Epoch Investment Partners is a small, rapidly growing asset management firm that offers both mutual fund and institutional services. Small asset management firms are rarely public, making Epoch somewhat unusual, but Epoch is even more unique because of the quality of its team, the scope of its ambitions, and the quality of its investment product. The company has grown from a standing start just four years ago to $6 billion in AUM, posting 50%+ annual growth in all quarters since they’ve been public. Just now on the cusp of sustained profitability, Epoch trades at a discount to private market value and offers an open-ended growth opportunity.

 

Company background

 

William Wallace Priest is the founder, CEO and Chief Investment Officer of Epoch. Priest has been around longer than just about anyone in the business – I found an article written by him in the Financial Analysts Journal, dated 1965. In the late 70s, Priest founded a money management shop called BEA Associates, which was partly owned by CSFB for much of its life. From its founding until 1998 – when CSFB acquired the company in its entirety – BEA grew its AUM to over $100 billion.

 

Early this decade, Bill Priest hit the mandatory retirement age at CSFB, which posed a problem since he had no intention of retiring. Finding no encouragement at CSFB, he recruited the core team that had built BEA Associates to move with him into a new venture, Steinberg Priest and Sloane. In 2004, however, a disagreement with a partner led Priest to form Epoch, again taking with him much of the core team from BEA. In an unusual move, Epoch chose to go public by reverse merger into a shell company called JNet Enterprises, which had been a dotcom incubator in 1999, when such things were fashionable. Last year Barron’s asked Priest why he wanted to be public, and his answer is telling:

 

Barron's: It's rare to see a new asset-management firm go public. Why did you do it?

Priest: The money-management business has changed dramatically since I first entered it in 1966. For one, capital matters more today than it did nearly 40 years ago. It takes more money to run this business than it used to. If you intend to build a firm of real substance, there are things you need. You need infrastructure and you need a team of experienced people who have substantial experience in the business and are in the sweet spot of their careers. That takes capital.

 

We felt that investors want not just a transparency of the investment process; they also want a transparency of the business practices. They want to know about you, your character, your integrity. People want to know more than just how you pick stocks or how you build portfolios. There is a growing demand for greater transparency among investors these days, and the publicly owned structure addresses that. So we went that route. And by we, I mean myself and three longtime associates—Tim Taussig, who is our chief operating officer; David Pearl, head of our U.S. equities; and Phil Clark, head of client relations.

 

Investment products

 

Epoch runs all its portfolios using a value-based approach with a special emphasis on free cash flow yield. The company believes – and emphasizes heavily in its marketing – that PE ratios peaked years ago, thus making cash flow, and the use of cash flow to shareholders’ benefit, the primary driver of equity returns. Priest published a book earlier this year, Free Cash Flow and Shareholder Yield, that explains his investment philosophy. I think most VIC members would say that Priest is “one of us” and very few would find fault with his investment philosophy. The company runs about ten investment portfolios, categorized as US All Cap Value, US Value, US SMID Cap Value, US Small Cap Value, Global Small Cap, Global Absolute Return, International Small Cap, Balanced Portfolios, and Global Equity Shareholder Yield. Please see the company’s web site or the 10-K for more info on how they describe and market these products.

 

The AUM breakdown is as follows:

 

 

All of the firm’s investment products have put up competitive returns since inception. Please note that some of the investment products here have inception dates that predate the foundation of Epoch because they were managed by Priest while at Steinberg Priest and Sloane or his previous firm. Also note that the company uses slightly different, more granular categories in their presentation of these performance records than they do for tallying up AUM totals.

 

The company also advises three mutual funds through a distributor called The World Funds. Performance for these funds is included in the next table:

 

AUM Growth

 

In the last two years, Epoch has grown faster than any asset manager I can find, save Diamond Hill Investment Group, and in the last few quarters, Epoch has continued its growth while Diamond Hill has stalled. AUM over the last thirteen quarters is presented in the table below:

There is significant customer concentration risk within Epoch, as two clients represent 41% of the company’s business. CI Investments, the large Canadian investment firm, retains Epoch to sub advise some of its mutual funds. This client represented 17% of total revenue in the first quarter of fiscal 2008, down slightly from 19% in 2007. Genworth Financial, through subadvisory relationships and through investments in the firm’s mutual funds, accounts for 29% of revenue in the first quarter, up from 22% in 2006, indicating strong inflows from this channel. While this is a risk for the company, it is one that fast growth in other segments of the business, particularly the direct-sold institutional business, can mitigate over time. In fact, CI represented 36% of total AUM for Epoch as recently as 2006, so the company has made excellent progress already in developing a more diversified customer base. Going forward, new initiatives, like a new sub-advised fund with John Hancock, and a subadvisory relationship with Grant Samuels in Australia, should reduce this concentration even further.

 

Valuation

 

Epoch is just now turning profitable. The company has invested heavily in infrastructure and people sufficient to serve a company many times larger than they currently are. In addition to the core team from BEA Associates (Priest, plus the COO, CFO, and a few others), the management and investment team brings experience from AllianceBernstein, Mark Partners, Omega Advisors, Citigroup and Goldman Sachs Asset Management. Thus, we’ll need to make projections for future profitability without the benefit of historical results. Such an exercise is, by definition, imprecise, so please understand if this analysis doesn’t present financials projections down to the penny.

 

My model is presented in the table below:

 

	Growth factor	60%	40%
in thousands
	FY 2007A	FY 2008E	FY 2009E
Revenues	23925	38280	53592
Op income	-2517	7656	18757.2
shares	21789	22,225	22,669
EBIT/share	-$0.12	$0.34	$0.83
EBIT multiple	12	$4.13	$9.93
EBIT multiple	18	$6.20	$14.89
plus xs cash	$30,000	$37,656	$49,848
per share	$1.38	$1.69	$2.20
Stock target	EBIT multiple	12	$12.13
		18	$17.09

 

The first place to start is the growth rate of revenues and AUM. Clearly, triple digit growth rates will not last forever, and a case for investing in Epoch doesn’t depend on such assumptions. However, even large, mature asset managers routinely post double digit annual growth in AUM. Consider these examples (I have excluded firms like Blackrock/Merrill Lynch and Legg Mason/Citi that have gone through large mergers):

 

For my assumptions, I’m assuming that growth moderates to 60% in 2008 and 40% 2009, which is still an impressive number, but less than half the rate the company was posting as recently as a year ago. There are no capacity constraints on Epoch’s growth – Bill Priest said in the same Barron’s article mentioned above that the firm could “become a $10 billion to $12 billion entity in a three to five year period” (he said this in July 2006, when AUM was $3.25 billion). And many of the funds and strategies have far less than $1 billion in AUM today.   

 

As for profitability, let’s look at the operating margins of the comp universe again:

 

Firm	2006 operating margin
Franklin Templeton	33%
Federated Investors	32%
Eaton Vance	20%
Janus	25%
T Rowe Price	44%
AllianceBernstein	29%
Diamond Hill	32%
Hennessy	44%
Calamos	39%
Epoch	4% (mrq)

 

So, for my projections, I’m assuming that EPHC ramps to 20% operating margins in 2008 and up to 35% margins in 2009, putting them in the mid to high end of the comparable universe.

 

So, what multiple should the stock trade at? In the table above, I use EBIT multiples of 12 and 18. A multiple of 12 would correspond to the median of recent takeout values, as reported in the JNC/Madison Dearborn acquisition materials. This would put a downside risk on the stock of just above $12 per share, attractive for a stock currently trading at $11.54 (again, this is assuming AUM/revenue growth continues).  JNC itself, however, was bought for 18X EBIT, a pretty astonishing number for a sleepy closed end bond shop posting mid teens AUM growth. If that is a fair price for JNC, then it’s surely a fair price for EPHC, a much faster grower with a wide open opportunity for growth ahead of it. If EPHC were valued at 18X EBIT, it would be worth $17.09 per share, implying annualized gains of 30% if the stock were to reach that value by the middle of 2009. After 2009, the shares should increase in value at a rate that corresponds to the growth in revenues and AUM, which should continue to be substantial.

 

An additional point of upside for the stock would be the commencement of stock buybacks. I don’t expect this for at least a year, because the company needs to show a history of solid profitability to its customers before it undertakes to deploy its cash hoard to share repurchases. But Priest himself literally wrote a book on the importance of stock buybacks for investor returns, so I think it’s fair to expect this as a source of additional upside in the future.