Description

APO has been written up before, but I’ll give it a quick overview as a refresh.  

Business description:

Apollo (APO) is a value oriented alternative investment manager with over $230B in AUM, of which >$160B is fee generating. It operates within 3 verticals:

• Credit accounts for ~65% of total AUM and ~61% of management fee revenues.

• PE accounts for ~29% of total AUM and ~32% of management fee revenues.

• Real Assets (previously Real Estate) accounts for ~6% of total AUM and ~7% of management fee revenues.

How to think about this business:

I think the best way to value an alternative asset manager, like APO, is to separate the business into 3 valuation components: (i) earnings from management fees (Fee Related Earnings or FRE); (ii) earnings from incentive income (carry); and (iii) net assets on the balance sheet.

• Fee Related Earnings are generated from management fees that APO charges on its AUM.  APO’s enjoys long lock-up periods with some AUMs that are actually under permanent vehicles. As a result, this cash flow stream is very stable and predictable.

• Carry income is generated from APO’s participation in profits on invested and carry eligible AUM. The harvesting period is driven by the overall health of the financial markets. Therefore, this earnings stream is far less predictable (than FRE).

• Balance sheet value represents the APO’s net cash position, co-investments and other investments.

Why I like APO and AAM sector:

• Attractive sector tailwinds that will continue to drive growth in AUMs:

• Need for yield to satisfy pension liability bogeys (in a low interest rate environment).

• De-regulation in financial sector - Banks and SIFIs are divesting assets in response to regulatory pressure

• LPs looking to consolidate their assets with fewer trusted managers – big AAM will just get bigger

• The whole sector, apart from maybe BX, is trading at an attractive valuation. I prefer owning APO over other AAMs because:

• APO currently has the most exposure to management fee business which is most stable and reliable, and management business alone yields ~5% dividend yield, pro forma for Fund IX.

• It’s increasingly becoming a credit business, which improves the stickiness / stability / business quality over time. Also, within the credit business their fastest growing business is Athene, which is a permanent capital vehicle.

• APO is still subscale compared to BX, which is ~2x APO’s size, so there’s long runway of growth (supported by tailwinds discussed above) that should come in at attractive incremental margins.

• APO has a “value / distressed investing” bend with $36B of dry capital ($25B in PE alone), which should allow them to take advantage of down markets, should we go into a downturn, while providing an attractive dividend stream that is weather-resistant.

Thesis:

I believe that APO is currently under-appreciated by the market, despite the recent run-up in the share price. Pro forma for the Fund IX step-up in FRE, APO should be worth $42 per share, or a 41% upside to current share price. Further upside, could come from faster deployment of capital at Athene and AGER. Furthermore, in rising markets, investors will show higher appreciation for carry potential (or carry distribution will come sooner thus improving the IRR profile). In down markets, APO should be supported by significant cash flow stream supported by the management fee business. I expect APO to generate $1.50 of after-tax FRE by 2018-end, vast majority of which will be distributed to shareholders as a base dividend, representing a ~5% base yield. As discussed, this management fee stream is unlikely to decrease even in a down market, which provides a margin of safety.

Building blocks to $42 per share valuation:

Sum of the parts valuation: $25.50 of management fee value + $13.70 in carry value + $2.78 in BS value = $42

• Management fee business: I expect APO to generate $1.50 per share in after-tax FRE in 2018, following Fund IX step up, to which I assign a market multiple of 17x. This implies that management fee business is worth $25.50 per share. Some might argue that this cash flow stream deserves a higher multiple since it’s steady, predictable and growing. However, due to the Athene concertation I think the market multiple is more appropriate.

• Carry value: I estimate that Apollo can generate $2.28 of annual carry per share (post-tax) over an entire cycle. Given the cyclical nature of this cash flow stream, I value it at a significant discount to management fee business. At 6x, the carry is valued at $13.70 per share.

• Balance sheet carries ~$2.78 per share in value.

Building blocks to $1.50 after-tax FRE at 2018-end:

A back-of-the envelope math on step-up in FRE:

• 2Q2017 FRE per share was $0.35, so annualized FRE is $1.39. Once we back out 20% tax, the annualized post-tax FRE per share is $1.11.

• Once APO turns on Fund IX, the management fee revenue should increase by $200M. (To be clear this is net of step down from Fund VIII and cessation of fees of prior funds.) Management expects virtually all of this $200M to drop down to the bottom line. In my model, however, I have it flowing through at 80% incremental margin, thus resulting in 31 cents of incremental after-tax FRE.

• The remaining 8 cents of after-tax FRE growth is driven by growth in Credit and Real Assets.

Upside to the $1.50 after-tax FRE:

The upside to my figures would come from faster deployment of capital at Athene and AGER. Both of these entities are over capitalized, so APO could see after-tax FREs grow by 33 cents without needing to do any fundraising. It’s unrealistic to assume that Athene or AGER will deploy this capital over next 12 months, but in the context of near-term growth potential it’s worth keeping this in mind.

Building blocks to $2.28 of carry over a cycle:

Below I estimate the potential carry value per share for APO. Note that my gross return assumptions are below historic levels.

Risks / things to get comfortable with:

• High beta name. As noted, part of the valuation is driven by carry realizations which are dependent on the health of the overall market. So in a downturn, there’s a chance that the market assigns 0 value to the carry. Meanwhile, the management fee business is largely, but not exclusively, insulated from market fluctuations so that $1.50 of after-tax FRE will provide strong valuation support.

• Athene concentration. APO has pretty high concentration of AUM in Athene, which accounts for 35% of fee-generating AUM and ~19% of management fee revenues. Athene could potentially choose to terminate the contract with APO, which would be a bad day for APO stock. But if you read the terms of the contract, you’ll learn that Athene can terminate the contract for bad performance or excessive fees. BUT APO would have 2 years to cure it, meaning that the contract is unlikely to be terminated.

• Complexities of financial reporting and what’s behind the curtain. Investors have hard time understanding the business (matching non-GAAP financials to GAAP financials) and projecting it. So it might draw a smaller subset of investors and it might never get the “full” value.

• Tax rate. I’m capitalizing FRE and carry at a 20% tax rate in my model. But any changes in tax legislature that would impact APO should be closely monitored. I don’t have a view if AAMs tax structure will change, but I do believe that APO will do whatever they can to minimize tax leakage.

• Liquidity / little float. There’s very little liquidity in the name, so any big buys or sells will move the share price. Also, since there’s very little liquidity in the name (and free float is at ~45%), APO might not be able to take full advantage of share buybacks during down periods.

Catalysts:

• Step up in FRE arising from Fund IX.

• Investor appreciation of AGER opportunity as AGER begins to deploy capital.

• Potential sizable acquisitions by Athene.

No reliance, no update and use of information. You may not rely on the information set forth in the above write­up as the basis upon which you make an investment decision. To the extent that you rely on such information, you do so at your own risk. The write­up does not purport to be complete on the topic addressed, and we do not intend to update the information contained therein, even in the event that the information becomes materially inaccurate. Certain information contained in the write­up includes calculations or projections that been prepared internally; use of a different method for preparing such calculations or projections may lead to different results and such differences may be material. We now own the security discussed above, and may decide to buy or sell such securities at any time of our choosing without providing an update.

Catalyst

Catalysts:

• Step up in FRE arising from Fund IX.

• Investor appreciation of AGER opportunity as AGER begins to deploy capital.

• Potential sizable acquisitions by Athene.