BlackRock, Inc. (NYSE:BLK) 2018 Goldman Sachs US Financial Services Conference Call December 5, 2018 8:00 AM ET
Gary Shedlin - CFO
Alex Blostein - Goldman Sachs
Okay. Good morning and thank you for joining us again, everyone. As I'm sure you're aware, today has been declared a National Day of Mourning to honor the life and contributions of the 41st President of the United States, George H.W. Bush in recognition of his service to our country. Before we begin today's presentation, please join us in taking a moment of silence in his honor.
Okay. Thank you. For first presentation, please help me welcome Gary Shedlin, BlackRock’s CFO. While 2018 has clearly proven to be a more challenging year for the markets, the firm continues to deliver industry-leading organic growth, particularly via its further success in the ETF franchise, fixed income and an alternative investments. In addition, BlackRock's technology offering remains a true differentiator, which we expect will drive further on correlated growth and asset flows over time.
Gary will open it up with a few slides and then we'll have some time for Q&A. Thank you.
Great. Thank you, Alex. Good morning. Good morning, everyone. As Alex said, I'm Gary Shedlin, the Chief Financial Officer of BlackRock. Thank you all for taking your day off from the markets to spend with us today.
For those not familiar with BlackRock, we are the world's largest and most diverse integrated asset manager and technology service provider. At September 30th, we managed $6.4 trillion in assets on behalf of clients worldwide. We also provide technology services to many of the world's most sophisticated asset owners, investors and wealth managers. The combination of our asset management and technology platform fosters deep, holistic relationships with our clients.
As clients are increasingly focused on outcomes, our integrated platform is positioned to deliver investment solutions, leveraging the industry's most comprehensive array of active and index strategies across equity, fixed income, multi-assets, alternatives, and cash. More importantly, the diversification of our platform enables us to meet client demand in almost any market environment, enabling BlackRock to generate higher and more consistent organic growth than the industry and our traditional publicly traded large cap peers. Our scale and diversification translates into more consistent financial results across market cycles and the ability to invest for the future, whether in good markets or more challenging ones.
Many of you are also familiar with our framework for shareholder value creation, which guides our managerial decisions to simultaneously optimize organic growth, operating leverage and capital return, in order to generate differentiated earnings growth. Over the last five years, we've actually executed pretty well against this framework. As you can see, we've generated 4% organic asset growth but importantly 5% organic base fee growth, in line with our aspirational target.
We've expanded our operating margin by 330 basis points, as you leverage the benefits of scale while simultaneously investing for future growth. While we do not manage the business to a specific margin target, we like to say that we are always margin aware. And we've also returned significant cash to our shareholders. Earlier this year, we announced a 25% year-over-year increase in our annual dividend, which has now grown at a compound annual growth rate of 13% over the last five years.
We’ve also repurchased $5.7 billion of stock since 2013, enabling us to reduce our total share count by 6% over that time period. We remain committed to a consistent and predictable share repurchase program. We will not attempt to predict beta, and we do not intend to be market timers. However, we will act if we see attractive relative valuation opportunities as we did last quarter when we actually accelerated our buyback and repurchase $500 million of BlackRock shares.
In the aggregate, for 2018, we anticipate either reinvesting or paying out approximately 100% of the cash we generate. And as we do each year, we will reevaluate our capital management plans for 2019 at our Board meeting this coming January.
However, despite execution of our framework, which has resulted in differentiated organic growth, margin expansion and capital return, there is continued focus on the historical decline in our effective fee rate. To understand this change, I'd like to take a step back and look at the underlying drivers of growth and assets under management or AUM and our base fees.
As you can see on this chart, since 2012, AUM has grown by an aggregate of 66% while our base fees have grown by an aggregate of 35%. Together, the math is pretty easy that obviously results in a decline in our overall calculated fee rate.
Importantly though, as you can see over this time period, organic growth contributed a little over 25% of aggregate growth in both AUM and base fees, suggesting that despite mix change or product preference in any particular market, organic growth itself isn’t a driver of the decline in our fee rate. The same can't be said for the impact of beta and FX over this time. As you can also see, while AUM grew about 36% as a result of the market, base fees associated with this market growth only grew 10%. While the impact of beta and FX clearly added to our overall AUM and revenue growth over this time, it also resulted in a decline in our fee rates.
The difference in growth rates of AUM and base fees attributable to markets is primarily due to what we call divergent beta. At times, it can be accretive to our fee rate and at times it can actually be dilutive, much as it has been over the last five years. However, in any case, up or down, it’s something that’s just out of our control.
So, let’s take a closer look at what leads to divergent beta. We managed $3.5 trillion of equity assets across markets globally. U.S. exposures, which tend to be lower fee compared to Europe, Asia, emerging markets and commodities make up over 50% of our equity assets but contribute only 37% of equity base fees. On the other hand, AUM in those international and commodities markets represent only 15% of equity assets, but 36% of base fees.
Since the end of 2012, while overall U.S. markets are up about 94%, higher fee market exposures are up significantly less significantly less, including emerging markets which are actually down 6% on dollar basis and commodities markets which are down 14%. The result more generally is when lower fee developed markets outperform higher fee developing markets as we’ve basically seen for the last five years, the proportion of our AUM, weighted towards lower fee products increases resulting in a decline in our fee rate. We actually see similar results in periods of dollar appreciation, given that all of our U.S. products are dollars denominated. The impact of this beta and FX divergence has been meaningful over the last few years, as the global revenue weighted BlackRock equity index is up only 23% compared to significantly higher U.S. market gains. Ultimately, while both AUM and base fees have grown these divergent market factors have contributed to a disconnect between their respective growth rates and driven our fee rates down.
Overall, our fee rate is an output, driven by a number of factors, some of which we can control and some of which we can’t control. We can influence organic growth by having the right products on our platform, generating sustainable alpha and executing our global distribution strategy. We can also control the level of strategic pricing investments we make in our business. As you can see, over the last five years, the combination of those factors we can control has not resulted in a reduction in our fee rates, even taking into account, the impact of various pricing investments. Divergent beta and FX movements, however, are elements we can’t control and they haven’t had -- they’ve had an outsized negative impact on our effective fee rate over time. In fact, almost 100% of our fee rate decline over the last five years can actually be attributed to this divergent beta.
Our focus as the management team remains on what we can control, and that’s on optimizing organic growth in the most efficient way possible. We’ve purposely built BlackRock’s platform to deliver differentiated organic growth across market cycles. Because of the diversity of our business, organic base fee growth is even more important indicator of our results than organic asset growth. We’ve generated 5% organic base fee growth on average over the last five years. And these organic growth rates do not include strong growth in our cash and technology businesses. Over time, as client preferences have changed, the drivers of growth at BlackRock have changed as well.
Going back to 2014, for those of you who remember our first investor days, we talked about how our higher fee retail and iShares businesses would grow faster than our lower fee institutional business. As the ecosystem has evolved, however, and we've seen a shift towards ETFs, portfolio construction and illiquid alternatives, the shape of our growth has also evolved. The diversity of BlackRock’s platform is critical to our success and delivering organic growth in various market environments and responding to how clients’ needs are changing. We are not reliant on any one product or investment strategy or any one client segment. Instead, we're able to quickly pivot in changing market environments to address changes in clients’ demand. Now, while it would be fantastic, our business really isn't built to fire on all cylinders at the same time. Rather, the diversity of our platform means that a slowdown in any one area of the platform can actually be made up by growth in another.
Another question we're getting from investors recently relates to our ability to continue to grow at 5%, given our scale and the current market environment. Even in the face of meaningful clients derisking during the current year, BlackRock's all weather platform has still shown an ability to grow organically, obviously, though less than our long term 5% aspirational target.
To better understand our long-term growth potential, let's take a look at the broader industry. McKinsey data indicates that overall asset management growth is expected to be organically at around 3% over the next five years; that would suggest our 5% aspirational growth targets is actually in excess of the overall industry, which we think is reasonable given our product breadth, solutions orientation and technology platform.
However, as shown here, growth rates -- expected growth rates vary significantly depending on the type of asset class for products. More traditional parts of the business such as active fixed income, non-ETF index are expected to grow at a more measured pace than the industry overall. Active equities are actually projected to be in organic decay, though it continues to represent a significant portion of client portfolios and an important revenue pool for the industry. However, there are several areas of the industry which are expected to see outsized growth. These areas are areas in which BlackRock has made significant investment over time to ensure we're well-positioned to meet the changing needs of our client base.
Importantly, if you look at the right hand side of the page in the teal, these high growth areas including illiquid alternatives and ETFs represent nearly 50% of BlackRock base fees. In ETFs, we’re the market leader in one of the largest high growth categories of the market; and in the illiquid alternatives, we're seeing accelerating growth in the sector where we have significant room to grow our share.
So, how do we continue to be comfortable with a long-term organic growth rate of 5% for the future? Some context is helpful, especially after a record year in 2017 and a more challenged environment in 2018.
On the one end of the investment barbell, we have iShares, ETFs; and on the other end, we have illiquid alternatives. As you can see on the, slide both, iShares and illiquid alternatives delivered strong organic fee growth in 2017. Despite more moderate industry level growth from our traditional businesses, BlackRock was still able to achieve record organic base fee growth last year.
During 2018, we witnessed a slowdown in client activity as investors derisked and delayed tactical asset allocation decisions in the face of a more volatile beta environment. This is driven by trade tensions, geopolitical uncertainty, and rising rates. Notably, growth in our illiquid business has accelerated, while growth in our traditional businesses supported by continued alpha generation and technology-driven solutions has not really changed dramatically, even in a more challenging environment. The primary delta versus 2017 has been in iShares, which I'll come to in a moment. But going forward, we believe that both ends of the investment barbell, iShares and the illiquid alternatives will grow above our 5% growth target, and our traditional businesses will perform in line with or grow faster than the overall market. We believe this combination of growth businesses made possible by a globally diversified business model, purposefully built over time will result in an ability to meet a 5% organic base fee growth target over a market cycle.
So, what's really going on with iShares in 2018, and does it suggest a change in the long-term organic growth estimates for this business? Despite iShares maintaining the number one market share globally, industry-wide -- for industry-wide ETFs, flows for the year are now down 23% for the industry year-to-date versus the same period last year.
But, that's not an entire story. In order to better understand 2018 performance and its impact on our growth expectations, let's try and segment iShares into three categories. First is our core series. As many of you know, the core is comprised of 84 broad stock and bond ETFs, designed to be building blocks for long-term portfolios. Growth in the core, which represents about 10% of iShares base fees has actually been pretty consistently, supported by pricing investments as well, resulting in nearly 40% organic growth since inception and a leading market share of 50% in 2018. Another iShare segment includes fixed income, ESG and smart beta, which has higher fees and accounts for about 20% of iShares base fees and is also growing quite consistently.
The balance of iShares revenue is in an area we categorize as financial instruments and precision exposures. This category is higher fee than both core and fixed income smart beta, but flows are more highly variable and correlated to the broader capital markets environment. Financial instruments, which include products like EEM, HYG, IWM are favored by institutional users due to their high secondary market liquidity and the unique options ecology and lending markets around them.
Precision exposures include ETFs like sector and country funds, which investors use to tactically allocate the portfolios and will move in different ways depending on market appetite for specific sectors or geographies. As you can see, in a risk on environment like 2017, we saw record and perhaps unsustainable organic base fee growth in financial instruments and precision exposures compared to prior years. Post January, the negative risk sentiment in 2018 had the opposite impact, resulting in meaningful organic decay in this category. The delta between 2017 and 2018 was $340 million of organic base fees and contributed to the approximately 90% organic base fee decline we've seen in iShares thus far in 2018.
BlackRock is a strong believer in the growth of the global capital markets over time. And as we hopefully return to more stable and predictable markets -- please God, we believe the 2017 and 2018 were both unrepresentative of a longer term more normalized type of environments.
We continue to believe the long-term structural growth opportunity for ETFs across client types, and BlackRock is committed to being the market leader. The index investing industry has been growing rapidly with ETFs as a major beneficiary, driven by the migration from commission based to fee based wealth management, clients focused on value for money, the use ETFs as alpha tools, and the growth of all-to-all trading and fixed income.
Over the last five years, the ETF industry has grown organically at 13%, well in excess of the broader asset management industry. This differentiated growth has been driven by increased client adoption, as well as clients using ETFs in new ways as ETFs have increased market accessibility for both individuals and institutions alike. At our Investor Day this past June, we discussed the long-term trends and tailwinds that will drive structural growth in ETFs, and these have not changed. We continue to expect the global ETF market to more than double by the end of 2023, including significant growth in fixed income and in Europe. In the aggregate, iShares represents a large revenue pool for BlackRock and we expect it to grow in excess of 5% organic base fee growth target -- our target over the long-term.
ETFs are one end of the investment barbell. On the other end is illiquid alternatives, another expected high growth area for BlackRock and the overall asset management industry. Illiquid alternatives are a strategic asset class for BlackRock. We’ve been investing heavily in this area, both organically and inorganically; organically, via headcount and seed and coinvestment capital, and inorganically through target acquisitions in real estate, infrastructure and private credit. We’ve raised $40 billion of gross capital since 2015, and our fundraising has been broad based and diversified across illiquidity strategies and client segments.
At September 30th, we had $22 billion of committed capital, most of which is non-fee paying until it is deployed. Once deployed, that $22 billion of committed capital equates to nearly $160 million in future annual base fees and potential for significant performance fees thereafter. Today, performance fees from illiquid alternatives represent approximately one quarter of BlackRock’s total alternative performance fees. Despite the recent growth of our illiquid alternatives business, performance fees from this business are not generally booked and capital is returned to clients and represents a source for meaningful longer term future growth.
As an aside, the majority of our total performance fees are linked to single strategy hedge funds and funded hedge funds where market performance has been very challenged in 2018. We would currently expect fourth quarter performance fees to reflect these very difficult market conditions.
As we discussed previously, illiquid alternatives have been generating organic base fee growth well in excess of our 5% firm target, and we expect the benefits of BlackRock’s technology, global platform and scale will continue to drive differentiated growth in this area.
Our differentiated organic asset management growth is supported fully by a completely integrated technology strategy. BlackRock’s approach to technology touches all aspects of our business, generating sustainable alpha in our investment process, leveraging our distribution capabilities, and scaling our operations. Bottom line is core to absolutely everything we do at BlackRock.
For these reasons, technology is a significant strategic differentiator for us. We currently are spending approximately $1 billion on data and technology, and some 25% of BlackRock’s employees are in technology and data roles.
We generate technology enabled revenue throughout the organization, enabling us to customize solutions for clients at scale. We also have a large and growing financial technology business that generates direct technology revenue. Organically, we have built capabilities across Aladdin Wealth and Provider Aladdin, which are the core drivers of our direct technology revenue. We’ve also made key acquisitions such as Cachematrix and FutureAdvisor to supplement growth.
Our direct technology revenue continues to benefit from trends favoring global investment platform consolidation and multi-asset risk solutions. Technology services revenue grew 19% over the last 12 months, reflecting an outsize number of new clients sourced in 2017 and successfully implemented in the current year.
We continue to target low to mid teens growth for our technology business over the long term. We've also made strategic minority investments in a number of businesses, including iCapital, Scalable Capital, Acorns, and most recently Envestnet. These non-controlled investments enable us to enhance our knowledge base and accelerate growth by deepening our understanding of customers, how they use investment and distribution technologies, and the way they implement them in their own businesses.
Our overall goal is to position ourselves for long-term leadership and to accelerate existing tech-enabled and direct technology revenue opportunities. Technology enhances all aspects of our business and is an important differentiator in driving growth, efficiencies and ultimately, shareholder value.
In conclusion, we remain focused on the execution of our shareholder value framework. iShares and illiquid alternatives anchor the ends of our investment barbell and will grow above our target, while our tech-enabled, risk-oriented approach to portfolio construction and solution will enable us to grow faster than the broader asset market in terms of our more traditional asset classes. We will continue to optimize organic growth in the most efficient way possible, leveraging technology and operational excellence to drive operating margin expansion. And we remain committed to investing our business for future growth and consistently returning to capital to you, our shareholders.
With that, we’ll pause, and I'm happy to take some questions.
Q - Alex Blostein
Great. Thanks, Gary. So, maybe, I'll start with one, just around the organic growth trend, and thanks for the breakdown. I think it was definitely pretty useful for people to look at where some of the pressure points have been and where the organic growth points of strength have been. But, I guess, you mentioned in your prepared remarks that the volatility in the marketplace today is just causing a little bit of a pause in some of the decision-making. So, help us I guess peel back the onions a little bit. And if you think about the environment staying, maybe not as bad as it was yesterday, but kind of range bound equity markets for the next kind of 12 to 18 months. Where do you guys see the organic fee growth shaking out for the firm in that sort of environment?
What is the growth in that environment?
It's really hard to predict that, Alex. I mean, we are very-focused, whether it is for capital management, whether it's for budgeting, we're really trying not to predict beta at any point in time. We're really not trying to manage the firm in the context of a quarter-to-quarter or frankly, even a year-to-year type perspective. We think the strength of what we have at BlackRock is diversification. We have -- we’re top-10 player in active; we’re top-10 player in passive; we’re top-10 player in alts. We have the most global reach and access of any investment firm of the world. We have a differentiated technology platform. We're going make some bets as to where we think growth is coming from. So, whether it's ETFs; whether it’s smart beta; whether it's illiquids; whether it's portfolio construction and solutions; technology more broadly; retirement; China. I think the biggest issue for us in environment where it's harder to predict is we can't just invest in everything. We're going to have to really focus. So, we're spending most of our time not necessarily trying to predict where growth is going to come from over the next 12 months but really trying to think three years down the road where we want to be as a firm. And in an environment candidly where resource allocation is harder as by virtue of beta hurting revenue as opposed to helping it, we're trying to basically make sure we can be as efficient as we can to reallocate resources to our most, high growth areas where we have long-term conditions.
We are talking -- I mean, October tough year -- tough month; actually it was a tough year. November was a great month. Even in a market frankly that didn't feel like it had great momentum, I think iShares came in right around $30 billion for the month of November, which makes it the best month this year and arguably the best month in some period of time.
So, we're not necessarily trying to figure out the whims of everybody day to day and just trying to figure out more of a long-term perspective frankly.
You mentioned allocation of resources towards areas where you see the best growth opportunities. You guys kind of coined the term margin aware. So, maybe expanding on that a little bit again in a more challenging macro backdrop, can you talk to us a little bit about what's in the areas where you still see flexibility to reduce your expenses or slow down the pace of growth to sort of protect the operating leverage part of the kind of the EPS growth algorithm that you laid out.
Yes. So, again, the challenge -- frankly, the easiest thing in the world from my perspective to do is to cut costs. The harder thing to do is to have the conviction to invest through a market cycle that isn't necessarily rewarding everybody and to make sure you keep your eye on long-term growth. So, that really is the challenge for us. That being said, I mean obviously, we have a fair amount of variability built into our business from a cost perspective. Again, some of which we control, some of which we can't control. Probably the biggest lever is headcount and compensation. There's no strong desire to use that as the hammer unless you really have to.
So, we are continually thinking about trying to have the entire organization embrace technology. We like to talk about doing things better, faster, cheaper without giving up any of the risk and control of the organization that's obviously critical. We're spending a lot of time looking at our processes that tend to be very manual to see where we can bring technology in through the RPA or others types of scalable opportunities that basically reduce human content where we can either actually take cost out or again reallocate the human capital to more value added issues. We're also spending a lot of time looking at where people are actually doing their jobs. We now have about 1,500 people in India; we’ll be up to 500 or 600 people in Budapest by the end of the year. And we've recently announced our third leg which is our new iHub which will be in Atlanta, where we hope to have up to 1,000 people in the next few years.
Again, some lift and shift. We’re not moving our corporate headquarters out of New York, like some other people. We’re obviously committed to moving to Hudson Yards in 2023. But really trying to say, like if we really wanted to make sure that we capped our headcount growth in places like London and New York, and basically put incremental growth where we can in some of our innovation hubs, I think that’s a smarter decision. So, really, looking and trying to figure out, how we can scale our operations to be as efficient as we can, so that we can basically deliver value, both to clients and our shareholders.
We have a lot of people in the room. So, I just want to make sure we have couple of minutes for the audience to ask questions. So, if anybody got a question, raise your hand and Michael will come around.
Can you talk a little about what’s going on intermediate terms in the institutional index business, lots of pluses and the minuses there?
Yes. For the people that didn’t hear, the question was what’s going on in the institutional index business, lots of pluses and minuses. There are always lots of pluses and minuses in the institutional index business. We tend to report net and there are constantly tons of flows, both in and out of that business that are incredibly large. We see -- that’s a very competitive business. Obviously, the institutional index is obviously a very low fee business, less than 5 basis points on average for us, and one that is incredibly competitive. So, I think we’re trying to be smarter in that business where we are making more thoughtful pricing decisions and not trying to keep up with a lot of the bundlers. We’re not a custodian. So, we can’t provide that type of bundle service to many people who want it. But, in every quarter, we’re seeing tons of trends. We’ll see people who are in-sourcing; we’ll see people who are outsourcing; we’ll see people who are derisking; we’ll see people who are rerisking; we see that people are rebalancing. We’re losing purposely where we just don’t want to match price.
We will not really look to challenge somebody who’s trying to basically -- who already had capital allocated to this business or an extra -- managing it for a quarter of basis point is a good thing, unless we basically have a broader strategic relationship with that client across other products. So, if someone wants to basically hire BlackRock for, if you will, their entire portfolio, we’ll be as aggressive as we have to do as long as we can find ways to make money on that.
In recent quarters, we have clearly seen an acceleration at derisking around equity books around the world of our largest institutional clients. A lot of that has been official institution driven for lots of obvious reasons, especially where we’ve seen commodity prices declining. And so, again, it is an interesting observation for us, much as we use iShares to have a kind of bird’s eye view into what’s going on in the global capital market. But, we will see very outsized, moving from that business, frankly, that doesn’t really drive a huge impact on organic growth base fee growth. And that’s why we’re really trying to pivot people for us to think less about assets. And again, last quarter was a perfect example. We saw roughly $30 billion of outflows in our institutional index equity book, but still managed to put a positive organic growth from an asset perspective for the quarter, but really that has a much smaller amount of impact on the inorganic base fees. Remember, because of the fact that we’re offering everything from single basis point business to 2 and 20 business, it's really important to see where all that growth is coming from.
So, when you look at your own expectations for growth in active versus alternatives versus the ETF business, would it be fair to say that as you look forward that the growth in these will have to continue to be at least a modest discount to what AUM growth is, or is that not obvious to you, as you think about business?
Again, if you saw way -- if you think about them separately, I think we've put some stats up there where you can actually compare asset growth and fee growth in the iShares business. So, it's no question that that mid case of growth that we’ve put up, which is that, let’s call it the 12% or 13% growth rate, there is no question, that’s an asset number, and fee growth by definition will be less than that. We’ve given some historical correlation. So, you can take a look at that. It’s actually been amazingly consistent, 5 or 6 points around that.
On the alt, I don't -- at the moment, I don't think we're seeing major fee compression impression at all on the alt outside. I think, the challenge there is really not a fee game; it’s a deployment game, because there's lots of committed capital that needs to get into the ground. So, I think the question is, will the market have the discipline there to be able to maintain the returns, giving so much capital has to put up and obviously fees will follow returns in that respect.
And I think that lesson, candidly, is the key lesson for that big middle traditional business, which is that we think about that business on a spectrum, if you think about the far left, let's call it, more of the index hugging less high conviction type strategies, migrating to the right, return expectations go up. And as return expectations go up, if they're sustainable, fees should basically be able to go up with that.
We tend to think about life in that middle where sustainable alpha over time has to be 3 to 4 times the fee rate. And so, I think ultimately, the proof will be in how active does relative to the rest of the passive industry. And if active can continue to generate the returns to sustain the fees, I think it'll be fine. If it turns out on the other hand that active is continuing where it's been the last couple years, I think we're going to see some fee pressure, just because no one's going to believe that the sustainable alpha can support the level of fees today.
And when you look at what we did back in March of last year, when we kind of repositioned our active business, it was really in recognition of that very issue which is we're trying to better align that spectrum of products, the ability to have conviction about sustainable alpha with fees that we were charging. And while we actually reduced fee, it wasn't really a fee cut, it was really just more of an acknowledgement that the value proposition was out of whack.
So, look, we're going to -- we're big believers in active; we are investing heavily in the business. We think it's still a key part of portfolio, construction and solutions and outcomes. And we're fighting hard to make sure that we can contribute our part of the sustainable alpha argument to support it.
Thank you, guys, very much. I really appreciate you coming out today.