Artisan Partners: Down, But Not Out

| About: Artisan Partners (APAM)

Summary

Artisan Partners Asset Management is primarily an actively managed equity manager.

This is obviously not the business to be in when it comes to secular trends. Short-term fund underperformance only weakened shares further.

However, the equity isn't far off all-time highs, and investors get to pick up a (currently) covered 8.5% dividend to wait for a potential recovery.

Artisan Partners Asset Management (NYSE:APAM) has had a tough time in the market since its IPO back in early 2013. While many asset managers have turned towards offering passive products (chasing the swelling cash inflows) or have begun to offer fixed-income strategies (not seeing the rapid outflows that equity strategies are), Artisan Partners has stayed true to its roots. While it has one fixed-income product, it represents just a small fraction of the company's assets under management (AUM). Through and through, this is an active equity management shop. At these share prices, it is also an aggressive high yield investment that, with a little faith, could reward shareholders well over the next several years - if management can overcome some internal hiccups and fend off some tough secular trends.

Business Overview

The complaint with active equity managers is nearly always related to performance. Who here has heard the old adage "80% of mutual fund managers don't beat their benchmarks annually?" Many reading this article just raised their hands. That isn't a factually incorrect statement, but there are equity managers that still have healthy long-term histories.

Artisan Partners still fits that mold. Fully 75% of the company's strategies have outperformed standard industry benchmarks for those strategies over the past five years (measured by gross return). Keep in mind that this figure isn't net of fund expenses, and it is swayed to some degree by survivorship bias, but even considering these factors, the company's products perform substantially above average. Several are, in fact, closed to new asset flows in order to give management flexibility in investments, which leads me to believe management is intent on preserving the reputation and earnings of existing holders, and not chasing revenue that could break the reputational model. The takeaway here is that Artisan Partners has a stable of highly rated and generally well-regarded funds under its umbrella.

What has impacted Artisan Partners equity is short-term performance. Unfortunately, the company's strategies have done incredibly poorly over the last year compared to normal years, with a large number of strategies actually posting negative returns. Some of this is poor manager performance, and some of it relates to the large exposure the firm has to non-U.S. based strategies, which primarily invest in securities that are not denominated in the U.S. dollar (FX headwinds). Thankfully, this is yet to impact Morningstar or Lipper rankings (56% of AUM is in four- or five-star Morningstar-rated funds, which only top quartile funds receive), but it likely will be a headwind for both AUM growth through performance and for attracting new clients, some of whom might get hung up on the short-term weakness versus the long-term history.

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Granularly, AUM has fallen from $109.2 billion during Q2 2015 to Q2 2016, a drop of 13%. This has been split pretty much down the middle by outflows ($7.2 billion) and lagging asset performance ($7.0 billion). Revenue was down 14.6% y/y in Q2 2016, in large part predicated by the drop in AUM, but also impacted to some extent by mix shift (separately managed accounts versus mutual fund products). One of the strong points of active managers is the extremely high operating margins compared to peers that engage in passive strategies, but that works both ways. Declining revenues means large downward swings in profitability, just as much as revenue growth would drive higher profits.

Dividend Strategy

Artisan Partners currently yields 8.58% ($2.40/share annually), and it traditionally returns extra cash to shareholders when available via special dividend ($1.63/share in 2014, $0.95/share in 2015). The company only retains $100 million as a means to manage working capital and handle operations, and generally, any extra cash in excess of that number is returned to shareholders via these dividends. The company does not really repurchase shares, which is a shame, in my opinion, given the low multiples.

Currently, this dividend is covered, even given the rough current environment. Artisan Partners generated $84 million in net income through the first two quarters of 2016, which was more than sufficient to pay the $65 million in cash dividends. Cash flow coverage of the dividend was even better than this indicated in 2016, given the $44 million in positive working capital year to date. This is a massive amount of cash flow considering the equity's market cap/enterprise value ($1 billion). The market is clearly banking on a long-term downtrend in the company's shares, which isn't unfounded. There are some bright spots to be found here. Short interest does seem to be coming down, and institutional ownership remains exceptional. Even assuming continued marginal declines in AUM, the current dividend is well supported over the next several years. Investors should also note that the company also held $198 million in cash on the balance sheet at the end of Q2 2016, indicating a reserve of nearly $100 million that will either go towards special dividends or be used to fund dividend shortfalls (if they ever materialize).

It is tough to call a bottom in active equity management outflows, but Artisan Partners continues to stick to its roots. While market appetite for passive products continues to rise, this could change over time. While my preferred play on the sector is via Legg Mason (NYSE:LM), which has (in my opinion) better name recognition and diversification (active equity and fixed-income products), I could understand why some investors might take a speculative position in this company. The long-term track record of Artisan Partners in creating value in its actively managed products is there, as are the portfolio managers that created that alpha. It might be unwise to think that outflows continue unabated indefinitely.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.