Description

Company

Virtus is an asset management holding company that got spun out of Phoenix Co's (PNX) on Jan 1, 2009.  Virtus owns several brand name managers (depending on how generously you apply the term "brand name") such as Kayne Anderson, Duff & Phelps, and Zweig Funds.  Each manager has their own specialty with some focusing on fixed income, others equities, etc.  What makes Virtus interesting, at least from a small multi-manager standpoint, is that their distribution is surprisingly strong.  Virtus has solid, multi-year relationships with many of the wirehouses and they employ almost 50 wholesalers who've done a great job of turning net flows around in the last year.  Because of the diversification in products, the sales force always has something that's "hot" to sell...we know how much dumb retail money loves chasing performance.  This isn't like Cohen & Steers where if real estate is out of favor, there's no alternative.

Fund performance is okay.  Of the $11b in mutual funds that Morningstar tracks, 60% rank in the top half of their category for the trailing 12 months (70% of assets) while 60% of funds rank in the top half for trailing 3 years (80% of assets).  32% rank in the top quartile for the trailing 12 months (57% of assets) while 27% rank in the top quartile for trailing 3 years (57% of assets).  5 and 10 year numbers don't look as good...performance has improved of late, so they got that going for them, which is nice.

Bank of Montreal (BMO) effectively owns 21% of Virtus via 35k shares of convert preferred ($1,000 par; 8% coupon; $26 conversion price) and 375k shares of common stock.  They've got two board seats and there are a few special items of note, the most significant being a three year standstill agreement that prevents BMO from acquiring Virtus before 1/1/2012.

Virtus has a market cap of $190m on 6.2m shares outstanding.  They have $15m in debt, $35m in cash, and $35m in convert preferred.  Adjusting for the preferred they have a market cap of $250m on 8.2m shares outstanding and an enterprise value of $230m.  My share count for 2012 (7.5m) assumes full conversion less an anticipated share buyback of 700k in 2011.

Singles and Doubles

I give management, in particular the CEO George Alyward, credit for the changes they've implemented since gaining control of the company.  They were (are?) nobody's trapped inside a depressing Hartford insurance company before the spin, there was never any reason to have much confidence in them, so valuation is what I clung to.  But the ride over the last 18 months has been a surprisingly pleasant one.  Management has banged out a lot of simple things to improve profitability, as well as a few major changes that have yet to show up...there have been a surprising amount of levers for these guys to pull to increase value.

1) As noted in my original writeup, leading up to the spinoff, management did the right thing by reducing the headcount by 25% down to 300.  2008 compensation expense was $83m while 2010 is trending around $64m. 

2) In the first quarter, two legacy CLO's that Virtus manages had their sub fees turned back on, which should provide an additional $1.6m in annual revenue and $.25/share in FCF.  While this wasn't in management's control, it's positive development nonetheless.

3) Throughout 2009 and 2010, Virtus has been merging redundant subadvised funds into managed funds, thereby picking up additional fee income without adding any warm bodies (and in some cases being able to reduce expenses).  For example, in November 2009, Virtus merged (see note 12 on page 71) the Capital Growth Fund with $260m in AUM which managed by Harris Bank (Virtus only collects advisory fee) into the Strategic Growth Fund which is managed by Seneca Capital Management, a wholly owned manager.  The merger adds $900k to the bottom line.  As another example, in the first half of 2010, Virtus merged three small-cap funds (see page 73 of the same document) with $230m in AUM in a similar manner, picking up $800k in fees in the process, most of which havn't been reflected in the quarterly financial results yet.  The total revenue impact of these mergers has been about $2.0m, which should add $.30/share in FCF.

4) In July, Virtus acquired part of Phoenix's variable insurance trust business, bringing over $1.2b in AUM in the process (Virtus was already the administrator for these assets).  Actually, it's hard to call it an acquisition since they didn't pay anything for the assets.  Virtus will manage $500m of the assets through Kayne Anderson and Seneca Capital, thus entitling them to 100% of the fees, although they have to split half of the advisory fee 50/50 with Phoenix.  For the other $700m, Virtus is the advisor while Goodwin Capital and Aberdeen are the managers.  Virtus will earn an advisory fee (half of overall fees) which they again have to split with Phoenix.  In total, Virtus is picking up about $3.4m net in fee income (on average these assets carry higher fees around 65 bps because of the equity weighting).  Meanwhile, the additional headcount from the acquisition was exactly zero.  The only incremental expense is the higher incentive compensation paid to Virtus' PM's because of the higher AUM.  If we back out $300k for additional bonus expense, Virtus instantly added $.50/share of FCF with the deal.

5) In August, after amending their credit facility ($15m drawn on $30m), Virtus called 22% of the preferred stock owned by BMO which was the maximum amount allowed.  Not surprisingly, BMO elected to be paid in common stock rather than cash.  The move is accretive to EPS and FCF by $.14 and is indicative that management is (a) serious about shareholder value and (b) has their sights set on a common buyback.

6) In June, Virtus announced an odd-lot program that allowed shareholders with less than 100 shares to buy/sell/gift.  The offer itself isn't terribly important, but it's a clear sign that the odd-lot issue (140k retail investors with odd-lots) is something they're well aware of.  With a small float and this many retail investors, the writing is on the wall for an odd-lot cash-out program in the coming months which would be a cheap and quick way to repurchase stock.  Based on comments from management, Virtus could repurchase 700k shares (8.5% fully diluted) from shareholders who hold less than 10 shares (Virtus is a microcap spin-off of a small-cap demutualized insurance company).  It could also add a few pennies/share to the bottom line from reduced shareholder admin expenses.

7) In April, Virtus quietly raised fees on all of their non-money market mutual funds ($18b - 65% of AUM).  Here's an example from their Balanced Fund with $585m in AUM.  Comparing the old prospectus to the new prospectus, they raised fees by 8 bps across 11 products.  On average, the fee in crease was 10 bps across all funds, which means the potential net fee increase to Virtus (across all AUM) is about 3.1 bps over time (10 bps increase x 65% of AUM x 50% of all fees on average for Virtus).  While the effect is obviously positive, it's difficult to immediately quantify because of expense caps on funds.  Most funds need to clear an AUM hurdle in order for the fee cap to get lifted, but these hurdles are easily within reach.  This is another positive aspect of the aforementioned fund mergers, by merging funds Virtus will instantly surpass those AUM thresholds, so we get double-bubble going from earning only the advisory fee to earning the advisory fee, management fee, plus the fee increase.  I assume they realize the full increase in 2012, pushing their current (see page 17) 36.2 bps of investment management fee to 39.3 bps from this increase alone.  Each 1.0 bps fee increase adds $.48/share to FCF, so by realizing the full increase Virtus is boosting FCF by $1.50/share on today's AUM base alone.  Putting a 12x multiple on that alone is worth $18 to the stock today.

8) Along with the management fee increases, Virtus raised fees for fund administration.  Management was equally silent about this, but in Q2 we saw a small uplift in administration revenues from 5.6 bps to 6.2 bps.  Going forward, it should top out around 7.0 bps.  There is a brief (and purposefully vague) mention of the fee increase at the end of page 17 of the first quarter 10Q.  This is illustrative of the leverage that exists for the stock.  We're talking about a mere ~1.5 bps increase (btw, Virtus still underprices administration) that's translating into a $4.0m boost to ebitda/FCF ($.64/share).

9) In 2006, Virtus acquired the Harris Insight Funds for a token amount, and today Harris is the subadviser of $4.0b in money market funds for Virtus.  As part of the original acquisition, there was a four year 50% revenue sharing agreement with Virtus for these products.  In May, that revenue share expired and Virtus began capturing all of the fees instead of splitting them 50/50 with Harris.  Starting on May 1, Virtus earns an additional 2.5 bps on all money market funds, which comes to $1.0m in revenue or $.16/share in FCF.

I like that the m.o. is similar - simple deals that add revenues without adding expenses.  They aren't complicated transactions, this isn't accounting trickery, and they're not buying other managers or adding overhead...in other words, they're not taking much risk.  Instead, they're inconspicuously doing a bunch of things to take advantage of the massive leverage inherent to the company.  In the future, I see more fund mergers and the possibility of adding some select PM's (only if it's accretive).

Valuation

Before I walk through my stripped-down model and explain why I think Virtus is undervalued, I need to explain the tax situation.  The short explanation is that Virtus has $250m in NOL's which means they pay almost no taxes.  There are two pools of tax assets.  The first pool is $115m (able to offset $300m of GAAP net income) that is immediately usable by Virtus.  It's comprised of state and federal NOL's and intangible asset amortization.  Virtus has the unusual distinction of being a taxable spin-off, which helped preserve the tax assets and allowed BMO to use them in the future.  The value of the $115m NOL is debatable.  Virtus wont be paying taxes for a long time, so they got them going for them which is nice.  But it also means it'll take them an eternity to utilize the NOL, so the present value to them is low.  BMO, on the other hand, could use the NOL is a single year, so to them it's worth something in the ballpark of $100m.  I get a PV for Virtus of about $65m, or $9/share.

The second pool is $140m (able to offset $400m of GAAP net income) which might be stranded.  It relates to the decline in value of the money managers that Phoenix acquired in the 1990's and 2000's.  The problem here is that Virtus would need to realize these losses (sell the assets) to transform the tax basis into a usable tax asset.  Same as before, this NOL pool would theoretically be usable by BMO but not by another acquirer.  I don't assign any value to this asset, although management feels there's a decent chance they're able to realize it.  Given the esoteric nature of this NOL pool I mostly ignore it...but it's there.

Relevant acquisitions have been sparse in 2010.  Two notable deals were AMG's acquisition of Aston Asset Management in December for 1.38% ev/aum, and Nuveen's acquisition of FAF Advisors in August for .75% ev/aum.  The FAF deal was a pretty low multiple (basically what Virtus trades for today) but it was nearly a distressed deal.  FAF had no ebitda while Virtus is currently on a $16.5m ebitda run-rate with the same amount of AUM.  Aston could only eke out $3m of ebitda on $6.5b in AUM, and they still got taken out for price that would value Virtus at $51 today.

Here are the comps for asset managers.  The stocks with low multiples tend to be mega-managers like Blackrock and/or companies with high exposure to low margin products.  The group average ev/aum is 2.3% while the normalized ev/ebitda and P/FCF are 8-12x and 12-15x, respectively, but you can see that there are three stock (LM, BLK, AB) that are outliers on the low end.  Virtus has a long way to go before it trades with an average multiple.

Here's my base case model.  I'm not going overboard with any assumptions about flows or market performance.  I'm assuming Virtus increases their AUM by a modest 8% per year through 2012 though a combination of decent market performance and unspectacular net flows.  More importantly, I'm factoring in higher fees and a relatively flat expense base, consistent with what I laid out earlier.  I assume that compensation expense increases and that it comes in above the industry average as a % of AUM (industry average 198 bps, I assume an industry-high 222 bps). 

There's a tremendous amount of leverage in the business model, and the small share count only adds more juice.  So look at my estimates and assuming you think the analysis is right, tell me what you think this is worth at the end of 2011.  12x FCF?  10x ebitda?  15x earnings?  If you answered "yes" to any of the preceding questions, Virtus is worth between $57-65/share. 

What's really interesting is that if 2011 sees absolutely no change in AUM, Virtus should earn $30m in ebitda and $4.10/share in FCF, which is why I think the downside protection looks pretty good from here.  If I model in net outflows and a weak stock market (down 8-12%), all of the fee increases and additional revenue streams should allow Virtus to earn $25m in ebitda and $3.00-3.50/share in FCF.  The stock looks like it's pricing in a dreadful 2011, or maybe the market simply doesn't understand the changes going on.  Of course, the market could repeat 2008 and asset managers, including Virtus, could get killed...that's the risk.  By the way, those ebitda margins in the model are well below the group average, all management is doing is restoring the business to "normal."

Let's have some fun with the upside and assume that markets do well over the next two years - not stellar, just pretty good.  We'll say that the S&P gains 5%, 16%, and 10% in 2010-2012, so that it hits 1500 at the end of 2012.  Picture it, Virtus is a small asset management company with tons of upside leverage in a rising market; they're well beyond the "show me" phase post-spin; in the past three years they've gone from a company losing $2.50/share in FCF to generating $6.50-7.00/share in FCF; they've bought back stock; the standstill agreement with BMO has expired, leaving Virtus up for grabs.  This is a recipe for a big valuation, perhaps as much as 15-20x FCF.  Throw in the value of the NOL's and the cash and Virtus is worth $100-140/share.  As a check that I'm not insane, that price would represent 2.0-2.6% ev/aum, which is easily below average for the top 75% of the asset management group (excluding LM, AB, and BLK).  I'm not saying it should happen, nor am I saying it will happen, just that it's not a stretch.

In any event, I expect BMO to acquire Virtus sometime in 2012.  BMO tried to buy them in 2008 but they could only get the preferred deal as part of a sponsored spinoff.  BMO has made recent comments about wanting better wealth management in the US and Virtus is the most logical platform.

Catalyst