Friday, December 2, 2011

Blackrock (BLK) is a decent buy with high beta to equity markets - Alpha


BUSINESS DESCRIPTION

BlackRock, Inc. (BLK) is an independent investment management firm with $3.345 trillion of assets under management (“AUM”) at September 30, 2011. BLK focuses exclusively on investment management and risk management, with no proprietary trading or other activities (like banking). BLK invests capital throughout the world and its clients include taxable, tax-exempt, and official institutions, plus retail investors and high net worth individuals. After combining with BGI in 2009, Blackrock has a platform of active (funds and managed accounts) and passive (ETF/index) products. Big competitors are Allianz (DB:ALV), State Street (STT), Franklin (BEN), Invesco (IVZ), Legg Mason (LM), and Fidelity (private).

BLK generates most of its revenues from fixed fees as a percentage of AUM; performance fees on a small asset base are much more volatile and adding or reducing revenues by 1% (so while most of this benefit flows to margins, it is variable and seen as a boost and not as core). The two largest topline drivers of BLK’s business, then, are total AUM overseen and the level of fixed fees, which varies by segment (it is higher for alternatives, lower for fixed income). Active equity, iShares, and active fixed income are the three largest product lines, accounting for 53% of total revenue. For expenses, employee compensation is by far the largest (36%), with G&A being almost half that.

INVESTMENT MERITS

Diversified investment product platform not-reliant on any asset class, fund, or region. As of December 2010, 67% or revenues are from the Americas and the rest from Europe and Asia-Pacific. The AUM base is split between equity (48%), fixed income (32%), multi-asset class (5%), alternatives (3%), and cash management (8%). The AUM mix is also split between active (38%), institutional index (43%), and ETF/iShares (19%). BLK’s strategy is to offer every type of product to clients, though its historical strength has been in fixed-income and ETFs (via BGI). As the CEO Fink noted on his recent earnings call, clients are reaching for yield and income products in the current uncertain environment, and BLK can promote existing products that meet this need.

Strong FCF generation and smart allocation of capital (though weak cash). As the chart to the left shows, BLK generates about $2.5bn of OCF with only $200-300mn of capex required. It pays a solid 4% dividend yield. One problem: currently if you add BLK’s excess cash balance of $2.92bn, its $1.40bn of investments, and deduct $4.79bn of total debt, BLK has -$0.47bn of net cash and investments. The lack of capital was driven by the recent capital drain from the BAC ownership repurchase. However, BLK is increasing its cash balance by natural cash flow generation.

BLK's Cash Flows and Dividends are Attractive

Superior management team and board. The management team headed by CEO Larry Fink is one of the best in the investment management business. No other publically traded investment management firm has anything like it. The company also has a strong board of financial experts (John Varley, Bob Diamond, Tom Montag, Deryck Maugham, Bill Demchak, etc.), unlike many other financial companies with general corporate or non-profit execs on their boards.

Valuation. Consensus forecasts for 2012 and 2013 suggest BLK will earn $12.5 and $14.4 per share in 2012 and 2013 for a 13.5x and 11.7x forward P/E. Compare BLK to peer multiples which trade in the 11x to 13x range. The FCF yield on the current price is about 4.4% based on 2010 FCF figures (OCF-capex), which is attractive when the 10-yr UST yields ~1.9% and the Barclays Aggregate yields ~2.4%. A DCF valuation suggests that BLK common stock is worth between $197 to $255 (key assumptions are revenue growth rates from 4.4%-7.0% with constant margins and equity discount rates of 9.1%-10.4% per the CAPM). The free cash flow yields on BLK are strong but its ROE at 6.4% is weak.

INVESTMENT RISKS

Active products could see outflows if they underperform peers, plus securities lending is a risk. Revenues in the active equity products can be quite volatile as AUM fluctuates. While the ETF and fixed income products are stable, the reputation risk of a real estate fund or niche equity fund blowing up could adversely affect other active products. Securities lending is akin to picking up dimes in front of a bulldozer. While BLK claims to only do this for clients and not take principal risk, investors should worry about risk controls in such a business.

Competitive fee pressures, low barriers to entry, and clients internalizing asset mandates could hurt pricing and revenues. Fees in BLK’s business range from 20bps to 2/20% deals for alternative funds. In general, the barriers to entry in the investment business are low as two people in an office with a computer terminal can compete. Also, as CEO Fink mentioned in his latest conference call, a worrisome trend is that some large plan sponsors may be internalizing investment operations to bring down costs; losing $10-$50bn mandates at a time is a risk.

Merrill Lynch or Barclays may fail in their distribution and backstop roles. First, Merrill Lynch provides distribution, portfolio administration, and servicing for certain BLK products and services through its various distribution channels. Loss of market share within Merrill Lynch’s Global Wealth & Investment Management (GWIM) business could harm BLK’s operating results (distribution concentration risk). Second, Barclays has certain capital support agreements in favor of a number of cash management funds acquired in the BGI Transaction; this lasts till December 2013. Failure to meet these could cause a cash squeeze at BLK.

Concentrated control of BLK stock by the board. Approximately 28% of the BLK’s common stock is held by Barclays and PNC. Both entities have given proxy control of their ownership to the board, which now has strong corporate governance control but significantly different economic upside vectors. This could lead to agency problems and the latest proxy statement suggests executive compensation is high (the top 3 execs earned about $20 million each in 2010).

RECOMMENDATION AND PRICE TARGET

• Possible Catalysts: No clear catalyst other than strong continued revenue and earnings growth. Weak global equity market performance could be a downside catalyst.
• Market Misperception: BLK, like most asset managers, trades at a P/E discount to other firms with similar cash flows due to the perceived volatility from their AUM and revenue sources. To the extent that BLK is diversified and has many passive products, its revenue volatility could be much lower (justifying a higher premium).
• Price Movement: The stock has moved within the $140-$240 price range in the last few years after bottoming at $92 in the 2009 trough.
• Buy, Sell, and Stop-loss Points: Target = $220.0, Current price = $169.02, Undervaluation = ~23%
• Recommendation: BLK is a fair BUY because it is a large-cap stock that is misunderstood by many sell-side analysts and large buy-side institutions. The current valuation gap is barely enough to make this underappreciated “blue-chip” stock a buy - it is roughly priced below the market with a potential for 3% to 5% of alpha over the next few years. BLK is a decent security to hold in a moderately concentrated pool of 15-20 securities for the financials bucket of the portfolio, instead of highly levered broker-dealer or commercial banks. Alternatives like V or MA should also be considered.

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