T. Rowe Price Is Best Positioned of Its Peers

In an environment where active fund managers are under assault for poor relative performance and high fees, we believe wide-moat-rated

While T. Rowe Price will face headwinds in the near to medium term as baby boomer rollovers affect organic growth in the defined-contribution channel, we think the company and defined-contribution plans in general have a compelling cost and service argument to make to pending retirees, which should mitigate some of the impact. We also believe T. Rowe Price is uniquely positioned among the companies we cover (as well as the broader universe of active asset managers) to pick up business in the retail-advised channel, given the solid long-term performance of its funds and reasonableness of its fees, exemplified by deals this past year with Fidelity Investments’ FundsNetwork and Schwab’s Mutual Fund OneSource platform. With T. Rowe Price likely to generate low- to mid-single-digit AUM growth on average going forward (driven by 1%-3% annual organic growth in a forecast period that includes a 20% decline for equity markets), we see top-line growth expanding in the low- to mid-single-digit range annually, with operating margins of 42%-43% on average.

Consistency Is T. Rowe's Biggest Advantage In our view, the asset-management business is conducive to economic moats, with switching costs and intangible assets the most durable sources of competitive advantage for companies operating in the industry. Although the switching costs might not be explicitly large, inertia and the 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. For the industry as a whole, the average narrow redemption (retention) rate, which does not include exchange redemptions, has been 25% or less (75% or greater) annually during the past 5-, 10-, 15-, 20-, 25-, and 30-year time frames. Including exchange redemptions, the rate has been less than 30% (greater than 70%). Because T. Rowe Price does not break out its net flows (which are gross sales less investor redemptions), we assume that, based on its historical record of positive organic growth, its average annual redemption rate has at its worst been no worse than the industrywide rate, especially given the tailwinds that have been provided at times by defined contribution plans the past couple of decades--noting that redemptions have outpaced inflows into 401(k) plans since the baby boomer retirement phase started in 2011.

During the past 5 (10) calendar years, T. Rowe Price’s organic growth rate has averaged 0.0% (positive 2.6%) with a standard deviation of 1.4% (3.3%), which meant that the company was in most years compensating for investor redemptions with new flows into its products. As a reference point, the group of 12 U.S.-based asset managers we cover (including several above-average organic growth generators in BlackRock BLK, Eaton Vance EV, and Cohen & Steers CNS) had an average annual organic growth rate of 0.7% (positive 0.7%) during 2013-17 (2008-17) with a standard deviation of 4.3% (6.2%). Meanwhile, the industry as a whole (denoted by flows into U.S. open-end funds and exchange-traded funds tracked by Morningstar) generated a negative 0.6% (positive 0.7%) average annual organic growth rate the past 5 (10) calendar years with a standard deviation of 2.1% (3.1%). We expect that T. Rowe Price will generate a 1.5% organic compound average growth rate during 2018-22 with a standard deviation of 1.6%, compared with a group CAGR of negative 0.1% with a standard deviation of 3.2%. Driven by recent large investments in retail distribution, enhanced product/vehicles and technology, T. Rowe Price should continue to have a better-than-average switching cost profile than its peers, despite continuing to see redemption rates that we believe are at/above the industry average due to the continuation of the baby boomer retirement cycle.

We believe that traditional asset managers like T. Rowe Price can improve on the switching cost advantage inherent in their business models with organizational attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong and respected brands and manager reputations derived from successful, sustainable records of investment performance). This can provide them with a degree of differentiation from their peers. While the barriers to entry are not all that significant for the industry, the barriers to success are extremely high, as it takes time and skill to put together a long enough record of investment performance to start gathering assets and even more time to build the scale necessary to remain competitive in the industry. This has generally provided the larger, more established asset managers with an advantage over the smaller players in the industry, especially when it comes to gaining cost-effective access to distribution platforms. Competition for investor inflows can be stiff and has traditionally centered on investment performance, especially in the retail channel. Although institutional investors and retail gatekeepers are exerting pressure on pricing, competition based on price has been rare, aside from what we’ve seen in the U.S. market for exchange-traded funds. While compensation remains the single-largest expense for most asset managers, supplier power has been manageable as many companies have reduced their reliance on star managers and have tied manager and analyst pay to both portfolio and overall company performance.

Asset stickiness (the degree to which assets remain with a manager over time) tends to be a differentiator between wide- and narrow-moat companies, as asset managers that have demonstrated 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), charging reasonable fees, and with singular corporate cultures dedicated to a common purpose that have 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.

T. Rowe Price, in our view, has a wide economic moat around its operations. We think the company’s size and scale, the strength of its brands, and its consistent record of active fund outperformance provide a huge leg up over competitors. While T. Rowe Price’s product mix is not overly diverse, with more than three fourths of total AUM dedicated to equity (57%) and balanced (22%) strategies, the company derives approximately two thirds of its managed assets from retirement accounts (41%) and variable-annuity portfolios (26%). With the switching costs for these types of tax-deferred accounts being significantly higher than those for most other accounts (the majority of which are non-tax-deferred), T. Rowe Price has traditionally had a much stickier set of assets than many of its peers. Benefiting from a steady stream in investor inflows into defined contribution and other retirement plans, the company has recorded net long-term outflows in only 14 calendar quarters during the past two decades.

Furthermore, the company’s cost-conscious culture and stable AUM and revenue levels have allowed it to consistently generate operating margins in excess of 40%, the highest of the U.S.-based asset managers we cover. T. Rowe Price’s ability to generate more stable revenue, profitability, and cash flows than its peers has, in our view, provided the company with more than enough excess capital to continue building on the competitive advantages that it already possesses. The company has been fairly effective managing its scale, with margins of 45.0% on average over the past five years allowing it to generate around $1.3 billion in annual free cash flow on average, with adjusted ROICs exceeding 60% (and ROICs with goodwill exceeding 45%).

T. Rowe Price’s biggest advantage over peers has been the level and consistency of its investment performance. The company currently has close to 40% of its fund AUM rated 5 stars and another 20% rated 4 stars on a five-year basis. With most broker/dealer and advisory platforms tending to give deferential treatment to 4- and 5-star funds, T. Rowe Price is well positioned. With solid three- and five-year relative investment performance generated on a consistent basis also tending to be an important benchmark for the gatekeepers of retail-advised and institutional platforms, T. Rowe Price is also well positioned, with more than three fourths of its funds tending to outperform peers on a three-, five-, and ten-year basis for much of the past two decades. With 70%, 81%, and 79% of T. Rowe Price’s sponsored U.S. mutual funds beating their peers on a three-, five-, and ten-year basis, respectively, at the end of September, we expect the company to continue to generate better organic growth from its active fund platform than the industry as a whole.

Another measure that demonstrates the strength of T. Rowe Price’s investment acumen is Morningstar’s Success Ratio, which measures the potential for a company’s funds to generate sustainable, peer-beating returns over the long run. Morningstar calculates two different success ratios--the Morningstar Success Ratio and the Morningstar Risk-Adjusted Success Ratio--over three-, five-, and ten-year time frames, with the former considering each fund’s category rank based on total return and the latter looking at a fund’s category rank based on Morningstar Risk-Adjusted Return. The higher the Success Ratio, the greater chance that investors will see sustainable, peer-beating returns. By this measure, T. Rowe Price is the only winner among the 12 asset managers we cover, with a five-year Risk-Adjusted Success Ratio of 79.0 compared with a group average (median) of 48.3 (47.5). Compared with the broader universe of fund families, T. Rowe also scores well, with its five-year Risk-Adjusted Success Ratio of 79.0 beating the industry average (median) of 46.7 (44.0).

Much of the success T. Rowe Price has had historically has been built on it having a single corporate culture dedicated to a common purpose, which has been reflected in the level and consistency of its investment performance, the rate of organic growth the company has been able to generate, and the relatively small amount of employee turnover through the years. Morningstar views the management team at T. Rowe Price as being highly insular and very protective of the culture that the company has built--one that has cultivated a disciplined, risk-conscious investment process that has consistently produced successful results across its fund lineup, often with less volatility than peers. As part of ongoing efforts to enhance the company’s competitive positioning, though, management has been willing to evolve and has for several years now been focused on building additional scale through new investment products (like its target-date retirement funds), expanding the reach of its investment advisory business by further penetrating domestic distribution channels (like the retail-advised channel) and moving into non-U.S. markets (especially emerging and developing economies in the Asia-Pacific region), and bolstering technology (in an effort to improve performance outcomes, drive down incremental costs, and improve product distribution). CEO Bill Stromberg maintains an investment focus while recognizing that the business must evolve to flourish in an industry that’s gravitated toward passive investing.

All of this explains why T. Rowe Price receives some of the highest marks for corporate culture among the U.S.-based asset managers we cover. We believe T. Rowe Price is well positioned to navigate the headwinds that the U.S.-based asset managers will face during the next decade, and we expect it to be one of the rare organic growth generators in the group.

Balance Sheet Very Conservative With more than 80% of annual revenue derived from management fees levied on AUM, dramatic market movements, shifts in product mix, and/or changes in fund flows can have a significant impact on operating income and cash flows. T. Rowe Price's investment offerings are overwhelmingly tied to U.S. equity markets, with more than three fourths of its AUM invested in equity and balanced strategies. Additionally, 10 funds accounted for 29% of the company's AUM at the end of 2017, as well as 36% of the company's investment advisory revenue during the year. As T. Rowe Price increases its investment in overseas asset managers, especially in emerging and developing economies like China and India, it is exposing itself to myriad cultural, economic, political, and currency risks that exist in the markets these managers serve.

T. Rowe Price has traditionally maintained a very conservative balance sheet, with no debt on its books since 2002. The company has relied overwhelmingly on its internally generated capital to fund acquisitions and other investments, while still returning a sizable amount of capital to shareholders via stock repurchases and dividends.

T. Rowe Price announced a 23% increase in its quarterly dividend to $0.70 per share in mid-February. That said, the company’s current payout ratio of 37%, based on our (and the consensus) earnings estimate for 2018, remains well off the 45% payout ratio we saw during 2015-16. We expect the company to continue to increase the quarterly dividend each year until the payout ratio reaches a more normalized level of around 45% of earnings.

Management maintains a more opportunistic approach to share repurchases, with the long-term goal being to gradually reduce the company’s share count with an eye toward offsetting the dilution created by its own stock-based compensation programs. During 2017, the company repurchased 6.6 million shares (or 2.7% of its outstanding common stock) for $458 million. The company also issued $201 million worth of stock under stock-based compensation plans. During the first nine months of 2018, the company repurchased 5.4 million shares (2.2% of its outstanding shares) for $575 million.