60% Upside In KKR

Summary

• KKR is a premier asset manager selling at an extreme discount.
• The market overreacted drastically to ordinary earnings volatility.
• Strong momentum and high forward earnings expectations signal recovery sooner rather than later.

After a precipitous drop in 2015 following quarterly earnings volatility, KKR (NYSE:KKR) shares are trading at a significant discount to intrinsic value. The firm has a stellar track record for growing shareholders' capital and delivering outsized investment returns, yet trades at a substantial discount to its historic multiples. While the shares have already picked up 54% in the last 12 months, there is much more price appreciation left to go. Given its strong momentum and lofty analyst estimates for forward earnings, KKR is poised to gain another 60%. In this article, I will address reasons for the share decline, the underlying strength in KKR's business, valuation and timeline.

The opportunity

It is a universally accepted fact in the finance world that KKR is one of the world's finest money managers. Henry Kravis was one of the pioneers of the leveraged buyout, and since its inception in 1976, KKR has attracted some of the most sophisticated talent in finance, which works as hard if not harder than anybody else for returns on investors' capital and, of course, for performance bonuses.

Despite the asset manager's merits, its shares got pummeled in the latter half of 2015, falling to multiples that had not been seen since the aftermath of the 2008 recession. Amazingly (although not surprisingly), the market fell out of love with KKR not because of weakness in its underlying business or long-term prospects, but rather a single disappointing and pessimistic earnings report.

This drop, of course, was simply a classic display of the market's shamelessly short-term orientation and emotional biases. In names like KKR, it is most valuable to remember the core Graham and Dodd principle that a stock should never be judged on a single quarter's results. From this superficial perspective, it is immediately clear that KKR represents a simple opportunity to take advantage of a poor market overreaction. Further, earnings in the private equity industry are naturally volatile, with gains/losses recognized irregularly, forced quarterly marking-to-market, and reliance of different funds on various macroeconomic conditions as well as the inevitable occurrence of statistically improbable investment outcomes. As eloquently stated by Joel Greenblatt, no investment strategy posts strong returns 100% of the time (except for Bernie Madoff's). However, over the long term, KKR has proven itself to continuously attract capital and deliver outsized returns for investors.

In fact, looking at KKR's peer asset managers, namely Blackstone (BX), Apollo Global (APO), Carlyle (CG), and Oaktree (OAK), reveals that not a single one of these competitors has successfully navigated the last decade without a money-losing year. Logically, one would expect earnings volatility to be priced into these names at least to some degree, mitigating the effect of a bad quarter or year on share prices. However, these asset managers get crushed each time they underperform, providing an easy, attractive opportunity for the astute value investor to buy low and turn a profit on the inevitable rebound.

Strength in KKR's underlying business

Having identified the low hanging fruit of a blatant market overreaction, one must simply verify the underlying strength in KKR's business before pulling the trigger on a position. This underlying health is demonstrated in the asset management business by growth in shareholders' capital (book value), assets under management (AUM), management fees, and of course, long-term investment results.

Over the last 10 years, KKR has demonstrated a consistent ability grow the value of shareholders' capital, increasing book value by over 4X since 2010 (KKR SEC Filings), a statistic rivaled by none in its peer group.

KKR Book Value (Annual) data by YCharts

Further, KKR has continued to consistently grow both AUM and the resulting management fees, boosting AUM 2.3x and firm-wide management fees 1.8x since 2010.

Firm-Wide AUM ($ in Billions)

Private Market Management Fees

Public Market Management Fees

Images from 2017 KKR Investor Presentation

Finally, as of this year, KKR has generated a 26% gross IRR (19% net IRR) in mature Private Market funds since inception (Source: 2017 Investor Presentation). This return, of course, just about doubles the 10% return of the S&P 500 over the long term.

These results, combined with the long duration, locked-up nature of private equity investments, lead to reasonable assurance that KKR will continue to grow its asset base and enhance shareholder value for the foreseeable future.

Valuation

Having established KKR as a premier asset manager and its late 2015 share price decline as unjustified, the question remains - what are KKR shares worth?

A study of historical multiples reveals that KKR shares traded quite reliably on book value prior to the 2015 drop - remaining consistently in the 2.0-2.5x range.

KKR Price to Book Value data by YCharts

With shares trading today at around 1.4x book value, a return to the lower bound of the range, or 2.0x, would mean a 43% gain, from $18.54 to over $26. A return to 2.25x would mean a 61% gain to almost $30 per share.

Looking again at KKR's peers, we see that such a valuation is quite reasonable:

Company	P/E (TTM)	Price/Book
CG	24.9	4.1
BX	16.6	3.2
OAK	13.3	3.6
APO	8.8	5.3
Average	15.9	4.1
KKR	10.4	1.4

Click to enlarge

Source: Fidelity Investments

A 60% gain in share price would put KKR on par with its peers in P/E, but it would still be trading at a significant discount to them on book value. Further, KKR's own average P/E over the last 5 years is even higher than that of its peers, at 22.12 (Fidelity).

The upside is promising, but where is the bottom?

At current levels, KKR provides such an attractive investment opportunity because it is trading at quite a low multiple on its book value. Thus, not only can investors anticipate a return to previous price/book levels, but we can also rest assured with respect to the balance sheet value of our capital. Further, with the exception of the last 12 months, KKR shares have not traded at a multiple lower than the current 1.4x book value at all in the last decade. It is therefore quite unlikely that buying in now will result in significant loss.

However, having already established the regularity of earnings volatility in the alternative asset management space, one might worry that further volatility will bring a share price plunge like that of 2015, perhaps to even lower prices. This danger also seems unlikely with overwhelmingly positive analyst estimates for the foreseeable future.

These factors considered, KKR shares present a clear asymmetric risk:reward proposition at current prices.

Time Horizon

Since bottoming out in early 2016, KKR has steadily climbed back toward its early 2015 valuation. In the last 52 weeks, the stock has already gained 54%. Each positive earnings report has propelled the shares higher. With positive analyst estimates for the coming year, this upward price momentum should continue. The 2018 EPS consensus is $2.46 per share, 37% higher than TTM EPS of $1.79. Therefore, KKR shares should return to the pre-2015 multiples range within the next 1-2 years.

Conclusion

In summary, KKR is a stellar company that is currently out of market favor and trading at a substantial discount to intrinsic value. Short-term earnings volatility has created an attractive opportunity for intelligent investors to make a great return.

Analyst’s Disclosure: I am/we are long KKR. 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.