Description

Introduction

WisdomTree (ticker: ”WETF”) is a $1.7b market cap company that manufactures and manages exchange traded funds (“ETFs”).  The stock is up 46% since the presidential election and trades at 50x run-rate earnings and 25x run-rate EBITDA.  The operating trajectory of the business has not been good over the past 12-18 months: AUM is down 30%, organic growth is -23%, earnings estimates are down 70%, reported earnings are down 50%.  So despite the stock being down significantly since it peaked in mid-2015, WETF is significantly more expensive now then it was then. WETF trades at a lofty absolute valuation and a 230%+ premium to its peer group, is poorly positioned within the highly competitive ETF space, and represents a reasonably asymmetric short here.  Absent a glorious rise in AUM from two hedged currency ETF funds which slipped past competitors and is unlikely to repeat, organic growth has been unimpressive and lagged the industry. Of WETF’s 208 existing funds only 8% are above $500m in AUM and 78% are less than $50m in AUM.  I believe the stock will trade back to $7 (20-25x tax-reform adjusted 2017/2018 EPS of 30-34c), offering 40%+ downside.

Business

WETF is the 10th largest ETF sponsor in the world with $41b of AUM as of 12/31/16.  The company is the only pure play publicly traded ETF manager.  WETF offers ETFs across equities, fixed income, currencies and alternative assets.  The AUM is not well diversified however, and is broken down as follows: hedged equity (46%), US equity (30%), international developed equity (10%), emerging market equity (9%), Europe and Canada (2.5%), currency (1%), fixed income (1%), and alternatives (1%). The company uses internal and external wholesalers and maintains relationships with leading wirehouses and financial advisors to distribute its products.  Distribution by channel is RIA (37%), wirehouse (34%), institutional (11%), international (12%), and retail (6%).  WETF has offices in New York, London, Toronto and Tokyo with 151 employees in the US and 52 employees internationally.  

Background/Set up

WETF has been around for more than ten years and operated in relative obscurity for much of its existence as a public company.  The company was at least partially created and funded by Michael Steinhardt (who has been selling stock in recent years).  In 2012, WETF achieved some success with an emerging market fund suite that outperformed peers by focusing on more value oriented and dividend strategies that were in favor at the time.  Over this time period, WETF took in its fair share of industry inflows achieving 2-3% market share of the ETF industry.  The stock languished from 2006-2012, but in 2013 a combination of global QE/Abenomics/ZIRP and an intense push by the Japanese government to devalue its currency and stimulate its stock market resulted in a strong Japanese stock market and a staunch devaluation of the yen.  This was followed in 2014 and 2015 by similar moves by the ECB.   As RIAs, wholesalers, and institutional investors scrambled to find an index that was long European and Japanese stocks while hedging out a falling currency, they found two heretofore obscure funds called DXJ (hedged Japanese currency fund) and HEDJ (hedged European currency fund).  Since WETF was one of only 2 providers of hedged currency funds at the time (and had more than 50x AUM of the next competitor as the category was relatively new), WETF had a significant head start.  Assets in these two funds went from $1.2b at the end of 2012 to $38B by 2Q15, and this is largely why the stock has been up so significantly since 2012.  Since then, the funds’ performance have dramatically corrected resulting in significant outflows, driving negative earnings revisions of > 70% and a steep decline in WETF’s stock price. In any event, there are now 3 other competing funds in the hedged currency space (sponsored by BLK, DB, and SEI), and most recently DB has seen its market share grow (from 10% to 19%) within only the past six months.  It’s my contention that cyclically and structurally we are unlikely to see a return of these funds, if we do WETF will not capture the same amount, but most importantly its highly unlikely WETF is able to repeat this success anywhere else due to the competitive dynamics of the industry and its inability to grow the rest of its AUM base organically.

Why a growth investor would want to invest in a pure play ETF provider

Secularly, ETFs are a growth area within in financials and are taking share from the mutual fund industry. The ETF industry has grown at healthy double digit rates over the past ten years, with US equity ETFs drawing $1.3T in inflows versus a $500b decline in mutual fund AUM during the period since 2007.  As the ETF industry in the US is still only $2.4T versus long term mutual fund AUM at $13.7T (15% market share), ETFs are likely to grow organically in the high single/low double digits for years to come.

The drivers of this growth are several fold -   

For one, ETF’s have certain structural advantages relative to a traditional mutual fund.  First, in the US they offer tax advantages in the form of lower capital gains. This is a result of the industry structure whereby an authorized agent (market makers such as GS/DB/UBS) buys and sells the underlying shares that compose the ETF rather than the ETF itself.  Thus the tax bill effectively rests with the authorized agent.  This differs from mutual funds that are constantly buying and selling securities to meet inflows/redemptions.  In any event, generally speaking ETF holders don’t have phantom cap gains that aren’t reflected in the underlying gains/losses they generate while holding the security.    Secondly, ETFs are transparent.  Holders can see what they own at all times. Third, fees are lower.  A typical mutual fund expense ratio runs at 66 bps versus 13 bps at an ETF.  Sales load and 12b1 fees are also nonexistent in ETFs.  Fourth, ETFs offer instantaneous liquidity. An investor can sell at NAV at any time during market hours, differing from mutual funds where u get hit at NAV as of the close.  Lastly, ETFs are more flexible then mutual funds as they can be sold short, bought on margin, and options on ETFs can be bought or sold.   

Secondly, the current cycle has shown particularly poor returns for active managers.  With fewer managers generating alpha, investors are questioning why they would pay a 2/20 hedge fund fee or a load/12b1 fees at a mutual fund, when they can get a cheaper ETF product which currently is providing similar/superior returns. Poor returns and higher ETF flows have been exacerbated by QE and ZIRP policies which have driven money into equities and helped indexed returns perhaps at the expense of more traditional active management strategies.  Many institutions are dissatisfied and have allocated to passive investing at the expense of traditional long only or hedge fund allocations.  

Working alongside that is the recently proposed Department of Labor rule (“DOL” rule) which has put a more acute focus on fees charged to retail investors and amplified the wirehouses/RIA push into products deemed to be less expensive, such as lower fee mutual funds and ETFs.  

So it’s easy to understand why investors would want to invest in a company like WETF that is tied directly to the growth of ETF’s as a class.  Furthermore, an ETF manager like WETF should generate structurally higher margins at scale than a traditional mutual fund manager because they don’t have to pay portfolio managers and analysts.  The bull case/sell side dialogue seems to be that WETF has a small piece of a large growing market and If WETF could just attain 5% market share, the stock would be huge.  However, I think the sell side dialogue is confusing a good industry with a good stock.  The analysts that cover the space seem so desperate for a “story” with some tailwinds (the opposite of the majority of their coverage) that they cite the “long term potential” even in the face of rapidly deteriorating company specific fundamentals and the current excessive valuation.  One analyst goes so far as to compare WETF to more of a tech like company with competitive advantages/growth such as GOOG, AAPL, FB, V, AMZN etc.  Really? Has GOOG ever demonstrated -50% earnings growth?

Peeling back the onion a little bit, part of what makes ETF’s so attractive (transparency, etc), also makes them highly replicable.  And while it’s true that WETF operates in a growing industry, it’s also a highly competitive industry, and that doesn’t make for a good stock particularly at this price.

Short Thesis

WETF is the smallest player in a highly competitive, scale business –

ETFs are dominated by four large, entrenched players, Blackrock (“BLK”), State Street (“STT”), Vanguard (private company), and Invesco (“IVZ”).  Just to give a sense of sizing, the following are the respective ETF AUM, ETF market share, market caps, and EBITDA of some major competitors versus WETF.

As you can see, the top 4 players control approximately 85% of the market.  Competitors dwarf WETF in terms of size, scale, and spending ability.  This is important as the company’s competitors have more money to spend on marketing, sales and new product introduction.  Incremental margins are high (low variable costs, no need to hire new PMs and analysts), as such scale matters to cover a largely fixed cost base.  Vanguard is particularly interesting as a competitor, as they run as a cooperative and are not focused on profit but on providing the cheapest products possible for “shareholders” (investors in their funds).  As such they are a leader in reducing pricing for the industry, and have taken substantial share as a result.      

The industry is price competitive –

There is a rather large advantage of scale and liquidity in an ETF product. Once a particular ETF has reached such scale that it makes its expense ratio the lowest, it’s hard for competitors to launch and compete on price and liquidity.  As a result, competing ETFs will cut price to grow share which has led to a dramatic reduction in ETF fees over the past several years. Due to WETF’s relative size versus its larger competitors, the company is more susceptible to pricing pressure then its larger competitors (due to competitors having more diverse ETF businesses and the buffering of other businesses such as actively managed funds/custody businesses).  The table below illustrates pricing pressure in several popular ETFs over time…the final ETF is an example of “smart beta” or an ETF that weights its composition by fundamental factors.  Fees in the smart beta space are typically higher although not immune to price competition.

As you can see, in aggregate pricing pressure has been rather dramatic over time.  

Currently, WETF’s blended fee rate as of 3q16 is 51 bps.  This compares to BLK at 29 bps and GS at 10 bps. Fees in the most liquid ETFs are < 5bps.  WETFs existing pricing umbrella (fee rate is 2x industry average using BLK as a proxy) is due to the strength and first mover advantage of its two largest funds and its skew towards smart beta products.  The trend is not their friend however, as WETF’s average fee rate on new launches was 71 bps in 2011 versus 47 bps in 2015 and 39 bps in 2016.  

Most recently, BLK cut fees in 6 smart beta products totaling roughly $600m in AUM.  This is on the heels of BLK lowering fees on 20 ETFs in October on $220b of AUM.  The smart beta fee cuts took fees from 41bps to 25 bps on an AUM weighted basis (a roughly 40% decline).  The changes are immaterial to BLK’s revenue and earnings (revenue loss of < $1m), but consider how drastic such price cuts would be for WETF as price cutting becomes more apparent in smart beta over time.  

Barriers to entry are low –

It only costs ~$175k to create an ETF (listing fees, SEC filings, index calculation, fund accounting, etc), before marketing costs.  Marketing costs are an incremental $200k.  The low absolute dollar amount makes it easy for new entrants to enter the market, and for existing participants to recreate a competitor’s products.  As such, the number of ETF providers has grown rapidly over the past several years.  In 2015 alone, 23 new ETF issuers entered the market and 285 new ETFS were created. There are currently 6,000+ ETFs available in the US.

WETF is heavily concentrated in two funds that are down substantially YoY –

WETF’s success has been highly concentrated in two funds called DXJ and HEDJ, respectively hedged currency funds that are long an index of Japanese and European equities and short the currencies.  Both funds languished for 5-7 years (out of the eyes of competitors), until the unprecedented monetary stimulus, QE, ZIRP and currency volatility in 2013-2015 drew in dramatic inflows to the currency hedged group and DXJ and HEDJ specifically.

DXJ shares outstanding 2006-2016

HEDJ shares outstanding 2010-2016

WETF entered 2013 with $18B in AUM in aggregate.  By mid 2015, AUM expanded to a peak of $61b as DXJ and HEDJ drew in $33B of net inflows.  At this point, DXJ and HEDJ were $38b and represented 61% of AUM up from only 7% 30 months prior.  The two funds began to crater in mid 2015, and over the next 18 months DXJ and HEDJ AUM declined by $21b (driven by $15b of net outflows), stabilizing today at $17b.  These two funds still represent 42% of AUM.  While the share prices of DXJ and HEDJ rebounded significantly in 2H16 (likely due to a stronger USD) and are now down only 15% off of peak 2015 levels, asset levels in the two funds have not rebounded at all and are still down 54% in aggregate as investor appetite for the product has waned.

While the share price of DXJ has rebounded 20% off the August lows…

DXJ AUM has been stagnant due to reduced investor appetite for the product.

I think it’s unlikely HEDJ/DXJ make a comeback for cyclical and structural reasons.  Cyclically, HEDJ and DXJ were QE and NIRP plays, exhibiting momentum and faddish qualities and being used tactically by accounts for the race to the bottom in rates.  The relative appeal of QE globally has lessened, and Abenomics has become less potent (i.e. Abe moved away from the ten year at 0% policy).  Most recently, (pre the US presidential election) the Yen has gotten stronger and the relative appeal of currency hedged products seems to have decreased.   

Structurally, competitors have entered the space in full force.  BLK, DB, and SEI now have ETFs that are very similar to HEDJ/DXJ.  The following table summarizes the current competitive dynamics in the hedged currency space –

There are a few observations from this data. As the far right of the table shows, WETF is losing share in DXJ to DB’s product DBJP. In fact, DBJP market share has doubled in the past six months, from 10% to 19%.  Whether or not this is due to lower pricing, higher marketing spend, better branding, buyer preference, or what, I am not sure.  But the results have been rather dramatic.

Despite similar price performance of DBJP and DXJ….

Asset inflows at DBJP have exploded since June, as AUM inflows have nearly doubled costing WETF nearly 10% in market share.

The second observation is that there are clear first mover advantages to being an incumbent provider.  The early liquidity established by DXJ and HEDJ have been why they have been so successful at maintaining share.  However, this advantage is diminished when the underlying markets the ETFs are in are very liquid (as is the case here).  In this scenario, it’s easy for an institutional buyer to create new shares through an authorized agent in the primary market in almost any size at NAV.  Secondly, the benefit of transparency of the ETF also makes it relatively easy to replicate.  Note how relatively similar the holdings of DXJ are to two competing funds –

So with some combination of better pricing/marketing, in big liquid underlying markets, investors may decide to use primary market making it difficult but not impossible to displace an incumbent.    

I view the likelihood of a new hit product as small. In some ways, there were elements of luck versus skill involved with their success in DXJ and HEDJ.  They happened to have these funds at a time when an unprecedented economic stimulus happened driving desire for these products.  This was a huge miss for Larry Fink et al.  Given that BLK and others screwed up once by allowing an upstart to capture significant share of a product, and given the low cost of entry to new funds ($175k) and ease of replicability, I think it’s highly unlikely that BLK or another ETF provider ever allows this to happen again.    

With the two existing “hit” products continuing to represent 42% of AUM, I would also add that this "hit or miss” quality and/or “one trick pony” element are both deserving of a lower multiple for the business.

Outside of DXJ and HEDJ WETF organic growth is poor –

Isolating out DXJ and HEDJ, the rest of the business has underperformed the industry over the past several years.  While the company touts its innovation, I think the results of the rest of the business speak for themselves and are confirmatory of the competitive dynamics of the industry and the difficulty in launching a “breakout” product.  As can be seen in the table below, over the past few years ex DXJ and HEDJ WETF’s market share of industry inflows have only run at 20-60 bps.  This has translated into ex DXJ and HEDJ organic growth of 2% in 2014, 3% in 2015, and 7% in 2016.  While this is better than most publicly traded asset managers, this is below the broader industry ETF growth of 10%+ and is not indicative of a 40x multiple stock.        

I think this speaks to the fact that success/differentiation is hard to come by and there is a high failure rate of ETF launches.  Of the 10 funds that were created in the first 9 months of 2015, at year end, eight of them had assets of less than $5 million, or roughly what they were started with, and only one had assets over $18M. Going back a little further, of the 26 ETFs created since FY13, only two of them were above $50 million in AUM (IHDG with $500 million AUM and EUSC with $178 million AUM).  For an ETF to break even it must achieve $50m in AUM.  Of WETF’s 208 existing funds, 78% are less than $50m in AUM and only 8% are above $500m in AUM.

In aggregate, no other single funds have developed much scale or needle moving earnings growth ability.  The Company most successful franchise currently is its US equity franchise (29% of AUM, 15 funds).  This segment grew well in 2016 (+22% organic) but results have been inconsistent (-3% growth in 2015).  These are also relatively homogenous funds and generate a below average revenue yield (35 bps vs 51 bps firm-wide average), making any success relatively less impactful.   

Smart beta is a double edged sword -

The Company touts its innovation in “smart beta” funds which are funds that are constructed using fundamental factors (dividends, growth, valuation) as opposed to traditional market cap weighted passive ETFs.  While this has given them a pricing umbrella (for now), the flaw with this strategy is that it is more akin to an active management strategy and is susceptible to style bias and creates dispersion from the index, i.e. the very things that ETFs were created to fix.  For example, WETF’s emerging market franchise peaked in 2012 at $7.3b as they had a strategy that skewed to overweight value/dividends. While that strategy outperformed from 2010—2012, AUM has since fallen 48% to $3.8b and showed -11%, -22% and -7% organic growth in the past 3 years as the strategy underperformed the benchmark.  Similarly, WETF perhaps accelerated its success in its currency hedged funds franchise by “doubling down” and skewing its index towards exporters (who’s stocks benefitted from cheaper currencies, even more so then the general Japan/European index).  Again, this knife will ultimately cut both ways as well.  “Smart beta” is also replicable as well, as the number of smart beta sponsors is up 200% since 2010, from 13 to 40 as of 2015 and BLK has a particularly strong franchise here.   

Valuation and risk/reward

The asset management group trades at 13x 2017 eps (12x assuming tax reform), and 12x 2018 eps (11x assuming tax reform).  WETF currently trades at 41x my base case 2017 EPS of 30c (which assumes tax reform) and 36x my base case 2018 EPS of 34c (which also assumes tax reform).  So WETF trades at a ~230% premium to the group.  This is despite a) a still significant 42% concentration in DXJ and HEDJ which posted -40% organic growth over the past 18 months, and b) a mediocre rest of business organic growth profile (+2%, +3%, and +7% over the past 3 years) driven by competitive issues and a lack of traction in other products.  

For my base case, I assume -  

DXJ and HEDJ grow 9% per year (market appreciation and some inflows).

The rest of AUM grows 6% organically, market movements up 7% (13% total annual growth per year).

Modest fee rate compression of 2% per year.

26% comp ratio.

Corporate tax reform is enacted and WETF’s tax rate moves to 28% (down from 45% in 2017 and 40% in 2018).

This drives 30c EPS in 2017 and 34c in 2018, at 20x-25x = $6-$8.50 or 30-50% down.

*I view these growth targets as reasonably aggressive (assumes good markets, 2nd best organic flows in past three years, and a sharp reversal from recent DXJ and HEDJ trends).

For my risk case, I assume -

DXJ and HEDJ grow 12% per year

The rest of AUM grows 12% organically, market movements up 8% (20% total annual growth per year).

Fee rate compression of 1% a year.

25% comp ratio.

Same reduced tax rates as in base case.

This drives 32c EPS in 2017 and 43c in 2018, at 30x = $9.60-$12.90 or 20% down to 5% up.

*Note the risk case is intellectually crazy to me (ex DXJ and HEDJ AUM up 44% over next two years), but I’m trying to back into what’s in the stock here.

Catalysts

Potential dividend cut.  WETF is run-rating 6c in EPS per quarter, but pays an 8c quarterly dividend and a 2.7% yield.  They have around 2c in stock comp per quarter, so on a cash basis by their definition they are at a 100% payout ratio as opposed to underwater.  The company has $1.32 in net cash/share, so has the ability to fund the dividend from their balance sheet, but if I am right on the earnings trajectory (or if things get worse in 2017) it’s likely they will cut the dividend to a more reasonable payout ratio.      

Accelerating pricing pressure.

Low organic growth, outflows.

Risks

High short interest - WETF has a relatively high short interest at 29m shares or 25% of float and 11 days of ADV.

Corporate tax reform - WETF is a high tax rate payer (40-45%).  I already assume federal tax rates go to 20% leading to an all in WETF tax rate of 28%.  If tax rate reform does not occur, there’s 15-20% downside to my EPS numbers.

Takeout - I view the risk as low given the concentration in two funds, the ease of entry into the market, and the valuation. Deals of other ETF providers (BLK/Barclays, IVZ) were done at substantially lower P/AUM levels.

Catalyst

Potential dividend cut.  WETF is run-rating 6c in EPS per quarter, but pays an 8c quarterly dividend and a 2.7% yield.  They have around 2c in stock comp per quarter, so on a cash basis by their definition they are at a 100% payout ratio as opposed to underwater.  The company has $1.32 in net cash/share, so has the ability to fund the dividend from their balance sheet, but if I am right on the earnings trajectory (or if things get worse in 2017) it’s likely they will cut the dividend to a more reasonable payout ratio.      

Accelerating pricing pressure.

Low organic growth, outflows.