Invesco's Growth Headed the Right Way

There was little in narrow-moat

With average long-term AUM up 9.6% year over year and the company’s realization rate increasing to 0.472% from 0.468% in the prior-year period due to a mix shift into higher-fee-generating assets, the company reported a 16.0% increase in fourth-quarter management fee revenue and a 15.1% jump in total revenue, aided largely by an uptick in performance fees. Full-year top-line growth of 9.0% was right in line with our forecast for high-single- to double-digit revenue growth during 2017. The adjusted full-year operating margin of 25.8% was 55 basis points higher than the year-ago level and in line with our expected range of 25%-27% for 2017.

With respect to the cut in the U.S. corporate tax rate and the transition to a territorial tax system with repatriation provisions, Bermuda-based Invesco will see less of a benefit than some of its peers, but it still expects to see its effective tax rate drop from around 28% on average the past five years to 20%-21% going forward.

Invesco Keeps Overcoming Obstacles Invesco continues to impress us with its ability to overcome the hurdles in its way. During 2013 and 2014, the company was affected by two major events--the sale of Atlantic Trust and the departure of fund manager Neil Woodford from Invesco Perpetual--each of which led to the loss of more than $20 billion in assets under management. Yet its managed assets still increased from $667.4 billion at the end of 2012 to $775.6 billion at the end of 2015, with organic growth averaging 1.9% during those three years. During 2016, the company's shares were pummeled by the Brexit vote, but there ended up being relatively little impact on assets under management, which rose 4.8% that year to $812.9 billion. More important, AUM sourced from the United Kingdom closed the year at $98.2 billion, down just 5.8% from the end of 2015.

The road ahead may prove to be difficult, however, as Invesco faces the effects of the Department of Labor’s fiduciary rule, which (whether it is eventually repealed or watered down) has already influenced the decision-making of broker/dealer and advisory platforms, which are now more focused on fees and performance, leading them to be more selective about the investment products they choose to put on their platforms. We expect this to pressure asset manager revenue and margins in the near to medium term, as companies like Invesco have to cut fees to make their retail fund offerings more competitive (especially relative to low-cost exchange-traded funds) while spending more to improve investment performance and enhance distribution.

The best way for the asset managers to combat some of this pressure is to tap into areas of the market that have potential for AUM growth, which Invesco has done with its recent purchases of the ETF operations at Source and Guggenheim. With the Source acquisition, Invesco picked up a European specialist ETF provider with $26.0 billion in managed assets, expanding its reach outside the United States. The deal for Guggenheim, which had $37.3 billion in AUM at the end of September, brings aboard a specialist in strategic beta products, further diversifying Invesco away from plain-vanilla index-based ETFs.

Size and Scale Dig Narrow Moat The publicly traded traditional asset managers we cover tend to have economic moats, with switching costs and intangible assets their most durable sources of competitive advantage. Although the switching costs might not be explicitly large, inertia and uncertainty of achieving better results by moving from one asset manager to another tend to keep many investors invested with the same funds for extended periods. As a result, money that flows into asset-management companies tends to stay there, borne out in the U.S. by an average annual redemption rate for long-term mutual funds of around 30%. This basically means that the average asset manager in the U.S. will see its assets under management turn over every three to four years.

Asset managers can improve their inherent switching cost advantage by enhancing structural attributes, such as depth and breadth of product mix, distribution channel, and geographic reach. They also can boost intangible assets, such as their strong and respected brands and reputations for successful, sustainable performance records, which can provide them with a degree of differentiation from their peers. While the barriers to entry are not significant for the industry, the barriers to success are extremely high as it takes time and skill to accumulate a long enough investment performance record to start gathering assets and build the scale necessary to be competitive. This has generally provided the larger, more established asset managers with an advantage over smaller players, especially when it comes to gaining cost-effective access to distribution platforms.

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 the more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been companies with solid product sets across asset classes built on repeatable investment processes, reasonable fees, and singular corporate cultures dedicated to a common purpose that have generally done a better job of gathering and retaining assets. Companies offering niche products with significantly higher switching costs--such as retirement accounts, funds with lockup periods, and tax-managed strategies--have tended to hold on to assets longer.

Invesco, in our view, has a narrow economic moat. With $937.6 billion in total AUM at the end of December 2017, the company has the size and scale necessary to be competitive in the asset-management industry. The company provides investment management services to retail (68% of managed assets) and institutional (32%) clients under the Invesco, Trimark, Perpetual, PowerShares, and W.L. Ross banners. The company’s assets under management are broadly diversified across its equity (46% of managed assets), balanced (6%), fixed-income (24%), alternative investment (15%), and money market (9%) offerings. While passive investments account for just over one fifth of Invesco’s total AUM, they represent 30% of the company’s equity portfolio. Invesco also has a meaningful presence outside the U.S., with more than one third of its total AUM sourced from Canada (3%), the U.K. (12%), continental Europe (13%), and Asia (9%).

Invesco’s U.S. retail business (which includes its PowerShares ETF operations) is one of the 10 largest nonproprietary fund complexes in the U.S. In Canada, the company is a top 10 competitor for long-term assets with its Invesco, Trimark, and PowerShares fund offerings, and its Perpetual division is one of the largest retail fund providers in the U.K. Invesco also has a solid presence in Asia, with $85.0 billion in total AUM and operations in 12 countries in the region (including one of the first joint ventures in Greater China). While PowerShares is a smaller player in the ETF market, accounting for just 4% of the domestic market (and 3% of the global market), it is 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 Invesco’s passive flows. The Source and Guggenheim deals should lift the company’s total market share to 5% in the U.S. and 4% globally.

If there has been a single issue that has kept Invesco from carving out more than just a narrow moat around its operations, it has been the lack of consistency in profitability. Much this was due to the decentralized nature of the company’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 company squarely focused on developing a singular culture, putting a greater focus on improving the competitive positioning of its funds, and increasing overall profitability.

Market Movements Can Have Meaningful Effect With 80% of Invesco's annual revenue coming from management fees earned on its assets under management, 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 do expose the company to myriad cultural, economic, political, and currency risks.

Of some concern is the amount of manager turnover at Invesco. Manager retention has been relatively low compared with similar-size peers during the past decade, a byproduct of the fund mergers following the Van Kampen deal as well as some of the ongoing changes in the organization that led to changes in existing management teams. High-profile departures such as that of Woodford, who oversaw $48 billion for Invesco Perpetual in the U.K. and left the company in April 2014 to run his own shop, are disruptive, as they not only lead to outflows from investors that were wed to the manager, but they can lead to future performance and flow issues once that manager is gone.

Invesco faces longer-dated maturities with its debt, so we expect it to dedicate most of its excess cash to seed investments, acquisitions, dividend increases, and share repurchases. While the company continues to eye acquisitions that would plug holes in its product mix and geographic reach, we don’t envision it being in the market in a large way in the near term.

Invesco raised its quarterly dividend 4% to $0.29 per share in April 2017, and we’re likely to see similar increases in subsequent years. With asset managers like Invesco needing to spend more to remain competitive, and the prospect of a prolonged Brexit, we believe this is the more prudent move. That said, we do expect the company’s payout ratio to remain close to 40% over the next five years.