- Waddell & Reed is a cash-generative asset on offer at bargain prices.
- Historical buybacks mask the underlying book value - on an adjusted basis, the stock is on offer at ~0.6x tangible book.
- Though I think the ~27% trailing yield normalizes to ~7% going forward, the stock is still a compelling bargain.
In a low-rate environment, one would think Graham & Dodd-type value would be hard to find. Not so, in my view - Waddell & Reed's (NYSE:WDR) stock offers compelling value in a market all too willing to pay for growth.
At current levels, I think the market is overlooking the underlying value of the company's cash-rich balance sheet, masked by ~$766m of treasury shares. On an adjusted basis, WDR is on offer at a hefty ~40% discount to adjusted tangible book, despite still being a free cash flow-generative asset. Further, at the current dividend + repurchase run-rate, the total shareholder yield is running at ~27% on a trailing basis, making this a compelling buy, in my view.
Core Business in Secular Decline, But Buybacks Are Accelerating
WDR's total revenues of $264m (an anemic 1.7% YoY growth) for the quarter (Investment Management Fees of $105m, Underwriting and Distribution Fees of $137m, and Shareholder Service Fees of $22m) aptly characterizes where the business is in its life cycle. With the core business in secular decline, the focus is largely on operating expenses, which at $224m, drove an operating income of $39.4m for the quarter (+10.9% YoY).
Source: Form 10-Q
With a ~$0.12 headwind from negative marks on the seed portfolio, 1Q adjusted EPS landed at $0.32, which was well above consensus estimates of $0.29. WDR is holding firm on the dividend for now, with $0.25 declared for the quarter, though the increased buyback ($53.9m vs. $37.5m in 4Q19) was a positive surprise. For context, this would imply a trailing shareholder return run-rate of ~$241m (~27% relative to the $877m market cap at the time of writing).
Source: Company Filings
Signs of Resilience in 2Q
The updated guide offered little signs of a sustainable turnaround in the core business, but lower expenses should help cushion margins for the remaining quarters. No specific numbers on the magnitude of planned cost reductions, but management is targeting "controllable costs" (e.g., G&A, compensation, occupancy, and marketing) to come in lower than its prior guidance ($420-425m). The tax rate will remain elevated in 2Q20 on more one-offs.
Per management, fund fees are down across two products - a core bond fund (-9bps) and a large-cap growth fund (-4bps) on competitive positioning and demand. This should drive an annual ~$0.01-$0.02 drag on EPS, with more cuts likely on the way, in my view. We aren't far from the floor, though, as ~73% of the AUM is already at or below median pricing.
So Bill, today, we're sitting at about 73% of our assets under management for our funds family is a median or better as it relates to pricing. When we look at our top 10 or what we might refer to as our focus on, 9 out of those 10 funds right now are sitting in that range of that median of the below-average quintile from a Morningstar standpoint. - 1Q20 Transcript
To be clear, there is no turnaround here, and WDR remains in outflow mode. Net long-term outflows of -$2.3bn for the quarter (-$2.5bn long-term net flows offset by +0.2bn short-term flows) was narrower than the -$3.4bn in outflows seen in the last quarter. The 1Q20 split comprised -$0.1bn institutional flows, -$1bn broker-dealer, and -$1.1bn unaffiliated. While gross sales did improve sequentially on benefit from the new sales coverage model, I'd caveat that it remains unclear how sustainable these benefits will prove to be.
Source: Company Filings
The near-term outlook is looking relatively bright, though, as management disclosed April net flows are running better than 1Q20 levels despite COVID on both improved sales and lower redemptions, particularly in large-cap value.
We have seen an improvement in April flows to date with continued sales momentum and a moderation of redemptions. Additionally, within our wealth management business, both sales and redemptions improved compared to last year. Historically, this part of our business tends to be more resilient during periods of volatility, and the work we've done in transitioning the business model has certainly helped these dynamics. - 1Q20 Transcript
Good Things Happen When There's Cash and Equity Shrinkage
Good things tend to happen when you hold cash-generative assets, and WDR is case in point. All that cash is going to work, with weighted average diluted shares down 11% YoY on ~$54m worth of share repurchases for the quarter (vs. $38m in 4Q19). Note that the cash balance was still up 6% sequentially at ~$160m. The dividend also held firm, with the trailing capital return at ~$241m (dividend and buybacks), implying a ~27% yield.
But the value case lies in its balance sheet - continued share buybacks over the years, and a declining stock price have led to a massive ~$766m treasury stock pile, which masks the true equity balance (e.g., the ~$1.2bn of retained earnings). Adjusted for treasury stock, WDR is on offer at an implied ~0.6x adj tangible book. This seems unjustified to me, considering WDR is still very much a cash-generative asset, and the secular decline is likely to be gradual in the meantime.
Total stockholders' equity
(+) Cost of shares in treasury
(-) Goodwill and identifiable intangible assets
= Tangible stockholders' equity
Implied Adj P/Tangible Book @ $877m mkt cap
Source: Author's Est, Company Filings
To be clear, the current ~27% trailing yield isn't where I expect the sustainable capital return to be, with normalized levels likely ~7% assuming FCFE normalizes to $60m post-FY21 (a ~$95m repayment comes due in FY21). This may seem conservative given FY19 FCFE was ~$131m, but I like erring on the side of conservatism, and thus, I've penalized management fees in-line with the current net outflow trend. But even assuming an ~$60m/yr run-rate, this would still imply a sizeable ~7% total shareholder yield.
Upside risks to the thesis include a sustained upturn in equity markets amid a low-interest rate regime, which would be supportive for AUM given WDR's exposure to equity AUM at ~75%. Catalysts include more opportunistic repurchases and an unwinding of the elevated short interest levels, which should help to narrow the discount to book. Downside risks include deteriorating performance, which will drive lower fee income and weak fund flows, or a downturn in equity markets.
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