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State Street's Blue Blood Heats Up

The stodgy Boston securities custodian is on a tear and hopes a big acquisition will keep it going.
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State Street

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, the staid Boston security custodian whose stock performance has been anything but stodgy in the last month, hopes its new status as the biggest player in its field can keep the rally rolling.

On Tuesday, State Street said it would buy most of Deutsche Bank's securities services business, including custodian and fund administration operations, in a widely expected deal, for $1.5 billion. (The bank holding company also said that it would eliminate 1,000 jobs as part of the transaction.)

The bank's announcement followed a 30% rally in its stock since Oct. 9, the beginning of the broader market's comeback. Shares were lately up 4 cents, or 0.09%, at $43.30. Some of the run-up reflects the company's leverage to the improving asset markets, as the company gets a good share of revenue from fund companies.


As a custodian, State Street offers back-office accounting and safekeeping services for mutual funds and other asset managers. Among other things, the bank keeps track of shares bought and sold, and their net worth. A portion of the fees that State Street generates are based on its total assets under custody.

"One reason the stock has done well is because it was punished so badly earlier in the year, as a result of the market's drop in July and September," said Rachel Barnard, an analyst at Morningstar. "When people saw the market going up, they began to think that assets might start rising again."

The stock's 52-week high is $58.36; the low is $32.11. State Street trades at the middle to low end of a four-year valuation range, with a P/E of 20 times 2002 earnings. It had a P/E span of 18 to 28 in 1998, 15 to 25 in 1999, 17 to 38 in 2000, and 19 to 34 in 2001.

Shares of State Street may have also benefited from speculation about the Deutsche Bank deal. "With fewer players offering custody services, they have a real competitive advantage," Barnard said.

In the third quarter, custody made up $427 million, or a little less than half, of State Street's revenue. The rest of the bank's revenue came from asset management fees, foreign exchange and other services.


State Street's purchase adds $2.2 trillion of assets to the $5.7 trillion it has under custody, making it the world's largest trustee of assets, ahead of

Bank of New York

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J.P. Morgan Chase

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"We are determined to be the leader in the global securities industry," said David Spina, chief executive officer of the bank, on a conference call. "Today is a great day for State Street."

The acquisition has two key benefits, analysts say. For one thing, it makes State Street a lower-cost producer.

"They acquired economy-of-scale-type businesses which run electronic transactions through a computer," said Richard Bove, an analyst at investment bank Hoefer & Arnett. "To the degree that they can continually add transactions, they are lowering the cost of each incremental transaction."

The deal also enables State Street to penetrate a new market from a proprietary position, Bove argues. "It allows them to get into Europe in a far better fashion than they have been doing until this point," he said. "Instead of picking up one small client at a time, they now have a bulk in that market."

Speed Bumps

The purchase doesn't eliminate all the obstacles for State Street, however. For one thing, it will subtract 1 cent to 3 cents a share from 2003 earnings, and it will only add back that amount in 2004, the company said.

In the third quarter, State Street said it offset a "sharp plunge in equity market valuations" and an "adverse interest-rate environment" by getting business from existing and new clients. Earnings were $182 million, or 56 cents a share, up from $170 million, or 51 cents a share, in the year-ago period.

During that time, the bank did well by virtue of the fact that more firms are outsourcing back-office services. "State Street has benefited as fund companies are looking at the bottom line," said Barnard. "Particularly for smaller funds, it does not make sense to do this stuff in house. It is cheaper to outsource."

Other analysts argue that a real upturn in the stock is contingent a better equity market environment. With two months left, the

Dow Jones Industrial Average

is off about 13% in 2002, the


is behind 28%, and the S&P 500 has lost 21%, putting the market on track for a third down year in a row.

"The acquisition sets State Street up well for the long term," said Stephen Biggar, an analyst at Standard & Poor's. "But in the near term, there is no real catalyst for the stock."