BlackRock's Solid Growth Continues

There was little in wide-moat BlackRock’s BLK third-quarter results to alter our long-term view of the company, but we have increased our fair value estimate slightly to account for better assets under management levels and fees than we had forecast.

BlackRock closed the September quarter with a record $6.964 trillion in managed assets, up 1.8% sequentially and 8.1% year over year, with positive flows and market gains contributing to growth in assets under management during the period. Net long-term inflows of $52.3 billion during the third quarter were fueled by $741 million of active inflows (with strong flows from equity and alternatives operations offset by fixed-income outflows), $10.0 billion of inflows from the institutional index business (with the preponderance going into fixed-income strategies), and $41.5 billion in inflows from iShares. BlackRock’s annual organic growth rate of 4.7% over the past four calendar quarters is slightly behind management’s ongoing annual organic growth target of 5% but still within our long-term forecast of 3%-5% organic AUM growth annually.

BlackRock reported a 3.2% increase in third-quarter revenue compared with the prior-year period, as base management fees increased 3.4% despite a drop in the company’s realization rate to 0.173% in the September quarter from 0.180% in the third quarter of 2018. The company’s year-to-date top-line decline of 1.9% through the end of September was in line with our expectations for a low-single-digit decline for 2019, which we have increased to nearly flat year over year. While BlackRock reported a 170-basis-point year-over-year increase in third-quarter operating margin to 40.7%, we believe it will close the year with operating profitability of 37%-39% (it was 38% through the first nine months of 2019).

BlackRock reported the following from each of its equity platforms during the third quarter: active, $5.3 billion in inflows; institutional index, $8.5 billion in outflows; and iShares/exchange-traded funds, $13.1 billion in inflows. This was an improvement on the $5.9 billion in equity inflows during the second quarter, but still well off the $13 billion-plus five-year quarterly run rate over the past several years, much of which was driven by BlackRock’s iShares/ETF operations. This makes some sense, as we’ve seen the organic growth rate for equity ETFs overall falling off in anticipation of an eventual sell-off in the equity markets (with a corresponding uptick in flows into fixed-income products), as well as the product itself approaching saturation points in some channels.

Given the meaningfully higher fees that BlackRock charges for its active equity operations (54 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 (from a performance and flow picture) is beneficial to base fee growth. BlackRock closed the September quarter with 59%, 77%, and 85% of its fundamental equity funds above the benchmark or peer median on a one-, three-, and five-year basis, respectively, compared with 66%, 70%, and 80% at the end of the third quarter of 2018. Actively managed systematic equity funds have faltered in the near term, with 28%, 87%, and 90% of AUM beating their benchmark or peer median on a one-, three-, and five-year basis, respectively, at the end of September 2019, but still compare favorably with three- and five-year results of 85% and 92%, respectively, in the year-ago period. With improvements in BlackRock’s active equity operations being more miss than hit the past five years, we’re not putting much weight behind a long-term recovery in this business, believing that management’s goal is to run the unit for the cash flows and occasionally migrating active equity portfolios to more quantitatively based strategies.

BlackRock’s fixed-income operations, which accounted for 33% of companywide AUM at the end of September, drove the majority of the company’s inflows during the third quarter, with the company generating $35 billion in inflows, composed of the following: active, $7.3 billion in outflows; institutional index, $18.6 billion in inflows; and iShares/ETFs, $23.7 billion in inflows. Slightly better near-term performance on the active side, which accounted for 13% of companywide AUM, with 75%, 83%, and 82% of taxable fixed-income funds above the benchmark or peer median on a one-, three-, and five-year basis, respectively, at the end of the third quarter, compared with 66%, 72%, and 84% in the year-ago period, should allow the company to get back to positive flows in the near term. On the tax-exempt side, near-term performance has been weaker, with just 32%, 79%, and 77% of active funds beating their benchmark or peer median on a one-, three-, and five-year basis, respectively, at the end of September.

We continue to expect iShares’ fixed-income operations, which accounted for 8% of companywide AUM at the end of the third quarter, to continue increasing at a higher rate organically than its equity iShares platform, as well as the remainder of its fixed-income platform. This is primarily because equity ETFs already account for 75% of the global ETF market (compared with fixed-income ETFs at 20%), and organic growth for the equity part of the business has been trending down toward the 8% average annual rate 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 and more institutional and retail investors looking to ETFs to satisfy their fixed-income exposure needs, we expect the higher organic growth rates generated by fixed-income ETFs to continue over the near to medium term.

We also expect iShares, which has generated more than $1 trillion of inflows since BlackRock 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 high-single- to 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 continues to call for a doubling of the ETF market over the next five years, we believe the 15% compound annual growth rate required to achieve that goal is a pretty high hurdle, considering the growth we’ve seen (especially on the equity side of the business) in the past couple of years--even with the cuts in commission pricing among many online brokerage firms.

While BlackRock has historically seen stiff pricing competition from Vanguard, which holds 26% of the U.S. ETF market and 20% of the global market, and Charles Schwab SCHW, with just 4% of the market domestically and 3% globally, it has held its market share steady for close to seven 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, 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 4.1% year-over-year decline in the company’s fee realization rate during the third quarter was just outside the 3.8% rate of decline we’ve seen on average the past five years. 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. As this was well above management’s targeted $1.2 billion (or $300 million per quarter) share-repurchase plan for 2019, the company did not expect to make any more repurchases this year, unless the market provided an opportunity to buy back shares at meaningfully lower levels than we saw during the fourth quarter of 2018 and first quarter of 2019 (when the shares traded at an average price of $415 and a low of $361). As such, there were no share repurchases during the June quarter and just $100 million dedicated to share repurchases during the September quarter. BlackRock increased its quarterly dividend 5% to $3.30 per share at the start of 2019, equivalent to a 2.9% dividend yield at the current share price.