Image credit: Michael Nagle/Bloomberg
Brokers are looking to expand their offerings of low-cost passive exchange-traded funds (ETF). These capabilities are only concentrated with a few managers like BlackRock (NYSE: BLK). Currently, there are hundreds of active equity managers who are getting pushed off retail platforms, while institutional investors are shrinking relationships as well.
There is a supply-demand imbalance between asset managers. Brokers attributed this to the DOL fiduciary ruling that has caused brokers to limit their list of asset manager partners. Investors tend to favor retail brokers that command pricing power, generate strong organic growth and will benefit from higher interest rates. Invesco (NYSE: IVZ) and BLK are two of the very few asset boutiques that are benefiting from these secular headwinds.
BlackRock: Dominating The Market Breadth of ETFs
The second half of 2019 was a favorable time for most asset classes with the ACWI returning 3.8% and the S&P returning 4.3%. Fund flows were mixed across assets and fund managers.
Arguably, I believe that fixed income had a stellar performance this year as both the first quarter and second quarter each registering more fund inflows as compared to the entirety of 2018 flows. It is worth mentioning as well that a smaller but increasing portion of these inflows came from ETFs. The month of June alone generated $28.5 billion of fixed income ETF inflows.
The asset boutique booked an enormous $125 billion long-term fund inflow, on top of the $26 billion of money market inflows. It includes an unexpected $75 billion of fund inflows into active products which were driven by $64 billion of fund inflows into active fixed income.
1. Well-Balanced Active And Passive Strategies
I expect that BLK would continue to gain a higher market share over the near term. The secular growth in iShares is supported by cyclical tailwinds in cash management and fixed income. Near-term fund flows would remain in the mid single-digit organic growth range. It will be offset by fee rate compression amidst the US economy-driven negative mix shift and transfer towards lower-fee products.
I noted that BLK's record $151 billion of fund inflows underscores the unparalleled breadth of the company's customer reach. The firm is also building stronger relationships with brokerage firms, such as Fidelity (MUTF: FXAIX), to deliver commission-free iShares trading, adding 170 ETFs during 2018 to bring total ETFs on FXAIX's commission-free platform to 240 and driving the strongest inflows in the five-year strategic partnership.
Source: Company data.
2. Lower Than Expected Organic Fee
The US-China trade tensions intensified in 2018 and the global economy has been disappointing ever since. Policy uncertainty is also running high. There is investor skepticism about the effectiveness of monetary policies. The global trading order that was decades in the making, and forged under the strong influence of the US, is now being challenged.
A Goldman Sachs (NYSE: GS) analyst had expected a near-term pressure on the firm's organic growth given a challenging macro backdrop and soft near-term investment performance.
Historically, BLK's P/E multiple yielded a premium to SPX of about 10% when operating income growth was above 10%. The company exhibited a slower-than-expected organic fee growth in the first half of 2019. It will be challenging for BLK to deliver more than 10% growth without a significant market rally.
Further, the investors' radar screens are presently focused on the company's downward-trending fee rates. Long-term base fee rates decreased from 18.5 basis points to 17.9 basis points with fees down across most asset classes due to greater investor preference over funds offering exposure on smart beta and outflows from low-fee institutional offerings.
As a result, the company's 3% long-term annualized fund inflows hardly slowed down the decreases in AUM from the adverse market performance, given investor fears of fund outflows at other fund managers.
The lower blended fee rate was due to a mix of iShares fee cuts and continuous divergent beta. Investors are more selective in picking lower fee funds amidst global volatility which would become less intense, as recent geopolitical uncertainty eases.
3. Risk/Reward Analysis
I'm a Buy on BLK with a price target of $538/share.
Source: Seeking Alpha
BLK's historical P/E multiple of 16.5X which is in-line with SPX is considered more reasonable over the near term. That said, the risk/reward is compelling (with BLK stock down almost 25% during the last few months of 2018) given the following justifications of GS:
- if BLK's P/E gets dragged down closer to historical premium versus the SPX (implying about 12.5X P/E), GS sees roughly 12% downside to the stock,
- if BLK expects improving operating growth to more than 10% amid improved macro/reversal of unfavorable mix shifts, a stock premium to SPX is achievable, yielding 18X P/E or over 25% upside to the stock.
Invesco: Ultimate Dominator Of OppenheimerFunds
I'm a Buy on IVZ with a price target of $22/share.
Certain strategies are almost identical between IVZ and OppenheimerFunds while there is limited overlap. That said, investors are confident on IVZ that the deal to acquire OppenheimerFunds would strengthen the combined firm's position across both institutional and retail distribution channels. But I caution that revenue retention risks would likely remain considerable throughout the integration process.
OppenheimerFunds is more retail-focused, while IVZ is more institutional. In terms of value proposition, OppenheimerFunds is state-focused (portfolio concentration on municipal bonds), while IVZ is revenue-bond focused. In terms of high-yield risk profile, OppenheimerFunds is more high-octane yield focused, while IVZ targets less volatile returns.
Acquisition Capital Funding: Debt-Equity Mix
In terms of financial model portfolios, as an analyst, I believe that the combination of strategies of both companies should improve Sharpe ratios. OppenheimerFunds should be able to support IVZ's value-based strategies that should help improve solutions-based platforms such as model portfolios, asset allocation and creating the market potential for fund of funds.
1. Potentially More Share Buybacks
The company is now more focused on share repurchases as opposed to aggressively ramping the dividend (with a dividend yield of 5.7%). In terms of integration timeline, IVZ had already expected that the first quarter of 2019 to have a larger cash outflow given taxes and incentive compensation.
Source: Company data
The second quarter should see the onset of integration expenses. The company expects to recognize 85% of the $475 million expense synergies towards the end of this year and 100% by the year 2021.
Thus, this time around IVZ would be more aggressive around share buybacks given its current valuation. But the first quarter of 2019 is expected to be lighter in terms of capital return.
Subsequently, I can anticipate a potential increase in share repurchase activity by the second half of this year. The higher buyback activity is attributed to the incremental EBITDA from OppenheimerFunds which hovers in the run-rate and directed towards capital return.
2. OppenheimerFunds Equity AUM Is Down
OppenheimerFunds manages $250 billion in AUM, with over $200 billion managed through US-based mutual funds. The mutual fund portfolio is focused on equity funds which are more than 70% of the total portfolio. More specifically, these are concentrated in International Equities which is around 50% of the total mutual fund AUM.
The firm's five largest equity funds presently comprise 66% of the equity fund AUM, broken down as follows:
- Developing Markets - $39 billion
- International Growth - $25 billion
- Global - $11.6 billion
- International Small-Mid - $11.3 billion
- Main Street - $10.1 billion
Meanwhile, the fixed income franchise is quite balanced with the five largest funds comprising 41% of fixed income fund AUM. It is concentrated in the Senior Floating Rate fund at $15 billion in AUM.
OppenheimerFunds has experienced fund outflows over the last several years mostly in its Equity franchise. AUM is down 8% in the last quarter of 2018, with over $1.2 billion of fund outflows and negative excess returns. As a result, it raised market risks to the company's $10 billion fund outflow assumption throughout the integration period.
However, the speed of fund outflows appears to be moderating recently with the 1% annualized organic decay locked in 2017 and 2018. Hence, the company's fund performance has been challenging most especially on the equity side with three-year and five-year excess returns at -175bps and -140bps, respectively.
I noted that EPS accretion guidance is now $0.24 for 2019 and $0.58 for 2020 versus previous guidance of $0.10 in 2019 and $0.52 in 2020 (a 12% increase on 2020 EPS). Guidance in earnings before income tax and appreciation (EBITDA) is estimated to be higher than $2.6 billion in 2019, versus $2.5 billion in 2020. Initial guidance was more than $3.0 billion when the acquisition deal was announced.
To recap, BLK is considered as the structural winner in the asset management space with significantly promising paths in ETFs, best-in-class diversification across products and geographies as well as significant scale. On the other hand, IVZ remains on the sidelines, yet there seems to be better visibility around achieving its acquisition synergy target that could potentially enhance the investor sentiment.
BLK remains bullish on market share gains across its major products. In both active and passive strategies, financial products seem to be accelerating with lower reliance on beta to drive revenue growth amid a higher volatility environment.
IVZ has already outlined a clear and definite direction to enhance organic growth opportunities once the OppenheimerFunds franchises are already integrated. However, I believe that historically there is only limited success in organic synergies for asset management deals and that it would take a considerable time for these synergies to take effect.
I'm certain that both BLK and IVZ are well prepared and on track to tread these cyclical highs and economic uncertainties.
Interest rates have moved sharply lower. The US Treasury curve has flattened indicating rising investor pessimism due to geopolitical turmoil and increasing trade tensions. Financial markets are manifesting the greater possibility of a sharper US Fed easing cycle as compared to its earlier forecast in 2019. I'm still optimistic that the current macro backdrop will not dampen both boutiques' organic growth versus its industry peers in a more range-bound market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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