Asset Managers: Our Take on Earnings
Wide-moat BlackRock and T. Rowe may not be the cheapest, but they're the best.
With investors focused on organic growth and profitability when assessing the U.S.-based asset managers, we've seen a bifurcation in the group during the past year between the perceived haves (those capable of generating organic growth and maintaining margins) and the have-nots (those that are expected to struggle to do both or that have fallen into a pattern of poorer performance and positioning).
While some of the 12 U.S.-based asset managers we cover are currently trading at multiples not seen since the 2008-09 financial crisis, we recommend that long-term investors focus on quality over price by sticking with the only remaining wide-moat firms in our coverage: BlackRock (BLK) and T. Rowe Price (TROW). We remain wary of the companies trading at meaningful discounts to the group average, especially those with no-moat ratings; we expect the headwinds they will face--from the continued growth of passive products at the expense of active funds to fee and margin compression among most active equity managers, as well as the potential for a sustained bear market decline in U.S. equities--to keep their multiples depressed for some time, with few meaningful catalysts capable of getting them up off the mat.
Fee Pressure Trumps BlackRock’s Positive Flows
Wide-moat BlackRock (BLK) closed the second quarter with a record $6.842 trillion in managed assets, up 5.0% sequentially and 8.6% year over year, with positive flows, foreign-exchange gains, and market gains all contributing to assets under management. Net long-term inflows of $125.4 billion were fueled by $74.7 billion of active inflows (predominantly from BlackRock’s fixed-income operations), $15.0 billion of inflows from the institutional index business (with most going into fixed-income strategies), and iShares (where the company’s exchange-traded fund platform generated $35.7 billion in inflows). Although BlackRock’s annual organic growth rate of 4.1% over the past four calendar quarters trails management’s ongoing annual target rate of 5%, it was more in line with our long-term forecast for 3%-5% organic AUM growth annually.
Despite this, BlackRock reported a 2.2% decline in second-quarter revenue compared with the prior-year period, owing to a drop in its realization rate from 0.186% a year ago to 0.175% in the most recent quarter. The decline in base management fee rates was due more to product mix shifts than BlackRock reducing fees on any of its products. The company’s first-half top-line decline of 4.4% was at the lower end of our expectation for a low- to mid-single-digit decline in revenue in 2019, but given the easier comparables in the fourth quarter, we are sticking with our forecast. While BlackRock reported a 360-basis-point year-over-year decline in second-quarter operating margin to 36.6%, we believe it will close the year with operating profitability in the 37%-39% range.
BlackRock reported inflows from each of its equity platforms--active ($0.5 billion in inflows), institutional index ($1.2 billion), and iShares/ETFs ($4.2 billion)--during the second quarter, which was a marked improvement over the outflows reported during the first quarter. Given the meaningfully higher fees that BlackRock charges for its active equity operations (55 basis points relative to 24 basis points for iShares equity offerings and 4 basis points for institutional index funds), any improvement in this part of its business is beneficial to base fee growth. But considering that improvements in BlackRock’s active equity operations have been more miss than hit for much of the past five years, we’re not putting much weight behind a long-term recovery in this part of the company’s overall business. We believe management’s goal is to basically run the unit for the cash flows (all while taking fee cuts annually to make sure its active funds don’t lose placement on retail platforms) and occasionally migrate active equity portfolios over to more quantitative-based strategies.
BlackRock’s fixed-income operations (which accounted for 32% of companywide AUM at the end of the second quarter) drove the majority of inflows during the second quarter, with the company generating $110.4 billion in inflows--active ($65.1 billion in inflows), institutional index ($13.8 billion), and iShares/ETFs ($31.5 billion)--from its bond funds during the second quarter. CEO Larry Fink said some of the company’s institutional clients are finding it increasingly difficult to manage their fixed-income portfolios in house and are looking to companies like BlackRock, which can offer both active and passive solutions at cost-effective rates, to build deeper relationships with. This should be a net positive for continued fixed-income flows in the near to medium term.
We continue to expect iShares’ fixed-income operations (which accounted for 8% of companywide AUM at the end of the second quarter) to continue to grow at a higher rate organically than the equity iShares platform, as well as the remainder of its fixed-income platform. This is primarily because equity exchange-traded funds already account for 77% of the global ETF market (compared with fixed-income ETFs at 19%), and organic growth for the equity part of the business has been trending down toward the 8% average annual rate of organic growth we’ve seen from equity index funds historically (compared with the 15%-20% annual organic growth rate that fixed-income ETFs have put up the past couple of years). With more institutional and retail investors looking to ETFs to satisfy their fixed-income exposure needs, we do not expect the higher organic growth rates being generated by fixed-income ETFs to wane much in the near to medium term. We also expect iShares, which has generated more than $1 trillion in inflows for BlackRock since the company closed the deal to buy Barclays Global Investors in late 2009, to continue to be the primary driver of organic growth for the company. We expect the global ETF market to grow organically at a low-double-digit rate on average annually the next five years, with BlackRock maintaining market leadership domestically (39% of the market) and globally (37%).
While BlackRock has historically seen stiff pricing competition from Vanguard (which holds 25% of the U.S. ETF market and 19% of the global market) and Schwab (SCHW) (with just 4% of the market domestically and 3% globally), it has held its market share steady for more than six years and has been capturing a greater percentage of the industry’s flows. With most plain-vanilla large-cap index-based equity ETFs priced more in line with institutional index funds, we don’t envision massive fee cuts from here. The bigger challenge for the industry, in our view, is going to come from companies like Schwab, Fidelity, and JPMorgan Chase (JPM), which have their own built-in distribution platforms and have shown a willingness to offer index funds and ETFs with 0-basis-point fees, using other parts of their business to compensate for the lost management fees on their proprietary products. We continue to see compression in BlackRock’s active and ETF management fees, with the former being more conscious and the latter tending to be driven by product mix shift and the increased scale of iShares operations. That said, the 5.8% year-over-year decline in the company’s fee realization rate during the second quarter was well outside the 3.7% (4.0%) rate of decline we’ve seen on average the past five years (during 2018). As much of this was driven by mix shift, we’re not going to alter our forecasts, which continue to call for 3%-4% annual fee declines for BlackRock during 2019-23.
BlackRock spent $1.6 billion ($1.3 billion of which was done via a private transaction) on share repurchases during the first quarter, buying back an estimated 3.8 million shares, which was well above its targeted $1.2 billion ($300 million per quarter) share-repurchase plan for 2019. With its repurchase target for the year already met during the first quarter, management does not expect to make any more repurchases this year unless the market provides an opportunity to buy back shares at meaningfully lower levels than we saw during the fourth quarter of 2018 and first quarter of 2019 (where the shares traded at an average price of $415 and a low of $361). BlackRock increased its quarterly dividend another 5% to $3.30 per share at the start of 2019 (equivalent to a 2.5% dividend yield at the current share price), having raised it to $3.13 in the second quarter of 2018 and $2.88 (from $2.50) at the start of last year.
Volatile Equity Markets Lead to Mixed Results for T. Rowe Price
Wide-moat T. Rowe Price (TROW) closed the second quarter with a record $1.125 trillion in managed assets, up 4.0% sequentially and 7.7% year over year, despite more volatile equity markets. Net inflows of $2.5 billion probably would have been better had the equity markets not sold off in May, but they were still on par with the $2.3 billion quarterly run rate we’ve seen for flows at T. Rowe Price since the end of the 2008-09 financial crisis. Target-date funds continue to generate the bulk of the company’s organic growth, bringing in another $1.6 billion during the second quarter.
While average assets under management increased 6.1% year over year during the second quarter, T. Rowe Price reported a 3.7% increase in revenue compared with the prior-year period due to a 4.3% decline in administrative, distribution, and servicing fees as well as a lowering of its overall effective fee rate to 0.462% from 0.469% during the second quarter of 2018. First-half revenue growth of 1.9% was in line with our call for low- to mid-single-digit top-line growth in 2019, driven by the equity market recovery during the first half as well as easier comparables in the back half of the year.
Adjusted operating margin of 42.2% during the first half of 2019 was 195 basis points lower than 2018 levels, as compensation and other expenses expanded at a much faster rate than revenue. While this was slightly better than our full-year forecast for operating margins around 40%-41%, we’ll hold back on altering our projections as the company continues to make up-front investments in key regions and channels to help drive growth (and is likely to take advantage of the better margin picture to make additional investments).
In an environment where active fund managers are under assault for poor relative performance and high fees, we believe T. Rowe Price is the best positioned among the U.S.-based active asset managers we cover. The biggest differentiators are the company’s size and scale of operations, strength of brands, consistent record of active fund outperformance, and reasonable fees. T. Rowe Price has historically had a stickier set of clients than its peers as well, with two thirds of its assets under management derived from retirement-based accounts.
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 as it works more closely with these end clients. 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--an area of the market it has not focused too heavily on in the past--given the solid long-term performance of its funds and reasonableness of its fees.
While T. Rowe Price is currently trading at a 15%-20% premium to the group of 12 U.S.-based asset managers we cover, it is only slightly undervalued relative to our fair value estimate. The market tends to reward both organic growth and operating profits in the U.S.-based asset managers, which explains why T. Rowe Price (with a 2.3% compound annual growth rate for organic growth, 3.3% standard deviation over the past 10 calendar years, and operating margins averaging 44.0% annually) and BlackRock (generating a 3.6% compound annual growth rate for organic growth, 3.1% standard deviation during 2009-18, and operating margins averaging 37.4% annually) have tended to trade at premiums to the group. The group of 12 U.S.-based asset managers we cover had an average annual organic growth rate of 0.9% during 2009-18, a standard deviation of 7.6%, and operating margins averaging 29.6% annually.
With T. Rowe Price likely to average mid-single-digit growth in assets under management (driven by 1%-3% annual organic growth in a forecast period that includes a 10%-plus decline for equity markets), we see top-line growth expanding in the low- to mid-single-digit range annually in most years, with operating margins of 40%-42% on average.
Outflows Mar AMG’s Results, Pushing Out Expected Recovery
Narrow-moat Affiliated Managers Group (AMG) closed the second quarter with $772.2 billion in managed assets, down 0.3% sequentially and 6.3% year over year. Net outflows of $15.1 billion, driven by ongoing performance headwinds in quantitative strategies across liquid alternatives and global equities, were a letdown, being more on par with the $15.4 billion that AMG lost to outflows during a more volatile fourth quarter of 2018.
Institutional and retail outflows of $9.7 billion and $5.5 billion, respectively, during the June quarter, overshadowed the positive $0.1 billion of flows for AMG’s high-net-worth segment. From an asset class perspective, alternatives ($10.4 billion of outflows), global equities ($9.4 billion) and U.S. equities ($3.7 billion) remained in net redemption mode, with only multiasset/fixed-income generating positive flows. At this point, given the hurdle created by $22.5 billion in outflows during the first two quarters of 2019, we forecast negative 4%-6% organic growth this year, down from negative 1%-3% previously.
While average assets under management declined 6.7% year over year, AMG reported only a 1.4% decrease in second-quarter revenue due to improved mix shift. Top-line growth of negative 6.4% during the first half was in line with our forecast for negative mid-single- to high-single-digit revenue growth for the full year. AMG’s first-half operating margin of 32.8% was 120 basis points lower year over year, but we have seen a creep-up in compensation costs that we think will limit any potential margin expansion this year to 31%-33%.
Market Gains Offset Janus Henderson's Ongoing Outflows
Narrow-moat Janus Henderson (JHG) closed the second quarter with $359.8 billion in assets under management, up 0.7% sequentially but down 2.8% year over year. Net outflows of $9.8 billion during the period were on par with the fourth quarter of 2018 and first quarter of 2019. Aside from fixed income ($300 million in inflows) and multiasset products ($600 million), every segment recorded net redemptions during the period: equities ($6.0 billion in outflows), quantitative equities ($4.1 billion), and alternatives ($600 million). With organic growth being negative for the past three and a half years and a no-deal Brexit likely, we remain doubtful that flows will improve all that much in the near to medium term.
While average assets under management declined 3.1% year over year and Janus actually recorded positive performance fee income during the period, second-quarter revenue still fell 9.5% on lower management fees and other revenue. First-half top-line growth of negative 10.6% was basically in line with our forecast for a high-single- to low-double-digit decline in revenue for 2019. First-half operating margin of 23.0% was 680 basis points lower compared with the prior-year period. While this is below our expectation for operating margins to remain closer to 27%-28% over the course of our five-year forecast period, the company is still working through costs associated with the merger integration, which should wane over the next several quarters. Janus left its quarterly dividend in place at $0.36 per share and repurchased $75 million of common stock during the second quarter.
Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.