T. Rowe Price - Buy Thesis
It is likely that investors are familiar with T. Rowe Price Group (NASDAQ:TROW) as a brand, having invested in its sponsored mutual funds previously, yet it's not as well known for stock pickers. There is reason to believe that it shouldn't fly below an investor's radar for much longer. The stock currently trades at $63.77, and I am forecasting an $80 price target through 2013. Given the upside potential, perpetually increasing dividend stream, and minimal risk on the downside, TROW shares offer an attractive risk/reward. Following are a few key factors I foresee contributing to share price appreciation in 2013 and over longer time horizons:
- Reduced facility expansion expenses result in incremental gains to already industry leading margins.
- Sticky asset growth as a result of target date fund and institutional fund inflows.
- Undervalued on an enterprise value to assets under management and pro forma P/E basis.
- Long-term growth catalysts of improved unemployment and 26% interest in UTI Asset Management.
- Capable and focused leadership.
Advisory Business and Asset Base Overview
The asset management industry is extremely competitive, with offerings taking on every shape and size. AUM growth in such an environment primarily boils down to two factors - investment performance and distribution. With so many competitors, sales distribution will ensure mutual funds end up in investors' hands, but without performance, such efforts are meaningless. Appropriately, 86% of TROW funds have outperformed their 5-year benchmarks, and the company has one of the largest distribution networks around that utilizes a four channel approach. Notably, its fund supermarket (i.e. offering T. Rowe branded funds on Schwab's platform) and institutional channels are a core competency that have driven annual net inflows since the '90s.
Its approach to distribution also provides another key stabilizing benefit to AUM. For lack of a better term, distribution plays off the trends of smart and dumb money. The chart below evidences how net fund flows are buoyed in times of market distress by institutional money seeing the market as undervalued, thus replacing retail money that sides on the side lines. Such was the case during Q3 2008 as Lehman collapsed and during Q3 2011 when S&P downgraded U.S. treasuries. Institutional money drove significant portions of net inflows during distressed periods.
As a result of investment performance and distribution, organic growth has ranged from 5-10% annually, while AUM has increased two-fold since the early 2000's to $574 as of the MRQ. This attests to capable leadership that has been at the helm for an average of 22 years.
Expansion Charges Understate 2013 Margins
TROW undertook a large expansion of facilities in 2010. The firm added 441,000 square feet of office space to house mostly operational support employees. This was required to ensure growth in global markets could be fully supported by its business model. It is worth noting that almost all investment personnel are located out of Baltimore, MD, where current space is sufficient to house additional investment and operational staff. Facilities in Owings Mill, MD are near operational and will not require additional CAPEX beyond 2012. My estimates show that such charges in previous years accounted for a 30 basis point reduction in margins, mostly incurred in SG&A. A reduction of expansion charges alone will improve EBIT margins to 45.5% for 2013 compared to 44.8% in 2012 (an incremental EPS gain of $0.04). Other factors, such as flows to higher operating expense equity funds and favorable asset base mix, will contribute to increased margins as well.
Target Date Funds and Other Sticky Assets
T. Rowe introduced a line of target date funds as a means to drive AUM growth in more mature domestic markets. YTD, 34% of net inflows were funneled into target date funds, which are a fund of T. Rowe mutual funds. T. Rowe's target date funds have risen dramatically to $85bn AUM in a short period with minimal cannibalization to existing funds. Target date funds certainly aren't anything new, yet the differentiated asset allocation strategy T. Rowe employs sets its products apart, thus making for a more sustainable advantage. Target date funds strategically reduce equity allocations in favor of bonds as retirement dates near. T. Rowe differentiates itself by offering a more aggressive equity allocation than its competitors in later years to fund the shortfall that many retirees face as income streams are reduced.
Retirement assets in 401ks, such as target date funds, are more sticky and stay with the firm longer than say traditional retail assets that are invested in a brokerage or IRA account. Institutional assets are similar. Such assets are made up of pensions, endowments, and other investors with a long-term perspective. Accordingly, these assets tend to stay put for extended periods. T. Rowe is benefiting from sticky asset growth beyond target date funds, as its AUM share of institutional assets has increased from 40.3% to 41.2% since 2009. Similar trends have persisted in 2011, as the European crisis drove additional institutional flows, and institutional assets are now making up an increasing share of AUM. The downfall is that institutional assets are charged a lower operating expense for the scale of investment that each investment attracts. At face value, this trend would be a detractor, yet T. Rowe has offset institutional margin losses with its ability to increase high margin assets from actively managed equity funds. It's quite astonishing that T. Rowe has increased equity assets over the last years as a flight to safety has sent retail investors into lower expense fee bond funds. T. Rowe, once again evidencing its distribution ability, has bucked this trend and increased equity AUM share to 44% in 2012 from 43% in 2009.
UTI Asset Management and Macroeconomics
Keeping with its philosophy of funding growth with balance sheet cash, T. Rowe acquired a 26% interest in UTI Asset Management in 2010. UTI is located in India and provides advisory services to its branded funds, much like T. Rowe. India has certainly seen its share of difficult times the last year, with the rupee hitting all time lows and market indexes declining, although this distorts the investment outlook for UTI and is near-sighted. It's hard to ignore the middle class growth in India and assume that a near-term market decline will negate any long-term benefits. I was in India this past May (yes, far too hot at that time of year) and visited with management at Franklin Templeton in Mumbai. The mutual fund market is just beyond its infancy there - maybe we can equate it to the late '80s domestically when mutual funds began gaining acceptance. The streets are plastered with signs from firms such as Franklin Templeton and T. Rowe, among others. While additions to the bottom line for UTI are not perfectly quantifiable, the growth prospects over the long term are difficult to argue with. Somewhat more quantifiable and applicable to 2013 forecasts, and requiring more in-depth research, is that T. Rowe accounts for equity income in UTI on a quarter lagged basis. Indian markets have improved (BSE-100 up 12%) over the fourth quarter, which is likely to result in increased other investment income recognized in 1Q 2013 for T. Rowe. Historical income from UTI has been around $6mm/quarter, which translates to an additional $0.10-$0.15 EPS annually. At 21x EPS, UTI's contribution to share price increases could be as high as $3.00.
Macroeconomic happenings also warrant some consideration, especially within the financial sector. Increases in interest rates have the potential to add $0.05-$0.10 in EPS due to no longer having to waive fees for money market funds. T. Rowe waived $36mm in money market fees in 2011. Now, this is a longer-term unknown and the Fed has committed to its current low rate policy until at least 2015, but markets are forward looking with rate changes mostly past news when announced. Thus, money market waiver reductions (if the Fed lowers rates in 2015) will be priced into shares come later 2014.
Enterprise value to AUM and P/E Undervaluation
Those looking for a deep value or bargain bucket stock likely won't find TROW shares in their screeners. Market participants are aware of how well run T. Rowe is and this is a likely reason why shares historically trade at a premium to major indexes and competitors. Spend a couple of hours looking through their 10K, and you'll see there is a quality business underlying those financials. Even so, TROW shares are undervalued at 21x EPS, and a face value review without looking at underlying cash, overstates current multiples. My pro forma estimates show the stock trades at approximately 18x EPS and an EV to AUM of 2.5% (industry trades within a 2-3% range typically). When buying a stock, we are essentially buying a proportional ownership in the underlying core business, and we aren't necessarily buying cash on the books. Cash must be backed out to arrive at a true value of what is being purchased in the market. T. Rowe has listed cash of $1.2bn and hidden cash of $1bn. Hidden cash consists of the balance sheet line item of "investments in sponsored mutual funds", which is just seed capital for new fund offerings and existing fund investments. Not all of it is liquid, yet we can conservatively assume half of these mutual fund investments can be converted to cash in days and still leave new fund seed capital in place. Backing out cash per share for P/E purposes and cash from an EV calculation, we have a better picture of how undervalued TROW shares are when trading at 18x EPS and the mid-range of an acceptable EV to AUM. Please review the table below for peer EV to AUM calculations.
Risks, Well There Always are a Few
Business risk is low for T. Rowe, yet market risk resulting from AUM and market declines is very high. Sharp market declines are a risk on both the income statement and the balance sheet, with "investments in sponsored mutual funds" coming into play again. Firstly, market declines result in lower total AUM, and accordingly, lower revenue earned from fees on a smaller asset base. Now this risk is mitigated somewhat by inflow trends I've already discussed, but accounting for these investments as available for sale securities passes periodic unrealized losses onto the income statement. Such losses are recognized in other investment income, with each investment written down to fair value on the balance sheet. I don't think this risk that can be underestimated with potential market declines in 2013 from fiscal cliff or European crisis concerns.
ETF trends also pose a long-term risk for mutual funds in general, and T. Rowe looks to have shelved plans for actively managed ETFs. There were reports of ETF offerings coming to market in 2011, yet news of similar stories for the firm has not abated. Discussions with management have not generated any insightful news on this front either. My only assumption is that T. Rowe is sticking to mutual funds going forward and could serve as a headwind to distribution efforts. In addition, legislative barriers to allowing ETFs in 401k accounts have been breached. Many of T. Rowe's competitors are now offering ETF alternatives to mutual funds in 401k accounts and marketing initiatives to grow ETF AUMs have been relatively successful.
Share Price Target Through 2013
A base case scenario, using pro forma estimates and current P/E & P/B multiples, suggests an $80 price target come late 2013. My approach uses a blended multiples and DCF analysis. Add in a dividend that management has committed to increase annually (consistently achieved for 25 years), also share buyback efforts, and 30% is foreseeable on the upside with a forecast for diluted EPS of $3.38. Downside risk is attractive with a target price of $57. This scenario takes into account market declines, margin improvements not being realized, and faster than historical declines in operating expense fees for AUM. Please review the table below for further projections.
All in all, TROW shares are a rather attractive investment that won't keep me up at night. I find solace in that and wish my other investments were similar. Growth opportunities are abundant in both the near and long term, and leadership that has brought T. Rowe to where it is today, is set to oversee the next decade of growth. In the end, valuation is just a best guess. It is comfort with management's capabilities that ensures earnings misses will correct and result in the same historical EPS and AUM trajectory over longer horizons.
Disclosure: I am long TROW. 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.