomberg of William Blair.

Perhaps expand a little bit more about the exchange rated fund business, how that has added to business this year compared to last. How you might make money in that business a little differently, some of your core business, and then talk about the opportunity there in the fixed income ETF business of BGI is rolling out, and what type of market you think is out there for those markets. Thanks.

Sure. The ETF business for us in terms of what it's meant has grown significantly since December of last year. I think we started the year at probably 19 billion, we ended this quarter in 27 billion of assets in that product. We pretty much own the market in terms of number of funds out there. I think we have 75 percent of the funds in the marketplace and we probably have close to 30 or 40 percent of the assets in ETF. So the marketplace, we're a marketplace leader, I would say, Joel.

In terms of how that translates into our results, as the assets have grown over the first two quarters, we picked up our traditional asset based and transaction fee revenue, the other incremental revenue derive from the ETF, what's called accretion and redemption fees, and every time an authorized placement agent wants to create or redeem one of these units which is denominated, I believe, 50,000 shares, they give deliver us a basket of securities plus some balancing cash. We deliver back the 50,000 units or they can collect 50,000 units in the marketplace deliver back to us and we deliver securities and cash back to us and that creates a little more revenue on those products. It's part of the fixed income ETFs. So those are - just were approved by the FCC.

Our client enrollment was up in July. We believe there's an appetite for that market and they've been very successful in selling the car (phonetic) product that's growing extremely well and we think over time that's going to be accepted just as well as the equity ETFs.

Do you receive the same type of profitability or fees from the fixed income versus the equity ETF?

Joel, this is Mike. Really it works the same way where two pieces of income are involved, an asset based fee with a minimum setting out so the asset is raised to a certain point and then a transaction fee component as John said those of those transactions are accrual, one, and redeeming in kind to the portfolio.

Okay. Last question, John, the balance sheet grew by a billion dollars, period to period end. Could you explain that?

Sure, period to period end would happen at the end of this quarter. Well, first of all, our strategy in terms of our asset liability management was to (inaudible) the balance sheet at the at the end of this quarter we ended up with some late wires from clients where we had already gone and sold fed funds earlier in the day and now we were - we bought fed funds earlier in the day and then the $600 million of wires came in late in the day and we had to go out and sell fed funds. So you'll see we had a little inflation just for that one day for that $600 million that came in late day that we had to put out.

Unwind?

Next day.

Thanks a lot.

Yes.

We'll next hear from James Allen of JLS.

Yes. Great quarter. Could you give me some comments in terms of what is the potential that you could sign another big deal that's kind of a transformation deal such as the one you signed in California and are you prepared to do that now and what's the potential we might see that by the end of the year.

We don't have anything to announce now. We certainly have the capability. When we nail one down, that's typically when we announce it.

Okay. Can you give us a little bit of guidance on when to think about when we might be seeing something of that size?

No, I think it's really difficult to do that. We're certainly competing for outsourcing business, but I don't think we're at a stage where we could give you any more than that for guidance.

Are there significant details that have a piece out right now?

We're probably bidding on seven or eight deals that are outsourcing deals.

That are all of that significant size to your company?

There's nothing that's $500 billion out.

So just give us an idea, are these more like $100 billion or smaller, the deals you're bidding for.

They could range anywhere from $25 billion to $300 billion.

But a $300 billion deal, that's pretty significant to your company at this point.

That's right.

That's very much.

Next we'll hear from Timothy Willi of A.G. Edwards.

Sure. John, if I could ask another question about the balance sheet. On an average basis you had nice link quarter growth, obviously the margins came down but you still had good interest income. If you could just give us some thoughts on - I know it's hard from quarter to quarter, given what your clients may or may not do but should we expect to see, you know, continued margin compression but very strong sort of sequential growth and average earning assets and are you giving any kind of thought there and also be sort of curious about you all articulated 125 basis point rate hike assumption, I believe, when you were giving guidance in the beginning of the year and you still see that happening or is that sort of changed as you sort of ponder what could happen through the next two quarters?

I would say, Tim, good morning, by the way, the projections we've talked about in the past I think we've now revised what we think our outlook is on interest rates a little bit and we don't think there's going to be much movement until the end of this year and then we've got our assumption is probably 100 basis points over the next 12 months after that is in our assumption. So if you look at our net interest margin and spread now I think you're going to continue to see some compression as the reset happen in the portfolio as we get paydowns within the portfolio and reinvest those at lower rates we're naturally going to gravitate downward, so I would expect some contraction throughout the rest of the year.

And then the other question was some of the value added services. I don't understand the seasonality in securities lending which you talked about, but could you talk about the actual sort of growth of customers or the portions of customer business that you've been able to gain, year over year sequentially just the seasonality or the market volatility. We now have 20 percent of customers giving us 20 percent more business. Any way you can quantify that?

Off the top of my head, all I can say to you is all the new business that we bid or win, as we win business, if it comes with all the ancillaries, we add them. If we don't get all the ancillaries, out of the box, we continuously working with clients the customers to get them converted on FX and securities lending. I would say that we have more opportunity now in our customer base given the fact that we've added more clients to grow those revenues in the future than we did year over year if you looked at it. So I think the opportunity is greater. I really can't tell you.

I'd like to help you out. We added five new clients, Tim, year to year, in the second landing side and our assets under loan went up approximately a billion half although market conditions really have turned back some of the spread that we were traditionally making on some of those loans. So some of our efforts were diminished by the general market conditions.

Thank you very much.

Next we'll hear from Brad Moore of Putnam Lovell.

Hi, good morning. A couple things it first off, just to circle back to the guidance again, you did speak to interest rates, but also be curious to know, originally your flat equity markets when you first put out your assumption, is that still your assumption or what is the assumption into your new guidance now.

The assumption is we're going to be down where we are. I think we can still make the guidance that we have out there.

Okay. And is that - is that your expectation for 2003 as well with regard to the equity markets?

We will hope that will knock down, but right now we're expecting most of our growth is going to be organic and from new sales in '03.

From the fund flows you mentioned this quarter can you give us some idea as to the clients that contributed materially to those fund flows? Was it largely BGI? And can you give us some color as to who was responsible for the fund flows?

I would say a portion of that was BGI and another piece that was Agone American Transaction (phonetic) business we discussed on this or a previous call.

Is it safe to say the majority was BGI?

No, I wouldn't say the majority is BGI.

Okay. And then with regard to new business, what's that pricing environment looking like? Do you see any change there?

I think the pricing environment is still competitive as we see every time we're on the marketplace and at the end of the day it still comes down in our opinion to the service levels and, you know, and technology and that's what we seem to be differentiating ourselves in the sales and the marketplace.

Okay. So any significant downward change in pricing or is it just variable like it has been in prior quarters?

I think it's similar to prior quarters, still competitive.

A couple of other things. Can you give us a sense, then, with specifically with regard to the value added revenue items, can you give us more color as to the actual growth rates for sec lining versus FX versus cash management.

Quarter over quarter or link quarter?

Year over year.

Year over year, FX were up 51 percent for the quarter and security funding were up 36 percent quarter over quarter. Six month numbers were up 37 percent for FX and 29 percent securities lending.

And then finally can you give us the amount of BGI revenue this quarter?

We won't disclose BGI revenue.

Okay. Great. All right. Thank you.

You're welcome.

Again, star one to be placed in the queue for a question or comment. We'll next hear from Carla Cooper of Robert W. Baird.

Good morning.

Hi Carla.

I note the small item value added services but investment advisory actually shows some spectacular growth. Could you tell us a little comment on that?

That's what Merimac (phonetic) mutual fund products, five money market funds that we distribute to our institutional customers as security lending customers and then to the outside world for cash management. The yields on those funds have really performed very well over the last 18 months, and I think it reflects some benefits we've gotten from that yield with outside distribution as well as reflects investment advisors pulling back out of equities and using that cash vehicle as a holding place where hopefully market conditions will improve.

Great. And one other question I think one of the questions you made on the last conference call the amount of business buying early in the year actually gets you to the point where you're quite comfortable with guidance based on the business you just won. Am I remembering that correctly? Any update to that?

What's that question again, Carla? I didn't understand that.

I thought what we said on the last conference call was that the amount - the significant amount of business that was signed that's been signed so far in a year actually gives you - brings you almost all the way to the point where you could actually achieve the current guidance even without signing new customers? Am I remembering that correctly?

Yeah, that's probably correct.

Okay. So all right. That was the question. Thanks.

Next we'll hear from Thomas Kanler (phonetic) of KBW investment bank.

Great quarter. A couple of questions if I might, one for John, one for Kevin. Can you help us understand what was the size of the uptake in transaction volumes that you're processing on a late quarter basis?

Sure. The processing was up, I think, 36 percent in terms of dollars and the volumes were pretty much up relatively the same. That's link quarter annualized?

Not annualized?

The way transactions work is we've had buy or sell a transaction. There's a fee associated with that so we annualize that item.

Okay. Second question. Would you elaborate a little more what is the source of positive change that creates new guidance up a few pennies.

New guidance I think we converted more asset on some of the new business that we had expected, the markets haven't taken us down as much as we had thought, that interest margin remains strong. I think prior guidance was they thought it was going to go up in the second half of the year. Now it's not moving. And in all those positive things, last to bring guidance up.

I guess I'm trying to understand the positive on the net income. If I look correctly it's a little flat in the quarter and I thought you guys were looking for a little higher expectation than just income growth, so am I correct to infer that the noninterest income growth is actually better than you expected in offsetting the flat and interest growth?

No, I would say we would expect say we would expect that interest margin remain strong, as I mentioned earlier in the call, we prepaid some FHLD advances that costs a little money to basically lock in some long term spread for '03 and '04 and that's why the margin was off a little bit and I think we'll see a little bit of pickup from that next quarter.

That helpful, John. Kevin, just some sort of a theoretical question, pick your broken, the lady who has done such a good job of running BGI stepped down for health reasons and there's a team of management below them, but there's been some discussion in the marketplace I guess as to whether or not there is as much pressure for management buyout or the unit would be sold. Do you have any thoughts as to whether or not her stepping down changes that outlook for what's likely to happen there?

You know, I don't, and I think if I did it would be really inappropriate for me to comment. We do have a five year contract with them with really no outs in that contract and as you'll recall, we picked up the 300 odd people that went with the transaction and have spent certainly significant resources in converting that into this institution, so I think we feel pretty secure with the relationship, whether they aggressively pursue their management buy out at this time or defer it, but I really don't have any guidance that I can confirm for you in terms of where they're going to go with that.

That's fair. Just a point of clarification, if I may, when you say no outs, what does that mean exactly?

Basically it's a no cut contract. It's a five year deal with four years left to run.

Thanks a bunch.

Yes.

And actually we have a follow-up from Timothy Willi of A. G. Edwards.

Kevin, I guess I want a theoretical question but you've had a lot more experience in this business than myself and probably others covering your name, but I think I would be curious working your years of this business in this type of environment that we've volatile and we've now taken another leg down, have you seen where this postpones decisions even further or another enterprise that's moved fairly far down the path, they continue to plug ahead, you know, despite fairly volatile or quick changes in market directions or, you know, has it been your experience this will cause people to sort of stop and reevaluate again?

No, I think we've found in the past although it sounds lot of intuitive, I think this is the time when a lot of people investing the next dollar coming through the door look strategically, look at costs, those costs they this outsource and typically tends to be an environment where we get the focus of the strategic thinkers and the decision makers in the organizations and typically they move more aggressively, I think, in terms of closing business or looking at the possibilities of changing the way they do business.

Okay. So then it's actually sort of speeds up the process or makes it more pressing to kind of get the R and P and all that stuff wrapped up and moved forward.

That's our feeling.

One more question on that note. Could you refresh my memory on what kind of costs are beared by, you know, your customers, whether there is a conversion from one company to another, any significant outlays they have to make or painless from that perspective?

It's painless.

Next we have another question from James Allen from JLS.

Great. Could you give us an idea just when you talked about the back half in terms of your guidance not going up what sort of market expectations are you building in there? Are you expecting improvements or a flat market?

We've got a flat market built into that right now. As soon as the markets went down, we went back and reforecasted and we're comfortable with our guidance today based on our reformed values.

And one other point I didn't see in the press release, maybe it's there, if we expensed options for EPS, what would EPS have been?

For 2001, it would have been let me see, I don't have that number right in front of me, but would have been 18 percent off of $1.53. Let me do a quick calculation. $1.35, probably.

And does that - I take it it's significantly smaller for this quarter; is that correct?

Would have been $1.26, I'm sorry.

I take it it's significantly less for this quarter?

It would be if you were looking at - actually no. It wouldn't be any different unless the Black Shull's (phonetic) calculation changes would take the value down. I think it will take up from that if you had to expense because the valuation probably would come down a little bit.

But it's something approximately 15 percent, something like that?

Yes.

Something reasonable for a tech company that's growing quickly?

Yes.

Thank you very much.

We'll next hear another follow-up from Brad Moore.

Yes, just to be clear, on the assets, you said that assets were up 19 billion from new clients and I understood that those - that those flows related to the four or five clients you mentioned that you won last quarter. Could you give us the names of clients that you've won this quarter and therefore will show up in new flows for next quarter?

We didn't win any additional new business this quarter. The numbers we gave you were for the conversions of the assets from last quarter we announced and fund flows from existing customers to this quarter.

Okay. And so - I mean is that a little unusual, then, that you didn't win any new clients during the quarter, in terms of your historical velocity of new clients? Are you saying the market is relating to that or just a timing issue?

Just a timing issue, Brad.

But presumably, then, you were in the bidding process, I think, as you said, with seven or eight clients during the quarter and it's your expectation that some of those are clients to be signed earlier in the third quarter or should they just be clients that you expect to come in over the course of the entire quarter?

It's traditionally been our policy to disclose them only when we win them.

Okay. Thank you.

That concludes our question-and-answer session. A replay of this call will be available starting at 11:00 central today and will run through July 18th at midnight. To access this replay please dial 719-457-0820 and enter in the pass code of 718642. Again that number is 719-457-0820 with a pass code of 718642. This concludes today's conference call. Thank you for your participation.