Northern Trust Earnings Call Insights: Expenses and Last Year’s Initiatives

Northern Trust Corporation (NASDAQ:NTRS) recently reported its fourth quarter earnings and discussed the following topics in its earnings conference call.

Expenses

Cynthia Mayer – Bank of America: I guess just a little bit on expenses within the other bucket, it sounded like some was seasonal or one time and some might repeat. I can see the 3.3, but within the rest I’m just wondering if you could give us a sense of what wouldn’t repeat and what is maybe a step up?

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Michael G. O’Grady – EVP and CFO: Sure. Why don’t I on that Cynthia just step back a little bit given that there are a number of items in other and it’s that category that went up sequentially. Our expenses fluctuate from quarter-to-quarter for various reasons and we did see that in the fourth quarter. When you look year-over-year, expenses were only up 1%, but quarter-over-quarter they were up 6%. Third quarter expenses often can be lower. Often just with the summer months, they are slower from an activity standpoint, whereas fourth quarter expenses can be higher given that we just have much more activity at the end of the year, which we certainly did this year. Much of it cost our businesses, as I talked about. Some due to things that were different this year, like the fiscal cliff and other things that I think just happened every year where you try to get a lot done by the end of the year. This year we definitely saw the change in outside services and other operating expenses. Outside services includes a number of expenses, but certain things like sub-custodian costs and third-party advisor fees, which fluctuate throughout the year and there’s no real definitive seasonal pattern to those fluctuations, but they were higher in the fourth quarter. Other outside services such as contracted, technical, legal and consulting services are required to onboard new clients. I mentioned QIC, but there were some other large clients, which we finished the onboarding in the fourth quarter and so we saw those expenses go higher. Then similarly, as you point out in other operating expense, you have various charges such as accounting service – charges related to account servicing activities and those also tend to fluctuate and were higher in the fourth quarter. Then the largest category within other is business promotion. This includes things like travel, marketing, advertising, and these activities were lower in the third quarter and then higher in the fourth quarter. Other also includes staff related expenses. So things like expat costs and relocation costs and those were higher in the fourth quarter and to your point, not costs that in our view necessarily repeat each quarter. Then I would go on a little further to say that as we’ve discussed on the call in the past and it’s in our financial disclosures as well, there are several areas where in the first quarter, we see seasonal patterns as well. So if you recall, stock option expenses, typically higher in the first quarter of each year, just due to the requirement that we expense options that are granted to retirement eligible employees. FICA insurance is also usually higher in the first quarter. Then, as you know we also have the Northern Trust Open that is held in February, and that results in higher business promotion expense in the fourth quarter. If you also just recall looking at last year, our expenses in the first quarter of 2012 if you’ve adjusted out, the charges were fairly close to what our expenses were in the fourth quarter of 2011, and that’s also when we began the execution of driving performance. So, we’re beginning to see some of the benefits of driving performance. So, hopefully that gives you a little context.

Cynthia Mayer – Bank of America: That really anticipates what my next question was going to be, which was what carries into the first quarter. I guess, actually one more which is on expenses, which is you have ongoing technology investments and I am just wondering what you consider a normalized growth rate for that on an annual basis?

Michael G. O’Grady – EVP and CFO: There is no question that the technology cost for certain investments will continue going forward. That’s an area where in order to provide the services both on the personal side and the institutional side, that not only that our clients’ demand but that our competitors are looking to provide as well, will require us to continue to make those investments. As a result, the equipment and software line that you have there is one of the lines where we would expect that to continue to grow. Again, it’s more than just the depreciation and amortization in that line, so there is not just a steady state rate that will continue. There is some fluctuation, but for the most part that’s one where you saw approximately 6% growth in that line both sequentially and year-over-year and we expect that it will continue to have growth in that line. And frankly, that’s part of what we are doing with driving performance, it’s not to say that we don’t look at potential efficiencies and technology, because we are. But given that we know we are going to have the growth in that expense category, we have to find other areas where we can find ways to reduce the rate of growth.

Last Year’s Initiatives

Alex Blostein – Goldman Sachs: just I guess a follow-up on expenses, but maybe a little bit of a bigger picture question on, when you guys think about the initiatives you put into place earlier part of last year or 2012 I guess. The environment is probably tracking a little bit worse than you anticipated. So, NIIs down a couple of percent, FX down substantially. Clearly, you are tracking against a little bit above ahead of where you though you will be. So, but if we continue in this kind of (MLAs) throughout 2013 and what 2014 would look like. I guess are there any other initiatives that you could consider to kind of keep driving the cost down from here.

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Michael G. O’Grady – EVP and CFO: You are right Alex that, unfortunately due to the environment, many of the gains that we made in driving performance essentially were taken away by lower FX and spread income. And with the environment at least at this point looking that it’s going to continue like that, the first priority is to make sure that we continue to execute on the set of initiatives that we have in place. And with that as I pointed out and you just did as well, we are ahead of schedule on executing on that set of initiatives from a timing standpoint. So, we got to the levels of savings and benefit faster than what we had originally laid them out for. Also if you look at those, some of them were a little bit above where we thought we would get and some of them were a little bit below, and we will look to continue to execute on the remainder of those initiatives, and hopefully we can get to that $250 million level sooner than what we expected. So, that’s the first part. The second part is it’s not a two-year program and then we’re done with it, but it’s something that we’re looking to continue going forward. So, in 2013, we are executing on a number of those initiatives, but we are also looking to find additional initiatives that will help potentially later in 2013, but more importantly will be incremental in 2014 and beyond. And then the last thing I would say is beyond just specific initiatives what we are really trying to do with this is change the way that the corporation looks at productivity and that we just constantly look to improve our productivity and doing that will be beyond just initiatives, but also looking to just drive various metrics or measures of productivity, so that this is a longer-term permanent change in our approach.

Alex Blostein – Goldman Sachs: Shifting gears a little bit, I wanted to touch base on the core business and specifically C&IS. You obviously mentioned a big Bridgewater mandate you guys won that I guess is going to fund (indiscernible) in 2014 and without I guess getting in the weed on specific client relationships, it feels like that part of the business post Omnium acquisition continues to do quite well. How should we think about I guess those type of mandates, your pipeline for those type of mandates and then more importantly the fee rate and then maybe profitability on kind of this middle office hedge fund solutions business relative to your current C&IS mix of businesses?

Michael G. O’Grady – EVP and CFO: Number of questions, in there, but let me see if I can get them. As far as the growth in C&IS, yes agreed, it’s been very strong in the last couple of years certainly. Just with looking at the growth that we’ve had in new business, the one thing I would add beyond just the rate is the breadth of the new business. So you pointed out the growth in global fund services which has been very healthy, but likewise in 2012, we saw very good growth in our traditional business of working with pension plans and corporations and we also saw very good growth in our investment management products and solutions with our institutional clients. So when I look at our net new business, it’s somewhat equally distributed between those three broad categories. Now going specifically to hedge fund services, which you mentioned there, very successful year in winning mandates in that business, but you are correct in pointing out that the revenue impact from that is going to be seen more in 2013. So, the pipeline is very strong for that business. Then Bridgewater for example is the beginning of, I would call, the 2014 pipeline, because that’s when the revenues will begin to come online there. So, healthy growth across the businesses and from a pipeline standpoint, you’ll see that coming through in ’13. As far as the fee levels and profitability, I would just say that each of these businesses has a fee structure that works for that client base and for that marketplace, so they price things very differently because the services and it’s not just the individual services, but it’s the collection or bundle of services being provided to a pension plan may be very different than what we provide to one of the hedge funds. For example, just with the hedge fund, it’s primarily a admin fee if you will, hedge fund administration fee, asset servicing fee. There is less with regard to custody balances and therefore net interest income. There is less with regard to foreign exchange at this point and things like that, so it’s more around the fees, so hopefully that addresses. Then I would say as far as profitability, certainly with all of those businesses and all those clients, we’re looking to achieve the appropriate profitability for the Company and for that group overall, and there is a rigorous process around that in order to make sure that business is appropriately priced.

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Alex Blostein – Goldman Sachs: Then the last one for me. Just hoping you guys could dissect net interest income picture a little bit, so average balance is down I guess a little bit over quarter-to-quarter, slightly different I guess when we’ve seen from other so far given that the level of deposits has been fairly healthy, as in the ending balance, should I guess, was a little bit higher than the average. So, should we expect I guess the balance sheet to pick up a little bit – the average balance sheet to pick up a little bit heading into the first quarter? Then the second part to that, Mike, I think you and I spoke in the past that there is a little more flexibility for you guys to kind of reinvest then maybe given the liquidity on the balance sheet as well as the conservative position you have within your securities portfolio to do a little bit more to protect the net interest margin. Is that’s still the plan or should we think about reinvestments being where there are today, so the NIM could continue kind of roll further down from here.

Michael G. O’Grady – EVP and CFO: Again, number of questions and let me try just to go through it. So as far as net interest income on the asset side, so our average earning assets down a little bit in the quarter sequentially and if you look at the categories and again for us just three primary categories. The loans and leases, our securities portfolio and then the deposits with bank, each of those categories relatively constant. Where we saw the decrease was with our balances at the Fed, which – that allows us to handle deposits as they come and go. As you pointed out Alex, at the end of the year, our deposit levels and therefore our asset levels were a little bit higher. I would say we’re at a little bit of a point of transition with regard to the size of the balance sheet and what I mean by that is with the fiscal cliff at the end of the year we did see increased balances on the balance sheet. Having said that now that we’re past at least the first fiscal cliff and now we’re dealing with other cliff, we’ve seen further movement of those balances often into just deploying them into different asset categories. The other factor, which I think is important, is at the end of the year the TAG program, or Transaction Account Guarantee program by the FDIC expired. So that was unlimited FDIC insurance on deposits. When that was put in place, we saw an inflow of deposits onto our balance sheet, some very large both personal and institutional deposit balances. And now we’re seeing some level of diversification of those deposits on the part of our clients as opposed to concentration on any one institution. So there are inflows and outflows I would say with regard to the balance sheet. At this point I don’t necessarily see a significant directional move for the size of our balance sheet. With regard to NIM and margins, if I just go through the categories for you, looking at loans and leases first, we are at I think it was 2.73% in the quarter, which was down 12 basis points. As I mentioned – LIBOR was down 10 or 11 basis points in the quarter, a good portion of those loans are linked to LIBOR, so that’s going to bring those yields down and then also with our mortgage portfolio and some of the other loan category as we put on new assets which we have been talking about, if rates are lower than they are replacing mortgages that were at higher levels. Then the securities portfolio, it’s at 91 basis points, which if you exclude the one item from last quarter is actually relatively flat with the previous quarter and as you mentioned, Alex, one of the things that we’ve been trying to do is to maintain that yield, if you will, within the constraints of our asset liability policies and the committee that executes that. We are trying to maintain that yield as best as we could. We did extend the duration on that portfolio a little bit during the quarter, and so we are reinvesting a little bit further out the average duration now, the index duration, if you will, is a little bit over a year. So, that we were previously little bit under a year on that. So, we’ve been investing a little bit further out, but in doing so, just with where rates were in the quarter, that is at a rate that is below the average yield on the securities portfolio and as much as we are trying to manage through that to your point Alex, there is only so much risk that we think is appropriate whether that’s interest rate risks or credit risk that we are willing to take on in order to maintain that. Then finally just with deposits with banks that was I think at about 81 basis points, down 12 basis points and as I mentioned our deposits with Australian banks where the rate is much higher, the decline in yields was much greater. I think it was 30 basis points and that accounts for about 9 of the 12 basis points. So other currencies were down for the remaining three basis points, and that’s just where – short-term rates are very low in the euro and other currencies. On the cost of funds, that was down about 5 basis points, so it helped a little bit. Most of that is due to the fact that we have Australian dollar deposits as well, so when the rates go down there, we get the benefit of that as well. So hopefully, that gives you some picture. Obviously, much of it has to do with what the rate environment is and will be in the third quarter and in 2013.

A Closer Look: Northern Trust Earnings Cheat Sheet>>