Description
Want to short a stock still trading at 25x EPS (at its all time high valuation), where fundamentals continue to deteriorate and estimates are still too high? Short TROW. I think TROW offers very limited upside, with the potential for meaningful downside.
Valuation
TROW currently trades at 20.5x 2009 consensus estimates of $1.53 which I view as an unachievable target. I think it’s more likely they earn ~ $1.29 (which assumes the market is up next year). In fact even if the market is up 20% in 2009 (and assuming TROW funds perform reasonably close to that) I think it’s likely the company only earns ~ $1.44. As such TROW currently trades at 24.5x a base case estimate for next year.
The asset manager peer group trades at ~ 14x 09 EPS, as such TROW is currently trading at a near 75% premium to its peer group. Implied prices based on various valuations –
· Over the past 5 and 10 years, TROW has traded at an average of 20.5x, which implies a price of $26 or 20% downside
· Over the past 5 and 10 years, TROW has traded at an average 15% premium to its peer group industry average (18x), which implies a multiple of 20.5x, a price of $26 or 20% downside
· At its historical 15% premium to its peer group at the current group average of 14x, TROW would trade at 16x, a price of $21 or 35% down
· At a 25% premium to its peer group (just b/c it’s the darling of the industry) at the current group average of 14x, TROW would trade at 18x, a price of $23 or 27% down
· At its 5 year maximum of 25x, TROW trades right here
· Like I said, if the market is up 20% next year, I think TROW can earn $1.44 and at its maximum valuation over the past 10 years of 25x that implies a price of $36, so your risk to the short is 12%. (why it needs to trade at 25x in that scenario, im not sure, but I’m thinking in worse cases).
· In terms of earnings sensitivities –
o Base Case = $1.29 in EPS – Market +5% in 2009, +4% Organic flows, Comp ratio is 44.2%, Comp dollars down $71m (-8%)
o Bear Case = $1.09 in EPS - Market -20% in 2009, 0% Organic flows, Comp ratio is 44.5%, Comp dollars down $140m (-17%)
o Bull Case = $1.44 in EPS - Market +20% in 2009, +5% Organic flows, Comp ratio is 43%.5, Comp dollars down $33m (-4%).
Growth is decelerating
Over the past few years TROW grew AUM organically at ~ 10% annual, this quarter they are on pace to do -1.5% (-2.50% ex money markets). In 3Q equity mutual fund complex shrunk organically by 3% annualized. Given current run rates and performance, I’d expect only mid-single digit organic growth next year in a base case. Note that 70% of TROW's asset base is retail, 90% is US based, and 80% is equities, all of which puts the company at a relative disadvantage in this environment. In addition, most of TROW's mutual fund asset flows of late have been from some recently very poor performing funds. As of the second quarter 6 funds - emerging market, new era, real estate, value, latin america, africa and middle east - drew +1.75b in flows or 90% of the +1.9b total in mutual fund flows in the quarter. Year to date, these six funds were down -62%, -53%, -41%, -43%, -57%, and -55%. As the retail investor reacts on a lagged basis, I'd expect funds flows there to continue to be muted. Finally, the institutional channel was the largest flow driver from TROW in 2008 but along with everything else this will slow in 2009. Institutional grew organically 4% last quarter down from mid teens rates earlier in the year.
Expense leverage?
Not exactly. TROW is “investing in the franchise” and is not cutting expenses, per management, until at least q309 unless the market stays significantly bad. As such operating margins should fall nearly 1000 bps from 42% in 2008 to 32% in 2009. ~ 65% of comp is fixed.
Relative performance
Reminds me of John Candy and Steve Martin in “Planes, Trains and Automobiles” …“You’re going the wrong way!” Per Lipper percentile rankings below (lower is better), its clear that TROW ratings are worsening, which will make it incrementally difficult to achieve the robust flows it’s had historically. As the old years roll out and the new performance rolls in, the 3 year rankings (which I think are most important for fund flows) will trend lower.
· Equity complex percentiles – 10 year, 5 year, 3 year, 6 month – 29%, 36%, 46%, 53%
· Bond complex percentiles – 10 year, 5 year, 3 year, 6 month – 23%, 22%, 25%, 36%
· Largest fund (TROW Price equity income) - 10 year, 5 year, 3 year, 6 month – 26%, 58%, 59%, 61%
· Second Largest fund (TROW Price growth stock) - 10 year, 5 year, 3 year, 6 month – 15%, 31%, 47%, 73%
401k business
TROW has a large 401k business (~ 1/3 of AUM) which has been a source of reliable/steady flows and helped contribute to the premium valuation. I don’t think it’s a stretch to argue that this will not be a good year for 401k flows. This segment should be under pressure due to higher unemployment, less company matching, pinched consumer budgets, etc. In addition, should the Obama administration allow a hardship 401k withdrawal next year (i.e. help the consumer in the near term by allowing them to withdraw from their 401k without penalty) this would pressure the stock. If 10% of 401k assets are redeemed that would be an ~8c headwind to TROW.
To summarize - numbers too high, valaution stretched, growth decelerating, performance weakening
Risks
Flows are still better than the rest of industry, $5/share in net cash
Catalyst
Continued muted flows, estimates coming down, new administration 401k hardship plan