Eaton Vance Faces Stiff Headwinds

| About: Eaton Vance (EV)
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Asset manager Eaton Vance (NYSE:EV) is well known to investors thanks to its status as one of the largest "manufacturers" of closed end funds. This name recognition has probably played a role in the run-up of the stock this year (along with the general run-up in the market of course). Unfortunately, EV's "manufacturing" profits may soon take a hit as the firm underperforms other asset managers in attracting new assets in the equity categories. Based on this, and the firm's ambitious valuation at current levels, I believe the stock is too risky for investors at current levels. On the other hand, Eaton Vance has brought an important new category of mainstream investing to the market and this should help offset other headwinds the firm is facing.

For those who are unfamiliar with Eaton Vance, let me take a second to lay out the firm's business model in brief. Basically, the company is in the business of coming up with new closed-end funds (or CEFs) and then marketing them to investors. Investors buy shares in the closed end fund, and Eaton Vance then makes money off the investor by charging them a small annual fee for managing the closed end fund (usually less than 1% on assets under management or AUM, but there are a few exceptionally expensive CEFs). The firm also provides advice and investment management services to high net-worth investors, big institutional investors, etc.

Of Eaton Vance's AUM, roughly 75% is from individuals. This is very important for EV, and is both a good thing, and a bad thing for the firm. The good news is that individual investors are usually less sophisticated than institutions - this gives Eaton Vance the ability to extract higher fees for its asset management services since retail investors tend to have a lower fee elasticity than institutions (meaning they are less prone to choose the low fee investment and more prone to consider other factors like recent returns).

Headwinds ARE Coming:

Unfortunately, these "other factors" that individuals are considering are exactly what is hurting Eaton Vance right now and what is likely to continue hurting the firm. Eaton Vance's overall investment performance over the last few years has been relatively weak - or at least weaker than peers. Given the run-up in the market, EV's funds have mostly done just fine in relative terms, but compared with its competitors' products, Eaton Vance has underperformed. This is particularly true over the three-year time horizon, which is a critical comparison period. Since retail investors tend to chance returns, Eaton Vance's poor performance is hurting the flow of funds into AUM. This is likely to continue for the next few quarters at least, and it will probably be intensified by the broad rebalancing between stocks and bonds that is going on around the expectations of Fed tapering.

Do not misunderstand me - Eaton Vance is not seeing net outflows in AUM over any sustained period - at the end of FY 2012, the firm saw AUM increase 14% y-o-y. These AUM consisted of 56% in equities, 25% fixed income, 13% floating rate income, and ~6% alternative assets. This fairly large fixed income position is causing the firm some outflows, but given EV's equity funds, and the fact that a lot of money is coming in off the sidelines, Eaton is still pulling in positive net asset flows on a fairly consistent basis, but the trends are not as healthy as they should be. For example in FY 2012, EV pulled in $0.2 billion in new funds compared with $4 billion in FY 2011.

This year, the trends are better for the company, largely due to an important new product category and a major acquisition (the Clifton Group, which had AUM of $35B, was acquired by EV through a subsidiary in Nov. 2012). On both the equity and fixed income sides, new inflows have been somewhat disappointing with net flows of $0.1B and $1.5B in the most recent quarter.

The other major headwind that Eaton Vance is facing is also impacting the asset management business as a whole. This headwind relates to the concept of fund "manufacturing" alluded to earlier. EV's business basically is fairly simple; (1) create a new and hopefully unique fund that represents an asset class of interest, (2) market that fund, (3) distribute the new fund through an "IPO" like process, and (4) earn profits by managing the fund. In order to distribute these funds, firms like Eaton Vance have to pay a "shelf fee" to brokers. The consolidation in brokerage firms has caused reduced competition and as a result shelf fees across the asset management industry have come up significantly. This change is extremely significant. As little as 5-7 years ago, most asset managers made money when distributing new funds, now they all lose money. This was partially driven by the disappearance of B-class mutual fund shares (which carried both upfront and annual fees), but the increased shelf fees have also played a significant role. This trend is changing either.

Distribution margins on average have fallen from +15% in 2006 to -15% today, and they will likely continue to fall for the next few years at a minimum. While EV and other asset managers offset these losses through annual management fees, in the past the firms made money on both distribution and management fees. Unfortunately for EV and the industry as a whole, those days appear to be gone for good, as traditional brokerage firms struggle to survive against the backdrop of discount trading, internet brokerage firms, and anemic retail equity trading volumes. I estimate that EV's gross profit margins are 9% lower than they would be otherwise as a result of this reversal in distribution profitability.

Fed Hysteria and EV's Biggest New Product:

Despite EV's poor comparable returns performance over the last three years, and the two major headwinds discussed above, the firm does have a unique new product that is pulling in buckets of assets for the firm; floating rate CEFs. The company's floating rate funds such as (NYSE:EFR), (NYSE:EFT), and (NYSE:EFF) are a novel new closed end category that appeal to retail investor concerns over Fed tapering.

In a rising rate environment like the US appears to be entering, these floating rate funds should do very well. The new CEF funds invest primarily in medium term floating rate corporate bank loans, so they are reasonably safe but still offer a fairly attractive yield even at current low-level interest rates. Thanks to these new funds, net flows for EV were a positive 8.8 billion dollar inflow for the last quarter even after accounting for the miserable performance of the equity and bond CEFs.

In addition to pulling lots of new assets for the firm, the floating rate funds also carry an attractive asset management fee compared with traditional fixed income products. Based on management guidance in the most recent quarter, the firm pulls in 65 bps on equity CEFs, 62 bps on alternatives, 45 bps on fixed income funds, and 55 bps on floating rate CEFs. Thus while the new floating rate products aren't quite as profitable as equity funds, they are much better than traditional fixed income, and they likely have lower associated expenses as well since asset turnover within the fund is likely to be lower.

All things considered, if there is one product that is saving Eaton Vance from a run of bad luck right now, it's these new floating rate funds. Their importance to asset growth rates is huge, and EV can likely continue to pull in 4.5-5.0B quarterly off this asset class for at least the next few quarters while the mania around Fed actions continues.

That said, EV and the rest of the asset management industry as a whole is benefiting from returning interest in active equity investing thanks to the improving stock market and the recent volatility in bond prices. As mentioned previously, fixed income funds management is not nearly as lucrative as equity funds management, especially active equity management. Given this, the Fed tapering and slowly recovering economy should also continue to shift funds out of bonds (and bank savings accounts) and into the more lucrative equity products of Eaton Vance and other asset managers. Unfortunately, with this shift also comes greater compensation expense, as EV's latest quarter showed, but all things considered the trend is still a mildly positive one for profit levels of both the firm and the industry.

Valuation is Too Rich Given Mixed Headwinds and Tailwinds:

Eaton Vance, like most other asset managers, has benefited from the explosion in interest from retail and institutional investors in exchange traded multi-asset investments (i.e. ETFs and CEFs). The firm's financials reflect this as the table below shows. A company, which has more than doubled revenues over the last 10 years despite the severe recession, is surely doing something right. So while Eaton Vance may be a good long-term holding that is not the same thing as being a good buy right now. In fact, with the firm currently trading at a P/E of ~22x ttm EPS, this is probably not the right time to be buying EV as the chart below illustrates.

Year Ending:

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

Cash Flow/Share

1.99

2.11

1.61

1.25

1.68

1.14

1.28

1.18

1.09

0.79

EPS

1.72

1.75

1.42

1.08

1.57

1.06

1.18

1.13

1

0.76

Dividends/Share

0.77

0.73

0.66

0.63

0.61

0.63

0.4

0.32

0.28

0.2

Payout Ratio

45%

42%

46%

58%

39%

59%

34%

28%

28%

26%

High P/E

19

19

25

29

32

47

28

25

26

25

Low P/E

13

11

18

13

9

31

20

19

16

15

Revenue

1,209

1,260

1,122

890

1,096

1,084

862

753

662

523

Net Income

203

215

174

130

196

143

160

160

139

106

% Return on Rev.

16.8

18.1

15.5

14.6

17.9

18.4

18.6

21.2

21

20.3

% RoA

10.7

14.6

14.8

12.7

20.2

17.4

23.3

22.1

19.8

16.6

% RoE

38

52.3

46

44.3

83.4

39.3

32.9

35.4

32.1

26.9

While EV is still doing fine overall and indeed the firm is close to having record profits, RoR and RoA are way down from what they were previously, and while the stock is paying out a nice ~2.1% dividend, the payout ratio is getting to be a bit steep suggesting there may not be a ton of room left for dividend growth in excess of profit growth. Further with the run-up in stock price over the last two years, investors clearly have high expectations for the firm going forward - expectations that may be disappointed.

In summary, asset manager Eaton Vance is facing a serious mix of significant headwinds and has a rich, though not absurd valuation. However, the firm's innovative new floating rate funds are drawing in significant assets and the industry as a whole looks to have good momentum going forward. As such, investors interested in EV need to either be buying for the long term, or else they should wait for a better entry point and for the challenges the firm faces to subside. Alternatively, going long a firm like Alliance Bernstein (NYSE:AB) or BlackRock (NYSE:BLK) while shorting EV should be a profitable strategy as both of these asset managers face less threatening hurdles in the near term than EV does.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.