Description

BEN is a cash-rich S&P 500 constituent that has come under significant pressure due to its high fixed income exposure (40% of AUM versus peers’ 20%) as well as the decline in its equity business (international equity is about â…” of equity AUM). Since the beginning of 2015, BEN has underperformed S&P by 28% (inclusive of dividends). AUM peaked in the second quarter of 2014 at $920.5 bn, and has declined to $763.9 bn at the end of 2015, and $728.1 bn at the end of January, 2016.

The table below depicts the aggregate funds flow from 3/31/2014 to 12/31/2015:

Expressed in percentage terms:

As can be seen from the table above, both the equity business and the fixed income business experienced net outflows as well as market value declines.

However, at $35.85, we believe that investors are only paying, net of net cash, ~13x earnings in a scenario where AUM declines 20% from the 1/31/2016 level.

BEN ended the most recent quarter with $8,125 mm of cash, split between 32% in the US and 68% offshore. Even if we tax foreign cash at 35%, BEN still has $10.3/share of net cash.

We think this is the most conservative way to look at BEN’s cash position. If we were to include the cash and investment securities of BEN’s consolidated SIPs (newly launched funds in which BEN has a controlling interest) and VIEs (CLOs), as well as the corresponding debt on these vehicles, BEN has about $9.5 bn of net cash (untaxed), or almost $16/share, almost 45% of the market cap.

Historically, the company has operated with a strong and stable operating margin. In the last 10 years, average operating margin was 35.2%. Operating margin was lowest in FY 2009 when it dropped from 34.8% to 28.7%, a year in which average AUM dropped 26.5%. In the most recent quarter, despite the AUM decline, BEN’s operating margin was 37.2%.

It is not hard to construct an earnings model based on BEN’s historical operating ratios. Below, we estimate the earnings power of this business at three different AUM levels: $728 bn (1/31/2016), $442 bn (2009 average AUM), as well as a middle case of $585 bn.

A few notes:

1. In FQ1 2016, compensation was 67% fixed and 33% variable. That works out to be $920 mm of annualized fixed compensation. Similarly, in FY 2015, 62% of $1,453 mm, or $900 mm, of compensation was fixed. We assumed that in the low AUM case compensation would be $967 mm; in other words, there would be only $50 mm variable compensation in that case. In 2009, total compensation was $958.5 mm.

2. Other revenue: this is interest and dividends from the consolidated SIPs, and we annualized the number in MRQ for our estimates.

3. “Investment and other income, net” line: this line consists of dividend and interest income from non-consolidated SIPs, income from equity method investments, foreign exchange, etc. Equity method investments are SIPs in which BEN has significant influence but no control (20% to 50% stake). All components, except the dividend and interest income line, vary wildly from quarter to quarter as well as year to year, as can be seen from the historical financials. For simplicity, we annualized the MRQ’s dividend and interest income, and ignored other components.

So at $585 bn AUM (20% decline from 1/31/2016 level), BEN could still earn $2/share. Asset manager peers on average trade at 14x 2016 consensus earnings, and on average BEN itself traded at 13x consensus NTM earnings in the last five years. Applying 13x to our $2/share of EPS in the mid case, and add $10.3/share of fully taxed net cash, the stock is worth $36. In other words, we think the current stock price is already pricing in a severe further AUM decline.

On the upside, if BEN could stabilize its AUM at the current level, the stock is worth $45.5 assuming a 13x P/E and $10.3/share of net cash. This represents 27% upside from the current stock price.

And management are decent capital allocators. In the last 10 years, management has shrunk share count from 785 mm shares to 593 mm shares, which represents ~2.8% annual decrease. And in addition to the regular dividend (18 cents/share; 2% div yield at current stock price), BEN paid $2.17/share of special dividends from 2011 to 2014. Insiders own 39% of the company, so we doubt that they will do anything stupid with their cash.

For these reasons, we think BEN is interesting at this price if you believe that fixed income and international equities will recover at some point in the future.

Catalyst

We think for this to work, funds flow needs to improve at some point.