Schroders: 6% Dividend Yield Stock At Cyclical Trough

|
About: Schroders plc (SHNWF)
by: Blue Sky Capital
Summary

Many asset managers' earnings naturally grow at “GDP+”, from asset price appreciation, broadly stable fee margins and operational leverage.

SDR is a "best-of-breed" U.K. asset manager with 2013-18 CAGR of +9.1% in assets, +7.1% in revenues and +8.4% in profit before tax.

Shares are at their 52-week low after earnings declined in 2018, from a combination of cyclical market downturn and one-off factors.

We expect SDR earnings to resume growing at mid-to-high single digits after 2019, after the market cycle turns and IT cost savings materialize.

At 1,962p, non-voting shares pay a 5.8% dividend, which is well-covered and maintained even during the 2008-9 financial crisis.

Introduction

Schroders (OTCPK:SHNWF) non-voting shares (U.K. ticker SDRC) fell another 6.6% in the two days after their 2018 results on Mar 7, reaching a new 52-week low, as shown in the chart below. At 1,962p, SDRC shares now trade at a dividend yield of 5.8% and P/E of 9.3x – making them the least expensive in many years.

SDRC Share Price (Last 12 Months)

Source: Bloomberg Markets (08-Mar-19).

(Note: Schroders has two classes of shares, ordinary and non-voting. Both classes have the same economic rights, but the non-voting shares are 23% cheaper. In this article, all mentions of SDR refer to the company while all mentions of SDRC refer to the non-voting shares.)

Company Overview

SDR is one of the oldest names in U.K. finance, with a history going back to 1804. It has focused on asset management since selling its investment banking business to Citi (C) in 2000. SDR today is primarily involved in Asset Management (which generates 88% of its PBT), but with a growing Wealth Management business (12%), as shown in the table below:

SDR Revenue & PBT by Segment (2018A)

NB. Figures exclude exceptionals (£93.2m); exceptional include £56m of restructuring, with the rest mostly amortisation of acquisition intangibles. Source: SDR results press release (2018).

SDR revenues are highly recurring, with 93% coming from management fees, which are charged regularly on client assets as a percentage of assets under management ("AUM"). Other revenue lines include performance fees, carried interest, transaction fees, banking interest, etc. Asset management customers include institutions (which are 40% of SDR revenues) and individuals through intermediaries (which can be advisors, platforms, etc.) (44%).

SDR financials are weighted towards the U.K., but reasonably diversified in terms of both clients and asset location. Clients domiciled in the U.K. represent 40% of AUM; U.K. assets are a minority of each asset class (8% of equities and 7% of fixed income). SDR assets are also diversified in terms of asset classes, with 38% in equities, 25% in multi-asset, 17% in fixed income, 11% in wealth management and 9% in private assets & alternatives. The charts below show the breakdown of SDR's AUM by client domicile and asset location.

SDR AUM by Client Domicile (2018)

Source: SDR results data pack (2018).

SDR AUM by Asset Location – Equities & Fixed Income (2018)

Source: SDR results data pack (2018).

SDR has a pending wealth management partnership with Lloyds Banking Group (LYG), with Lloyds taking a 20% stake in SDR's wealth management business in return for transferring both assets and staff to SDR.

The Schroder family is the controlling shareholder, with 47.9% of SDR's voting shares and 38.3% of all shares.

Natural “GDP+” Growth

Many asset managers' earnings naturally grow at “GDP+”, from a mixture of asset price appreciation, broadly stable fee margins and operational leverage. They also have other favourable attributes such as high recurring revenues, a diversified customer base, high barriers to entry, etc. SDR demonstrates all of these positive characteristics and has achieved PBT CAGR of +8% during 2013-18, as we will show below.

SDR has shown the ability to grow its AUM over time, both in aggregate and in individual channels, as shown in the charts below. During 2013-18, SDR's AUM grew with a CAGR of +9.1%, and grew year on year every year except 2018:

SDR AUM – Total and By Channel (2007-18A)

Source: SDR company filings.

SDR AUM Growth Y/Y (2011-18A)

Source: SDR company filings.

(Note: Currency was a +13% benefit in 2016 but a -3% negative in 2017 and was also negative in 2018.)

SDR's AUM growth has enabled it to achieve a management fee CAGR of +7.1% and profit before tax ("PBT") CAGR of +8.4% in 2013-18, with PBT growing faster than management fees due to the operational leverage in SDR's business model, as shown in the charts below:

SDR Mgmt. Fees Growth Y/Y (2011-18A)

Source: SDR company filings.

SDR PBT Growth Y/Y (2011-18A)

Source: SDR company filings.

Active Management in Good Health

SDR has maintained solid growth in its management fees, despite fears about a structural decline in active management and in public equities, as well as about fee compression.

SDR's AUM figures for 2013 and 2018 are shown in the first chart below. During 2013-18, SDR's AUM in equities had a CAGR of +5.7% in the Institutional channel and a CAGR of +4.6% in the Intermediary channel, both solid growth figures. Growth rates were even stronger in multi-asset (CAGR of 18.0% for Institutional) and in private asset & alternatives (CAGR of 15.5% for Institutional, 19.8% for Intermediary).

Fee margin in each channel, after declines in earlier years, has stabilized in 2017 and 2018, as shown in the second chart below. The stabilization in fee margins has been helped by SDR's development of more sticky, higher-margin products in private assets & alternatives. The fee margin decline in the earlier years was also not as bad as it appears, coming in part from SDR diversifying into lower-fee products (fixed income and multi-assets).

SDR AUM by Asset Class (2013A vs. 2018A)

Source: SDR company filings.

SDR Fee Margin by Channel (2013-18A)

Source: SDR company filings.

Long-Term Competitive Advantages

We believe SDR to be the "best-of-breed" among listed U.K. asset managers.

SDR's competitive advantages include its scale, its brand name, its comprehensive offering, its long-term relationships with institutional clients and its geographic diversification. We also like SDR's higher Institutional focus compared to its peers, because this means an asset base that is less exposed to the volatility of retail clients.

The strength of SDR's franchise can also be seen in its ability manage its people costs, as both clients and employees are attracted by the value of the franchise. This is demonstrated in SDR's highly consistent cost ratios for both compensation and overall costs:

SDR Operating Expense & Cost Ratios (2008-18A)

Source: SDR company filings.

SDR is also pursuing a number of new initiatives that could be meaningful growth drivers for the next 5-10 years. In particular, its partnership with Lloyds in wealth management holds particular promise, as it would be utilizing Lloyds’ retail banking network (#1 in the U.K.) to generate referrals for SDR. (The partnership includes a 49/51 financial planning joint venture with Lloyds, targeting the mass affluence segment, as well as Lloyds taking a 20% stake in SDR's wealth management business.)

We believe SDR will be able to grow its AUM by mid-to-high-single digits sustainably over the medium term (in line with its 2013-18 track record but subject to currency moves), and its revenues and earnings at roughly the same rate.

2018 Cyclical Decline

Asset management is a cyclical business, with AUM always volatile, driven by investor sentiment and market prices. Over the last 10 years, SDR has seen its AUM growth fluctuated from year to year - market and FX movement tends to be the key driver for AUM fluctuation, while net flows have generally been a positive for SDR, as shown in the first chart below:

SDR AUM Growth Y/Y – Total (2008-18A)

Source: SDR company filings.

SDR AUM Growth Y/Y – By Component (2008-18A)

Source: SDR company filings.

(Note: Currency was a +13% benefit in 2016 but a -3% negative in 2017 and was also negative in 2018.)

2018 was the first year since 2011 when SDR has had an AUM decline, and the first year since 2008 when SDR has had a negative net flow. The key question for investors is whether the 2018 decline represents a structural change that will lead to a lower level of growth in the future. We believe this is not the case - instead the decline is due to a cyclical market downturn and other one-off factors.

SDR's 2018 net outflows were concentrated in EMEA and APAC, and in both Equities and Fixed Income, as shown in the charts below:

SDR Net Flow by Region (2018A)

Source: SDR results presentation (2018).

SDR Net Flow by Asset Class (2018A)

Source: SDR results presentation (2018).

The EMEA decline was described by management as due to a risk-off atmosphere among European investors during the market correction in Q4. Interestingly, despite the uncertainty around Brexit, the U.K. had a net inflow of approx. £2bn during 2018, partly reflecting SDR's strong franchise in its home market.

The APAC decline was due to continuing challenges in Australia (£3.7bn net outflows) and the loss of a large mandate in Japan (£6.2bn net outflow). Both of these are one-offs, in our view, because:

  • The challenges in Australia have been there for some time, due to the market there being concentrated among a few superfunds. However, SDR's exposure to Australian institutions is now down to £14.9bn (3.7% of SDR total AUM), which means there is only limited potential for further damage.
  • The lost mandate in Japan was a bond mandate (so lower-margin) that SDR exited when a client consolidated several mandates into one and drastically reduced the fee margin. In previous years, Japan had been a source of wins for SDR and was a growth driver for APAC both in 2016 and 2017.

Earnings Trough in 2019

Last week's poor performance of SDRC shares came after the company released their 2018 results, which showed PBT declining by 5% year on year, primarily due to cost increases, as shown below:

SDR PBT (2018A vs. 2017A)

Source: SDR results presentation (2018).

The cost increases in 2018 include a number of "investments", such as (1) £25m in higher technology costs in 2018 due to a new IT platform going live but the old one still running while full migration takes place; and (2) £20m in higher office costs due to new offices in New York (2017) and London (2018).

Based on management guidance, SDR's PBT will face another headwind (equivalent to approx. 10% of 2018 PBT) due to:

  • Non-compensation operating expense may rise to £490m (from £449m), due to continuing dual running of systems. This implies a 5.3% headwind.
  • The lower AUM at 2018 year-end means management fees would be £37m lower year on year. This implies a 4.9% headwind to PBT.

SDR management has guided to 2020 as the year when cost savings from IT efficiencies will finally materialize on the P&L. We have also seen a strong rebound in asset prices during early 2019, which may continue for the rest of the year. For these reasons, we believe 2019 will represent the trough for SDR earnings.

Over time, we expect SDR's AUM growth to resume its long-term trend of mid-to high single-digits (subject to currency), and for SDR to maintain its track record of cost discipline, both in people and non-people costs. Under these conditions, SDR earnings should again grow at mid-to-high single digits.

Well-Covered 5.8% Dividend

SDR paid a dividend of 114p in 2018, equivalent to a 5.8% yield on SDRC shares. The dividend policy is progressive, and management has notably paid a rising/flat dividend every year in the last decade, even during the 2008-2009 financial crisis, as shown in the chart below:

SDR Dividends Paid vs. EPS (2007-18A)

Source: SDR company filings.

The dividend is well-covered, with a payout ratio of 53%, and management has confirmed on the recent earnings call that it is “quite unlikely” to be cut.

Valuation

At 1,962p, SDRC (non-voting) shares are currently trading on a P/E of 9.3x and a dividend yield of 5.8% (on 2018 financials). These represent a multi-year low valuation; SDRC's dividend yield is the highest since 2009.

Share Price History

The weakness in SDRC shares in the last 12 months reflects a broader weakness among both U.K. and European listed asset managers, as shown below. This is consistent with the risk-off behaviour we see among European investors in the second half of 2018. All but one of the asset managers saw their shares fell, the sole exception being Ashmore (OTCPK:AJMPF), which is focused on emerging markets and has a concentration in fixed income.

SDRC Share Price vs. Other UK Asset Managers (Last 12 Months)

NB. Source: Bloomberg (08-Mar-19).

SDRC Share Price vs. European Asset Managers (Last 12 Months)

Source: Bloomberg (08-Mar-19).

Conclusion

SDR operates in a sector with a highly-recurring revenue stream and a natural tendency to grow earnings faster than GDP. It has a number of competitive advantages that make it the "best of breed" among its peers. Its earnings will likely trough in 2019 due to a cyclical market downturn and other one-off factors, and its shares are trading at a 52-week low. We believe its earnings will resume its long-term mid-to-high-single digit growth after 2019.

At its current price of 1,962p, SDR's non-voting shares are trading at a P/E of 9.3x and a dividend yield of 5.8%. The dividends are well-covered with a payout ratio of 53% and were maintained even during the 2008-9 crisis.

Over the next 12-18 months, we believe the stock can offer 15-25% upside, from the 5.8% dividend being paid and an upward re-rating once earnings growth resumes. Our recommendation is Buy.

Disclosure: I am/we are long SHNWF. 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.