A Sigh of Relief for State Street

The firm announced a $279 million charge to cover investor lawsuits, easing worries about the size of its litigation exposure

State Street Corp. (STT) is the latest financial firm to get a lift by quantifying how much it may have to cough up to settle lawsuits from investors angered by losses in what they thought were fairly conservative investment strategies.

On Jan. 3, the Boston-based company said it will take an after-tax charge of $279 million, or 71 cents per share, in the fourth quarter to set aside a reserve to cover legal exposure and other costs associated with the poor performance of certain active fixed-income strategies managed by State Street Global Advisors, its investment unit.

State Street said it expects to earn between $3.42 and $3.45 per share on a GAAP basis for the full year 2007 and estimated its return on equity at roughly 13%.

Excluding the fourth-quarter charge and merger and integration costs tied to its July, 2007, acquisition of Investors Financial, the company projected 2007 operating earnings to be between $4.54 and $4.57 per share, with a return on equity of about 17.5%

On a conference call to discuss the charge early Thursday morning, State Street said it's currently facing five lawsuits, three of which are class actions. The lawsuits include one by a unit of Prudential Financial Inc. (PRU) over $80 million in losses suffered by 165 retirement plans it manages from holdings in State Street fixed-income funds. Prudential has asserted that it wasn't told that its clients' money had been put into highly leveraged investments.

"By taking the charge, they took off the table the uncertainty about the magnitude of what the potential settlements could be," said Thomas McCrohan, an equity analyst at Janney Montgomery Scott in Philadelphia. And the business trends that State Street is benefiting from trump the charge, he added.

Shares of State Street rose 7.9% to trade at $85.10 on Jan. 3. Earlier in the day, the stock hit a new 52-week high of $85.49.

After taking the charge, the company will still be flush in cash and plans to raise non-dilutive capital to address the one capital ratio – the tangible common equity ratio, which has gotten thin at 3.5% -- that has been threatened, said McCrohan, who has a neutral rating on the stock.

Analysts agree that the company's core business is firing on all cylinders, with its foreign exchange unit in particular benefiting from the turmoil in the credit markets. But the recent environment has been a stress test for financial companies' internal risk management controls as their exposure to riskier asset classes has eroded their profits, said Patrick Schumann, an equity analyst at Edward Jones & Co. in Kansas City, Mo.

Much like the major investment banks, State Street isn't immune to the turbulence that's pervaded the markets since the summer, he said. Its exposure to investment vehicles backed by subprime mortgages – estimated at roughly $7 billion, or 20% of the value of its fixed income strategies – has come as a surprise to customers who believed they were investing in fairly conservative asset classes, he said.

"There's competition for yield and return and State Street appears to have stretched to become competitive in its investment management business, and that necessitated going into riskier type investments," Schumann said. "Going forward, there has to be a tighter review process to identify where those exposures were being taken."

While the $7 billion exposure to the subprime market is sizable, it's not a major piece of the firm's overall assets under management, he added.

The ramp-up of the foreign business, together with the volatility of the markets, have helped drive State Street's core business to higher levels of growth than most people had expected, Schumann said.

Based on the firm's revised profit estimate for the fourth quarter, the company's earnings projection for 2008 is 25 cents higher than the average estimate among Wall Street analysts, said McCrohan at Janney Montgomery Scott. Edward Jones is reviewing its estimate for the firm's 2008 earnings and believes other firms will be raising their projections as well, Schumann said.

Schumann has a hold rating on the stock because he believes the stock price already reflects State Street's "fantastic franchise" and positive business momentum.

Credit Suisse raised its estimate for State Street's fourth-quarter operating earnings to $1.40 from $1.00 per share and for 2007 earnings to $4.55 from $4.15 per share, citing strength in foreign exchange trading, securities lending, fee income and net interest income. Analyst Susan Roth Katzke also boosted her 2008 profit outlook to $5.10 from $4.75 per share and raised her price target to $85 from a prior range of $75 to $80. (Credit Suisse does or seeks to do investment banking with the firms it covers in its research reports and it also makes a market in State Street's securities.)

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