Apollo Global Has A Unique Growth Engine

| About: Apollo Global (APO)
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Private equity leader Apollo Global (NYSE:APO) is one of the best plays in the financial space today due to its top-tier investment returns, strong assets growth, attractive valuation, and most uniquely, it's significant relationship with insurance company Athene Asset Management. This last factor - APO's relationship with Athene is a strategically important growth driver for Apollo that differentiates it from other private equity firms like industry giant Blackstone (NYSE:BX). With 42% of Athene's portfolio directly managed by Apollo through sub-advisory agreements, Apollo's business model will scale directly with Athene, and this presents a huge growth lever for APO shareholders going forward.

All of this opportunity is available to APO shareholders at a recent share price of about $32.50 a share, less than 9X my estimate of 2014 earnings (Adjusted GAAP EPS of $3.50, cash EPS of $2.90). While APO's dividend payout fluctuates a lot, I think investors can expect an average mid-cycle dividend yield of about 8% going forward ($2.60 a share or about $0.65 a quarter), plus 50% capital gains upside (given my target price of $48 or about 16.5X FY 2014 cash EPS).

One important point to note at the outset though: throughout this article, when I refer to Apollo, I am talking about Apollo Global, the private equity firm. I am not talking about Apollo Investment Corp. (NASDAQ:AINV), the asset manager whose prospects I am considerably less sanguine about as I noted in a previous article.

For those not familiar with Apollo, I will discuss the firm briefly and some of its advantages before getting into the unappreciated feature of the business; its highly lucrative growing partner Athene. (Please note that all of my graphics throughout this article come straight from the company's investor presentations, so those are a good place to start when doing further due diligence.)

Apollo Global has roughly $160B under management as of year-end by my estimate (up roughly 5% YOY due to a rough year for credit markets and of course as a result of significant payouts to investors over the last year), spread across three different segments: private equity (about $45B), credit (about $105B), and real estate (about $10B). (Note: figure below does not include the Athene Aviva acquisition which added considerably to the credit AUM for APO as I will explain later.) While the private equity segment may be smaller than the credit segment, it still generates the lion's share of cash earnings - anywhere from 80-90% in most quarters. Here the company focuses on its nine "core" industries for opportunistic buyouts and deals.

This strategy has been very successful for Apollo thus far with the firm bringing in nearly 40% gross and 26% net IRRs since its inception more than twenty years ago. While the firm has only been publicly traded for a few years (since early 2011), I believe over time investors will become more comfortable with the space and award APO a higher multiple based on its rich dividend yield, consistently good earnings, and significant growth potential. The fact that Apollo has consistently beat sell-side earnings estimates including positive earnings surprises in five of the last six quarters (in-line on the sixth), should only speed this process along.

Apollo has been outperforming operationally over the last year generating exceptional results across its portfolio and throwing off mountains of cash for shareholders. 3Q2013 cash distribution alone was $1.01 for example ($3.95 over the last year), while investment returns were up 18% quarter-over-quarter. As a result of this performance, Apollo looks poised to be in the only publicly traded alternative asset manager to avoid the PE fund cliff by still raising post-Crisis funds at similar levels to before the crisis. Its newest PE fund (Fund VIII) for example is reported to have more than $12B in commitments as of 3Q2013. Perhaps this fund raising success is a result of APO's track record, or perhaps it is a result of the firm's exceptional liquidity across many of its investments. In fact, I believe this latter factor is an important driver for APO's stock price as the liquidity and transparency of many of its investments should help to support sustainable, visible, and significant distributions going forward. Roughly 75% of Apollo's assets are categorized as Level I & II assets meaning that these cash-generating, credit-oriented assets are exactly the type of investments that shareholders and prospective shareholders can easily access and value. Further, with APO sitting on more than $1.25B in accrued carried interest, the firm has plenty of firepower to keep paying dividends out going forward.

If this were all there to Apollo, I would probably still find it an attractive investment, but maybe not an outstanding asymmetric risk-return opportunity. While private equity funds are doing well in general, and Apollo is certainly one of the top players in the space, it would be hard to point to something the market was not seeing that would tremendously benefit Apollo over others in the space. Apollo's Athene relationship changes all that (and brings the company into my wheelhouse; the insurance industry).

To be clear, APO is a good long-term investment without Athene. The firm is a great way to gain exposure to the post-Crisis secular trend towards alternative investments, and the firm has high-quality earnings buoyed by consistent carried interest realizations, a healthy orientation towards liquid transparent credit investments, and robust AUM growth driven by outstanding underlying cash earnings. And most importantly the company is cheap at today's levels. With these benefits, over time, Apollo will go higher as investors come to appreciate its consistency and give it a higher-multiple. After all, larger slower-growing peer Blackstone trades at a P/E of roughly 13-14X its expected adjusted forward EPS, hence there is no reason that faster-growing APO shouldn't reach this same multiple over time, providing 50% upside to shares at current levels (13.5X $3.50 = $47.25).

But what is missing here so far to make APO a truly great investment rather than a good one is a key earnings driver… a catalyst… something that the market is missing thus far which will ultimately drive shares much higher without investors having to wait for the slow process of company familiarization with the markets and the subsequent multiple expansion. Athene and its unique relationship with Apollo fills this gap.

The Unappreciated Part of Apollo: Athene

Athene Asset Management was created in 2009 during the Financial Crisis with an experienced management team led by Jim Belardi the former President of SunAmerica Life Insurance. Since that time, the company has grown into a $60B player in the fixed annuity and life insurance business. Essentially Athene's business model is focused on capturing the spread between what it pays out for life insurance and annuities and what it earns from its investments. The Financial Crisis created a unique opportunity for Athene as life insurance companies stampeded out of the fixed annuities markets and looked to divest large blocks of their liabilities. At the same time, the volatility in the markets created greater demand for safe secure income streams like annuities. (This stampede and sequence of events was also a key component in the rise of today's capital-flooded reinsurance world, but that's a story for another time.) Since its formation, Athene has been on a tear growing rapidly both organically and via the acquisitions of Liberty Life Insurance, Investors Insurance Co, Presidential Life Insurance, and most recently Aviva. This last transaction basically tripled Athene's asset base and provides roughly 15-20% upside to Apollo's profits going forward as I will explain in a moment.

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In short, Athene is filling a growing demand in a market that other competitors have abandoned and it is growing rapidly gobbling up assets as others shed them at fire-sale prices. So Athene is doing well and looks poised to keep doing well. But investors can't invest in Athene - it's not publicly traded - so what does this have to do with Apollo?

The relationship between Athene and Apollo is somewhat complicated. Basically Apollo operates a permanent capital vehicle called AAA which owns the vast majority (roughly 75%) of Athene's shares. So Athene is essentially a subsidiary of Apollo. The exact benefits that Apollo receives from Athene are impossible to determine as the disclosure docs between the two companies are purposely vague. In total though, I estimate that Apollo will generate $300 million in cash from its ownership share in Athene in 2014. As the lucrative nature of this relationship becomes clear (especially in the wake of the Aviva transaction which greatly increased the size of Athene), I think the market will begin to at least partially apply an insurance multiple to Apollo. This will dramatically increase Apollo's multiple as insurance companies frequently trade at mid-teen or low-twenties multiples of their adjusted earnings.

AAA (formally called AP Alternative Assets and traded under the ticker (OTC:APLVF)) was created in December 2006 to provide investors with exposure to Apollo's investment strategies. In October 2012, the two firms entered into a transaction that swapped AAA's private equity fund investment stakes in Apollo's PE funds for Athene shares. Athene is mainly owned by public shareholders, but Apollo still holds a 3% stake. Yet APO has fee and equity arrangements with both Athene and AAA making it eligible to receive significant income from both and entitling it to 20% of AAA's book value growth. This in essence gives APO an outsized stake in Athene. At the same time, given the complexity and lack of transparency in the agreement, it's not hard to see why the market has been heavily discounting this important growth engine for Apollo.

Yet the Athene growth engine got a turbo-charge of sorts when last December Athene announced the acquisition of Aviva's US annuity and life insurance operations for $1.55B - a full 50% discount to Aviva's statutory book value of $3.2B as of June 2013. This acquisition significantly scales up Athene and gives it expanded sales and distribution muscle. This was a very significant transaction as Aviva brings $45B in AUM, tripling Athene's base. It also gives Athene ownership of the third largest US fixed annuity franchise. Since Apollo manages a healthy block of Athene's investment portfolio, this acquisition gave APO a huge boost to assets under management. Prior to the acquisition, Athene was 14% of APO's assets. Today it is roughly 40%. This deal will double Athene's net income and boost APO's income by ~15% as a result of the cash fees Athene pays to Apollo. In addition, Apollo will benefit from Athene's growth in book value (which does not appear to be slowing down and which will get an immediate boost once the Aviva deal closes and AAA writes up the value of Aviva to its full statutory levels). Since Apollo is entitled to 20% of increases in AAA book value, what's good for Athene and AAA is also good for Apollo.

Athene's continuing growth and income will add $300 million in cash earnings to APO's bottom line this year with further increases in the future at perhaps a 10-15% growth rate. In addition, Athene is scaling up with the intention of going public. Apollo has the ability to convert some of its management fees into additional equity ownership in Athene. This would perhaps bring Apollo's stake in Athene up to 19% by my estimates. With Athene having a book value right now of perhaps $4.8B, and growing at a low double-digit rate, Apollo's stake in the company is worth nearly $1B - a figure which the market does not appear to have incorporated into Apollo's value at all. As Athene moves closer to an IPO - an event which could occur within the next 1-2 years based on historical PE spin-off propensities- the value of Apollo's stake should become much more obvious.

Risks to an Investment in Apollo

The primary risk to this story is a breakdown in the credit markets similar to what we saw in 2008-2009 which would lead to a breakdown in private equity returns. On the other hand, even if this were to occur, it would drive more demand for fixed annuity products like those which Athene sells and thus it would ensure a flood of cash for APO to invest thereby shoring up the firm. On the other hand, if the economy were to take-off again and life insurers came flooding back into the fixed annuity business and alternative asset returns were very good, fixed annuities would become less attractive, hurting Athene, but APO's private equity funds would do very well, leading to overall firm outperformance. On the whole then, it would seem that counter-cyclical Athene balances out pro-cyclical Apollo very nicely.

Interest rate increases should actually help both companies by providing new investment opportunities (though they would temporarily ding Athene's book value), and emerging market weakness should lead to increased interest in both Apollo and Athene's products resulting in greater AUM flows. All things considered then, other than a complete operational breakdown at Apollo, the firm has relatively few risks compared to peers and the broader market going forward.

In summary, Apollo Global looks like a great investment at these levels given its high degree of operational excellence over the last twenty plus years, the company's very attractive dividend yield, and its strong positioning to capture further equity market outperformance. At the same time, Apollo is inexpensive on both an absolute and relative basis and its ownership in Athene offers an exceptional catalyst and growth driver for the future. The Athene stake adds at least 20% to Apollo's overall value as a result of the cash earnings and its minority stake in the firm. Given this, more than 50% upside for Apollo shareholders looks very likely (based on comparable P/E multiples to the market and Blackstone as explained above). As the Athene/AAA/Apollo relationship gets explained better to the market and APO gains a longer and more credible track-record, I expect significant share re-valuation.

Disclosure: The author is long APO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.