What Low Rate Environment?

| About: Waddell & (WDR)


Waddell & Reed Financial, Inc. has paid its shareholders without any dividend interruptions since 1998.

Current valuations for WDR are reflective of 2008, financial crisis lows. Is this justified?

WDR is exposed to asset prices in general, but the high yield concerns have been over-hyped.

With a safe dividend yield around 7%, today's valuations could pose a strong income investment with high potential for even future income growth.

Waddell & Reed Financial, Inc. (NYSE:WDR) is a asset manager that primarily manages mutual funds as well as a retail financial advisory firm. Under its asset management company, Ivy Funds, it offers closed-end funds, mutual funds, 529 plans, and variable insurance products. Ivy manages both equity and fixed-income funds in many areas including allocation, domestic, international, sector specific, and various fixed-income and municipal bonds.

In the recent environment, it seems that most analysts are concerned by the Fed's interest rate policy, the current collapse of the energy sector weighing on junk bonds, and the recent high yield fund closing of Third Avenue. All of these fears seem to be extrapolated entirely to WDR, without any regard to the entire scope of their business.

To help give a perspective on where WDR currently trades, we'll quickly go through some basic valuation charts showing its historical price compared to its book value, earnings (NYSE:TTM), and sales . Then, we'll review how WDR compares to its own industry of asset managers. I believe these charts help illustrate how this stock can be used as a good income investment; however, I also believe there is plenty of room for capital appreciation, assuming the company continues similar returns on its book.

Price to Book

WDR now trades at a price to book value of 2.519. This compares to a record low value of 2.444, which was posted at the bottom of the financial crisis. I would like you to think about that for a minute. This company, which is primarily engaged in the retail investor side of finance, is trading at a similar value that was seen when some believed our financial system would no longer exist.

As briefly mentioned in the company introduction, WDR also does business under Ivy Funds, which manages a flagship high yield fund. Many point to this as a reason for such a discount, citing exposure to the asset class in general. Also, another asset manager Third Avenue recently closed its doors on its high yield fund, and some say Ivy may soon follow. However, I do not believe that the two funds are even remotely comparable. For example, the majority of Third Avenue's holdings were comprised of unrated securities. Ivy's holdings are made up of only 4% of unrated assets.

Looking more specifically at the asset class, high yield spreads traded almost as high as 2,000 basis points in 2008. Currently, spreads sit at less than half of that spread, at 787 basis points. In 2011, spreads got as high as 841 basis points. The Fed's current interest rate policy could be affecting these spreads, by tightening monetary policy further and potentially causing more stress on high yield debt. Also, the energy sector has also caused excessive stress on the asset class as well, now comprising of roughly 10% of the high yield market. But I do not believe this to be good cause to price the company at such extremes. WDR's business does not solely rely on high yield debt. They are a diversified asset manager and financial advisory firm. It's odd for me to hear this argument about their junk bond fund when it's just a piece of their business. I do not believe the company will, but it could close its high yield fund, and I wouldn't be too concerned. In the short-term, I believe international exposure to be a more logical concern than junk bonds. Ivy has several allocation, domestic, international, sector specific, fixed income, and municipal funds with billions in assets spread among their funds.

Price to Earnings

While WDR is battling to set records for its price to book values, it still has some room on the earnings side. However, please note these are trailing numbers. In 2008, the stock was able to register a PE of 6.864. At current earning levels, WDR would have to trade down to $21.62 in order to reach the same level, which is almost another 15% off from its closing price on January 25th. Yes, it could trade down to these levels, but there is no guarantee. I believe it is already incredibly attractive at these levels.

Price to Sales

The price to sales (PS) ratio tells a similar story as the earnings, which should not come as surprise. WDR saw a PS ratio of 0.941 at its bottom in 2008. I would be surprised to see these levels again, but everything is possible.

Price to Free Cash Flow

As a bonus, I just wanted to show a chart that is now breaking records for the company. When looking specifically at free cash flow, we find that WDR has never been valued this inexpensively. To help you better understand how this is calculated since some methods differ, YCharts uses the following formula:

Net Income
+ Depreciation/Amortization + (Interest Expense - Interest Income) * (1 - Tax Rate)
- Changes in Working Capital
- Capital expenditure
= Free Cash Flow

So how does it stack up to the competition? Well, below we see a chart pulled from Morningstar comparing WDR to the industry averages for asset managers.

Data from Morningstar.com

The first data point that may stick out to you first is the excessive price to book value when compared to the industry. However, WDR has an ROE level three times higher than the industry average. In my opinion, this justifies a much higher valuation on the price to book (NYSE:PB) value when compared to its peers, which is why I posted the charts above to help illustrate additional metrics as well. Historically, WDR is currently trading at relatively low PB values. WDR's low debt levels are just an added bonus, and it puts more security in its dividend, which is my primary driver for investing in the name.

Currently, the company has a dividend yield above 7%. But, how sustainable is this yield? Looking at the history of WDR's dividend yield and payout ratios, we do not find ourselves at excessive levels nor are we left with any concerns. The chart below visually expresses this.

The red line above expresses the historical payout ratio. This ratio shows how much of WDR's earnings are being used to pay shareholders with dividends. There is debate on what level is considered too high, but I marked 100% to help you see the company has been beyond these levels before. I wanted to focus on the company's personal history in paying dividends. Now, paying out more than all your earnings to shareholders would logically seem unsustainable. In this event, debt would usually have to be issued, which the company has plenty of room to issue, if necessary. However, especially at this point in time, it should not be necessary, since payout ratios are currently barely above 50%. Even the last two times payout ratios exceeded 100%, WDR did not have any net debt issuances. In fact, the company hasn't had any net debt issuances since 2004. I would expect payout ratios to increase as earnings should decline in the short-term, however, we will address this in more detail below.

During the recent financial crisis, many companies at least halted or lowered their dividend payments, which was a prudent act. But, WDR was able to continue paying shareholders at a constant rate and did not issue debt or even lower dividends. At its highest dividend yield level, WDR was paying out 7.01%. You would have only been able to achieve this yield by perfectly timing your stock purchase and cherry picking it at its bottom. This is, of course, difficult to do. However, yields have again reached these levels. In essence, you are being given a second opportunity to achieve such high income levels in similarly low interest rate environment.

Let's go back even further than the recent financial crisis. Looking at data from DiviData, we see WDR has been paying dividends since 1998. The company has been able to raise dividends over time, and it has never once lowered dividend payments. The only caveat being the one-time special dividend paid in 2012 due to tax concerns for its shareholders. A special dividend was paid, causing dividend payments to temporarily spike and quickly returning to normal levels. Many other companies participated in paying out special dividends in 2012 as well.

So, hopefully these charts made it clear that WDR should continue to pay its dividend, and there isn't a single, imminent concern that I can find implying an inability to do so. If the company's situation were to deteriorate further and begin to justify these current price levels, WDR could issue modest debt to cover the dividend if there was a sustained hiccup in earnings. But, I must also remind you about the information presented above, the company has reach levels above 100% payout ratios twice in the last decade. In both instances, WDR continued paying the dividend and eventually saw payout ratio levels fall. Once levels fell, WDR was able to increase dividends further.

Admittedly, I do not foresee any massive business specific catalysts to propel the stock price higher at this time. Sure, the company could continue to face increased competition. Asset prices may fall. Fund flows may adversely affect the firm. FinTech may continue to play a more demonstratively role in the advisory business and cause pressure on margins. However, I strongly believe the stock to be priced at an incredible value without any current justification for such low levels. Given the recent swings in the market, I would inherently expect the company's earnings to slide slightly lower, but I only expect this for the near-term. As markets recover, the company's earnings will also follow. These are just the normal swings of an asset manager's income stream. Asset managers charge fees as a percentage of assets. As asset prices increase, so goes the income of the manager. The inverse is also true, which is why earnings could be temporarily impacted.

As a harbinger for risk of not collecting the dividend, we can look specifically at its payout ratio. At these levels, WDR's earnings could fall by almost 50%, and it would just begin hitting the 100% payout levels. It seems this would be well worth the risk with this large of a cushion. At its peak in September of 2006, WDR posted payout ratio levels of 140%. Currently, the payout ratio rests at 52%. While payout ratios could easily move higher in the near-term due to slightly lower earnings, I do not find this to be of much concern for the dividend.

It seems the market has priced the company at levels indicating a severe recession and continued decline of financial asset prices. Currently, it appears that WDR is being priced identically to its valuation levels that it saw in the midst of the greatest financial crisis the world has seen this century. I, being an eternal optimist, do not believe we will see anything like 2008's black swan for several decades. With that perspective, WDR appears to be on sale at 2008's low valuations. By accepting some volatility, WDR can give you a seemingly safe, high-yield dividend. If valuations simply normalize, you will have collected some good income, while watching your capital generously appreciate. I believe the company will eventually see valuations normalize, as long as the US does not spiral into a recession in 2016. I do not believe recession is in the immediate cards, however if WDR was able to maintain their dividend in the financial crisis, I strongly believe it will be able to handle the next recession with ease.

It should also be noted that WDR has not and is not issuing stock. The company continues to manage itself in a very shareholder friendly manner. It's average diluted shares outstanding has remained relatively stable over the last decade. I personally would prefer to see them on a buying spree at these valuation levels, even if its only a modest share repurchase program. I would not want to see debt issued to accomplish this, but rather plow retained earnings back into buybacks until valuations begin to rise. Honestly, it would be nice to simply see the company just authorize such a buyback plan and not even act on it unless continued record low valuation levels are observed. Buying back stock at these levels could have tremendous future benefit for the company, as it seems to be such a strong dividend grower. I believe it would strengthen its ability to increase dividends even further sometime in the future, if it were to buy back stock at a current yield of 7%.

With all the concerns surrounding high yield debt which is arguably weighing on WDR, I wanted to show a quick comparison in dividend or income yield between WDR and the JNK ETF, which is a diversified ETF of junk bonds.

While it was not the case in 2008, you can now receive similar yield in WDR as you can the JNK ETF. Given the choice of buying-and-holding one moving forward, which would you choose for the long-term?

Disclosure: I am/we are long WDR, BEN.

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.

Additional disclosure: This is not a personal recommendation, but simply an illustration to show what we believe to be an attractive dividend investment. It should not be taken as advice, and you should speak with your investment advisor before making any personal decisions.

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