Could State Street be the Builder of Independent Managers?

State Street Corporation (STT) began its reduction in force over the last couple of days. Not the first Boston behemoth to cut its work force since the global downturn in financial services, but a 6% reduction is no small amount. With the removal of 1,600 to 1,800 jobs, State Street has the opportunity to save up to $400 million a year in expenses. While no one likes to see job cuts, the reality is that the downturn has made such activities necessary. With the global demand for money management services declining, the back office operations and custodian business has been hurt badly.

But has the financial downturn justified a 54.9% decline in the price of STT since the start of 2008? Granted, like many securities, the cliff really arrived on September 16th, when the stock was still trading at almost $72 per share. Still, with a closing price of $36.60 yesterday, there appears to be a real opportunity in State Street.

Looking at the numbers, we view STT as significantly below its historical average multiple of cash earnings and have for some time. While our ratings chart shows that we have viewed this company as undervalued on and off since mid-2007, we generally have viewed financial services as way too overheated to really view STT as an opportunity. Now that much of the financial services industry has reset to realistic values, we are identifying companies like STT for a closer look.

At Ockham Research, we look at the last 10 years of cash earnings levels for STT to identify where the current high and low price levels have been historically in relation to profit per share. This analysis, (on a weighted basis) brings us to an average high Price to Cash Earnings ratio per share of 23.29 and a 14.43 low over the same period.

Now that STT’s current price is $36.60 and its Price to Cash Earnings ratio is 7.20, we are very positive on its outlook from the cash earnings perspective. Now, we recognize that these job cuts and their impact on generating superior cash earnings will take time. But consider this fact about STT: State Street is now trading a full 57% below its average historical Price to Cash Earnings ratio at these profit per share levels. When our clients ask us why STT has great long term potential, the Cash Earnings levels to current stock is one of our primary reasons.

Another positive we see about State Street is the dividend yield. The highest dividend yield from STT in recent history was 3.42% while the lowest dividend yield was 0.48%. With a current dividend yield of 2.28%, STT is trading 16.92% above the historical median. Don’t get us wrong, lots of stocks are now trading at very high yields, but combined with definitive management efforts to cut costs and react to the market, State Street is well positioned.

One last item about State Street verse the other Boston based financial service firms. As a custodian and back office solutions provider, there is a real possibility that the shake out in the bulge bracket financial service firms could lead to an expanding revenue base with better margins. This is due to the fact that many of the investment professionals at major brokerages and money management firms are striking out on their own. They no longer feel tethered by brand loyalty to these major institutions. However, if they want to hang out a shingle and begin an RIA or wealth management firm, they will need back office infrastructure. Firms like State Street provide these services to independents, and from what we have seen, it appears that this area of the business is growing rapidly.