Oaktree has been written up twice; first by trev62 in Dec ’10 and also by rh121 almost exactly two years ago in May of ’12 shortly after the company went public.

Rh121 had great timing (and a good write-up), basically bottom ticking the shares after a weak IPO.  Since that report, the shares have returned 63% including dividends vs 53% for the S&P 500. 

I believe the same situation is occurring almost exactly two years later as the shares are down YTD nearly 12% including dividends after a weak secondary and questions regarding dividend outlook for 2014.  I believe OAK is worth $75 / share today, or 50% higher than current levels; and I expect that value to compound low to mid-teens over time.

For those not familiar with the story, Oaktree is an alternative asset manager run by Howard Marks and Bruce Karsh.  OAK is best known for its distressed debt investing, but also has significant real estate, mezzanine and senior lending funds.  The company has $86B of AUM, $74B of which is fee paying and $33B of which is can create incentives.

When rh121 wrote up OAK last, AUMs were $78B, Fee Paying AUMs were $68B and incentive creating AUMs were $37B.  From then to now, the company has returned nearly $14B of Fee Paying AUM to clients through realizations, which were particularly robust last year.  More than offsetting those realizations was capital raising activity (hence the net $6B additions to FPAUMs despite $14B of capital returned).

Capital returns mean realization activity, which generally means incentive payments, and ultimately, dividends to shareholders.  Indeed, OAK has paid $8.58 / share in dividends in the two years since the company has been public, or 24% on the $36 price when last the stock was written up.

So the stock has performed well (30% annualized), the business has performed well, and the dividend yield has been better than I think anyone would have figured two years ago (12% annualized).  So where do we go from here?

Oaktree is a single business with three economic value drivers:

1)      A balance sheet, with three buckets of value

2)      A management company with long term contractual revenue (7-10 year locks)

3)      An “incentive” company with a call option on 1/5^th of profits generated for clients over 8% annually

Most investment managers (and many of the alternatives) have either one or two of these drivers of value, but few have all three, particularly to the degree that Oaktree does, which I believe makes it harder to value (but also creates the opportunity).

The Balance Sheet

Oaktree has $11.60 / share of net assets on its balance sheet which consists primarily of cash, T-Bills and Investments in Oaktree funds, offset by some modest leverage.  As you can see, this value has grown nicely over time and is now $3.60 / share higher than the time of the company’s IPO (1Q’12).

Tables can be found in a PDF copy of my writeup here...

Oaktree also has accrued (i.e. earned) but unrealized carry of $8.00 / share (pre tax) which is not on its balance sheet.  I have estimated that number to be $6.40 / share if you assume 20% taxes (coupons are taxable, much of the equity appreciation is not).  Accrued carry is up slightly from the IPO which is impressive considering the company has paid out nearly 100% of the accrued carry that was on the books at that time (through the $8.58 / share in dividends).  Oaktree has been able to ‘refill the coffers’ so to speak through incremental investment returns over the last two years, so despite getting outsized dividends, there has been absolutely no loss of underlying carry in the business.

Lastly, Oaktree owns 20% of DoubleLine Capital LP which generates approximately $50m in net income to OAK (run rate, excluding placement fees).  At 18x that is worth $900m or about $6.00 / share pre tax.  

The Management Company

As of the end of the first quarter, Oaktree had $74 billion of fee paying AUM, much of which is subject to long term 7-10 year locks.  On this FPAUM the company earns about $795m in management fees and ~$225m in fee related income (after tax) which translates to about $1.50 per OAK share annually.

Despite FPAUMs and management fees growing, the per share FRE has not seen much growth due largely to compensation growth.  That comp expense has grown for two reasons, first because the company is investing in people to support new products, and secondly because some (not all) of the performance based compensation for non-investment personnel run through that line item.  In effect, FRE has been a victim of the success OAK has had in the last two years.  If performance were to suffer, somewhat ironically the FRE would actual show significant growth due to the lack of performance bonuses.  Using the mid 40’s margin as a guide, I believe that “non loaded” FRE / share is closer to $1.80.

The easiest and most rational way (in my opinion) to value the management company inside of OAK is to compare it to traditional asset management businesses.  You could argue (successfully in my opinion) that the fee stream is more valuable at Oaktree vs traditional managers given the capital is locked.  Offsetting that is the fact that OAK funds have defined lives and capital is returned after the fund expires (five to ten years depending on the fund).  Bottom line here is Oaktree is a best of breed manager with an incredible track record, and their ability to raise capital is second to none – to me that warrants a premium multiple.

At 18x, Oaktree’s management company is worth about $27 per share.

Incentive Income

The primary differentiator of Oaktree or other Alternatives manager from a Traditional Asset manager is the ability to earn incentive payments on profits generated above a hurdle rate on its funds.  Oaktree earns 20% of all profits above an 8% hurdle (captures 80% of profits from 8% to 10%, then 20% thereafter).  This income is only reported when it is realized – not when it is earned (which is why they have accrued carry).  Below is the history of realized incentive income by quarter since OAK went public.

Tables can be found in the PDF here...

Again, it is important to note that this is only income from realizations – the incentives earned but unrealized have gone to accrued carry (reference the ‘accrued carry’ table near the top of the write up).

Realized incentives were $3.68 / share on a TTM basis pretax, and ~$2.40 / share assuming a theoretical 35% tax rate (actual tax rate much lower due to capital gains tax treatment).  

Incentive income is inherently unpredictable in the short term (particularly realized incentive income), but over the life of the fund is actually pretty predictable based on the historical returns of the OAK funds (which have consistently achieved low 20 / high teens IRRs).  Based on the amount of AUM OAK has subject to incentives, and an expectation on future returns on capital, we can calculate the run rate future incentive income per share.  

I believe it is reasonable to assume OAK will achieve mid teens returns on funds over time (lower than historical returns to be conservative, but also to acknowledge that we are in a lower return environment generally).  I also believe it is prudent to assume that incentive income for the industry will at some point be fully taxed.  Assuming a conservative ~14% return on current funds go forward, and a fully loaded 35% tax rate, OAK should average $2.40 / share in run rate incentive income.

The key question is: what is that worth?  Cash flows are completely unpredictable in the short term, but reasonably predictable in the medium term.  I frame this like an investment banking or trading business.  Fee for service, high returns on capital, but lumpy and capital markets dependent.  Those businesses inside of banks trade for ~10x which implies mid $20’s (call it $24 / share) of value.

Total Value

So the cash and investments are worth $11.60 / share, accrued carry is worth $8.00 and DoubleLine is worth $6.00.  In total that puts the balance sheet value at about $25.50.

The management company at 18x is worth another $27.00, and the incentive income at 10x is worth maybe $24.00.

In total that is $76.50 / share in total value, or 50% higher than current levels.

Said another way, the balance sheet is worth $25.50 and the management company is worth $27.00.  So the easier to value assets are collectively worth $52.50 or $2.00 higher than the current share price.  You’re getting every dollar of future incentive income OAK funds can generate for free today – whether you think it is $1.00 / share, or the ~$4.00 trailing number, its completely free.

While you wait for the market to reflect full value, OAK is paying out 100% of the FRE and most of the earnings from the balance sheet (which should average about $1.00 / share) and all realized incentive income (which has been positive every single year with a low of $0.50 / share).  That is anywhere from $3.00 / share on the low end (6% yield) to $5.00 / share on the high end (10% yield).  Not a bad outcome.

Risks

Oaktree is very capital markets sensitive, both on the trading of the stock and the fundamentals in the short term.  While the capital is locked and the management fee is protected, if the markets were to turn significantly negative, you would expect to lose some of the accrued incentives (of $8.00 / share).  Under that scenario you likely have multiple risk on the management company and on the DoubleLine piece (3 turns off both multiples would cost the valuation about $5.50 / share).  Also, the market would probably severely discount both amount of expected future incentive income (to the $1-$1.50 / share range) and the multiple it should trade for (to call it 5x). 

Under that adverse scenario, I believe fair value in the short term would fall to about $50 / share, or roughly where the stock is now.

Said another way, OAK shares are currently pricing a severe, extended, market pullback.  And if that were to occur, I don’t believe there is significant downside risk to OAK shares from current levels.

Another risk, which is real but hard to quantify is the key man risk.  Howard Marks (68) and Bruce Karsh (58) are the face of the business, and either of them leaving would clearly be an adverse event.  That said, I think at this valuation much of the risk to that happening is mitigated.

Unfortunately there are no major catalysts here.  Earnings and distributions should be positive catalysts for the remainder of 2014, though we know distributions will be lower in 2014 vs 2013 unless the realization activity starts to pick up (again, completely unpredictable).  If the realizations do not occur and the distributions are lower, I would absolutely expect accrued incentives to grow (meaning the value will be there, even if it isn’t paid out this year).