A Good Time to Visit State Street

We may never know whether Investors Financial could have returned to positive operating leverage, but it appears certain that State Street is taking advantage of this stumble by striking a deal, even though the premium paid is high. The companies expect to reduce expenses by an amount equal to 50% of Investors Financial's total expense base, while projecting 10% client attrition. They also have a reasonable chance to cross-sell State Street's products to Investors Financial's clients, as there is little client overlap.

Therefore, if State Street can execute on this merger plan -- growing revenue while cutting costs -- it will then be acquiring a business with significant operating leverage. If Investors Financial had not had a recent misstep, any price to acquire it would likely have been much higher -- if the company would have sold at all.

A Matter of Scale

Execution risk is real, but State Street has done well with its acquisition of Deutsche Bank's global securities business, which happened four years ago. That business had multiple systems to consolidate, while Investors Financial has one, and the Deutsche Bank property was far more geographically disparate. Investors Financial is mostly in Boston and the "usual suspect" offshore hedge-fund locales.

In addition, two of State Street's principal competitors will be consolidating at the same time: Bank of New York (BK Quote) and Mellon (MEL Quote). This is good timing, as it reduces the possibility of client attrition, though there are other good competitors in the space as well.

My bottom line is that this is a business where scale matters. Both State Street and Investors Financial have shown exceptional revenue growth. State Street has grown its earnings per share for each of the past 28 years, and at 13% compounded for the past 10 years.

This deal will further help State Street achieve its long-term targets of 8% to 12% revenue growth, 10% to 15% operating EPS growth and 14% to 17% return on equity. For 2007, a stand-alone State Street expects to be in the top half of these ranges. Its price tag of 15.4 times 2008 EPS does not seem expensive at all. After the deal closes, which is targeted to happen July 1, State Street expects to repurchase $1 billion of its shares, providing a cushion.

State Street is holding a previously scheduled analyst meeting at 12:30 p.m. EST Tuesday. I expect the company to provide the Street with more reassurance about how it will meet its long-term goals, making a P/E/G of 1 look pretty cheap.

I believe State Street shares can move over their preannouncement price over the next few weeks as investors digest all of this information.