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Buying Blackstone (BX) ahead of Thursday’s 1Q11 Earnings Release

|Includes:The Blackstone Group L.P. (BX)

We expect BX to increase to $21 in the next year as we believe the current $18 stock valuation underestimates the sustainability and future growth of BX’s free cash flow. Based on our proprietary private equity and real estate quarterly realization schedules as well as conservative estimates for future Blackstone fund performance relative to historical results, we project BX's free cash flow per share grows 47% to $1.11 in 2011 and an additional 39% to $1.55 in 2012.

We base our projected $21 valuation on a 7% forward free cash flow yield on our 2012 free cash flow per share estimate of $1.55. We believe a 7% forward free cash flow yield is reasonable based on 1) 40% annualized free cash flow growth in the next two years, and 2) lower interest rates for non-investement grade corporate debt (BB and B rated names) of approximately 6%. We believe the volatility of cash earnings from realized carry merits a higher free cash flow yield than yields currently available in investment grade and BB-B rated credits.

Purchasing BX today at $18 and collecting our projection for $1.20 in per share distributions in the next year and selling at $21 gives us a projected total return of 23%. If the stock moves to our target price before we collect the distributions, that still gives us 17% of price appreciation.

We also think there could be near-term upside in BX shares as our estimate for 1Q11 economic net income per share is 24% above the consensus estimate. Based on recent earnings releases from financial companies and a 5% increase in the S&P 500 in 1Q11, we think the contribution of unrealized appreciation to financial results might move the numbers past analyst expectations. We believe a contribution to earnings from fair value appreciation may help maintain momentum in BX shares. We believe the current consensus estimate for BX’s economic net Income (we believe most earnings forecast summary agencies are picking up the analyst's "adjusted" earnings, which may approximate BX's economic net income calculation instead of BX's calculation for distributable earnings) is about $0.41 per share compared to our $0.51 estimate.

One risk to our above-average estimate is the amount of management fees BX earns this quarter on its last two private equity funds. For instance, the management fee for BCP V may decrease in 1Q11 as this fund recently completed its investment period. In comparison, management fees may increase for BX's most recent fund, BCP VI, as BX starts to invest capital and earns fees on committed capital. We believe the timing of these fee adjustments may carry over to 2Q11.

Investment Positives

We expect Blackstone to continue to avoid the regulatory scrutiny and problems from on-balance sheet leverage that hobbled many financial firms over the last three to four years. We also think BX can continue to grow AUM and earnings even with 2-3% annual GDP growth as M&A activity should still eventually increase and as cheap financing continues to be readily available. Another reason we like BX now is that BX may be less sensitive to higher short term interest rates and inflation expectations compared to other spread-based financials. This may help BX outperform other financials if the Fed Funds target rate increases earlier than expected.   

Investment Risks

Potential tax changes may increase the amount of uncertainty in the private equity business and limit share price appreciation. We believe changes in the tax code may increase the required return for owning BX shares, but we think regardless of the tax change there will a fair amount of questions regarding the accounting for partnerships like BX that need to carve out financial results from a consolidated entity that wasn’t all publicly listed in the first place. BX can carve up the points from carried interest however they want, and the visibility to the shareholder in terms of higher taxes only becomes clear once they get the K-1 statements for owning BX shares. We think higher taxes is something all shareholders may face, and that BX’s distribution should continue to exceed the taxes due on reported partnership income.

We believe downside risks to our estimates include delays in realizations in private equity and real estate funds and lower carried interest income from the hedge fund solutions business.

Also, BX does not need to distribute its free cash flow, and may decide to cut the per share distribution below our estimates for the first three quarters of the year and then make a larger payment in the fourth quarter.   

AUM projections

Our long-term projections for BX's fee-earning AUM can serve as a sanity check on our free cash flow per share forecasts. A key driver of our AUM forecasts is the amount of future fundraising rounds in private equity, real estate, hedge funds and other.

In the last four years, we believe BX’s fee-earning AUM had a 17% organic annual growth rate. Looking forward, we expect a 5-year CAGR of approximately 6% for all of BX's fee-earning AUM. This 6% CAGR for fee-earning AUM breaks down as follows:
 

Private Equity: 1% forward 5-year CAGR with fee-earning AUM growing from $24 billion to $25 billion by the end of 2015

Real Estate: 5% forward 5-year CAGR with fee-earning AUM growing from $27 billion to $34 billion by the end of 2015

Hedge Fund and Credit Funds: 8% forward 5-year CAGR with fee-earning AUM growing from $59 billion to $85 billion by the end of 2015

We project BX raises a $12.5 billion private equity fund by the beginning of 2016 after fully deploying its current $15 billion fund (BCP VI). In real estate, we forecast BX starts earning fees on a new $10 billion fund in 2012. In BX's credit and marketable alternatives unit, we expect almost $500 million of new commitments/equity raises per quarter, which is about 1% of the most recent fee-earning AUM in this business segment. We also expect market appreciation/investment performance in this business unit may contribute to an increase in fee-earning AUM.  

Stocks: BX