This is part of a series of reports on Virtus Investment Partners (VRTS). The parts cover: Recommendation and Overview, Valuation Analysis, and Key Points, Risks and Outlook.
Summary of Observations
Virtus Investment Partners has seen tremendous growth since it separated from Phoenix while many asset management peers have seen stagnation, declines, losses and buy-outs. Virtus grew revenue from $117M in 2009, to $205M for 2011, representing a compounded annual growth rate of 32%. The firm first came to our attention in 2008 as it was being spun-off from Phoenix. We took a second look at Virtus in March 2011 when analyzing potential asset management companies to invest in. We were impressed by the firm's ability to turn around operating performance since it was spun-off from Phoenix as well as generate 6.2% organic assets under management growth from net client fund flows in 2010, which exceeded that of other major asset managers. Virtus Investment Partners enjoyed good growth in client assets under management since it become an independent company; AUM has increased from $22.6B in 2008, to $25.44B in 2009, to $29.47B in 2010 and $34.59B in 2011, and we expect the positive growth to continue in the future.
We also like the improving operating margins the company enjoys. We expect asset managers to generate high operating margins of at least 25-40% and while margins are below asset management peers, Virtus is showing progressive improvements. VRTS' adjusted operating margins were about 28% in 2011, 20% in 2010 and 8% in 2009. Since revenue bottomed up in 2009 at $117.1M, it has increased by nearly 75% cumulative to $204.65M in 2011. Operating Income has increased from -$6.6M in 2009 to $13.9M in 2011, an increase of 210%. As Bank of Montreal (BMO) has converted the convertible preferred stock in Virtus to common shares, Virtus will no longer have to pay $3M in dividends and an allocation of earnings to BMO in 2012 and afterwards, which will allow net income to be attributed to common shareholders. We also like the fact that asset managers do not require the massive expenditure for property, plant and equipment in order to continue operations and Virtus Investment Partners is no exception. VRTS only spent $13.3M in capital expenditures and the purchase of investment management contract over the 2008-2011 periods. In comparison, VRTS's end of year holdings balances for liquid, marketable investment securities excluding cash increased by $15.5M during this time period (which accounts for new securities purchased and investment gains). VRTS averaged over 100% conversion of Net Income to Free Cash Flows (excluding a one-time non-cash tax benefit reversing out previously written off deferred tax benefits), which shows strong cash generation abilities. A glimpse at the VRTS balance sheet shows that Cash and Marketable Securities account for nearly 25% of company assets and Virtus has only $5.45M in net Property and Equipment on the balance sheet. Over 50% of VRTS' assets relate to accounts receivable and deferred tax assets receivable. Accounts receivable are secured by client assets, earned daily and typically paid on a monthly or quarterly basis. VRTS' deferred tax assets are used against taxable income and reduce the amount of cash tax payments required. The deferred tax asset benefit helped bolster book value, the company had a book value per diluted share of $26.80 as of the end of the year, including over $10/share in cash and liquid investment securities.
Virtus will enhance stockholder value by building upon its strengths and effectively executing the following strategies:
- Maintain, extend and improve the company's offerings of high quality investment management capabilities. In product categories where Virtus does not have the capability from affiliated managers, VRTS partners with unaffiliated sub-advisors, selecting managers whose strategies are not typically available to retail mutual fund customers.
- Leveraging internal capabilities to develop new products.
- Building upon current distribution access to generate higher levels of sales. Virtus will selectively expand distribution resources, including sales and relationship personnel. In the retail business, the firm's wholesaling force is smaller than many of its peers. We believe Virtus can build upon the growth it has seen in the retail market by expanding these resources.
- In addition, through intermediaries, Virtus currently does business with a large number of producers that employ only one or two of its products. Its strategy is to focus on these producers in order to become a preferred mutual fund family. We believe this can be accomplished through appropriate incentives, focused activities and targeted marketing efforts. Virtus will also expand into specific growth areas where it has a smaller presence, such as the RIA channel, which is one of the fastest growing advisory industry segments.
- Enhancing shared administrative and distribution services to achieve greater economies of scale
Valuation and Projections
Our $97.97 value is based on applying a 15 times price-to-earnings multiple to estimated 2015 earnings per share of $10.16 and discounting the terminal value back to 2012 at a cost of capital of 11%. VRTS' forward PE ratio is higher than its peer competition in the asset management industry, however we believe that the company has more opportunities to grow its revenue as well as improve its operating margins, which will provide a high level of EPS growth from the 2012-15 period. Also we believe that the multiple used is justified considering that the firm has grown faster than its industry recently and that top tier investment boutiques traded at a multiple of 20-30 times trailing earnings before the 2007-2009 financial crisis.
We believe that the company will continue to grow its revenue faster than the competition. In our model we estimated that VRTS would see a 25% annual growth in its fee-based revenue from 2012-2015, based on adding new investment management mandates, market appreciation of assets overseen, potential introductions of new product offerings and potential bolt-on acquisitions of smaller firms or acquiring the asset management divisions of weaker financial services firms. The key driver of revenue and profitability for VRTS is client assets under management. We expect compensation and distribution expenses to grow at a healthy rate, yet slower than revenue growth, which is prudent to ensure that top performing team members remain satisfied and less likely to stray from the firm while ensuring operating margin growth. We also believe that competition in the asset servicing operations segment will allow VRTS to ensure a slower growth in other operating expenses (10% annually) versus revenue growth, which will allow a greater percentage of revenue to fall to the bottom line to reward shareholders and bolster the balance sheet instead of being utilized to hire new employees or buy new (in)tangible assets.
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In the next report on Virtus we discuss the keys to our investment thesis, the risks involved, and the outlook of the industry.
Disclosure: I am long VRTS.
Additional disclosure: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.