Distorted AUM Growth Makes WisdomTree Investments Vulnerable To The Downside

| About: WisdomTree Investments, (WETF)
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On the surface WisdomTree Investments (NASDAQ:WETF) appears to be a rapidly growing company that justifies its lofty valuation of 60-times trailing earnings, 17-times sales, and 24-times book value. In fact the company's revenues doubled from the third quarter of 2012 to the third quarter of last year. Profits more than tripled during the same time frame.

While investors don't expect growth to continue at break-neck speed, they do foresee profit growth exceeding 50% in the next year. This is due to secular growth in the ETF market generally, and the company's track record of launching innovative ETFs--most notably the Japan Hedged Equity Fund (NYSEARCA:DXJ).

However, I think that the company's 2013 growth was largely the result of the unrepeatable success of the Japan Hedged Equity Fund, which saw its AUM surge from about $2 billion a year ago to nearly $13 billion today.

In order to more accurately measure the company's growth I submit that we should "correct" the company's actual AUM and sales growth to exclude the Japan Hedged Equity Fund's success on the assumption that, while it was a great success, it almost certainly cannot be repeated. In doing so I maintain that the company's future growth prospects are far more modest than what analysts have projected.

Without the success of the Japan Hedged Equity Fund WisdomTree's AUM growth would have been modest--24%. But it gets worse. About half of the growth ex-DXJ was due to growth in U. S. equity funds, which saw soaring stock prices as a significant tailwind. U. S. equity AUM grew by nearly 60%, but equities were up nearly 30% when over the past 20 years the S&P500 has a CAGR of about 7.5%. If we normalize last year for an "average" U. S. equity market performance we have to shave 1/4 of the growth we saw from WisdomTree last year, and so we are down to about 18% AUM growth.

But how long can 18% AUM growth continue? Given the company's current AUM figure of $35.1 billion, if this were to continue for 20 years we would have to assume that WisdomTree would have nearly $1 trillion in AUM, or more than half the current ETF market! While this is not impossible I think it is extremely unlikely. Ultimately if we are to model WisdomTree's future growth we need to factor in some deceleration in AUM growth from this 18% figure.

Finally, not only do we have to assume deceleration in the company's AUM growth, but we must consider the realistic possibility of margin compression. ETF management is a phenomenal business from a margin perspective because once the fund is designed and once it gets past the regulators it is a matter of collecting and distributing assets and paying small brokerage fees. As a result WisdomTree saw net profit margins at over 25% last quarter. But recently we have seen the company's realized net expense ratio fall from 0.54% to 0.51%. Some of this is due to the fact that the Japan Hedged Equity Fund has an expense ratio of 0.48%, but the fact of the matter is that because ETF management is such a great business lots of money managers want to participate, and increased competition will lower expense ratios and compress margins.

We can see additional margin compression if the company launches ETFs that fail to accumulate a significant asset base. We have seen this recently from WisdomTree, which launched the Germany Hedged Equity Fund (NASDAQ:DXGE) ($7 million in assets), and the Korea Hedged Equity Fund (NASDAQ:DXKW) ($2.3 million in assets). Since margins on funds rise with assets these funds do little more than add to expenses.

Ultimately I think WisdomTree can grow its AUM and its profits over time. Furthermore, I think it is a solid company with a competitive advantage, as it has proven that it can offer products in which investors find value. But the presumed growth implied by the current share price is unrealistic, and the shares should be avoided for the time being.

"Normalizing" WisdomTree's AUM Growth Rate

In the past year--from January 18th 2013 to January 17th, 2014 WisdomTree grew its AUM as follows.

AUM Category/Year 2013 2014 Growth
Total $20.1 Billion $35.1 Billion 75%
DXJ $2.1 Billion $12.9 Billion 614%
U.S. $4.5 Billion $7.1 Billion 58%
Normalized U.S.* $4.5 Billion $6.2 Billion 38%
Normalized Total** $18 Billion $21.3 Billion 18%

*Note that the normalized U. S. figure assumes 20% less asset growth, which is roughly the difference between last year's S&P 500 performance and the 20-year average. I believe that this normalization is conservative. WisdomTree offers a lot of small-cap and mid-cap U. S. equities, and these did even better than large caps in 2013 (e.g. +40% for the Russell 2000), but over time they do not outperform the S&P by much. Normalizing last years AUM increase by 25% would have been more accurate, but I want to be conservative.

**Note also that the normalized total excludes DXJ altogether. There are potential variations that we can consider such as including DXJ but assuming the average growth of the Japanese equity market, which is negative given Japan's extended bear market. This makes my 18% figure generous, but not unrealistic.

Valuing WisdomTree Investments

The above table should raise some eyebrows considering that the company's shares trade at 60-times trailing earnings, or 37-times Q3 earnings assuming they are annualized.

But paying 37-times earnings for a company that is going to grow its earnings at 18% annually isn't such a bad proposition. What concerns me is that this growth rate is unsustainable, as is margin expansion.

Therefore, I want to assume some deceleration in the company's AUM growth in calculating the company's discounted cash-flow. I will use 5% and 10% deceleration rates, although I will give the company the benefit of the doubt and assume a minimum AUM growth rate of about 8%, which is slightly faster than the growth of the S&P 500 over the past couple of decades. This means when I calculate the company's 20-year accumulated discounted cash-flow I will freeze deceleration at 16 years for 5% and at 8 years for 10%. In my first calculation I will put aside my concerns regarding future margins and assume that margins remain flat.

The following table calculates WisdomTree's accumulated discounted cash-flow over the next 20-years using 8% and 12% discount rates and the aforementioned assumptions. I am also adding $91 million to account for the company's equity

Discount Rate/Deceleration Rate 5% 10%
8% $2,701 million $1,641 million
12% $1,763 million $1,169 million

Given this matrix we see that only in the most optimistic scenario does the stock have upside from its current $2.3 billion valuation, and this is only 17.4% upside vs. larger potential downsides, as the following matrix illustrates.

Discount Rate/Deceleration Rate 5% 10%
8% 17.4% upside 28.7% downside
12% 23.3% downside 49.2% downside

Clearly the risk does not justify the reward even when we consider that the company has stable margins.

But as we have seen the company's margins are at risk. This hits valuation significantly even if we assume a modest compression of margins of just 3% per year after 5 years of flat margins.

Discount Rate/Deceleration Rate 5% 10%
8% $2,096 million $1,360 million
12% $1,418 million $1,000 million

Even a modest reduction in margins leads to a set of scenarios in which we cannot justify owning the company with its $2.3 billion valuation. Furthermore, the downside risk is clearly heightened.

Discount Rate/Deceleration Rate 5% 10%
8% 8.9% downside 40.9% downside
12% 38.4% downside 56.5% downside

Conclusion

Ultimately we can only justify owning the stock using a slow deceleration AUM rate with flat margins and a bullish discount rate.

This makes for a very poor investment thesis, as one usually justifies owning a security if it is worthwhile to own even in less favorable scenarios. Given these valuation matrices one has to conclude that WisdomTree shares are a good short-candidate.

Of course there are risks to this. The two obvious ones are that AUM continues to rise at a faster than expected rate due to rising asset prices in the short term. We know that in the long run we can expect normalization in asset price appreciation but this doesn't mean that we can't see a double digit increase in stock prices in the next few years. If this also occurs in international equities then we can see far more rapid growth in WisdomeTree's AUM than anticipated. Further, given such a scenario my concerns over the company's margins will likely not come to fruition and the profits can grow at a faster rate than sales and AUM.

The second risk to this is that another fund becomes popular amongst investors and its assets soar. We saw the incredible impact that the Japan Hedged Equity had on last years AUM growth. This is not a very likely scenario--rarely do ETFs go from minimal AUM to becoming one of the largest ETFs in the world. DXJ went from less than $1 billion in assets in late 2012 to nearly $13 billion in assets presently, making it the 29th largest U. S.-traded ETF. However, this could happen again, and such a scenario would skew my above figures and would force me to re-evaluate my thesis.

Ultimately, however, these scenarios are fairly unlikely, and more importantly they are out of the hands of the company. WisdomTree certainly cannot control asset prices, and it cannot create a popular trend such as buying Japanese stocks and shorting the Yen. A more realistic scenario will likely pan out and be characterized by slowing growth and flattening margins. Therefore I think that holders in WisdomTree shares should consider selling at the current lofty valuation. Investors who are more aggressive or who expect a more pessimistic scenario (e.g. weak stock prices or a more competitive industry with rapidly shrinking margins) should consider taking a short position.

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.