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State Street Corporation (STT - Analyst Report) reported third quarter 2012 operating earnings of 99 cents per share, outpacing the Zacks Consensus Estimate by 3 cents. Though this compares favorably with the previous-year quarter earnings of 96 cents, it came in slightly below the last quarter earnings of $1.01.

After considering certain non-recurring items such as acquisition costs, restructuring expenses, litigation settlement costs, loss on sale of Greek investment securities as well as discount accretion related to former conduit securities and claims associated with Lehman bankruptcy, net income was $654 million or $1.36 per share. This compares favorably with the year-ago net income of $543 million or $1.10 per share and the prior-quarter net income of $480 million or 98 cents per share.

Better-than-expected results benefited from improvement in net interest revenue and fall in operating expenses. Moreover, capital ratios and asset position remained robust during the quarter. However, decline in fee revenue was the primary dampener.

State Street’s net income available to shareholders was $473.0 million on an operating basis, down 1% from $476 million in the prior-year quarter and 4% from $494 million in the prior quarter.

Earlier this week, State Street closed the deal to acquire Goldman Sachs Administration Services (GSAS) – a leading hedge fund administrator – from The Goldman Sachs Group, Inc. (GS - Analyst Report). The all-cash deal worth $550 million was announced in July. The acquisition will further strengthen State Street’s hedge fund business.

Behind the Headline

Revenue for the quarter was $2.36 billion, down 2.9% year-over-year. Revenue on an operating basis came in at $2.35 billion, declining 2.7% from $2.41 billion in the prior-year quarter. Operating revenue was also lower than the Zacks Consensus Estimate of $2.39 billion.

For the reported quarter, net interest revenue on an operating basis grew 8% year-over-year to $611 million. The improvement was primarily driven by higher earning assets and lower funding costs, partly offset by lower asset yields. Net interest margin was 1.44% in the quarter, in line with the prior-year quarter.

Fee revenues came in at $1.72 million, waning 7% from $1.84 billion in the previous-year quarter. The decline can be attributed to lower trading service fees along with fall in processing and other fees, partially offset by higher investment management fees and securities finance fees.

On an operating basis, non-interest expenses were $1.66 billion, declining 2.9% from the prior-year quarter. The fall was due to lower compensation and employee benefits, reduced transaction processing service costs as well as occupancy costs, partially mitigated by higher information systems and communication expenses.

Asset Position

Total assets under custody and administration were $23.44 trillion as of September 30, 2012, up 9% on a year-over-year basis. Moreover, State Street’s total assets under management stood at $2.07 billion, up 11.3% from the prior-year quarter.

Capital and Profitability Ratios

State Street’s capital ratios continued to remain strong. As of September 30, 2012, Tier 1 capital ratio was 19.8%, up from 17.9% as of September 30, 2011. Likewise, Tier 1 common to risk-weighted assets increased to 17.8% as of September 30, 2012 from 16.0% as of September 30, 2011.

Further, the estimated Basel III Tier 1 common ratio was approximately 11.3% as of September 30, 2012, up from 11.0% as of June 30, 2012. For the reported quarter, return on common equity (on an operating basis) came in at 9.6% compared with 9.8% in the prior-year quarter.

Share Repurchase

In March, State Street, after receiving the approval for its capital plan, announced a new share repurchase program authorizing the purchase of up to $1.8 billion of stock through the first quarter of 2013. During the reported quarter, State Street bought back 11.4 million shares at an aggregate cost of $480 million.

The company has $840 million remaining under its stock repurchase authorization, effective through March 2013.

Our Take

We anticipate State Street’s restructuring programs along with stable core servicing and investment management franchises to help offset the weakness caused by the slow economic recovery. Further, the recent acquisitions will augment revenue.

Nevertheless, given the ongoing weakness in the mortgage market, we remain concerned about the considerable amount of mortgage-backed and asset-backed securities in the company’s investment portfolio.

Also, the low interest rate environment and deteriorating net interest revenue are expected to dent State Street’s top line in the upcoming quarters. Despite these concerns, sound capital deployment activities will boost investors’ confidence in the stock.

State Street currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we maintain a long-term Neutral recommendation on the shares.

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