Description

Eaton Vance is not under the radar, a deep value, or a special situation. I write this up with the full understanding that I will get penalized by VIC readers because Eaton doesn’t fit into one of these categories. Like my write up on Matthews International or UST, the degree of difficulty here rests almost solely in combining the paper trail with judgment, and I hope to make a convincing argument here why I think my judgment on Eaton Vance trumps Mr. Market’s.

My thesis is that Eaton Vance is quietly moving from good to great in one of the most profitable industries around. Add to the mix room for growth, a demographic tailwind, and future value accretion at the expense of recently tainted competitors and you have a valuation today that looks compelling.

Let me briefly describe the company and then lay out my thesis.

Eaton Vance is a Boston-based investment manager for mutual funds, institutions, and individuals. The firm was founded in 1924 and has evolved from a small bond shop in the mid-80’s to a full-service financial services provider under the leadership of James Hawkes. The company manages $89 billion today (actually $94 billion with latest new product offerings since July but I’m going to stick to the latest filing so all the numbers tie up) and is ranked as the 59th largest investment company. The asset mix today is 60% equity, 24% fixed income, and 16% bank loans. Total AUM is broken down as follows: $66 billion fund AUM (over 100 fund portfolios, over 1.1 million shareholders), $19 billion high net worth and institutional and $5 billion in over 40 retail managed account programs. The firm’s Enterprise value is 2.7 billion or 3% of AUM, is trading at 19x 05 earnings, has ROE of 30%+, and pays an ever increasing 1.5% dividend yield.

a) Good to Great: James Hawkes Leadership


89 96 04
Total AUM 7 17 89
Equity AUM 4 54

89 to 96 AUM CAGR: 14%
96 to 04 AUM CAGR: 24%

96 Asset Mix: 60% Fixed Income, 24% equity, 16% Bank Loans
04 Asset Mix: 60% Equity, 24% Fixed Income, 16% Bank Loans

So what happened in 1996?

James Hawkes took over Eaton Vance as CEO.

Hawkes joined the firm in 1970, after receiving a business degree from Harvard and a brief stint as an aerospace engineer. He started as a research analyst and quickly rose up the ranks to become CIO in 1985. The product innovation soon followed with new offerings like a municipal bond fund in 1985 and a first ever bank loan fund in 1989. Hawke seems to have an uncanny ability to respond to changes in the investment environment and has differentiated Eaton Vance by making sure the firm introduces new and diverse niche product lines to meet these changes ahead of the competition.

For example, in 2003, Eaton introduced its first closed end stock fund and by the end of 2003, Eaton was recognized as the largest issuer of closed-end funds in 2003. It should be noted that particularly in 2003, EPS were depressed ($1.51 in 03 vs. $1.70 in 02) because of the stair step nature of these offerings: many of the new products carry one-time sales and marketing costs that are recognized at the time of the offering.

b) Room for Growth:

Total Asset Growth Past 3 Years (July 01 – July 04):

Fund Industry: +8%
Eaton Vance ex-acquisitions: +35%
Eaton Vance: +78%

II 2003 Top 300 Money Managers ($ Billions):

1. State Street Global – 1,100
2. Barclays Global – 1,070
3. Fidelity – 964
4. Capital Group – 814

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59. Eaton Vance – 77
60. Affiliated Managers – 77
61. Brandes Investment Partners - 76


Institutional Investor Top 300 Managers - Eaton Vance Historical Rank:

Year: Rank AUM ($B)

2003 59 77
2002 65 57
2001 71 49
2000 80 46
1999 90 41


Taking a page from the Affiliated Managers playbook, Eaton acquired two companies on September 30, 2001: Atlanta Capital Management and Fox Asset Management. Eaton acquired a third company in late 2003: Parametric Portfolio Associates. This is why there is a gap between Eaton’s organic (35%) versus inorganic growth (78%) over the past three years.

The results since the acquisition:

AUM@Acquisition AUM 7/31/04

Atlanta: 6.1B 9.0B
Fox: 1.8B 2.8B
Parametric: 5.3B 7.8B
$13.2B $19.6B

Favorable business economics (much higher D&A vs. CAPEX, ROE 30%+) has allowed Eaton to make these acquisitions by taking on negligible debt. At the same time, Eaton has increased its dividend 150% since 2001 and reduced shares outstanding from 76mm in 1996 to 70mm fully diluted today.

Total Long Term Debt (mm):

96 01 04
55 215 120

I expect future acquisitions of this nature going forward and have every reason to believe the results will mirror the success of the first three.

c) Baby Boomers Retire:

There were 75mm Americans born between 1946 and 1964. Eaton Vance will profit as this population ages and more people need help managing their money. Eaton Vance’s avoidance of the mutual fund taint and diverse product mix will help EV grab market share from competitors. The statistics below are from a speech given last month by the White House.

• In 2006, the baby boomers will begin to turn sixty and in 2011, sixty-five. In the coming decades, there will be a significant increase in the number of elder boomers and in their proportion to the total population. By 2030, the boomers’ proportion will increase to 20% of the population up from a current 13%, and the number of elderly will double. Put in different terms, from 2010 to 2030, the 65+ population is projected to “spike” by 75% to over 69 million people. Then from 2030 to 2050, the growth rate is projected to grow about 14% with the number of elderly totaling about 79 million.

Valuation:

I have run a 10 year excess return DCF using conservative historical inputs: 12% revenue growth, 30% operating margins, historical D&A and CAPEX as % of revenue, and a weighted average cost of capital of 10% (CAPM suggest closer to 8%). After year 10, I assume the company earns their cost of capital.

The two key inputs are operating margins and revenue growth and below is the sensitivity table that lays out the value of Eaton Vance depending on the assumption range. Eaton Vance is of very little value if margins contract to 26% and revenue growth is projected at 8% going forward.



My base case suggests 44% upside from the current price or $63 intrinsic value per share today.

Intrinsic Value:
Operating Margins Revenue Growth
8% 12% 16%
26% 45 57 74
30% 50 63 81
32% 52 66 85

Comps:

I have more detailed comps in excel but because of the difficulty of inputting it here, this is an abbreviated version. These multiples are for 2005 (or next 12 months estimated) except for BKF which is the current year.

TEV/REV TEV/EBITDA P/E


Waddell Reed 3.4x 9.5x 15.6x
Affiliated Managers 3.2x 10.6x 12.9x
Gabelli Asset Management 5.2x 11.4x 22.9x
BKF Group 1.7x 17.0x


Eaton Vance 3.8x 10.8x 18.9x


Conclusion:

We are still in the early innings of the Eaton Vance story. Though not “cheap” at first glance, this high quality asset management firm is a bargain if the assumptions I have made about the company turn out to be true (James Hawkes ability to continue to execute going forward, the mutual fund taint ramifications, the coming demographic tailwind etc.) If these assumptions do not come to pass, then my revenue growth and operating margins assumptions could be called into question.

Key Risks include:

Stock not as cheap as it was in July – up 15% since latest results
Macro/Industry issues (sluggish equity market etc.)

Catalyst

Acquisitions and more niche product offerings
James Hawkes