Was BlackRock's Merger With BGI Worth It?

While concerns have been raised over the past year about increased price competition in the market for exchange-traded funds, the 2009 merger with Barclays Global Investors transformed  BlackRock (BLK), making the firm agnostic to shifts among asset classes and investment strategies and improving its assets under management, revenue, and profitability over the long run. The BGI deal was instrumental in making BlackRock the world's premier asset management company. Although admittedly late to combat the growth of Vanguard's ETF operations, BlackRock's move to cut pricing on some of its core funds should limit share losses and maintain the iShares brand. We still see growth in the retail channel as a big priority for the firm and expect iShares to be the spearhead for its now-integrated U.S. retail salesforce. Currently trading near our $290 fair value estimate and at a slight premium to our asset manager coverage overall, BlackRock's shares are slightly less attractive than in past periods, but they still represent a solid holding for long-term investors.

BlackRock Has the Widest Moat in Our Asset Manager Coverage
Asset managers tend to have economic moats, with switching costs and intangible assets being the most durable sources of their competitive advantage. And we believe BlackRock has the widest moat in this industry. With close to $4 trillion in total assets under management at the end of the first quarter, the company is the world's largest asset manager. BlackRock's product mix remains fairly diverse, with 51% of managed assets in equity strategies, 32% in fixed-income products, 7% in multi-asset class strategies, and 7% in money market funds (with the rest of its AUM invested in alternative investments and long-term portfolio liquidation strategies). Passive strategies make up more than half of BlackRock's managed assets, with index funds and ETFs dedicated to equities accounting for 43% of total AUM, fixed-income index funds and ETFs making up 15%, and a very small percentage coming from alternatives. BlackRock's product distribution continues to be weighted more heavily toward institutional clients, which we calculate account for more than 80% of the firm's total AUM. These assets tend to be far stickier than those garnered from retail investors, but can also be lumpier, as institutional investors tend to allocate large amounts of capital to their investment mandates. The company is also geographically diverse, with clients in more than 100 countries and close to 40% of its total AUM coming from investors outside the United States and Canada.

Before the BGI merger, BlackRock was already a formidable force, with more than $1.4 trillion in managed assets. The BGI merger, which brought with it the iShares ETF business, more than doubled BlackRock's asset base and turned it into the largest asset manager in the world. It would be easy to classify the BGI acquisition as a big-getting-bigger deal, but we continue to view it as a strong-getting-stronger transaction--one that turned BlackRock into a major force in both active and passive investing and cemented many of the attributes that had already endowed it with one of the widest moats in asset management.

A key differentiator for BlackRock has been its commitment to risk management, which has been an integral part of the firm's methodology since its founding more than two decades ago. Having been principally focused on institutional investors for much of its existence, BlackRock has had to be concerned not only with investment performance, but with the risks taken to generate those results, as most of its institutional clients have required levels of performance and volatility in their investment mandates. Since its inception, BlackRock has been focused on the assessment of security- and portfolio-level risks, developing tools that would allow its managers to make investment decisions in rapidly changing markets and execute transactions efficiently, while ensuring strict adherence to risk management and compliance guidelines. Much of this involved investing heavily in technology and analytical processes that would allow BlackRock to not only monitor millions of trades daily, but provide it with the ability to drill down into the holdings of each of its clients' portfolios and determine the impact of potential changes in interest rates, currencies, financial markets, and other influential events.

We believe BlackRock's insistence on one common culture, focused on one common vision, operating on one common platform has provided it with another leg up over its peers. This has been a steeper road for BlackRock to travel, given that it has done two major deals--the 2006 merger with Merrill Lynch Investment Managers and the 2009 merger with BGI--during the past decade. Mergers and acquisitions in asset management have rarely gone well, primarily because their success depends on managers (who often come from distinctly different corporate cultures) sticking around once a deal is completed. The fact that BlackRock has done two big deals and yet continues to have one of the lowest turnover rates in the industry--about 4% versus the industry norm of 10%-12%--is a testament to its culture, which actively encourages employees to spend their entire careers at the firm.

Acquisitions Have Transformed BlackRock Over the Past Decade
In an industry where mergers and acquisitions have not always worked out well, BlackRock has done an extraordinary job of building out not only its product platform but its reach--by product channel and geography--through well-executed deals. Before 2006, BlackRock was one of the premier names in institutional fixed-income investing. While the company made efforts to expand its equity operations over the years, about two thirds of its managed assets were still tied up in fixed-income products. That changed in early 2006, when BlackRock agreed to merge its business with MLIM. This more than doubled the company's total AUM and greatly expanded its exposure to equity strategies, leaving managed assets split more evenly across equity, fixed-income, and cash management strategies when the deal closed. At more than $1 trillion in combined AUM, BlackRock became not only the largest publicly traded asset manager in the U.S. but also the world's largest active manager of fixed-income products and the world's 13th-largest equity manager. The deal also turned BlackRock into a more powerful global organization, with the combined firms serving clients in more than 50 countries and sourcing more than one third of total AUM from international investors.

The MLIM merger worked out well for BlackRock, in our view, because it not only added to the company's existing product lineup, but expanded its footprint into other channels and markets, which ultimately eliminated the need to find major cost savings through layoffs or product eliminations. We also believe that the firm's more diversified product portfolio, along with its scale and untarnished reputation (especially with regards to risk management), played a big part in its ability to retain assets during the financial crisis and attract investor inflows in the immediate aftermath of the meltdown. This allowed BlackRock to hold up much better than almost all of its peers and left it extremely well positioned for the risk-aversion cycle that emerged in the years following the financial crisis. It also put the firm in the best possible position to undertake its next big deal.

BGI Deal Was a Strong-Getting-Stronger Transaction
BlackRock's second major transaction was its 2009 acquisition of BGI from Barclays, which was the company's biggest transaction and its most transformational. Like the MLIM merger, the BGI transaction more than doubled BlackRock's AUM while doing little to alter the company's successful business model. At more than $3.3 trillion at the end of the fourth quarter of 2009, BlackRock became the largest asset manager in the world, with total AUM at the time on par with the managed assets of its two largest competitors combined. The deal also left it sourcing more than 70% of its managed assets from institutional clients, even as the firm was increasing its exposure to equities and passively managed products, and further expanded BlackRock's global reach, with the combined firms serving clients in more than 60 countries and sourcing more than one third of total AUM from international investors.

For BlackRock, the biggest change following the merger with BGI was its transformation from primarily an active manager of assets to one whose passive strategies accounted for more than half of its total AUM. This move effectively made BlackRock agnostic to shifts among asset classes and investment strategies, limiting the impact that market swings could have on its AUM and providing an additional option for investors looking for passive investment products. BGI was of particular interest to BlackRock not only because of its history as an innovator, having launched the first index fund and target-date portfolios, but because of iShares' industry-leading market share, which at the end of 2009 accounted for 47% of the domestic market for ETFs (with 43% market share worldwide).

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The biggest question mark surrounding the purchase of BGI was BlackRock's ability to effectively meld what was primarily a passive management group at BGI with its own operations, which were focused on active management. There were few synergies between the two firms; their manufacturing processes were completely different, and the sales and distribution approaches they followed were based on the product mix and investment styles that dominated their operations. Even so, CEO Larry Fink was convinced that the two firms' close cultural similarities would allow them to merge with few issues.

It didn't hurt that the two firms were fairly familiar with each other before the deal was announced. As far back as 2002-03, BlackRock had held talks with Barclays about some sort of combination between the two organizations, but both companies concluded that the time was not right. Around the same time, BGI hired BlackRock as a provider of risk analytics, eventually becoming one of the largest and most important users of the firm's Aladdin enterprise investment system. Thus, BlackRock entered the deal with a much deeper understanding of BGI's culture and processes than most other acquirers would have had, eliminating some (but not all) of the risks that come with any integration. About the only area where we think BlackRock faltered was in setting expectations for merger-related outflows.

The company took a slight hit to its credibility when merger-related outflows became a major stumbling block in 2010. All told, BlackRock lost about $150 billion (or just under 5% of its total AUM at the time the deal closed) to merger-related outflows during 2010-11. While not much in the whole scheme of things, this was a bit of a disappointment given the rosier outlook that management had offered before the start of the integration. It also highlighted just how hard it could be for BlackRock to grow off an asset base that was already as big as that of its new two largest competitors combined. Having believed that BlackRock would see some decent cross-selling opportunities as a result of the BGI deal, we were disappointed to see some of those sales cannibalizing other products, leaving the firm with relatively meager organic growth over the past three years (results were somewhat better after excluding the impact of the merger-related outflows). The firm's iShares division has generated the lion's share of its flows over the past three years, with total inflows last year approaching $82 billion worldwide, and we don't expect that to change much in the near term.

Growth of ETFs Adds to Increased Focus on Passive Investing Industrywide
While the growth of ETFs has been astounding--with total AUM for the category increasing at a 29.5% compound annual rate during the 10-year period ending in 2012--it has only accelerated the trend toward passive investing that started more than 20 years ago. According to data provided by Morningstar Direct, the U.S. market for ETFs remains the largest in the world, accounting for $1.4 trillion (or 70%) of the $1.9 trillion that is dedicated to ETFs globally. Some of this is due to the fact that many non-U.S. investors remain invested in U.S.-based ETFs because of the depth of the markets and liquidity of the products that exist in the U.S. versus those in their own home markets.

Barriers to entry for the ETF industry are not significant, but with five firms controlling 90% of the U.S. market, it has been extremely difficult for smaller competitors to make any real headway. While we believe niche players offering truly unique offerings will be able to pick up some assets longer term, we think the current makeup of the domestic ETF market, which has been shaped as much by the more recent bout of price competition in the industry as it has been by the ever-increasing size and scale of the largest players in the segment, will continue to limit the amount of share smaller competitors can capture longer term.

For a business that is highly dependent on scale, with industry dynamics that look certain to lock out many of BlackRock's more traditional competitors, and a trend for passive investing that started to take root more than two decades ago, one can see why the firm was interested in BGI in the first place.

Appealing to Both Retail and Institutional Investors, ETFs Still Have Room to Grow
There is no clear data on who actually uses ETFs more, given the level of anonymity that exists on the trading exchanges, but we estimate that institutional investors probably make up a slightly larger piece of the overall pie than retail investors. Although the rule of thumb for many years has been that the market is split 50/50, some of the more recent research suggests that the split is closer to 55/45, with institutional investors holding a slight edge. With BlackRock using iShares to spearhead a bigger push into the retail channel, we could see things moving back toward equilibrium in relatively short order. However, this is based more on domestic markets than on those overseas, which are still in the early stages of development, with different concentrations of usage evident in these markets. We expect this to change over time as ETFs gain even more scale overseas and acceptance increases among retail and institutional investors in markets outside the U.S.

While there is potential for greater ETF growth overseas, it does not mean that all of the focus will be on those markets, as there are still plenty of opportunities for growth in the U.S. More than a few segments of the domestic market have yet to be fully penetrated by ETFs, including defined contribution plans, variable annuities, retail wraps, separately managed accounts, and the investment portfolios of insurance companies. The larger prize is the expected flow of capital that will arise as millions of baby boomers transition out of the workforce, rolling the contents of their defined contribution plans into individual retirement accounts. Current estimates put new IRA rollover contributions at more than $2 trillion over the next five years, a nearly 50% increase over the amount of assets that flowed into IRAs over the previous five years, making it one of the largest opportunities left for domestic asset managers and a potential bonanza for ETF providers.  

Although we don't expect the U.S. ETF market to continue growing as rapidly as it has over the past decade, we believe it has the potential for about a 15% compound annual growth rate (including both organic growth and market appreciation) over the next five years, slightly below the 16.7% CAGR that we've seen over the past five years. At that rate, we should have more than $2.7 trillion invested in domestic ETFs at the end of 2017 (relative to the $1.3 trillion that was invested in these funds at the end of last year). We expect global growth to be a bit stronger, as greater adoption of ETFs in markets like Canada and Europe leads to much higher levels of growth in the near term, with the non-U.S. ETF market growing at about a 20% CAGR (including both organic growth and market appreciation) over the next five years, slightly below the 17.7% CAGR that we've seen over the past five years. At that rate, close to $1.5 trillion should be invested in non-U.S.-based ETFs by the end of 2017, putting these markets on more equal footing with the current domestic market for ETFs.

Were BlackRock to end up with 33% market share worldwide at the end of our five-year forecast, which is likely given that the firm has lost a little over 1 percentage point of market share annually during each of the past five years, it would have around $1.4 trillion in total AUM dedicated to ETFs at the end of 2017, which is where we currently have the firm positioned in our valuation model.

Scale Disparity and Price Competition Raise Barriers to Success in ETF Market
For much of the past two decades, the domestic ETF market has not seen a great deal of negative competition, with the largest players in the industry remaining fairly rational, despite the exponential growth of providers and funds looking to tap into the growth being offered by the market. This is partly because the largest providers have continued to hold the lion's share of the market even as more and more competitors entered the fray. With some of these same players starting to compete more heavily on price in the past couple of years, the competitive dynamics of the industry have shifted to the point where price has begun to dictate growth and gains in market share. The best example of this is Vanguard, which went from 1% of the domestic ETF market at the end of 2002 to 18% at the end of last year, using a low-cost proposition to attract investors.

For BlackRock, drastically reducing prices on ETFs to match competitors would undermine the iShares brand and lessen the profitability of its offerings, while doing nothing would invite even more dramatic losses in market share. At first, BlackRock dismissed calls to lower its pricing (which in some cases was as much as 50 basis points higher than competing products) by insisting that its clients were more focused on secondary market liquidity and tracking error than pricing, and that ceding market share to Vanguard was not only inevitable but consistent with a profit-maximizing strategy. Eventually, though, market share was being lost far too rapidly, forcing the firm to act.

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In October 2012, BlackRock announced it was cutting fees on six of its larger, more liquid core asset class ETFs, where it was being hit the hardest. In addition, it would offer four new long-term ETFs with lower fees. This group of 10 ETFs, referred to as the iShares Core Series, would be aimed at long-term buy-and-hold investors who want low-cost, broad index-based ETFs. The new expense ratios for these funds were usually within a few basis points of ETFs being offered by Vanguard. So far, BlackRock's decision to cut fees and move forward with its iShares Core Series has shown some success. During the fourth quarter of last year, the 10 funds generated about $4.6 billion in net new business, representing more than 17% of iShares' total U.S. flows during the period. They also accounted for 19% of the more than $17.5 billion that flowed into iShares' domestic operations during the first quarter of 2013.

That said, we have to wonder how much of the improvement in flows was tied to BlackRock's actions to reduce fees on these core offerings, as opposed to the firm benefiting from Vanguard's decision to switch 22 of its biggest index funds (and their corresponding ETFs) away from benchmarks provided by MSCI, as part of an ongoing effort to reduce costs for investors. At the time, we thought institutional investors that were wed to the MSCI benchmarks in their international investing mandates would probably switch to iShares from Vanguard rather than go through the effort of adjusting their mandates. It looks as if BlackRock saw some benefit at first, with the iShares MSCI Emerging Markets ETF seeing some of its best quarterly flows ever in the fourth quarter of 2012, while Vanguard experienced its first ever quarter of outflows for its emerging-markets ETF. Although that trend continued in the first part of this year, both funds have been in net redemption mode the past couple of months.

Another key development at the time that BlackRock announced the launch of its iShares Core ETF Series was the decision to integrate the iShares and BlackRock U.S. retail sales teams, creating the largest retail field force in the domestic asset management industry, capable of offering financial advisors and distribution partners a fully integrated combination of index and active products. While there are obvious cost savings from integrating these two sales teams, the bigger benefit is that they'll be speaking with one voice about BlackRock's broader platform of solutions-based products. This is important in an environment where both retail and institutional investors are looking for solutions, as opposed to individual products, to meet their long-term investment needs.

IShares Still the Spearhead for BlackRock's Growth in the Retail Channel
For much of the past three years, BlackRock has been committed to expanding its presence in the retail channel. The results have not matched the amount of effort the firm has expended. At the end of 2009, BlackRock derived 12% of its total AUM from retail and high-net-worth investors. At the end of last year, the firm still sourced 12% of its total AUM from those clients. While we believe BlackRock may have lost some traction by not addressing the price discrepancy that existed in the ETF market, we think its move to realign its pricing with the launch of the Core ETF Series should allow it to more effectively use iShares as a spearhead for its retail efforts. Combine this with an integrated retail salesforce and BlackRock should actually start seeing more tangible results. With the firm generating an average realization rate last year of 0.68% on its retail AUM (which is derived primarily from actively managed funds), compared with 0.37% for its iShares offerings (which encompasses both retail and institutional investors) and 0.12% for its institutional AUM (which comprises mostly of index-based funds), any growth in the retail channel is a net positive for revenue and profitability in the long run.

As such, we're encouraged by the recent announcement that Fidelity Investments is expanding its three-year-old partnership with BlackRock's iShares unit. The new deal more than doubles the number of iShares ETFs that can be traded commission-free by Fidelity clients and has BlackRock partnering with Fidelity to create new ETF portfolio strategies using iShares for Fidelity's managed account offerings. We expect BlackRock to benefit from the increased penetration of iShares offerings on Fidelity's distribution platform as well as the incorporation of iShares ETFs into Fidelity's managed account offerings and sector strategies. Growth should come not only from Fidelity's existing clients, which tend to be more focused on actively managed funds, but also from new clients interested in the option to invest more passively. It also gets BlackRock preferred placement on one of the top six retail platforms.

We see the iShares deal as a sign that Fidelity has thrown in the towel on passively managed ETFs, preferring to partner with the largest provider of beta products (with top brand-name recognition) for its needs and focusing any efforts in the category on actively managed ETFs. We think this is good news for BlackRock and the other top players and expect to see them further cement their positioning in the retail channel with deals like this. We also believe that BlackRock's deal with Fidelity not only highlights the importance of scale in the industry, but is a clear sign that we're starting to see some maturation in the business. The leaders in this part of the market are extremely well positioned, with established brands, product liquidity, distribution reach, and scale. We expect them to use their scale and distribution advantages to gain control of the market for more complicated ETF products, which are able to command higher prices in exchange for increased sophistication. This is likely to lead to bouts of consolidation in the U.S. industry, as smaller players realize that they cannot successfully challenge the incumbents and either sell out to the larger firms or exit the market.

IShares Having a Big Impact on BlackRock's AUM, Revenue, and Profitability
Before the close of the BGI deal, BlackRock was generating fairly decent organic growth (of about 2% per quarter on average during the final three quarters of 2009), with much of the flow activity coming from its equity and balanced fund offerings. This has not been the case since the start of 2010, as iShares has generated close to $180 billion in net new business (equivalent to an 11% CAGR from the end of 2009 to the end of 2012), while the firm's active and institutional index businesses have gone into net redemption mode. Some of the outflows can be attributed to the merger, with investors pulling about $150 billion out of BlackRock over concerns about concentration risk, but the firm has also struggled with performance issues in its actively managed funds. As a result, annual organic growth has been relatively flat in the past three years.

That said, we think the firm can still produce organic growth (on average) of around 2% per year during the next five years. We expect more of this growth to come at the front end of our five-year forecast rather than in the final years, with the iShares business generating most of the organic growth. With the company picking up more than $25 billion from its iShares operations (and another $15 billion with its institutional index funds) during the first quarter of 2013, BlackRock is already well on its way toward generating organic growth in excess of 3% this year. We think the expanded manufacturing and distribution relationship with Fidelity, which will start to hit flows in the back half of 2013, will only add to the higher growth rate that BlackRock is generating with iShares.

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We'd prefer to see better investment results out of BlackRock's fundamental equity and fixed-income operations before getting too constructive on the growth that these businesses can generate longer-term. The firm has had some of the lowest fundamental AUM growth, especially on the equity side of the business, in our coverage universe. This further highlights the importance of the BGI deal, which has been the largest driver of the growth in BlackRock's AUM since the end of 2009. Absent this deal, the company would probably be in much worse shape. Exactly how bad is hard to judge, given that BlackRock would not have lost $150 billion in AUM to merger-related outflows and probably would have been on top of its fundamental performance issues much sooner (as it would not have had to deal with the integration of BGI during 2010-2011).

At this point, any incremental growth that BlackRock can generate with its actively managed funds and ETF operations (both of which generate higher fees than the institutional index business) will be a net positive for revenue growth. In fact, BlackRock is one of only a few companies in our coverage universe where we are projecting a slight improvement in realization rates longer term. We expect its product mix to continue shifting toward higher-fee-generating assets, even as we forecast declining fee rates for just about every one of its business lines due to the impact we expect the growth of ETFs and fee-based accounts, along with the consolidation of the third-party retail distribution channel, will have on fee rates industrywide in the long run.

One of the basic tenets for asset management is that it typically does not take twice as many people to run twice as much money, so operating margins tend to expand as revenue expands. There is, however, some variability in the cost structure of most active managers, with compensation being tied to investment performance or AUM growth, which can limit margin expansion. This effect does not necessarily carry over to the passive side of the business, and because it generally takes fewer people--portfolio managers and research analysts--to run passively managed funds than it does active funds, there should be some difference in the scalability of the two businesses. As it turns out, BGI's operations were much more scalable than we forecast, with BlackRock's operating margins expanding from less than 35% during 2010 to close to 38% last year.

Expecting a Strong 2013 From BlackRock
With global equity markets up solidly through the first four months of 2013 and equity ETFs continuing to see some of their best inflows in years, BlackRock has come out of the gates strong this year. Augment this with iShares' expanded partnership with Fidelity, as well as the company's purchase of Credit Suisse's European ETF operations, and BlackRock's managed assets should expand at a double-digit rate this year (with organic growth exceeding 3%).

While we do expect to see some compression in fee rates for ETFs and actively managed funds (which will be an ongoing issue for BlackRock as well as the other asset managers), the firm should still generate double-digit revenue growth this year and next. Longer term, we see top-line growth moderating between 6% and 7% per year, with the firm's product mix shifting more decisively toward equities, which tend to carry higher fee rates than BlackRock's other asset classes. The net result is an 8% CAGR for revenue from 2012 to 2017.

We expect BlackRock to close out 2013 with operating margins in excess of 38%. While we recognize that asset managers tend to see meaningful improvements in their profit margins as the size and scale of their operations increase, which we believe will be the case for BlackRock longer term, we expect the impact to be damped somewhat as the firm commits greater resources to its sales and distribution efforts, with operating margins hovering around 40% at the end of our initial five-year forecast.

We continue to believe that BlackRock can comfortably produce an average of more than $3 billion in annual free cash flow (equivalent to cash flow from operations less capital expenditures) during the next five years, with a fair amount of that capital being returned to shareholders through share repurchases and dividends.