Description

“Investing is where you find a few great companies and then sit on your ass.” – Charlie Munger

I think an investment in Envestnet (NYSE:ENV) around $30/share offers the opportunity to compound capital at a +20% rate over the next ten years.

Envestnet is an end-to-end enterprise software offering for financial advisors and institutions. They are the market leader and they have a defensible moat. I think the business is incredibly high-quality, benefits from a long-term secular growth runway and is currently valued at a deep discount to intrinsic value. Historically, Envestnet has been valued at 20x EBITDA. Thanks to concerns around slowing growth and a large, expensive, poorly communicated (but moat enhancing) acquisition, Envestnet’s stock has been cut in half from its 52-week highs and is down 38% year to date.

Pro forma for this acquisition, I believe Envestnet trades at roughly 12x exit 2016 EBITDA and nearly a 6.5% free cash flow yield. The company has articulated a long-term growth target of 20% top line and 25% EBITDA growth (versus 20% and 33%, respectively, in 2015). I think the growth runway has +10 year legs (perhaps at slower rates in out years), hence my expectation that this is a long-term compounder. I think fair value today is $50 but, as is typical with secular growers, pinning down a static price target is difficult. Suffice to say, a 40% discount to intrinsic value gives me a lot of margin of safety for a business I think so highly of.

The following is my attempt to bullet point the investment case.

-          Envestnet is a high quality business…

• Generates ~25% ROIC

• Has a high market share – 44 of 50 top independent financial advisory firms, 12 of 15 top banks and a majority of the largest RIAs are customers

• Has scale – +$800B on the Envestnet platform

• Operates with barriers to entry that result in a deep and wide moat – owns a full suite of offerings that could not be economically recreated; at this point they own many of the service providers for current and would-be competitors

• Customers captivity – it can take well over a year to transition to a new technology system; customer retention rates are in the high 90s

• Stable, visible revenues – pro forma revenues are 70% asset based (billed quarterly in advance) and 30% license

-          …growing at a high rate for a long time….

• Independent/RIA advisors market share take from wire house is a 20 year, 5 MPH tailwind. RIA assets have grown over 1.5x the overall advisor market over the last five years. Their market share is expected to grow from 20% in 2013 to 28% in 2018 (Cerulli Advisors).

• The advisory business is shifting from a commission-based model rife with conflicts of interest to a fee-based, fiduciary standard model. Fee-only market share is less than 20% currently, but will likely grow at high single digit rates for the next several years.

• Envestnet currently supports 42k financial advisors, with contractual access to customers with +120k advisors. Their total addressable market is +240k advisors. They will grow share within existing customers and add new customers for a long time to come.

• The average advisor is 51, and 43% of advisors are over 55. As the advisor business becomes younger, technology adoption will increase

-          …and reasonably priced.

• Attractive on both a relative and absolute basis - 3x revenue, 12x NTM EBITDA, and a 6.5% free cash flow yield

• There aren’t any great comps, but earlier this year Advent Software sold for 6x revenue and 17x EBITDA when it was growing revenue and EBITDA at 7% and 9%, respectively. SEI Investment Company(NYSE: SEIC), a not great but best we have comp, trades at 12x EBITDA and is growing top line 10% and EBITDA 15%

Overview

“The company appears to be building the proverbial “Holy Grail” of advisor technology – a fully integrated combination of CRM, portfolio accounting and reporting, and financial planning software for advisors.” – Michael Kitces, Nerd’s Eye View

Founded in 1999 by current CEO Jud Bergman, Envestnet was one of the first cloud-based software companies. Jud had previously worked for Nuveen Investments, initially as a municipal bond investment banker and then as the Managing Director of Mutual Funds. Colleagues note that he successfully built the business from scratch by selectively acquiring “best in class” components that would be worth more together. He recognized two things in the wealth management business – the wirehouses were likely to lose share and the industry would transition away from a commission-based model to a fee-based model. The economic rationale for wirehouses losing share is obvious – most advisors get less than a 50% cut of the revenue they generate. It doesn’t take a lot of AUM to cover the costs of putting together your own service providers for back office, compliance, technology and office space. However, access to product is another thing. Understanding that access to investment managers was the strongest hold wirehouses had on their advisors, Jud started Envestnet with the idea that it would help give independent advisors the product access they needed to provide their clients with a wide range of investment solutions. Today Envestnet has relationships with over 1,100 investment managers and believes they have 90-95% product overlap with most wirehouses. Many have commented that the networks effects that come from this level of scale almost requires that an independent advisor have access to the Envestnet platform.

The second trend Jud identified was the industry’s pivot away from commission-based wealth management towards a fee-based model. The conflicts of interest in a commissioned-based structure are obvious. The incentives to place clients into the highest commission paying products are simply too great. Fee-based accounts are taking share from commissioned accounts. By 2018, fee-based advisory assets will eclipse commissioned assets (from Cerulli Associates, a research firm that specializes in asset management and distribution analytics). The trend will continue for several years. Recently, the government has taken a more active role in enforcing a fiduciary standard for retirement accounts. This will only serve to highlight the mis-alignment of interests present in commissioned relationships and could accelerate the adoption of fee-based models.

After connecting the advisors with managers, Jud embarked on a fifteen year process of building out a full-service financial planning suite in order to provide advisers with: proposal generation, billing modules, portfolio analytics, manager research, investment planning, trading and rebalancing tools, CRM integration, and, just recently, account data aggregation. The following table from an Envestnet investor presentation outlines the spectrum of services and functions that the company offers its advisors.

This wide spectrum of services offered in a customizable (a la carte), open architecture (use any products you like and pick your own custodian) is unique. While there are several turnkey asset managers platforms (TAMPs) like SEI and Genworth, and portfolio management/accounting software providers like Advent, and financial planning tools like eMoney – none have the end-to-end service offerings that Envestnet provides. Furthermore, none provide an offering that can serve corporate purposes for overseeing advisor activities.

As a result of their breadth of offerings and independence, Envestnet has successfully attracted customers across the entire wealth management spectrum.  Their clients include large RIAs, broker dealers, banks, custodians and “break away” advisors of all shapes and sizes. Envestnet has over $800B in assets on its platform. Of these assets, $258B are fee-generating assets under management or assets under administration (AUM/A) and the remainder are assets which use Envestnet solely for reporting and portfolio management purposes. Of the 42,000 advisors using Envestnet, 29,000 are AUM/A advisors and 13,000 are using Envestnet strictly for reporting. The following graphic details their customer base by category.

Yodlee Acquisition and Q2 Results

Before diving into the business model, I’ll take a moment to address the reason why Envestnet is trading at a 40% discount to its historical valuation levels. On August 10th Envestnet announced their second quarter results and their intent to acquire Yodlee for $660MM ($590MM net of cash; $540MM net of NOLs); the acquisition price was around 33% of Envestnet’s enterprise value. The following day, Envestnet’s stock declined 35%.

The quarterly results were mixed, but in line. Management guided to the lower end of their annual guidance – 20% top line and 33% EBITDA – but this was largely expected due to industry-wide slowdowns (LPL and Raymond James also had weak numbers), market volatility and already known delays integrating some fairly large advisor conversions (namely, the acquisition of Prudential’s Wealth Management Services). The Yodlee acquisition, however, took everyone by surprise and management did little to build confidence in the move. Hating the deal was easy. The headline purchase price was 5x NTM revenue and +40x EBITDA. Often prone to meander along weirdly cerebral analogies, Jud spoke more about the “geometric strength of triangles” and “opportunities that we can't even imagine at this point” than he did about the financial rationale of the acquisition. It was easy to conclude that management had fallen off the capital allocation wagon and that they were attempting to acquire SAAS-cache as their core business was slowing. But I don’t think that is correct. I think Yodlee makes Envestnet’s moat very deep, and very wide. It also could offer a decent return.

Here is my best attempt at (hopefully succinctly) summarizing Yodlee’s business and the acquisition rationale:

Yodlee is a consumer financial data aggregator. They have data feeds into 14,000 financial institutions. These feeds send anonymized consumer financial data. They have 3x as many fixed connections as the next largest financial aggregator (CashEdge, left to wallow in the depths of Fiserv, is the next largest) and 10x the revenues according to the former head of CashEdge. With their connections, Yodlee can populate an individual’s entire financial picture by delivering real-time feeds of savings and checking accounts, car loan balances, mortgages, investment accounts etc. They also are able to complete real-time verification. Due to the IT security hurdles and significant scale benefits, I think displacing Yodlee will be very difficult. Furthermore, Warburg Pincus and the venture funds that preceded it put over $300MM into building Yodlee. The success of Yodlee was modest. I seriously doubt anyone could justify the financial requirement to vie for, what has turned out to be, a relatively small pie.

Yodlee’s customer base consists of retail financial institutions (9 of top 15 banks), wealth managers (6 of top 10), e-commerce clients (PayPal, Amazon and Google) and peer-to-peer lending companies (Kabbage, OnDeck). Financial and wealth management institutions offer their customers FinApps that enable customers and wealth advisors to track personal finances. Offering these services increases customer captivity and offers the opportunity to better market to clients and increase wallet share. Their e-commerce and peer-to-peer lending customers use Yodlee more for financial data verification.

Yodlee is a “B2B2C” company, meaning they license their data feeds and white-labeled software to other businesses, who then make their products available to end customers. They grow by adding new clients and increasing their penetration into those clients’ end customers. They have 850 clients and over 20 million paying users, which represents around 10% penetration with existing customers. The average ARPU per user is around $4.50/yr. Customer retention is very high since their service is low-cost and, especially for their commerce and lending clients, mission critical.

Yodlee is growing topline at a mid-20s rate. The S-4 proxy statement for the Envestnet acquisition shows their internal revenue growth estimates top 28% per year through 2020. They are just hitting their stride from an operational leverage perspective – 55% of 2015 revenue growth is expected to fall to the bottom-line. They are also developing new revenue sources. Yodlee’s data feeds capture billions of financial transactions. Once scrubbed, this data can be very valuable. It’s early days, but selling this data may prove to be a very significant revenue generator (http://www.wsj.com/articles/provider-of-personal-finance-tools-tracks-bank-cards-sells-data-to-investors-1438914620).

Though I think Yodlee is a high-quality company, uptake on the retail banking side hasn’t been as robust as expected (people care far more about their social lives than their personal finances, surprise!) and everyone involved with the company has been there for a long time. The CEO, Anil Arora, has been with the company since its inception. Warburg Pincus (owns 27%) has been invested since 2002. Impatience abounds. The door was already open when Envestnet came knocking.

On the call announcing the transaction, Envestnet talked about buying Yodlee because a partnership would have given all the financial benefits to Yodlee. My interpretation: We would have been the largest customer of a company that has a ton of operational leverage. The S-4 details Envestnet’s attempt to make a minority investment in Yodlee, but when that was turned down and a competing acquirer emerged, Envestnet decided to acquire the entire business.

Just this week, Envestnet detailed the revenue synergies they expect to achieve by owning Yodlee. They are targeting $200MM in revenue synergies, on top of the $400MM revenue estimate Yodlee forecasts, for 2020. At a 25% EBITDA margin (Q4 2016 estimate is 17%), Yodlee would generate $150MM in EBITDA in 2020; representing a modest 3x multiple on today’s purchase price. Management has noted that they only require 33% of their targeted revenue synergies in order to achieve a 25% IRR.

In sum, while I can’t say I would have been thrilled with the acquisition if I were previously a shareholder (it is 5% dilutive in the near term), I can say that I think the acquisition significantly enhances Envestnet’s incumbent advantage and does little to shake my confidence in the management team’s capital allocation discipline. Furthermore, the industry seems to love the acquisition:

http://wmtoday.com/2015/08/15/5-reasons-why-the-envestnet-acquisition-of-yodlee-was-brilliant/

https://www.kitces.com/blog/pfm-and-account-aggregation-acquisitions-in-advisor-fintech-reaches-a-new-level-as-envestnet-buys-yodlee-for-590m/

http://www.riabiz.com/a/4948800317685760/envestnet-buys-yodlee-and-its-treasure-trove-of-permissioned-data-by-selling-its-vision-of-the-future-of-financial-advice

http://www.americanbanker.com/news/bank-technology/envestnet-yodlee-deal-shows-convergence-of-wealth-pfm-worlds-1075962-1.html

Now back to discussing Envestnet’s core business.

Envestnet Business Model

The business model is straightforward – customers pay Envestnet a combination of asset-based and licensing fees to use a menu of services. The highest touch service occurs when advisors outsource the investment selection process to Envestnet’s research team, PMC (acquired in 2001 http://ir.envestnet.com/phoenix.zhtml?c=235783&p=irol-newsArticle&ID=1659429). In this role Envestnet serves as the fiduciary and the assets are considered AUM. As of June 30th, there were around $76B in AUM. The company does not break out the exact fee on these assets, but says it’s in the mid 30bps range. The AUM business contributes 55-60% of the pre-Yodlee acquisition revenues, but only around 35% of EBITDA since most of the cost of revenue is attributable to fees paid to subadvisors on their platform. Growth in the AUM business is lumpy. Year to date it is tracking in the low double digits annualized, but the industry is believed to be growing at slower than average rates due to recent volatility, and Envestnet has several conversions on their platform that have taken longer than expected. Over the long-term, I believe that assets will migrate into the AUM bucket as advisors realize there is much more downside than upside in taking on fiduciary obligations. While the AUM business is lower margin in percentage terms, the dollars are much much bigger.

For assets under administration (AUA), the advisor uses Envestnet for access to product and reporting, but does not cede fiduciary responsibility. As of June 30th, AUA totaled $182B. Again, management doesn’t break down the fees for AUA, but backing into the “all in” 13 bps fee and mid 30s comments from management gives you around 5 bps. On this math, the AUA business is around 25% of pre-Yodlee revenue and 35% of EBITDA. AUA growth is similarly lumpy, but growing a touch faster.

And finally, Envestnet’s licensing business, which primarily consists of their Tamarac division that caters to the RIA market, offers rebalancing, reporting and customer relationship software. The fee rate is around 0.4 basis points. Licensing revenue is ~15% of revenues, but nearly 30% of EBITDA. It is growing at +30% yoy, and has the highest contribution margin (+60%) in the business.

Growth Drivers

Envestnet illustrates their growth opportunity with the following slide.

They build up their 20% long-term annual growth target with the following growth buckets. In any one year each component will vary, but, directionally, I believe that these components add up to a substantial long-term growth runway.

• Organic Advisor Growth – Guidance 6-8%: As mentioned previously, Envestnet has 42,000 advisors on their platform. This represents less than 35% penetration into their existing customer base.  Their asset penetration is even lower, with only $800B of a potential $3.2T accessing Envestnet’s services. This speaks to the fact that older advisors with larger books of business have been slower to incorporate fee-based, technology driven advice models. As the industry continues to adopt fee-based advice and more integrated technology Envestnet will continue to grow its share of advisors who are affiliated with existing customers.

• Account Per Advisor Growth – Guidance 10-12%: The overall wealth management industry is growing around 4% per year. Over the last several years you have seen a growing percentage of households utilize financial planners and that trend, though moderating, is expected to continue. Envestnet maintains that advisors who use the platform grow at +2x the market. Additionally, as the industry shifts towards a more fee-based model, the number of fee-based accounts per advisor will grow. Historically, accounts per advisor has grown 10%. I think this number is likely a bit high, but not excessive.

• Add New Relationships – Guidance 3-5%: The company believes their total target market is 240,000 advisors and $8.1T. Envestnet is less than 50% penetrated. They will continue to add new relationships, and the number of potential relationships will grow as the break-away broker trend continues.

• Add Products and Upsell – Guidance 1-2%: Envestnet uses their “a la carte” offerings to bring on new advisors, especially recent breakaways. Over time, advisors tend to integrate more technology and use more services.

Competition

Envestnet is competitively advantaged because their extensive roster of services increases their customer’s productivity in a manner that their competitors cannot match. Envestnet faces competition from several disparate service providers. Their competitor groups generally fall into three categories –

• Turnkey asset management platforms (TAMPs) which provide access to investment product and practice management tools

• Single-service software providers which provide one-off functions such as  financial planning or performance reporting

• Custodians which offer low-cost trading tools

Envestnet’s key competitive advantage is that, for most advisors, opting for one of Envestnet’s competitors will require the advisor to make several service provider decisions. Incurring the risks of managing each vendor relationship and ensuring that they properly integrate with one another is not an attractive route for most. Though it is possible to assemble a lower cost suite of services, the productivity loss very frequently overwhelms the potential dollars saved. Envestnet has given several data points for how an advisor allocates their time. For instance, they claim they can save a typical advisor 30-40 hours per client onboard and, with the benefit of Yodlee, they will save 60-100 hours per client per year when providing financial planning. Their advisor growth supports these claims. The average Envestnet advisor grows their business at a 2.2x rate the industry. For an advisor that manages $250MM, the difference between growing at 5% and 11% is around $150,000 of additional high-margin revenue per year. Considering that the average fee paid by Envestnet’s AUM/A customers is around 13 basis points, the revenue from additional productivity far outweighs any potential cost savings in most scenarios.

Acquisitions

Envestnet has been an acquisitive company since its formation. They segment their acquisition strategy into two types – consolidating and strategic. Not including Yodlee, Envestnet has completed seven acquisitions totaling just over $200MM since 2010. Consolidating acquisitions are aimed at buying sub-scale technology platforms and converting their advisors to Envestnet users. These acquisitions are exclusively geared towards growing cash flow. They articulate their hurdle rate by saying that consolidated EBITDA must exceed 25% of the purchase price. Over the past four years Envestnet has completed three consolidating purchases (FundQuest, WMS and Placemark) for a total price of $130MM. These acquisitions brought $50B onto Envestnet’s platform and, though Placemark has yet to be fully integrated, the company has met or exceeded its 25% EBITDA as a percent of purchase price goal. Management thinks there are around 40 sub-scale TAMPs with anywhere from $500MM to $20B in assets that could make for future consolidating acquisitions.

The focus for strategic acquisitions is aimed at building out existing competencies or expanding to adjacent verticals that fit well with the technologies. The hurdle rate is measured over longer horizons, and the company targets a 25% IRR. Over the last five years Envestnet has completed five strategic acquisitions (Tamarac, Prima, Klein Decisions, Upside and Finance Logix) for a total price of around $100MM. Of these, Tamarac and Finance Logix are the most significant. Tamarac is a web-based tool for rebalancing, portfolio management, trading and tax loss harvesting that is offered primarily to RIA clients. Envestnet bought the business in 2012 for $54MM, paying almost 6x revenue. Three years later, Tamarac (offered under the product name Advisor Xi) has grown revenues 500%. The 25% IRR hurdle rate will be well exceeded.

Finance Logix is a financial planning software tool that will tie in with Envestnet’s interface. It was acquired earlier this year for $30MM. While Finance Logix’s market share in the financial planning market is relatively small (estimated at 3.4%), it was one of the last independent offerings of size and it brought Envestnet much closer to realizing their goal of becoming a truly full service investment management platform.

With the recently announced Yodlee acquisition, the build out is all but complete. While I expect that Jud will likely find tuck in acquisitions, I don’t expect anything sizable in the near to intermediate term. I expect that as the company looks inward to focus on integration, modest debt reduction and, eventually, share repurchases, the operations will improve, margins will expand and the share count should come down. These three factors are the strongest components I know for driving excellent shareholder returns.

Financial Modeling

An investment in Envestnet will work well if they can simply grow EBITDA and free cash flow at the same rate as the top line. In the S-4, Envestnet estimates that the combined business will grow revenue at a 24% CAGR for the next five years and EBIT at a 40% CAGR, as margins expand 900 basis points. If this scenario plays out, Envestnet will be generating +$1.6B in revenue and +$460MM in EBITDA. At a modest 10x EBITDA multiple, the stock would be worth over $100/share. Factoring in cash generation over the way, the annualized return would exceed 27% - an outstanding outcome for a five year investment. Even with more tempered expectations, like 17% revenue growth and 500 basis points of margin expansion, the return still exceeds 20%.

In all candor, I have no idea whether topline will be 17% or 24% over the next five years. Envestnet has grown revenue at a 33% CAGR over the last five years, but the business is maturing. The combination of Envestnet and Yodlee is in its infancy, and while I have every reason to believe that the management team will continue their track record of dramatically increasing the revenue and profitability of the businesses they buy, I don’t claim to have any special insight into future success. Either way, at the current price I’m not paying for anything close to flawless execution.

The following details my base case estimate for revenue and cash flow generation over the next five years. The only confidence I have in this estimate is that it is not correct and that, regardless of the magnitude of my errors, the intrinsic value of the business will be substantially higher in future years.

Risks

The two biggest risks are capital markets performance and a potential combination of competing service providers that could assemble a more like-for-like offering. There aren’t any good options for hedging out the second risk. Considering the incumbent advantages Envestnet has already established, and relatively small number of profit dollars available for a potential disruptor, I am okay accepting this risk. As for market risks, shorting the equity markets could be an acceptable hedge. On a pro forma basis, approximately 70% of the revenue is tied to assets and 50% of these assets are tied to equities. Factoring in the contribution margin from changes in asset based fees, a market short equal to around 50% of a potential Envestnet position size should roughly address equity markets exposures.

Catalyst

Plain ol' operational execution