Northern Trust Corp (NTRS) — Q1 2020 Earnings Call Transcript

Thank you, everyone, and welcome to Northern Trust Corporation's first quarter 2020 earnings conference call. Joining me on our call this morning are Mike O'Grady, our Chairman and CEO; Jason Tyler, our Chief Financial Officer; and Lauren Allnutt, our Controller. Our first quarter earnings press release and financial trends report are both available on our website at northerntrust.com. Also on the website, you will find our quarterly earnings review presentation, which we will use to guide today's conference call. This April 21st call is being webcast live on northerntrust.com, the only authorized rebroadcast of this call is the replay that will be available on our website through May 19th. Northern Trust disclaims any continuing accuracy of the information provided in this call after today. Now for our Safe Harbor Statement. What we say during today's conference call may include forward-looking statements, which are Northern Trust's current estimates and expectations of future events or future results. Actual results could differ materially from those expressed or implied by these statements because the realization of those results is subject to many risks and uncertainties that are difficult to predict. I urge you to read our 2019 Annual Report on Form 10-K and other reports filed with the Securities and Exchange Commission for detailed information about factors that could affect actual results. During today's question-and-answer session, please limit your initial query to one question and one related follow-up. This will allow us to move through the queue and enable as many people as possible the opportunity to ask questions as time permits. Thank you again for joining us today. Let me turn the call over to Mike O'Grady.

Thank you, Mark. Let me join Mark in welcoming you to our first quarter 2020 earnings call. Amidst this crisis, I hope you and your families are healthy and well. I also want to acknowledge and thank all the healthcare workers, other first responders, and the entire community of essential workers for their heroic efforts during this pandemic. Inside Northern Trust, we often speak of our four key stakeholders: clients, employees, community, and shareholders. I know we will devote a lot of this call to discussing the impact of the crisis on shareholders, but I would like to take a moment to describe our actions and how they relate to the other stakeholders. We have been engaging with our clients more than ever. Despite the pandemic, markets have remained open, and our clients have needed to make investment decisions and complete important transactions. Turbulent times such as these show the importance of a strong capital base and liquidity profile, as well as robust technology and resiliency plans. We've been able to provide support to our clients and the exceptional service they have come to expect from us. We saw global transaction volumes increase 70% in March compared to February and 60% compared to one year ago. We were able to utilize our global operating model to transfer work around the globe to manage peak volumes. During the first quarter in support of our clients, we saw deposit growth of over 22 billion and funded loan balances increase by over 6 billion. In a short amount of time, our team also created a solution to provide access to the paycheck protection program and we began processing applications. Whether it's through video conferencing or phone calls, our clients want the advice and counsel of Northern Trust. The vast majority of our employees, whom we call partners, made a significant shift to working away from our offices, with over 90% regularly working remotely. For the critical functions that require a small number of our staff to be in our offices, we're taking extra measures to ensure their safety throughout the duration of the crisis. For certain eligible partners, we are providing supplemental compensation to support them and their families during this difficult time. We're also offering increased flexibility for alternative work options due to mandated school closures and other impacts of the pandemic. The commitment, expertise, and professionalism of our staff has been extraordinary. I’m pleased we've been able to provide this support. Northern Trust businesses and therefore the communities we reach are truly global, with over 20,000 partners across North America, EMEA, and APAC. We announced philanthropic support to several nonprofit organizations around the world and created a COVID-19 matching gift program to support the efforts of our partners. Our guiding principles of service, expertise, and integrity have guided our actions over the last several weeks and we will continue to focus our efforts as we navigate the difficult environment we all face. Northern Trust has endured crises before and we are extremely confident in the resiliency of our business and our staff. My sincere appreciation to everyone working so hard throughout this crisis and our sympathies to everyone impacted by this disease. Our annual meeting is taking place later this morning, so I have another opportunity to speak to our performance and strategy, but for now I'll turn the call to Jason to review our results for the quarter and discuss the financial implications of this pandemic.

Thank you, Mike. Before I start, I want to take a brief moment to recognize all those affected by this crisis, especially those working on the front lines. Our thoughts are with you, and we hope you and your loved ones remain safe and healthy. I'd also like to express my sincere gratitude to all Northern Trust partners for their continuing hard work, resiliency, and flexibility in these uncertain times. I am extremely proud to be part of this team that achieves greater for all of our stakeholders no matter the adversity. Now let's delve into the financial results for the quarter starting on Page 3. This morning we reported first quarter net income of $360.6 million. Earnings per share were $1.55, and our return on common equity was 13.4%. You can see on the bottom of Page 3 the macroeconomic environment became more challenging during the first quarter. However, recall that a significant portion of our trust fees are based on quarter lag or month lag asset levels, and thus the current quarter's fees do not fully reflect the impact of the decline in equity markets during the quarter. Let's move to Page 4 and review the financial highlights of the first quarter. Year-over-year revenue on a FTE basis increased 7%, with noninterest income up 11% and net interest income down 3%. Expenses increased 4%. The provision for credit losses was 61 million in the quarter while net income was up 4%. In a sequential comparison, revenue increased 2%, with non-interest income up 5% and net interest income down 3%. Expenses decreased 1%, while net income declined 3%. The provision for credit losses of $61 million during the quarter was primarily due to an increase in the reserves driven by current and projected economic conditions resulting from the ongoing pandemic and the related market and economic impact, the largest increase in the commercial and institutional and commercial real estate portfolio. Return on average common equity was 13.4% for the quarter, down from 14% a year ago and 14.8% in the prior quarter. Assets under custody/administration of $10.9 trillion were flat compared to a year ago and were down 10% on a sequential basis. Assets under custody of $8.3 trillion were up 1% compared to a year ago and down 11% sequentially. Assets under management were $1.1 trillion, down 4% on a year-over-year basis and down 9% on a sequential basis. Let's look at the results in greater detail, starting with revenue on Page 5. First quarter revenue on a fully taxable equivalent basis was $1.6 billion, up 7% compared to last year and up 2% sequentially. Trust, investment, and other servicing fees represent the largest component of our revenue, reaching a record $1 billion in the first quarter, up 8% from last year and up 1% sequentially. Foreign exchange trading income was $89 million in the first quarter, up 34% year-over-year and up 38% sequentially, driven largely by higher client volumes and increased market volatility during the month of March. The remaining components of other noninterest income were $87 million in the first quarter, up 37% compared to a year ago and up 24% sequentially. Securities commissions and trading income increased by 79% compared to a year ago and 50% sequentially, driven by higher interest rate swap and core brokerage-related revenue. Prior quarter other operating income included a $20.8 million loss relating to the sale of leases. Excluding this prior period loss, the sequential decline was primarily due to lower income associated with supplemental compensation plans and a market value adjustment for seed capital investment, partially offset by lower Visa-related swap expense and the impact of a full quarter run rate of the bank-owned life insurance program. Net interest income, which I'll discuss in more detail later, was $416 million in the first quarter, down 3% growth year-over-year and sequentially. Now turning to Page 7, net interest income was $416 million in the first quarter and down 3% from the prior year. Earning assets averaged $111 billion in the quarter, flat versus the prior year. Average deposits were $95 billion, and we are up 4% versus the prior year. The net interest margin was 1.51% in the first quarter and was down 7 basis points from a year ago. The net interest margin decreased primarily due to lower short-term interest rates, primarily offset by a balance sheet mix shift. On a sequential quarter basis, net interest income was also down 3%. Average earning assets increased 3% on a sequential basis while the net interest margin declined 8 basis points. Looking at the currency mix of our balance sheet for the first quarter, U.S. dollar deposits represented 69% of our total average deposits. This was flat to a year ago and up slightly from 68% in the prior quarter. Turning to Page 8, expenses were $1.1 billion in the first quarter and were 4% higher than the prior year and 1% lower than the prior quarter. Compensation expense totaled $500 million and was up 4% compared to one year ago and up 8% sequentially. Last year's compensation expense included $10 million relating to severance related charges. Excluding these charges, the year-over-year growth was mainly driven by higher salary expenses driven by staff growth and base pay adjustments, as well as an accrual for supplemental payment to certain employees in response to the COVID-19 pandemic. The sequential increase was primarily due to higher expenses related to long-term performance-based incentive compensation due to the vesting provisions associated with grants to retirement eligible employees in the current quarter, as well as the previously mentioned supplemental payment, partially offset by lower cash-based incentive costs. The quarter's compensation included $34 million in expenses associated with the retirement eligible staff compared to $30 million in the prior year. Employee benefit expense of $98 million was up 14% from one year ago and 6% sequentially. Both increases were driven by higher retirement plan expenses and payroll taxes. The sequential growth was partially offset by lower medical costs. Outside services of $193 million were up 2% on a year-over-year basis and down 6% sequentially. The year-over-year growth was primarily driven by increased third-party advisory fees and technical service costs. The sequential decrease was due to lower consulting, legal, and technical services. Equipment and software expenses of $162 million were up 9% from a year ago and down 2% sequentially. The year-over-year growth was reflected by higher depreciation and amortization and software support costs. Sequentially the decrease was driven by lower software disposition charges, partially offset by higher depreciation and amortization. Occupancy expense of $51 million decreased 1% from a year ago and was down 11% sequentially. The sequential decline was primarily due to the renegotiation of the lease resulting in a $7 million reduction of related asset retirement obligations. Other operating expenses of $62 million were down 15% from a year ago and down 30% sequentially. The year-over-year decrease was primarily driven by lower staff-related expenses, partially offset by increased contributions to the Northern Trust charitable foundation. Sequentially the decrease was primarily driven by lower staff-related and business promotion expenses, partially offset by increased contributions to the charitable foundation. The lower staff-related costs were related to a decline in supplemental compensation plan expenses and resulted in a related decline in other operating income. As we've discussed on previous calls, our value for spend initiative, which we started in 2017, has been realigning our expense base with the goal of realizing $250 million in annualized expense run rate savings. With our results this quarter, we surpassed that goal. While we have exceeded our goal of $250 million, our efforts around our value for spend and overall productivity were broadly not fees, and we further embed a culture of sustainable expense management across the company.

Yes, this is Mike. I would just add to what Jason said that there are near-term actions that we've already taken and can continue to take, which definitely looks to bring down the expense run rate from where we were in the fourth quarter and then where we are now. Just given that the world has changed and will change, there are new opportunities for productivity over the long term. Even if you think about real estate costs and other costs that come with having everybody in facilities versus now, as I mentioned earlier, we're roughly 90% of people working from home. It's not going to stay at that level, but I also don't think the operating model will be the same once we get through this.

Hey, good morning, everybody. Thanks for taking the question. So I wanted to start with your thoughts around the organic fee growth in the current environment. In the past, you talked about low to mid-single-digit growth across institutional and wealth businesses, so I am wondering how the current sales cycle, likely being extended, is impacting the fee growth outlook from an organic basis? As a follow-up to that, obviously, I want to get your thoughts on expenses. While again, similarly, you talked about aligning expense growth with organic fee growth, again, around 3% to 5% range, how low can you guys take that, given the current environment, and any thoughts around 2020 expense growth would be helpful?

Sure, good morning, Alex. Let me start on the first dynamic of organic growth. It was a strong organic growth period and I think both year-over-year and then sequentially it was nice to see we had organic growth both in the C&IS business and used it at a high level. It was a little over 1% of pure net new business that contributed to the growth in C&IS and then we also had overall positive growth from an organic perspective in the wealth management side of the business. A lot of it was driven by the very strong movement into cash. I was looking every weekend; I think there were over $30 billion in flows overall into that category, and our NIF treasury fund is number one in its peer group and investment performance. And just that set of funds alone has AUM of over $60 billion right now. So in a lot of ways, things are going well. I think it's also important to take a second to think about some of the interactions we've had with our business, and this, I think, feeds into your question about how we should think about this in the longer term. In wealth management, for example, I was talking to some of the leaders there, and just some interesting notes. One, their call report volume, just activity with clients has really skyrocketed. Over 100% increase in call reports just from our central region gives a sense of the activity there. We do these webinars to teach clients about and talk more from our experts about what's going on; typically, we get about 800 or 900 people showing up for those virtually, and they're at record levels now. There are over 3,000 people consistently coming in to those. And then even the marketing material, we track things as granularly as the page views that we get from the marketing material we send out. That averages about 1,200 page views, and over the last several weeks, we've been averaging 6,000 to 10,000. I think in the short run, it was interesting to see that we were able to actually close good pieces of new business that were already in the pipeline. I think the long term bodes very well for us, given some of the statistics I just threw out, the engagement we've had with clients. I think if there's an area of caution, it's going to be in that midterm pipeline. I think there are not as many clients that are going to be spinning up new opportunities, whether it's on the C&IS side; they feel the same, or the wealth side. So I think we're going to close all the business that we can that was already in the pipeline. The long term looks very good, and we can talk about the more counter-cyclical dynamics of outsourcing that lead into help on the new business side for C&IS. The long term feels good; I think the short term, we obviously have to be cautious about. Regarding expenses, I will start, but maybe Mike or Mark will join in. We want to bucket it into a few different categories. The best way to think about it might even be just to look at Page 7 of the earnings release. First of all, we had a long list of different paths on this, from just saying let expenses play through to doing a full replan of expenses. We took the latter approach; we were aggressive at unwrapping our expenses based on what we knew the environment was going to look like in the short run at least. We unbucketed things the way we traditionally do for inflation, productivity, business growth, and investments. We've been very aggressive at outlining where we can address expenses. If you look at Page 7, the areas that are more related to client activity or markets have to do with outside services and equipment and software. Super high level, roughly you get kind of 30% to 40% of those have that correlation to markets and new business. Those are the areas we've been laser-focused on, even on an IT investment. We're just re-rationalizing everything that we've committed to do.

Yeah, this is Mike. I would just add to what Jason said that there are near-term actions that we've already taken and can continue to take, which definitely looks to bring down the expense run rate from where we were in the fourth quarter and then where we are now. Given that the world has changed and will change, there are new opportunities for productivity over the long term. If you think about real estate costs and other costs that come with having everybody in facilities versus now – as I mentioned earlier, we're roughly 90% of the people working from home. It's not going to stay at that level, but I also don't think the operating model will be the same once we get through this.

Great, great, that's helpful. And I don't want to put words in your mouths, so maybe just to clarify. In the past, you talked about expense growth aligning with organic fee growth. In the near term, organic fee growth sounds like it's obviously going to moderate considerably. Should we think about the total expense, business expense, maybe flattish year-over-year, or is there a way to bring that down? Just hoping to get some more granularity?

Yes. You are correct in characterizing the way that we have talked about the organic expense growth rate for expenses aligning with fee growth. Yes, as that comes down, the fee growth comes down, the organic expense growth rate comes down as well. Beyond that, as you're saying, Alex, yes, we are also saying, outside of the organic part, looking at total expenses, we're trying to bring those down. I wouldn't put a specific stake in the ground as to whether that's flat or up or down because some of those expenses are affected by the environment. But that's what we're trying to drive to. It's as Jason said, it's a replan. There's no part of this that says we're just plowing through with the same plan that we had at the beginning of the year.

Hi. Thanks very much. I wonder if I could ask a question; I could use some on this, particularly on the provision and the loan book. Could you talk generically about what type of economic backdrop you wrote that provision to? Because the world was changing a lot right around quarter-end? And then if we could talk about the loan book that produced most of that. I'm assuming it's almost all in C&I and CRE, so maybe you could talk about what in, say, office retail and construction, where that's derived from, how much of it is clients that are across the firm versus some things that are syndicated. I really appreciate that; we normally don't have much of a discussion about your loan book. Thanks.

Sure, Glenn. Let me just start with some of the assumptions that went into the forecast. Much like a lot of firms, the SEC is very specific in saying you've got to pick and use your end-of-period date, use your forecast at that point to drive your increase or decrease in reserves. We obviously followed that. If you look right at the end of the period, we were looking at unemployment of 10%. We had a peak-to-trough change in GDP of just over 6%. It's not like we have those assumptions and then it spits out the $61 million provision number. We have a variety, dozens of factors that go from there. From the number of forecasts we use, the weights, and the priorities of those forecasts drive the expected loss assumptions. We go through a very rigorous governance process to take the output of the forecasts and the models to drive to a final number for provision. Now after we did that, like all other financial firms, we went through a new forecasting period. The economic inputs and the market were changing dramatically. We're watching that closely. Within the next couple of weeks, we went through a forecast that went to an unemployment peak of 14.5% and peak-to-trough GDP change of 7.5%. That gives an indication that directionally the provision number, if we were to go through that same governance process, would have yielded a higher provision number at that point. We didn't finalize the governance process after that second forecast. We could do that every day; it's a rigorous process, but we followed what the SEC and the accounting guidelines provide us to do. We'll continue to do those updates as we always do with our forecasting process, and we'll have that rigorous process added to it as we get into the next reporting period. Regarding the loan book itself, why don't we go through some headlines and I'll start, and then maybe Mark can jump in.

Looking at the entire loan portfolio, over 20% of the loans are given to private clients secured by marketable securities, primarily custody of Northern Trust. You do have about 20% of the portfolio which is residential real estate. Again, the nature of these abattoirs is somewhat unique. For example, over 75% of those would have FICO scores of 740 or higher. When you start to look at the commercial and the commercial real estate, the commercial is predominantly investment grade. On the commercial real estate side, lending is to investors as opposed to developers. Over 95% of those commercial real estate loans have personal guarantees as well. So, a pretty high quality when we look at the C&I portfolio as far as where the high impact or low impacts might be from the current situation we find ourselves in. We would say we're predominantly in what we would hope is in the lower impact when we look at the kind of industry segmentation there.

There's just one tiny clarification. The GDP numbers that you mentioned, is that full year 2020 or second quarter?

Oh, no, that's for the full year. That's the peak to trough change for the full year. So at a high level, the assumption that we used had a sharp second quarter decline and then a relatively strong recovery, but not to the current levels of GDP.

Good morning, and thanks for taking the questions. First, can you provide a bit more color on the net interest income outlook, particularly given the rise in deposits and expectations in the backdrop with a lot of liquidity out there, coming into the NIM, how you're thinking about the portfolio and reinvestment rate?

Sure. Thanks, Mike. I will start. Well, first of all, the more time we spend around NII; I think what jumps out to me is that the key is actually less the size of the balance sheet, which is driven so much by the deposit growth. It has much more to do with what's happening with loan volume. If you think about it, the size of the balance sheet and the size of average earning assets is going to be dominated by client deposits coming on. In a different interest rate environment, that's going to have an impact on NII. But in the short run, you think about it, and on an incremental basis, we're not investing those deposits long and we're not investing them with credit risk either. So the dynamic there is that effectively you're bringing the size driven by deposits that are going to be reinvested a lot in IOER 10 basis points and maybe something a little somewhat different than that, but not dramatically. The things that are going to drive in, IOER will be really two things: one, the volume of loans and then secondly, we've talked about this before, but the spread of one-month LIBOR to the bottom end of Fed funds or IOER is very important. It really gives you a sense of the NII impact of the earning assets and how they will behave and contribute to NII. Those are really the big factors, and I mentioned that because I think it's just important to decouple and not try to predict NII based on where that 151 in NIM is going to go. You have to have more of a bottoms-up approach of thinking about particularly loans and then what LIBOR is going to do. LIBOR has been coming down a couple of basis points a day effectively, and where you think the trajectory will go is a very important factor.

Okay, that's helpful. And then just as a quick follow-up, can you help us just think about fee waivers ahead?

We have a lot of the information out there to help track that a little bit, but as we sit today, none of the large funds are in a position where their yields are below their fee rates. If we look out on that a little bit, you guys can see as much as we can without a real contrarian approach; you don't see that changing, at least in the next several weeks or so. Now, that said, I mentioned early in the opening that our NIF treasury fund is at $60 billion to $70 billion. If we fall below those rates by even 5 basis points, you're talking about an annual run rate from a math perspective of potentially $30 million. We’re not there yet, but if we were to try and point you to something to track in between the time that we're able to talk publicly, those would be the line items to look at.

Great. Thanks very much for taking my questions. Maybe just staying with the balance sheet for a minute on that LIBOR to IOER spread. Down to 7% to 10% down, is that considering current LIBOR; one month LIBOR rates were that, or are you factoring in LIBOR to compress further with that? And could you just remind us again on the loan repricing mechanism? I think it's three quarters of balloons repriced quarterly to one month LIBOR with the rest lagged for one year.

Sure. Let's just start with the end. It's actually a little higher than that; about 80% of the loan book is actually floating at this point. That's tied mostly to LIBOR. The down 7% to 10% number we provided reflects a tightening of the spread between LIBOR and IOER. We've looked at that and continue to think that that's going to compress a decent amount. LIBOR was around 70 to 72 basis points against an IOER of 10. We think that could continue to narrow a fair amount. If you think about where LIBOR was a couple of weeks ago, it was significantly higher than that; we certainly feel like that has to be part of any projection.

Okay, and deposit levels April versus the period end in the 7% to 10% guidance?

Down. The last page of the press release shows where the balance sheet ended at $160 billion or so. The size of the balance sheet is completely driven by the size of client deposits. There were significant increases throughout the quarter, but we ended not at where it peaked. The balance sheet has had very strong growth, driven by client activity, as clients derisked and came out of larger equity positions or other fixed income positions. They wanted balance sheets that they were comfortable with, and they were comfortable with ours, and we wanted to be there for them.

Hi, thanks, good morning. On the balance sheet, Jason, can you talk through where the floating six mixes of the balance sheet right now, what the duration of the portfolio is, and just how do you decide, based on your prior response about the ins and outs of deposits, where you're going with reinvestment yield so much lower in terms of the asset side of the earning assets distribution?

Yeah, we are reinvesting, sure, is the quick answer to your question. We don't feel that the potential need from clients to have very spiky aggressive needs and desires to be on the balance sheet is necessarily over. We want to ensure we've got plenty of dry powder and capacity for them on both the loans and deposits side. Our duration is, I think, as of the beginning of last year of 2019, probably around 1.1. We had stepped that out and gotten all the way out to about 2. Recently, as we reinvest in maturing securities, that'll come in a little bit as we position the portfolio to maintain maximum capacity. But that's not reflective of a long-term strategy; it's reflective of our desire to be there for clients in the short run.

And the fixed floating mix you have that available?

The split between the shorter securities book and the longer has been running closer to 50/50 historically. Recently, the longer book was a little larger. As Jason said, as we reinvest, depending on where those reinvestments go, that can shift a little bit. We try to stay matched on the reinvestment side. As we continue to go shorter in the near term, that's going to lean a little bit more short.

Hi, just my question was answered, but just one follow-up. You said 90% of people were working from home; can you elaborate more on what sort of more permanent business model change that might lead to?

In the way we've thought about the operating model over time, it's never been one that we thought in a stabilized way that we would be at 90% working outside of facilities. What we've learned through this crisis is that we can meet client needs and operate the business, execute the business even at that high level of remote working. Having said that, this is not the level we want to sustain. We'll have to be careful as we have people return to the office. That will happen in a phased approach. There are efficiencies in having everybody come in and out of the facilities around the globe. There is certain work that's easier for partners to do remotely. Longer term, we think that there are opportunities for greater efficiency and additional satisfaction on their overall work-life.

Hi, good morning. So noted earlier in a question relating to credit that you have lower exposure to the higher risk industry categories. Given some of the stress in energy markets, I was hoping you could speak to any direct exposure to the energy sector, maybe what specific energy categories in particular, such as EMP, Midstream, etc.

So at a high level, the exposure to energy is very, very low. A lot of our clients have garnered their wealth from the industry, but our lending exposure specifically to oil and gas is very, very low.

So we have just a couple of quick modeling items you should consider. The other income line had a lot of noise this quarter. As we think about the right jumping-off point for Q2, BOLI tailwinds, the appropriate run rate beginning in the second quarter?

It is a hard one because there is a lot that moves around within that category. If you looked at it over a longer period, you could use that potentially as kind of an average run rate.

So let me give you a little bit more detail on how I think about the subcategories in there. In outside services and other fees, some are going to be mixed; some will be able to moderate lower and some are going to have more activity as we've invested to maintain operational resiliency. That's all part of our conversations from prior planning.

Hello. I wanted to start on your thoughts regarding the organic fee growth in the current environment. In the past, you've mentioned low to mid-single-digit growth across institutional and wealth businesses, can you give us some insight into how the current sales cycle being extended could impact your fee growth outlook on an organic basis?