Description

Summary Short Thesis:

Beyond the secular active-to-passive headwinds facing traditional asset managers, FII continues to lose share in its core money market business to BlackRock, Vanguard, trust banks, etc. and has yet to see the type of inflows you'd expect with rising rates. With money market flows shifting from prime to government following the 2016 floating NAV rule change, FII's competitive advantage in prime has eroded as government funds are generally a more commoditized product. On the equity side, with FII’s flagship Strategic Value Dividend fund in outflow for the past 12+ months, total equity flows should remain pressured. There is also risk on the distribution side as distributors are poised to cut down the number of funds they offer (outside of FII's top core funds, its smaller funds are less relevant and are at risk of being cut). Across its product lines, growth is only coming in separately managed accounts (SMAs), which tend to be stickier but carry half the fee rate. The mix away from equities (5x fees vs. MMF and 2x fees vs. FI) and from funds to SMAs (funds 2x fees vs. SMAs) will continue to erode FII’s overall fee rate more than expected, while valuation seems stretched after recent outperformance driven mostly by tax reform and market appreciation.

Business Description:

FII manages over $360B in assets globally, ranking it among the top 25 largest asset managers in the world. Best known for its money market funds ($240B AUM, 67% of total), the company also manages nearly $120B spread across equity ($67B, 18%) and fixed income ($53B, 15%) funds. FII’s clients are predominantly domiciled in the U.S., accounting for close to 95% of AUM, and its funds are distributed through all major channels and include over 6,100 institutions and intermediaries as clients, including corporations, government entities, insurance companies, foundations, endowments, banks and broker/dealers.

Business Headwinds: 

• Ongoing shift from active to passive; FII lacks products in areas that are attracting capital

  • The asset management industry has been facing the “active-to-passive” headwind for quite some time as increased fee transparency, relative performance in the midst of an 8+ year bull market,  regulation and technological advancements have continued to shift dollars from active strategies to lower-cost passive vehicles or to actively-managed strategies that are more difficult for an ETF to replicate. While the pace of active outflow has improved this year, passive flows continued to accelerate as more cash keeps flowing into the market and passive now represents 47% of equity fund AUM.

• Shorting asset managers on the active-to-passive theme alone has been a losing proposition over the last two years with the DJUSAG index outperforming the S&P 37% vs. 30%. This shift is nothing new, and asset managers have adopted various strategies to both defend against and capitalize on the changing environment, expanding product suites in growing areas such as ETFs, alternatives, target date and international. However, FII doesn’t have exposure in these areas and gets less of an AUM lift from equity market strength given its high composition of money market AUM.

• FII continues to see long-term outflows; equity complex is heavily concentrated and overall performance is mixed

  • With $14B of mutual fund AUM, the Strategic Value Dividend Fund (SVAIX) makes up more than a third of FII’s total equity AUM. Including SMA AUM and other funds in the strategic value family, the strategy comprises ~$40B of AUM, 60% of FII’s total equity (funds + SMA) AUM. Performance has been mixed depending on the time period and what you use as a benchmark; Morningstar places it in the large cap value category, but management is more focused on the income component and believes the Morningstar benchmarks to be inaccurate. FII benefitted from strong flows into SVAIX in 2016 after a stellar outperformance year in 2015, but the fund has been outflowing every month since November 2016 and the strategy is generally less attractive in a rising rate environment. FII’s popular Kaufmann fund (KAUFX) comprises 15% of equity fund AUM, so together SVAIX and KAUFX represent >50%. Focused on growth, KAUFX has had a strong year, which has driven some fee revenue upside (faster AUM growth, high 130bps mgmt fee) but continues to outflow despite the good performance. While one can debate the future trajectory of flows, the bottom line is that FII has seen -4% organic growth in its long-term strategies over the last four quarters (-5.5% ex-SMA) and carries high concentration risk within its suite of equity funds.

• Money  market business structurally challenged and continuing to lose share

  • In response to the Reserve Primary money market fund “breaking the buck” during the financial crisis, the SEC introduced new regulations in 2014 that upended the cash management industry. Stable $1 NAVs were preserved for government funds, but prime institutional and tax-exempt muni funds are now required to have floating NAVs and to impose liquidity fees and redemption gates to keep the funds stable in event of an extreme market downturn. As a result, leading up to the October 2016 deadline, a massive shift occurred with dollars moving from prime and muni funds to government funds. 

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• After lapping the implementation date in October 2017, prime funds have started to tick up y/y again given the easier comp, but demand remains muted. FII has insisted that, eventually, spreads between prime and gov’t funds will widen to a point where prime becomes attractive again, but you’ve yet to see it play out with spreads widening to 30bps, double the historical average spread. FII has shown some initiative to drive flows, introducing two new prime funds that are set up in a way to avoid the mandatory fees and gates; but while these funds have gained initial traction, they remain a relatively small piece of the pie.

• FII has also been talking about legislative efforts to reverse the floating NAV regulations (https://www.wsj.com/articles/bringing-back-the-money-fund-buck-1513247400), which could then lead to a big influx back into prime with mandatory liquidity fees and gates lifted. Even though the proposal seems to have bipartisan support, D.C. sell-side analysts close to the situation view its passage as unlikely given other priorities in congress (not a big enough deal  to devote floor time to) and that it lacks support from large players like Vanguard and BlackRock who have already adapted to the new status quo.

• FII has the fifth largest share of money market AUM with ~190B as of the end of November, representing 6.3% share according to Crane Data, trailing Fidelity (19.0%), Vanguard (9.6%), BlackRock (9.4%) and JP Morgan (8.6%). (Note: these percentages provide a relative illustration, but the market share as quoted by FII mgmt is 7.3%, down from 7.5% a year ago.) The top four are participating in the recent money market fund inflow and are increasing share: “Fidelity, Vanguard, Wells Fargo, and BlackRock had the largest money fund asset increases over the past 3 months, rising by $​14.​1B, $​13.​1B, $​11.​8B, and $​10.​6B, respectively. The biggest decliners over 12 months include: Goldman Sachs (​down $​23.​6B, or -​12.​2%), Morgan Stanley (​down $​16.​1B, or -​12.​1%), Federated (​down $​4.​7B, or -​2.​4%), and Western (​down $​4.​5B, or -​13.​1%)” (https://www.cranedata.com/archives/all-articles/6955/). See chart of market share over time -

   

  

• On average, FII money market funds have higher fee rates relative to the rest of the industry, particularly in prime funds. The behemoths seem more than willing to continue to cut prices, as money markets don’t really move the needle for them and are seen more as a way to gather a bigger share of clients’ wallets. FII has historically resisted pricing cuts, but it is likely that they will have to make the choice between lowering prices or continuing to cede share, as the more commoditized nature of gov’t funds and general industry-wide fee sensitivity will make it difficult for them to win with higher priced products. See expense ratio chart below –

• Negative fee migration from a) increased competition, b) shift from equity/FI to money markets and c) shift from mutual funds to separate accounts

  • FII has among the highest fees in its mutual funds and increased fee focus/transparency has continued to put pressure on high-fee products that don’t demonstrate a clear performance advantage. As mentioned above, FII management has historically been resistant to lowering its fees, but it has made some selective pricing cuts in the past year (i.e. the Small Cap Kaufman Fund highlighted on the last earnings call) and with industry-wide fees gradually trending down over the past five years, it seems likely the trend will continue in that direction.

  • As illustrated by the table below, even if fees at the individual fund level remain relatively unchanged, FII’s blended fee rate will continue to move lower as outflows continue in active equities and flows shift across all strategies from funds to separate accounts (stickier but half the fee rate)

• Distribution risk on sub-scale funds amidst changing landscape

  • The majority of FII funds are distributed through the retail channel, and in light of the DOL fiduciary rule and increased focus on fee transparency, broker dealers have been consolidating the amount of funds that they offer on their platforms with a focus on fees, liquidity and performance. While FII generally has strong broker/dealer relationships and has large enough scale with many of its core funds, its smaller funds are at risk of being trimmed down as brokers and wirehouses continue to reevaluate their offerings.

• Expenses have come in lower than expectations for the past three quarters – at what point does FII need to invest more into the business?

  • FII’s 2017 quarterly earnings results have had a similar theme: disappointment in flows offset by lower than expected expenses. Operating expense excluding distribution costs has decreased 2-3% y/y in each of Q1, Q2 and Q3 while total operating costs as % of AUM declined 1.5bps last quarter. FII has done an admirable job of managing expenses, expanding its operating margin in the face of declining revenue and lowering costs nearly 5% y/y vs. the industry average of -1%. However, consensus estimates call for the industry average to increase 7% and 6% in the next two years as many asset managers are entering investment cycles (technology spend, expanding distribution) while FII’s expenses are expected to grow LSD. Without pulling levers on pricing or investing more in the business, it’s difficult to see a path towards reaccelerating stagnant organic growth trends.

Why Stock Has Worked This Year: 

• FII outperformed the market in 2017, appreciating +27% vs. the S&P +20%, which was in-line with the performance of the DJUSAG index, also +27%. Much of the positive performance can be attributed to industry-wide dynamics: flows being “less bad” in the face of negative sentiment and market strength driving AUM growth / positive estimate revisions, compounded by generally high tax rates that boosted the group towards the end of the year as the tax reform picture became clearer. FII, however, posted three disappointing flow quarters in a row that each saw the stock trade off 3-4% only to later rebound on the aforementioned industry-wide tailwinds. The most recent quarter would have likely followed suit if not for a surprise $17B mandate that FII won. This mandate is low-fee (management said MSD bps fee relative to the firm-wide blended yield of 20 bps), so the earnings impact isn't all that meaningful, but it does drive a 3-4c run-rate benefit and a big win like that helps for sentiment purposes. For context, the $17B would basically offset 1.5 quarters of equity fund outflows at the current outflow pace (~$1.2B of equity fund flows).

 Key Risks to Short Case: 

• Market performance – as 2017 showed, strong equity markets can propel AUM growth enough to keep earnings numbers moving higher despite the business headwinds mentioned above.

• Better than expected flows in money market or long-term funds, which would be beneficial to both earnings and multiple potential.

• New one-off mandates similar to the $17B announcement in Q3 are impossible to predict and would be EPS accretive even if they are fee rate and/or operating margin dilutive.

• Special dividend – typically issues a special dividend every two years and last one was October 2016 (anticipated tax windfall could accelerate/increase special dividend this year).

• Takeout risk – however, I view a takeout as unlikely given the nature of family ownership (100-person Donahue family across 4 generations, which holds ~10% economic interest but owns all of the voting stock and relies on dividends for income) and relative unattractiveness of the money market business to an acquirer.

Valuation Considerations:

• The UBS tax cut beneficiaries basket (UBSTXCUT) is up 14% since 11/15 - the first day it started to run as the pathway for the tax reform bill to pass started to seem more certain – so I’ll use this date as a proxy to try to isolate FII’s market movement strictly as a result of tax. On consensus EPS of $2.17, FII was trading at 14.0x, a premium to the ~13.0x it traded most of the year, likely already baking in some semblance of tax rate upside. Fast forward to 12/29, and FII is trading at 16.1x $2.25, which reflects only one analyst thus far updating his estimate to incorporate lower taxes. If we adjust the original EPS estimate +22% (may prove to be lower depending on how various deductions are impacted) for a lower tax rate, FII is trading at 13.6x the adjusted $2.65 estimate, so even though all of the estimates have not yet been revised, I believe the market is fully incorporating the maximum tax benefit FII is set to receive before considering whether FII will reinvest any of those tax savings in either price or cost (compensation, technology, distribution, etc.).

• Over the past year, FII has traded at a 0.5x-1.5x multiple discount to its asset manager peers, which is warranted given FII’s lack of organic growth and less attractive business mix. Doing a similar tax analysis for FII’s peers, the group looks to be trading at 14.3x 2018 estimates on average, but 13.1x the pro forma estimates adjusted for tax. Therefore, I believe 11.0x-13.0x is a reasonable range for FII, subject to multiple uplift if the group continues to re-rate.

• Assuming money market flows turn positive to +LSD but long-term flows remain under pressure (-2%), I get to a $2.50 base estimate for 2018 at a 25% effective tax rate with downside of $2.40 if flows/fee rates are worse than expected. Absent additional outsized mandates, I expect EPS to decline in 2019, illustrating FII’s even less-advantageous positioning relative to peers as we get later in the years and investors look towards 2019.

Catalysts / Event Path:

• Recent flow data (tables below as of 12/27/17) suggests continued outflows in equity and fixed income funds, while money market flows have returned to industry average after a strong week (most recent week accounts for >100% of FII’s QTD money market flows). Despite the recent pick-up, BLK and STT (and presumably Vanguard) are still taking share in money markets, and FII is one of the worst performers from an equity outflow perspective.

  • According to EPFR Global (which tracks mutual fund flows but excludes SMAs), FII’s equity fund flows are -2.8% QTD (-11% annualized) vs. the industry average of +0.7% (+3% ann.) and total long-term flows are -1.5% (-6% ann.) vs. the industry average of +0.8% (+3% ann.). Both statistics are among the worst of its peers on a percentage basis.

  • Similarly, FII’s QTD money market flows are +$4.9B (with $5.1B of inflows in the past week), representing +2.6% growth compared to +$24.3B (+5.9%) for BlackRock and +87.3B (+2.2%) for the industry.

• FII provides fairly limited guidance, but on the Q4 2017 earnings call (est. 1/25/18), they should guide to their expected tax rate and provide some qualitative forward-looking commentary.

• Outside of flow data, earnings reports and any regulation related to money market reform, I expect the short thesis to gradually play out over the next 6-9 months. Though FII would be viewed as defensive relative to its peers in a market downturn given its money market exposure, valuation already appears to be stretched when baking in a normalized 7% market tailwind. If we do see any sort of sustained market correction (or even stagnation), it’s difficult to see a path to earnings growth (on a tax-normalized basis). It’s interesting to note, FII has had stagnant EPS for the past 10 years (earning what they did in 2007).  Therefore, I believe the risk/reward sets up well with relatively limited upside in a good market backdrop and both earnings and multiple downside risk if the market underperforms.

Catalyst

Flow data, continued market share loss, potential for uptick in expenses