Solid Start to 2014 for World's Largest Asset Manager

Despite the volatility in emerging and developing markets during the first quarter, which had a negative impact on flows for one of  BlackRock's (BLK) largest exchange-traded funds--iShares MSCI Emerging Markets (EEM)--the company closed out the period with a record $4.4 trillion in total assets under management, right in line with our projections. While total equity inflows of $3.8 billion were below our forecast of $13.9 billion, BlackRock more than made up for it with stronger inflows into fixed-income products, especially institutional index funds and ETFs (with iShares' $6.6 billion in net inflows representing the lion's share of total fixed-income ETF flows during the first quarter). Management continues to view fixed income as a growth area, especially in its ETF business, and we agree, having forecast stronger flows for BlackRock's fixed-income operations over the near  to medium term than we're willing to afford other fixed-income-heavy firms like Franklin Resources (BEN), Legg Mason , and AllianceBernstein (AB).

With total AUM increasing 12% year over year and average AUM up 12% as well, BlackRock was able to post a 9% increase in revenue compared with the first quarter of 2013. An ongoing mix shift in the firm's portfolio toward lower-fee-generating products, along with the ongoing trend of declining fee rates for the industry overall, diminished the impact that BlackRock's AUM growth had on revenue. With top-line results during the first quarter slightly lower than our forecast, we've adjusted our full-year projections for revenue growth from 10% to a high-single-digit rate. BlackRock is, however, seeing much stronger operating leverage from its business than we were projecting, with operating margins exceeding 39% during the first quarter. This leaves the firm on pace to close out the year with margins about 50 basis points higher than our forecast. With full-year cash flows likely to end up about where we expected them to be, we see no reason to alter our $340 fair value estimate.

ETFs Are Driving Organic Growth
We continue to be impressed by BlackRock's ability to generate solid organic growth, especially considering the size of its operations, which at $4.4 trillion in managed assets makes it the largest asset manager in the world. Unlike many of its peers, BlackRock has been generating inflows with its fixed-income operations, as many of its clients (which have to remain invested in fixed income) look for more unconstrained bond solutions in the face of rising interest rates. We expect this to continue in 2014 as retail and institutional investors reassess the duration and maturity risk in their bond portfolios. The firm has also gained from its ownership of iShares, the leading provider of ETFs both domestically and globally, which itself has benefited from the trend toward passively managed equities in place over the past two decades. ETFs continue to be the biggest driver of organic growth for BlackRock, which generated $65.9 billion in inflows with iShares in 2013 (equity ETF inflows accounted for $72.8 billion of the firm's total flows).

Improved performance in BlackRock's actively managed equity and fixed-income platforms has put these offerings in a better position to generate positive flows, but the results remain inconsistent. The performance of firm's actively managed fixed-income funds over the past one-, three- and five-year periods places them in the top quartile relative to peers, which should allow them to produce solid organic growth going forward, even with the pressures created by rising interest rates. With just half of BlackRock's actively managed equity funds beating their peers on a one-, three- and five-year basis, the hurdle is a little higher. However, we think that as performance improves, the firm should be able to generate a more consistent level of flows from these operations, perhaps even picking up business from investors moving to active funds from passively managed products.

Size, Brand Strength, and Asset Diversity Result in a Wide Moat
The publicly traded asset managers tend to have economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage. Although the switching costs might not be explicitly large, the benefits of switching from one asset manager to another are at times so uncertain that many investors take the path of least resistance and stay where they are. As a result, money that flows into asset management firms tends to stay there--borne out by an average annual redemption rate for long-term mutual funds of around 30% during the past 5-, 10-, 15-, 20-, and 25-year time frames. We believe asset managers can improve on the switching cost advantage inherent in the business with structural attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong brands and entrenched sales relationships), which provide them with a level of differentiation.

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Although the barriers to entry are not significant for the industry, it takes time and skill to gather the level of assets necessary to build scale. This provides large, established asset managers with an advantage over smaller players, especially when it comes to gaining cost-effective access to distribution platforms. Asset stickiness (the degree to which assets remain with a manager over time) tends to be a bigger distinguisher between wide- and narrow-moat firms, in our view. Companies that have shown an ability to gather and retain investor assets during different market cycles have tended to produce more stable levels of profitability, with returns exceeding their cost of capital for longer periods. While more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been firms with both solid product sets across asset classes and singular corporate cultures dedicated to a common purpose that have tended to thrive. Asset managers offering niche products with significantly higher switching costs--such as retirement accounts, funds with lockup periods, and tax-managed strategies--have also been able to hold on to assets longer.

BlackRock, in our view, has a wide economic moat around its operations. The size and scale of its operations, the strength of its brands, and the diversity of its AUM by asset class, distribution channel, and geographic reach provide it with a leg up over competitors. BlackRock is the largest asset manager in the world, with $4.4 trillion in total AUM, and a product mix that is fairly diverse, with 54% of managed assets in equity strategies, 29% in fixed income, 8% in multi-asset classes, and 6% in money market funds at the end of 2013. Passive strategies continue to account for 60% of BlackRock's long-term AUM, with the company's iShares ETF platform maintaining a leading share of the market on both a domestic (39%) and global basis (39%). Product distribution is weighted more heavily toward institutional clients--accounting for more than 80% of total AUM, by our calculations--which tend to be much stickier than retail investors. The company remains geographically diverse as well, with clients in more than 100 countries and close to 40% of its total AUM coming from investors domiciled outside the United States and Canada.

Another key differentiator for BlackRock has been its commitment to risk management, product innovation, and advice-driven solutions. Having been principally focused on institutional investors for much of its existence, BlackRock has had to be concerned about not only investment performance, but also the risks taken to generate those results, as most of its institutional clients come to the table with required levels of performance and volatility in their investment mandates. As a result, the company has developed tools to assess both security- and portfolio-level risks, which it not only uses internally but offers to external clients for a fee. This has enhanced the firm's ability not roll out new products as well as combine existing products to create outcome-based investment offerings.

We believe that asset managers with a single corporate culture dedicated to a common purpose--which is ultimately reflected in the level and consistency of investment performance, the rate of organic growth, the focus and importance placed on risk management, and the amount of employee turnover--tend to do a much better job of holding on to assets in the long run. Thus, we also highlight the success that BlackRock has had with its insistence on one common culture, focused on one shared vision and operating on one platform, even as it has made several transformational deals over the past decade. We think BlackRock's ability to generate more stable cash flows than most of the other publicly traded asset managers has allowed it to continuously reinvest capital in its business (especially in regards to technology and new products), making it that much harder for smaller and weaker competitors to compensate.

Market Movements Still a Risk
BlackRock has staked its future on its ability to manage and market both passive and active investment strategies. With more than 80% of annual revenue derived from management fees levied on AUM, dramatic market movements or changes in fund flows can have a significant impact on operating income and cash flows. Shifts from active to passive strategies can also have an impact, with management fees much lower for index and ETFs. Shifts among asset classes can be problematic as well, with fees for actively managed fixed-income and money market funds lower than those for equity and balanced strategies.