Updated T Rowe Price Thesis - Taking Profits
It is with a heavy heart, a pocketful of dividends and a deep respect for T Rowe Price's (TROW) management team, that I must say farewell to my shares. While I have not lost a wink of sleep worrying about shares in my portfolio, I believe there are certainly more attractive opportunities on the horizon. Minimal upside remains with few catalysts into 2014 and shares now trading at premium valuations of 3% EV-to-AUM and 22x EPS.
In my original thesis published in late 2012, I made a case for purchasing TROW shares as there were clear catalysts throughout 2013. They were as follows:
- The great rotation to equities would gain steam as retail investors moved assets from the sidelines into equity funds.
- Operating margins would increase on reduced CAPEX/facility expansion charges and sales leverage.
- Sticky target date fund assets would drive AUM growth.
In early 2013, post-sequestration concerns, the great rotation indeed gained traction as bond fund flows reversed and the investing environment tilted toward risk-on as equities rallied. January and February experienced heightened equity flows of $37bn and $14bn, respectively - a reversal from previous months of negative equity flows to the benefit of bond funds. As it pertains to profitability and AUM growth, operating margins ticked up 220bps Y/Y and sticky target date assets grew by 23% to $110bn.
Fundamental Performance YTD
Impressively, TROW's scale has allowed it to increase profitability in spite of an extremely competitive pricing environment. YTD, operating margins increased while the average operating expense ratio for TROW funds declined 11bps to 0.35%. This is a far steeper decrease than historically tallied by the firm - more than a 25% pricing decline compared to a couple percentage points in prior years. Competition among mutual fund assets and loss of share to ETF's is driving pricing down faster than what would be expected. Further down the line, EPS increased 14% to $2.92, primarily leveraged off a larger AUM base boosted by market value gains, not net inflows. For the first time in almost 20 years of operations, net inflows turned negative to $12bn as institutional investors pulled assets. Leadership has yet to provide further color on these redemptions, although one can presume ETF's outside of TROW's management benefited as institutional investors favored lower operating expense index funds.
Competition is Outperforming
YTD, perennially troubled firms such as Janus (JNS) and Legg Mason (LM) have experienced net fund outflows of $13.5bn and $19.2bn, respectively. TROW, while a much more operationally sound company, has had similar absolute levels of outflows of $12.1bn, yet is trading at premium valuations. Invesco (IVZ) and Ameriprise (AMP) are gaining share, with net flows of $29.2bn and $10.2bn, respectively. Both firms offer more diversified investment vehicles than does TROW and better AUM growth opportunities as a result. I do believe TROW warrants a premium valuation, although shares trade a 15.7% premium to peers that are executing better than TROW has to date. There is little room for shares to grow from multiples expanding in 2014 and we can only assume shares will increase in concert with EPS and revenues around 11%. TROW appears to be fairly valued by the market at 22.0x EPS and an EV-to-AUM of 3.0% (premium asset managers generally trade in a range of 25-3%).
Outlook Lacks Growth Opportunities
Analysts are forecasting revenues to increase 10.7% for CY14 to $3.8bn from $3.4bn in CY13. Similarly, EPS are expected to increase 10.9% to $4.26 from $3.84. Both estimates are below the mutual fund industry average of 12%, which is a result of minimal head room for margins to increase on competitive pricing pressure and slower AUM growth. Many asset managers are moving beyond traditional mutual fund advisory services into ETF's and offering more diverse investment vehicles. TROW leadership has been hesitant to jump into the ETF space, rather relying upon its bread & butter mutual fund advisory business and leveraging scale to gain share. As TROW has generated net outflows YTD, 92% of ETF's have experienced net inflows, and competitor Vanguard has taken a 40% share of those flows.
Share appreciation will ultimately be tied to rather unpredictable and volatile factors, such as market appreciation, fickle institutional investors reversing course and moving to mutual funds or a potential announcement that TROW will begin offering ETF's. Accordingly, it is difficult to wager capital on the probability or timeliness of these events occurring. I don't envision an industry environment where TROW's AUM growth will outpace more diversified competitors who are taking share of a faster growing pie by diversifying into adjacent markets.
Wrapping It Up
I'll admit I am hesitant to remove TROW from my portfolio as I have become accustomed to the dividend and safety it provides. Unfortunately, with competitive pressures on pricing and AUM growth, accompanied by a premium valuation, I must move my capital to other investments that can offer better relative growth. Perhaps investing in a TROW mutual fund would serve as a better investment vehicle for 2014 as 85% of their funds continue to outperform peer funds.