Waddell & Reed: Proven Results, Future Profits

| About: Waddell & (WDR)


The vast majority of people lack the time and inclination to manage their own money which creates opportunity for those who can do it for them.

Providing a product or service that embeds a business into the life or business of its customers enhances customer retention and creates dependency on that business.

The profits potential for Waddell & Reed is well above average.

The risk is small given the proven ability of management to navigate through a crisis.

There are two exceptional ways to profit from this business.

One of the lessons I have learned over 20-plus years of managing my own investment portfolio is that it takes a fair amount of time and effort to perform the function successfully and the larger my net worth the more time and stress there is involved in the process. I do not see the demand on my time as a burden, it has actually become a passion for me over the many years I have been doing it. I love to monitor my results and "compete" against the overall market.

Most people have neither the passion, nor the time required, to be successful in these activities. They prefer to focus their energy in the areas where their particular strengths and passions fall and leave the mundane tasks of stock analysis and capital allocation to be performed for them by others. This is why the financial services industry exists. It is profitable because it provides essential products and services to people who can and will pay handsomely for the comfort and security of having a professional who has earned their trust handle the details of this critical aspect of life for them.

One of my favorite traits to find in a business I am analyzing is the ability to embed its products or services seamlessly into the lives or businesses of its customers in a way where they are difficult or uncomfortable to extract. The financial services sector fits the bill here in spades and Waddell & Reed (NYSE: WDR) has the track record and future potential to warrant the attention of potential investors seeking long-term steady growth.

How Deeply Can Waddell & Reed Embed Itself Into the Lives of Its Clients?

Waddell & Reed offers financial services to both individual and institutional investors. While it is a bit of a simplistic analogy, I think of institutional investors in almost the same way I view individuals. They are very loathe to change once a relationship has been established and they enjoy the feelings of comfort and security that they build from long-standing relationships.

Unless they happen to be clients, I imagine most people who hear the name Waddell & Reed have the same initial reaction I did and think "stock broker"; but this company is much more. It is easy to move a brokerage account and it happens on a regular basis. Moving one's entire financial structure is a completely different matter. When I was reviewing the products and services section of the Waddell & Reed website and realized how deeply the range of products offered could entrench this business in the lives of its customers, I was excited. For just about any financial event or need that you can think of, Waddell & Reed offers a product or service. In many cases, these products and services are branded and managed directly under the Waddell & Reed brand. How difficult would it be to move every financial product in your life, from your brokerage account and investment advisors to your long-term disability insurance from one place to another and how long would it take to rebuild that kind of relationship with a new advisor? I just don't think this is something most people are going to find an attractive undertaking once they have built a broad financial foundation with one company.

Building this kind of relationship with successful clients also provides Waddell & Reed the opportunity to receive very high quality referrals for new business through their existing clients. After all, when your successful friends or neighbors mention financial matters, don't you pay attention? I find it common for people I know to mention the name of their financial advisor on a regular basis. I also find it common for people to respond to me with: "I don't have time to do that," when I tell them I manage my own money and perform my own research. It is one of the factors that caused me to look into the financial services sector in the first place.

According to Barron's 2013 Best Mutual Fund Families, Waddell & Reed's Advisors Funds ranked number 4 out of 48 for 10-year performance. This level of performance provides clients with not only a reason not to leave but, even better, it gives them a strong incentive to stay.

Steady Growth; Solid Financials

I am a numbers driven analyst and that trait has served me quite well over the years. The results of my approach and analysis process are clearly displayed on my website where I publicly trade a portion of my portfolio. The numbers for Waddell & Reed reveal a business that grows steadily in almost every critical category needed for success while also growing the rewards for shareholders as well.

According to the company's financial disclosures, they have increased sales from $504 million in 2004 to $1.37 billion in 2013. During that same time period, EBIT (earnings before interest and taxes) has increased from $102 million to $253 million. For the most recent quarter, the company reported sales that increased 23.8% over the comparable quarter in 2013 and earnings that increased 50.4% respectively.

Over the last five years, Waddell & Reed has rewarded shareholders by increasing its dividend by 8.06%/year and still only has a payout ratio of just under 37%. This is a very sustainable ratio and also allows room for further increases through earnings growth, increasing the payout ratio or both. The 8% annual increases in a time of very low inflation and interest rates shows the willingness of management to reward shareholders. The current dividend at $1.36/share produces a very respectable yield of 2.23% based on the current price of $60.01.

In terms of how existing management takes care of shareholders money it retains for business purposes; the record shines brightly as well. Over the past five years, returns on equity, assets and capital have averaged 35.2%, 15.8% and 23.7% respectively. These are exceptional numbers and display the capital efficient nature of the business. In my experience, businesses that perform well in these three metrics will, over time, see the appropriate valuations assigned to the share price in the market.

The debt to equity ratio on the business is a very manageable 26% and the interest is covered 39 times by the earnings. There is very little risk that Waddell & Reed will default on the debt; making insolvency and virtual non-issue.

There Is Value; But Is It Compelling?

As a value focused investor, I find myself typically drawn to opportunities that, in my view, are vastly undervalued. In the case of Waddell & Reed, I do not see the business as currently being severely undervalued based purely on the financial metrics of the business.

The current price to earnings ratio based upon average projections of the analysts covering the stock is $16.04 for 2014. If the 2015 projected earnings are used, the ratio falls to 13.76 times earnings. If the business simply maintains its current earnings multiple into 2014, the share price would rise to $69.76 for a capital gain of 16.24% over the next 12 months plus investors would collect the 2.2% dividend for a total return of 18.44% over 12 months.

Over the past 90 days, the average earnings estimates for 2013 and 2014 have increased by 1.9% and 2.8% respectively which provides a reflection of the generally favorable and improving assessment of those who earn a living following this company. These same analysts also project the company to continue growing its earnings at an 18.9% annual pace for the next five years.

While this business does not seem to offer the potential for the kind of explosive upside I sometimes find, it does present the kind of picture I like to see and certainly offers the potential to produce a total annualized return in the 12%-15% range over the long term.

There Is Always Risk Involved

Any time I am analyzing stocks, I try to keep in mind the potential risk and perform an evaluation of the likelihood of the worst case event materializing and the extent of the potential damage should it do so. For better or worse, we can look back on one of the worst financial meltdowns of my life, 2008, and see how Waddell & Reed performed in a year when many of the marquee names in the industry collapsed in actual or near bankruptcy.

While the stock price was crushed, falling from $37.65 at the end of 2007 to $8.57 by November of 2008. However, even amidst the carnage of the worst financial collapse many have ever seen, Waddell & Reed still managed to report earnings of $1.15/share. This was a very impressive feat in an environment where many thought the entire global economy was on the verge of destruction. So, while there is always risk, management here has proven their ability to bring the business through crisis and continue to provide value for patient shareholders.

Actionable Observations

When I am considering capital allocation, I like to have choices of attractive options. Waddell & Reed easily clears the bar in this regard. I have found three potentially attractive ways to approach a new position in WDR.

Passive investors who are simply seeking a buy and hold position with good prospects for producing market beating returns over the next five years can simply buy the stock and hold it for the long term. This position could easily return 12%-15% per year for the next three to five years.

Those investors who are inclined to insist upon receiving a discount on everything they buy, can consider selling the $60 strike price July 19, 2014 put options. The current bid/ask on these options is $1.85/$2.30. If the options were sold at the current bid, they would produce an immediate return on the $60.01 share price of 3.08% or 32.09% annualized over the 35-day life of the trade. If WDR is trading below $60 on July 19, the shares would be assigned at $58.15 or a 3% discount to the June 13th closing price. If the shares are not assigned, the seller will just have to settle for making a 3% return in a month.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in WDR over the next 72 hours. 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.

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