道富銀行 (STT) 2006 Q2 法說會逐字稿

Good day, everyone, and welcome to the Investors Financial Services Corp. second quarter 2006 earnings conference call.

Today's call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to Ms. Anne Bourke, Senior Director of Investor Relations.

Please go ahead, ma'am.

Thank you for joining us on today's call.

We will be making a number of forward-looking statements which are based on management's assumptions and predictions as of today.

These statements including but not limited to statements regarding the Company's expected diluted earnings per share, drivers of revenue growth, effective tax rate, client fund flows, interest rate, projected shape of the yield curve, projected net operating revenue, core service fees, value-added service fees, foreign exchange service fees, net interest income, new customers, RFP activity, customer product launches, client renewals, balance sheet growth, reinvestment focus, reinvestment spreads, expenses, including compensation, technology, and office space, operating margin, and our pipeline are subject to risks and uncertainties.

The Company's actual results may differ materially from our current predictions due to any one of of a number of factors, information regarding the factors that may affect our actual results is set forth in our most recent 10-K and 10-Q filings with the SEC and in the Form 8-K we filed today which includes our press release.

I recommend that anyone listening to this call review these reports carefully.

Because this call will be archived on our website, www.ibtco.com I want to emphasize again for anyone listening at a later date that the statements made today are based on our assumptions as of today, July 13, 2006.

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 will now turn the call over to Kevin Sheehan.

Thanks, Anne.

Good evening, everyone.

I will begin by discussing the highlights from the second quarter.

This year Investors Bank and Trust was once again ranked number one in two prominent client satisfaction surveys.

In May we received the overall first place honors in the global investor magazines global custody survey for the second year in a row.

This marks the fourth time in the past five years that we have received the number one overall rating in this survey.

Last week we received the overall first place honors in the Global Custodian magazine's 2006 mutual fund administration survey.

These survey results validate that our clients consistently value our single source approach to client service that is supported by our global integrated technology platform.

Further evidence of our superior client service model is our continued revenue growth.

Net operating revenue grew 22% year-over-year driven by core service fee growth of 24% and value-added service fee growth of 67%.

Foreign exchange, cash management, and securities lending revenue achieved record levels in this quarter.

Total operating expenses were up 30% year-over-year for the second quarter.

For the full year, expenses are now expected to increase 17 to 21% compared to 2005 as a result of investments to position the Company for future growth such as additional personnel, technology, office space.

As I discussed in our first quarter call, these step variable costs are warranted investments as we continue to expand and enhance our product and services in several high growth securities processing areas.

Diluted EPS for the quarter came in at $0.67 which included a one-time tax benefit of $0.08.

This compares with $0.64 in the second quarter of 2005 which included a one-time tax benefit of $0.10.

Despite the challenging market conditions, we've processed approximately 1.95 trillion of assets for our clients as of June 30, up 1% from March 31, 2006, and up 30% from June 30, 2005.

Sales to existing customers accounted for most of the increase in assets processed during the quarter.

Turning to the sales environment, we continue to experience solid RFP activity and new product launches by our clients.

Our pipeline continues to be characterized as medium, representing adequate opportunities to meet our earnings per share growth guidance.

I will now turn the call over to John Spinney who will review the core financial results in more detail as well as our expectations for this year.

Thank you.

Good afternoon.

As Kevin mentioned second quarter diluted EPS came in at $0.67 compared to $0.64 in the second quarter of 2005.

Second quarter 2006 diluted EPS included a one-time tax benefit of $0.08 per diluted share related to a tax position that no longer met the probable recognition threshold under Statement of Financial Accounting Standard number 5 accounting for contingencies.

Second quarter 2005 diluted EPS included a one-time tax benefit of $0.10 per diluted share related to the recognition of the indefinite reversal provision of APB 23 with respect to our IRA subsidiaries.

Net operating revenue for the second quarter increased 22% year-over-year due to new business wins, strong value-added service fees and higher client fund flows.

Net operating revenue for the second quarter increased 8% linked quarter due to higher foreign exchange, core services, and securities lending fees.

Core service fees for the second quarter increased 24% year-over-year due to winning some new and existing clients as well as higher client fund flows and higher client asset values.

Core service fees increased 4% linked quarter due to new client funds and higher client fund flows.

Value-added service revenue increased 67% year-over-year as a result of record levels of revenue in foreign exchange, cash management, and securities lending.

Value-added service fees increased 33% linked quarter due to higher foreign exchange and securities lending fees.

FX fees increased 126% to 27.8 million year-over-year and 37% linked quarter due to increased market volatility and higher client volumes.

Next quarter we believe FX will continue to be higher on a year-over-year basis, but it will be lower than the first half 2006 run rate.

Securities lending fees increased 28% year-over-year and 69% linked quarter due to new business, higher volumes, and a favorable international dividend season.

Cash management suite fees increased 42% year-over-year and increased 16% linked quarter due to higher client balances.

Net interest income was down 8% on a year-over-year basis and 11% on a linked quarter basis due to tighter reinvestment spreads.

The linked quarter net interest margin decreased by 15 basis points to 1.36% while the linked quarter interest rate spread decreased by 21 basis points to 1.02%.

We continue to invest in same asset class as we have in the past.

We are focusing our investments on variable rate, short duration securities and we are not attempting to generate incremental yield by taking on increased risks such as duration and credit risk.

We also continue to run a closely matched balance sheet with an asset duration of approximately 1.6 years and a liability duration of approximately 1 year.

The high amount of variable rate securities in our portfolio has allowed us to continue to maintain the low asset duration.

Securities gains were 2.5 million this quarter compared to 5.6 million in the same period last year.

Total operating expenses were up 30% year-over-year and 8% link quarter due to investments to position the Company for future growth such as additional personnel, technology, and office space.

As we said last quarter, these step variable costs are warranted investments as we continue to expand and enhance our products and services in several high growth securities processing areas.

Now we'll detail the significant expenses separately.

Compensation and benefits expense increased 38% year-over-year due to adding approximately 700 employees and management to our North American and European offices and increased 13% linked quarter due to adding employees and management.

Annual salary increases, bonus accruals, and option expense also contributed to the growth in the compensation and benefits expense.

Technology and telecommunications expense increased 36% year-over-year and 3% linked quarter reflecting our commitment to our global integrated technology platforms which we view as a significant competitive advantage.

Transaction processing fees increased 35% year-over-year and 15% linked quarter due to increases in transaction volumes and higher market values.

Occupancy expense increased 29% year-over-year due to new office space in Boston, London, and Luxembourg and 5% linked quarter due to new space in Boston.

Turning to our 2006 guidance.

We expect our 2006 net operating revenue to grow approximately 12 to 15% compared to 2005 net operating revenue.

We expect revenue growth to be driven by the sustained strength of our core service business, continued sales of core and value-added services to new and existing clients, and historically comparable client fund flows.

We are forecasting approximately 17 to 21% growth in total operating expenses as a result of continued investments in our infrastructure which will position the Company for future growth including additional personnel, technology, and office space for both our North American and European operations.

As we've said before, we believe the long-term success of the Company is based on quality customer service and our integrated technology platform.

We are willing to forego some operating leverage in the short-term to invest for future growth in the long-term.

We are projecting 2006 diluted EPS to be approximately $2.40 to $2.45 per share which is our previous guidance of 2.32 to 2.37 adjusted to include the one-time fax benefit we recognized this quarter of $0.08 per diluted share arising from the reversal of the previously accrued taxes.

This guidance assumes the Federal Reserve will rate its short-term interest rates by an additional 25 basis points in 2006 and the yield curve will remain relatively flat without a sustained inversion in 2006.

We now expect our effective tax rate to be approximately 35.5% -- I mean 33.5%.

Excuse me.

We still plan to keep our balance sheet relatively flat until the interest rate environment improves.

I'd now like to open up the call to your questions.

[OPERATOR INSTRUCTIONS] We'll start first with Andrea Jao.

Good morning, gentlemen.

Good morning.

How are you doing, Andrea.

Good afternoon.

With respect to the underlying assumptions for your guidance, it looks like operating revenues increased by 100 bits versus your projections last quarter while expenses actually increased between 100 to 200 bits.

That's the first thing.

The second thing is you still assume a flat yield curve without sustained inversion whereas for someone who gets a chance to look at interest rates every day, the shorter end of the yield curve to the mid-point of the yield curve is essentially inverted.

So I guess what I am asking is what are the offsets or what makes you comfortable given these two changes to your underlying assumptions with existing guidance?

I think it is the outlook on the business itself with sales to existing clients continuing to be strong with the ancillary revenues continuing to be strong, with the ancillary revenues continuing to be strong, balances have been relatively strong, expenses I think the negative operating leverage we've seen the last couple quarters I think is going to pretty much stop going forward.

I think we have reached the point of operating margin that's going to be sustainable for the remaining quarters of this year.

The effective tax rate dropping to 33.5.

I think putting that all into our model gives us a confidence in the guidance that we put out there today, Andrea.

Okay.

So these things are -- but these things are supposed to be captured already in the projected revenue growth, right?

Yes, in the guidance I gave you, yes.

Okay.

Thank you.

Yes.

Next we'll here from John Arfstrom.

Can you hear me?

Yes, John.

Hit the mute button.

Yes.

The value-added revenue line, particularly FX surprised me.

I thought it was going to be strong, but it was stronger than I think everybody expected.

How much of that is second quarter specific?

I know you gave us a little bit of guidance.

How much of it is new business from the existing clients that's likely to continue on?

How would you look at that if you were in our shoes?

I think for the second quarter a lot of it was volume.

A good portion of it came from the volatility associated with that volume.

I wouldn't expect it to seasonality to a per se, but I think going into the third quarter with people going on vacations we do think it will trend slightly lower than that, John, going into third quarter.

Some of it was from new business from existing clients and new business in general.

Okay.

And then how much of your top expense can you give us an estimate is related to those higher value-added numbers?

Typically that hasn't tracked exactly, but when we see a higher value-added quarter we see higher comp expense as well.

Well, what we do is we accrue incentives commensurate with the EPS targets that are out there and our estimated projection of earnings, and during the quarter obviously EPS went up a little bit to 2.40 to 2.45 and as a result we've had higher accruals related to that higher earnings guidance coupled with the value-added services which helped us get there.

Those incentive accruals against that as well.

Okay.

You won't quantify it, but you're telling me that it is somewhat related?

It is somewhat related.

Clearly, if ancillary revenues are doing well, earnings should be going in lock step and hence the accruals will follow that.

Okay.

Just a couple more too, the margin was lower than I thought it was going to be, and I guess it is a difficult environment, but is there anything that's changed in the last three months or six months that we should be aware of?

I think it still continued tight reinvestment spreads that we're seeing on that front, and really that's probably the lion's share of it.

Okay.

And then I guess the other piece of it is that you continue to see higher client deposits and lower client repo balances, but it looks like the spread between the two in terms of the rates that you pay has narrowed a bit relative to last quarter.

Is there anything specific that's happened there and is there any further lag effect that we should be aware of in those two items?

No.

I think when you look at the repo line, it is a combination of client and external funding, so part of that difference may be just the mixes, we've had stronger client funding in the second quarter.

I wouldn't draw any conclusion between the two line items.

I would say in general client balances have been good.

They continue to be good.

Okay.

And as long as you continue to hold a balance sheet stable we'll probably see client deposits build?

That's our expectations over time.

Okay.

Okay.

Thanks.

Yes.

Next we'll hear from Brian Bedell.

Good afternoon, guys.

Hi, Brian.

Just staying on the average balance sheet, the MBS did not reprice up as much as I thought it would.

Can you comment on the effect of the prepaid fees on the premium amortization calculation.

The prepayments fees were a little higher this quarter than they were last quarter giving rise to a little higher amortization, nothing that really caught us off guard but clearly it was up from the first quarter slightly.

That would be a major explanation of why it didn't reprice as much as--.

I don't think it has anything to do with repricing, it just has to do with the yield.

You have a yield that you calculate, right.

And any color on if you were to normalize the prepaid -- not normalize but maybe keep the prepaid fees constant with the effective yield would have been.

No.

No guidance there other than what I said in terms of earnings and what our expectation is for the yield curve.

You guys didn't give any color on what you think net interest income would be given your yield curve assumptions, right?

You've just given total revenue, right?

No, we haven't.

Yes.

When you say flat yield curve I know you typically don't like to get into details, but relatively flat yield curve would you consider where we are right now as a relatively flat or a inverted curve as you would characterize it?

I think over time relatively flat.

I am not going to pick today versus tomorrow or the next day.

Because it changes every day.

Right, right.

Okay.

Clearly if we have an inverted curve there is downside pressure to your income forecast, correct?

In a sustained inverted yield curve situation, correct.

Right.

Okay.

And then just on the repo side, just following up to the prior question, you put together three good quarters now where it has not repriced up as much as it has in prior quarters.

Do you think that trend of getting the lower cost client balances is sustainable or do you think we'll just continue to see volatility over the next couple of quarters in that?

I am hoping it is sustainable and we get more client balances as we've seen the last two quarters.

As we get more client balances, that number should benefit us.

So you continue to lag the Fed, right, and in fact if the Fed stops that number should actually tail off in terms of its upward repricing?

Generally speaking, yes.

Your 2.40 to 2.45 guidance, backing out the $0.08 tax benefit, 2.32 to 2.37, that is inclusive of your 2.5 million gain in the 2Q, right?

The 2.40 to 2.45 guidance includes the gains, yes.

And then FX, I mean it seems like you're now guiding to your normal rate of FX in the second half of, what you said something would be below what we've seen for the average of the first two quarters, so below 24 million.

That's still a lot higher than you have been thinking of in the past.

Seems like you have made pretty good market share gains in FX.

Is there anything attributable to that?

Do you think it is just volumes related or have you made a conscious effort to improve cross-sell of FX to your customers?

I think it is a combination of new clients, continued volatility and flows from our existing clients that drove that number.

Right.

So the new clients are basically signing on for your FX program, so you're having pretty good success at getting--?

Yes, we are, and cross-selling as well.

Cross-selling.

Okay.

And then I guess just going back to the expenses of the second quarter, increase in expense, you said part of that was due to options expense; is that correct?

Slightly.

Slightly.

Okay.

So that's not a big factor.

It is really the incentives?

I am sorry?

We gave a guidance of $0.05 per share for option expense for '06.

That stays, right.

That's in the compensation increased numbers.

So the second quarter, then, that big increase is just what you said where you have a higher accrual based on the GAAP EPS number of 2.40 to 2.45, right?

Yes, coupled with the results that occurred during the quarter, yes.

Right.

If we have a lower seasonal environment in the third quarter, just a lower volumes environment we can expect that comp line to drop back down.

Even if you keep your guidance the same we should see it come back in somewhat on just lower volume?

Essentially.

Right, right.

Okay.

And then do you want to just highlight or just talk about the high growth areas that you're investing in, you've raised the expense guidance from 16 to 19 to 17 to 21.

Is that just due to the higher volumes that we saw in 2Q or have you changed your outlook in terms of what you're spending on the growth initiative?

We see several growth initiatives.

A few of them are alternative investments, middle office, the core business that we service today that continues to expand and grow, and as we get bigger, there is investments we need to make to support an institution with 4,000 people.

Now, has that part of your expense guidance changed from 1Q to Q2 or is your increase in expense guidance solely due to the high volumes environment that we saw in 2Q?

It is due solely to those initiatives, and one of the initiatives I forgot was Europe where we've expanded to London, Luxembourg as well.

Okay.

Is it possible we could see incrementally higher expense guidance in -- as you go through these plans, you might see more opportunities over the next couple quarters?

My expectation is no right now.

Not right now.

Okay.

Great.

Thanks so much, guys.

Yes.

Betsy Graseck has our next question.

Two questions.

One is follow-up on the investment spend.

How far along are you in your programs to build out these areas that you identified as high growth?

I think from a personnel perspective, very far along, technology wise in the middle of it, and securing the office space, probably halfway through that, and we'll see that ramp over the next four to six quarters.

The office expense?

Yes.

Okay.

And the tech expense should also ramp a little bit?

Yes, it will.

Okay.

And have you decided to increase the investment in these areas in part because of some of the positive results you've been getting in the ancillary or the value-added services?

I think a lot of it has to do with what our clients are doing in terms of product development, the growth areas that we see overseas in terms of the products that are coming out of Europe.

In general alternative investments are all very esoteric vehicles that require a lot of technology build, sophisticated personnel, locations to operate out of to support these particular initiatives, and our European office is growing at 30, 40% a year, and we need to make those investments to capture that and be successful.

Okay.

Just back on the FX question, can you give us a sense as to the percentages coming from clients versus the percentages coming from your own operations, training for your own account?

We don't trade for our account at all.

All of this is related to client activity.

But you are obviously facilitating client flows and as you're doing that, I would think that you are taking some view on the markets.

No, we're not.

Okay.

Thanks.

It is a matchbook, Betsy.

Right.

Okay.

Now we'll hear from Robert Rutschow.

Good afternoon.

Hi, Rob.

Can you just talk about the expenses a little bit more?

Looks like if I take your guidance versus the run rate for the first half of the year, you expect expenses to fall in the second half?

They probably will drop off a little bit as we get into the third quarter.

In the fourth quarter they may come back up from the third quarter.

In what areas?

Obviously some of it is volume dependent, the transaction fees in the third quarter.

Any other areas where you would expect the decline in both the -- in the second and third -- or third and fourth quarters?

Primarily the one that would move would be compensation, and even that may not move a [Expletive] of a lot.

And the -- just a small item, professional fees were down quite a bit this quarter which I think added maybe $0.01 versus last quarter.

What should we expect there and what was the reason for that?

A lot of those professional fees related to supporting a litigation which now is being picked up by the insurance carrier, so that expense was mitigated during the second quarter.

Okay.

And then finally, I guess -- just curious as to why you're taking securities gains and if you can comment at all on the OCI this quarter.

On the securities gains, that was really the last sale out of our repositioning of the municipal portfolio and with respect to OCI, I think what you're seeing in there is the net of the unrealized mark-to-market on the AFS offset by the -- and that's a unrealized loss against the unrealized gain on the swap portfolio, I think it amounts to roughly $30 million or something like that after tax.

Okay.

Actually, one more thing.

The effective tax rate I think you said it was going to be 33.5 for the year.

That's correct.

And does that include this quarter which I think was right around 25%?

Yes.

Yes.

So the tax rate in the third and fourth quarter are going to be higher, like maybe 35 or 36?

I am sorry.

The effective rate for the rest of the year is 33.5.

For the rest of the year.

Yes, my mistake.

Sorry.

Okay.

Thank you.

Yes.

Now we have a follow-up from Andrea Jao.

Last quarter, the first quarter you did not repurchase shares and doesn't look like you repurchased shares this quarter as well.

Is that correct?

That's correct.

Any update with respect to your view on repurchases for the remainder of the year?

I think as we've said in the past, if we see those opportunities for us to step in and buy stock, we will, Andrea.

Okay.

Perfect.

Thank you.

Yes.

This concludes our question and answer session.

A replay of this call will be available starting at 8 p.m.

Central time today and will run through July 19, at midnight Central time.

To access this replay please dial 719-457-0820 and enter in the pass code of 8496410.

Once again, that is 719-457-0820 with a pass code of 8496410.

At this time I would like to turn the call back over to Mr. Kevin Sheehan for closing remarks.

Thank you for joining us on today's call.

We look forward to updating you on our progress in October during our third quarter earnings conference call.

That does conclude today's conference.

We thank you for your participation.