Stronger Flows and Fewer Hurdles for This Asset Manager

Invesco has reshaped itself into a much tighter organization capable of not only generating profitability and cash flows on par with the higher-quality names we cover, but also overcoming any hurdles that get thrown in its way--like the departure of Neil Woodford from Invesco Perpetual last year. The company has started 2015 on a solid note, reporting January flows that would equate to a 3.5% annual organic growth rate on its long-term assets under management. This supports our belief that it can generate annual organic growth of 3%-4% on a more consistent basis, with market gains fueling the rest of the 6%-7% annual growth we forecast for its managed assets longer term.

Invesco closed out 2014 with $792.4 billion in total AUM, up less than 1% sequentially and 2% year over year. Both average AUM and revenue increased 4% during the fourth quarter, leaving full-year top-line growth at 11%, which was at the lower end of our 2014 10%-15% target for revenue growth. We expect top-line growth to slow some during 2015, but still expect the firm to generate 7% average annual top-line growth over the remainder of our forecast period. Invesco's full-year adjusted operating margins of just over 26% were right in line with our forecast. We expect profitability to continue to improve to levels more on par with peers, with adjusted operating margins exceeding 30% by 2018.

Total net outflows of $600 million for the fourth quarter were much better than the $3.2 billion we forecast. From a mix perspective, we were expecting $6.6 billion in outflows from Invesco's equity operations. The firm posted $5.5 billion in net redemptions during the period, with PowerShares QQQ (which had $3.2 billion in outflows) contributing to most of the decline. The company's balanced segment also generated about $1 billion less in outflows than we forecast, and its fixed-income platform contributed $700 million more than we had projected. Annual organic growth of negative 0.3% was a bit of a letdown compared with the 3.8% that Invesco generated in 2013, but excluding the impact of the outflows from Invesco Perpetual, organic growth was 2.6% during 2014. This was short of our target of 3%-4%, but still a solid result in a year that saw greater amounts of equity market volatility.

Transformation Continues to Impress Us Invesco is reshaping itself into a much tighter organization capable of not only generating profitability and cash flows on par with the higher-quality names in our asset manager coverage, but also overcoming any hurdles that might be thrown in its way. Even though we expect organic growth to be stymied in the near term, we believe Invesco should be able to generate annual organic growth of 3%-4% longer term, with market gains fueling the rest of the 6%-7% annual growth that we forecast for AUM.

We continue to believe that Invesco is one of the few asset managers we cover that has solid enough equity and fixed-income franchises to benefit from changing investor behavior over the long run. With a heavier presence in the retail channel, more equity exposure than fixed income, and better investment performance than many of its peers, the firm should benefit from a continued move toward equities, especially with five-year performance numbers for most active managers improving as their funds roll off poor results from the 2008-09 financial crisis. While PowerShares is a smaller player in the exchange-traded fund market, accounting for just 5% of the domestic market (and 4% of the global market), it is far more focused on niche products, which have so far been less susceptible to the pricing pressure we've seen in the core/index-based ETF market, and has been the driving force behind much of Invesco's passive flows. With most of its operations firing on all cylinders, and the firm continuing to improve its profitability, we believe Invesco is not only a more complete firm but a much stronger competitor.

Asset Managers Benefit From Inertia 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 last 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.

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 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 solid product sets across asset classes as well as 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.

We give Invesco a narrow Morningstar Economic Moat Rating. The company has the size and scale necessary to be competitive. Its AUM is broadly diversified across its equity (49% of managed assets), balanced (6%), fixed-income (23%), alternative investment (12%), and money market (10%) offerings, and it has a meaningful presence outside the United States, with close to one third of its total AUM sourced from Canada (4%), the United Kingdom (13%), continental Europe (9%), and Asia (7%). Invesco provides investment management services to retail (68% of AUM) and institutional (32%) clients under the Invesco, Trimark, Perpetual, PowerShares, and W.L. Ross banners. Its U.S. retail business (which includes PowerShares ETF operations) is one of the 10 largest nonproprietary fund complexes in the U.S. In Canada, the firm is a top 10 competitor for long-term assets with its Invesco, Trimark, and PowerShares fund offerings, and its Perpetual operation is one of the largest retail fund providers in the U.K. Invesco also has a fairly strong presence in Asia, with about $55 billion in total AUM and operations in 12 countries in the region (including one of the first joint ventures in Greater China).

If a single issue has kept Invesco from carving out more than just a narrow moat around its operations, it has been the lack of consistency in the firm's profitability. Much this was due to the decentralized nature of the firm's operations, which prevented Invesco from developing a common, scalable global platform for all of its brands, limiting its ability to gather and retain assets and diminishing many of the scale advantages that come with running an asset management business. We believe much of that has changed since Marty Flanagan took the helm in 2005, with the firm squarely concentrating on developing a singular culture, putting a greater focus on improving the competitive positioning of its funds, and increasing the overall profitability of the firm. We think the 2009 acquisition of Morgan Stanley's retail fund operations, which in many ways complemented Invesco's product lineup, not only improved the firm's competitive positioning, but also put it in a position to increase its profitability to the same levels being generated by many of its peers. At this point, the company has all of the tools that it needs to continue expanding the narrow economic moat that already exists around its operations.

With about 80% of Invesco's annual revenue coming from management fees earned on its AUM, dramatic market movements or significant changes in fund flows can have a meaningful impact on revenue, profitability and cash flows. Shifts away from equity strategies would also have an adverse effect on revenue, as management fees tend to be lower for fixed-income and money market funds than they are for equity-based funds. Invesco tends to earn higher fees on its global/international offerings than it does on its domestic funds, but its operations and investments in these overseas markets expose the firm to myriad cultural, economic, political, and currency risks. The company is also exposed to key person risk with some of its investment management professionals, who are vital to Invesco's ability to attract and retain clients, and the loss of which could lead to a meaningful reduction in the firm's AUM.

Flanagan Has Brought Focus While Invesco has had a long history of squandering its competitive advantages, many improvements have been made since Flanagan took the helm. Aside from cleaning up the clutter that kept the firm from being anywhere near as profitable as its peers, Flanagan has spearheaded acquisitions and divestitures that have put Invesco in the position to continue improving its AUM, revenue, and profitability. He has had the firm squarely focused on developing a singular culture, putting a greater focus on improving the competitive positioning of its funds, and increasing overall profitability.

Part of this process involved rebranding all of the company's offerings under the Invesco banner and changing the firm's name from AMVESCAP to Invesco in 2007. Flanagan also spearheaded the acquisition of PowerShares (a pioneer in the exchange-traded fund market) and W.L. Ross (a private-equity firm) in 2006, as well as the 2009 purchase of Morgan Stanley's retail fund operations, which included the Van Kampen family of funds. The purchase of PowerShares was important because it provided the firm with access to the fast-growing ETF market, just as interest in passive investment vehicles (and ETFs in particular) was about to take off in the aftermath of the 2008-09 financial crisis.

Rather than compete with other larger players offering core/index-based ETF products, Invesco has been far more focused on niche offerings, like its PowerShares S&P 500 Low Volatility and PowerShares S&P 500 High Beta funds. And unlike PowerShares in its early days, Invesco has adopted a more-robust vetting process before product launches by putting new ETF ideas through the same product development process the firm uses for its open-end funds, which has led to a decline in the pace of ETF launches, but has also kept the firm from offering funds that fail to gather assets.

We continue to believe that the company's purchase of Morgan Stanley's retail fund operations was transformational for Invesco, making it not only a more complete firm, but a stronger competitor. Van Kampen's brand recognition and distribution clout made it a prized acquisition. With Invesco strong in the defined-contribution and defined-benefit channels and Van Kampen strong in the broker/dealer channel, the combined firms have been able to cross-sell the best products from each of the fund families through these different distribution networks. On top of that, the deal improved Invesco's lineup of equity value and municipal bond funds, and provided it with more exposure to closed-end funds and unit investment trusts. Invesco did an exemplary job of merging the Van Kampen funds into its lineup. While manager changes and fund mergers can be disruptive, Invesco was swift and efficient, clearly communicating its intentions to both employees and investors. The net result is a product lineup that is better balanced and easier for investors to navigate.

One thing that has raised some concern, though, has been the amount of manager turnover at the firm. Manager retention has been relatively low compared with similar-sized peers over the past five years, a byproduct of the fund mergers following the Van Kampen deal, as well as some of the ongoing changes within the organization that led to changes among existing management teams. The most recent high-profile departure was that of Woodford, who oversaw $48 billion for Invesco Perpetual in the U.K. and left the firm in April 2014 to run his own shop. This kind of departure is disruptive to the firm, as it not only leads to outflows from investors that were wed to the exiting manager, but can lead to future performance and flow issues once the manager is gone.

From a capital-allocation perspective, management has been fairly frugal, sticking to a strategy of reinvesting in the business (including making select acquisitions), while still maintaining financial strength and flexibility, and returning a substantial portion of earnings to shareholders through dividends and common stock repurchases. Although Flanagan continues to talk about acquisitions as a way to plug holes in Invesco's product mix or geographic reach, we expect any future deals to be limited to small, bolt-on acquisitions. We expect debt (which is now more long-dated) to be paid down as it matures, with the firm dedicating cash to share repurchases and dividend increases as it sees opportunities to do so.