Description

Virtus Investment Partners is a recent spinoff that was done at a cheap price.  Some simple cost cutting and market improvements could help drive earnings which could triple the stock in 2 years.

Company Background

I'm guessing that even most VIC members, who are typically more attune to spinoffs than most people, probably missed this one.  Virtus was expelled from The Phoenix Companies (PHX) on 12/31/08 and began trading on the NASDAQ on 1/2/09.  Virtus is a relatively simple, if not boring asset management company.  It's an traditional manager with $22.6 billion in AUM as of 12/31 - 44% equity, 36% fixed income, 20% money market.  2/3^rd of the assets are in mutual funds or closed end funds.  The firm's proprietary managers include the Virtus family of closed end and mutual funds, Duff & Phelps Investment Management, SCM Advisors, Kayne Anderson, Zweig Advisors, and one or two others.

Virtus has 300 employees (though soon to be less) and a small advisory business that manages $3 billion in separate accounts.  63% of AUM are held in proprietary products while the remainder are subadvised.  They capture more fees with proprietary products, and on average Virtus earns about 40 bps on AUM (this is normal given the asset weights).  They also receive various fees for mutual fund sales such as 12b-1 fees.  This is basically the same business model as Legg Mason for all practical purposes, but without the SIV and debt headaches.

Financials

Virtus is in great shape.  They have $51 million cash, $6 million securities, a $20 million term loan owed to Phoenix which is due over the next 4 years, and a $45 million convert with a 8% coupon held by Harris Bank (Bank of Montreal).  Harris is more of a partner at this point as they're looking for better US distribution.  The convert is interesting to me.  Harris purchased this pre-spin.  Yes, the coupon is ridiculously high for a convert, but the conversion price is $26.  What is it that Harris sees here that would make them agree to a conversion price that's over 3x the spinoff price?? 

Virtus also has $115 million in NOL's for now, so they wont be paying taxes anytime soon.  Plus, they're owed additional NOL's from Phoenix as part of the separation agreement.  The amount of the NOL wont be known until Phoenix files its tax return in September.  It's an odd situation that I cant get much color on.  I think that when you combine the NOL's with Harris' existing interest in Virtus, it shows that there's a decent chance that Harris will eventually buy them.

Valuation

First, there's the multiple of EV/AUM.  Traditional equity asset managers tend to trade between 2-5% of EV/AUM, you'll see this is the case with a comp list of : WDR, PZN, JNS, AMG, TROW, BEN, CLMS, GROW, EV.  But when you look at firm structure and asset class weights, again, Virtus looks a lot more like Legg Mason.  Legg trades at .7% EV/AUM, which is about the lowest it's been in years.  It's traded as high as 2.5%, and should probably trade around 1% EV/AUM.  Anyway, Virtus trades at a measly .4% EV/AUM.  This is nothing for an asset manager, even bond managers like Federated.  I don't care if Virtus' margins do lag the industry right now, that's a fixable problem.  This multiple of AUM, for a traditional manager, is silly.  Legg, despite being an essentially distressed firm nearly left for dead, is still managing to trade at almost 2x the valuation of Virtus.  Plus, Virtus has the value of the NOL's, which are worth about $40m.

What about future EPS and FCF?  I assume a couple of things here: the S&P returns to 1200 by 2011, fund flows are  4% per year, fee structures remain in tact, and expenses are brought under control further more like a level of Legg (I think they can get down to 20-23 bps of AUM from current 29 bps).  Even after dilution from .8 million options set aside for employees, EPS could reach $3.00 in 2011.  Slap a reasonable 15x P/E and you're looking at a 2 year price target of $45/share.  Also in this scenario, FCF would be somewhere around $25 million, as Virtus would be generating $30 million in EBITDA with minimal capex requirements.  Again, you can just assign a 10x FCF multiple to that and it's a $38/share target.

But the story hinges on expense control for a while.  Management needs to right-size their compensation to reflect a level that Legg, Waddell, et al operate with, which is about 20 bps of AUM.  Right now Virtus is operating between 25-30 bps, although management has aggressively cut costs in response to declines in AUM.  If management fails to adjust their company the stock will probably go nowhere.  But if they can simply hold onto assets and bring down costs to levels that should easily be attainable, I think there's serious upside here, perhaps triple the current price.

Catalyst

Earnings; Market improvements; Harris acquires the company