Risks to Achieving $18.20 Common Stock Fair Value Target Price
- Failure of investment community to recognize MN's competitive advantages, resulting in a stagnant or declining price/earnings ratio.
- Failure to maintain their outstanding investment performance.
- Dependence on 3rd-party distribution sources to market their asset management solutions.
- Economic headwinds (European debt crisis) affecting asset flows & market valuations of their client assets under management in their asset management & servicing businesses.
- Revision of the Dodd-Frank Wall Street Reform law to increase regulations on asset management firms.
- Non-Cash Compensation Expenses from 2012-2014 relating to the vesting of current economic ownerships of their employees exceeding projected estimates.
- Loss of key personnel to other firms.
Manning & Napier has a strong, liquid asset position on their balance sheet. While the liability side leaves much to be desired before the IPO, their strong operating cash flows allow them to support a low equity capitalization, as well as provide cash to support liabilities. After the IPO, they will have more equity capital than liabilities, plus they did not need to rely on bond or bank debt. They had over $27 million of cash and other investment security assets, which represents 41% of their balance sheet assets as of Q3 2011 and $81M of cash in Q4. They have generated about 80% annualized return on assets as of Q3 and are planning to initiate a $.16/share quarterly dividend in the second quarter of 2012.
We are also pleased that they generated over $67.4 million in adjusted free cash flows (Net Cash Flows Provided by Operating Activities minus Net Capital Expenditures & Mandatory Redemption Liability Interest Costs (as of Q3 2011)), which was 90% of their Net Income, which shows that they are able to convert net income to free cash flows which they can use to benefit shareholders and reinvest in their business to generate incremental returns. We are also pleased by their adjusted profit margins which were nearly 21% in YTD 2011, despite the fact that they had nearly $46M in a noncash non-recurring interest expense relating to mandatory redemption of employee stock ownership.
Asset Management Industry Outlook
We are noticing a bifurcation of the asset management industry between boutique firms that can add value through active management and large quantitative-style low-cost index driven passive managers. We are seeing consolidation of the "middle class" of asset managers globally and the remaining firms are typically pure play firms, who have the advantage of no longer being trapped under the bureaucracy of a commercial bank, brokerage or insurance institution.
We have noticed the demand for Global Assets Growing Faster than US Assets. With more than 50% of the global market capitalization represented by non-U.S. companies, U.S. investors are increasingly looking to diversify their assets through non-U.S. investments. We believe U.S. investors are under-allocated in global equities relative to global benchmarks, particularly in the defined contribution channel, with only 7% of defined contribution assets invested in non-U.S. equities.
In response to increased demand, Cerulli Associates indicates that 65% of managers are allocating over 30% of new products to international strategies and 47% are allocating over 70% of new products to international strategies. According to the Investment Company Institute, flows to foreign stock funds increased more than 210% in 2010 relative to 2009.
Demand by U.S. investors for life cycle funds has been driven by investors' desire to diversify their investments across various asset classes as well as to automatically shift to less risky asset classes as these investors near or enter retirement. Cerulli Associates estimates assets in life cycle funds will increase by 40% per year from 2009 through 2015. As part of the Pension Protection Act of 2006, target-date funds have become a default option of 401(k) plans that have an automatic enrollment feature subject to safe harbor protections for plan sponsors.
A study by Hewitt Associates and Financial Engines found that participants that receive help in the form of professionally-managed target-date funds, managed accounts or online advice achieve better returns than participants that do not receive help. As a result of the Pension Protection Act of 2006 and subsequent U.S. Department of Labor guidelines, plan sponsors are now actively seeking automatic retirement savings solutions for their employees. Under the Pension Protection Act of 2006, employers who automatically enroll their employees in what are known as Qualified Default Investment Alternatives, or QDIAs, are safeguarded from fiduciary and legal risk if they adhere to certain regulatory guidelines.
Increased focus on employee benefit plan management due to rapidly rising healthcare costs, managers taking holistic approach to benefit plan design and provide solutions to retirement & health benefit plans. For example, Hewitt Associates estimates healthcare costs are likely to rise 9% in 2011. According to Towers Watson's 2010 Health Care Cost Survey, employers pay 28% more for healthcare now than they did five years ago, $7,896 in 2010 versus $6,169 in 2005, and employees pay 40% more, $2,292 in 2010 versus $1,642 in 2005, over the same period.
We see a renewed Focus on Intergenerational Planning. A 2011 U.S. Trust survey of Americans with at least $3 million in investments highlights a gap between the importance such investors place on providing family financial security and the actual estate planning such families are doing. Nearly 40% of such individuals acknowledge they do not have a comprehensive estate plan and only 3% of business owners have a business succession plan as part of their overall estate plan. Intergenerational planning is also a concern, with only 34% of individuals surveyed feeling that their children will be able to manage any inheritance left behind. More than 27% of such individuals have never discussed intergenerational wealth transfer with their financial advisor. We anticipate significant opportunities for investment managers that can position themselves as trusted advisors to high net worth investors.
Increased Risk Management Interest based on a reaction to 2008 & 2009 crisis. Following the credit crisis and global bear market that began in 2008 and early 2009, investors and financial advisors have become increasingly interested in absolute return strategies, or strategies that seek positive returns over full market cycles. A 2010 survey of financial advisors and brokers by Putnam Investments states that 59% of advisors were likely to recommend absolute return strategies to their clients. The study states that advisors generally see the benefits of absolute return strategies as minimizing portfolio volatility and serving as an asset class diversification strategy.
We believe our active and unconstrained investment approach within our blended asset class portfolios is well suited to meet the demand for absolute return strategies using traditional asset classes and is likely to be less expensive than alternative investment-based strategies with similar absolute return goals. Industry consultant Casey, Quirk & Associates predicts that over the next 10 years, managers will increasingly be paid for investment solutions as opposed to investment products, and Pensions & Investments notes that top money management firms are starting to strengthen their solutions units in an effort to provide highly customized investment solutions for their clients, with a goal of forming strategic partnerships, and, as a result, stronger relationships with clients.
Overall, we feel the industry is undervalued and we would use declines in the market to add to positions in high quality asset managers like Manning & Napier and gains in the market to sell weaker asset managers.
Additional disclosure: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this MN report.