Description

In keeping with my goal of submitting ideas to VIC that provide reasonable liquidity, and the opportunity to build solid, long-term positions for larger (institutional) investors, I decided to focus on Waddell & Reed Financial (WDR). As with my previous VIC idea, I think WDR offers above-average returns over the next few years with a very low probability of permanent capital loss.

Business:

The company, based in Overland Park, Kansas, was founded in 1937 and manages mutual funds that are primarily distributed through a proprietary network of Waddell & Reed financial advisors. The company operated as a subsidiary of Torchmark (the large insurance company) until it was spun out in an IPO in March 1998.

The company operates using three “brands” with the following characteristics:

Waddell & Reed
·WDR’s primary business is distributing proprietary mutual funds through a proprietary network of financial advisors. At the end of 2001, the company had 3,165 advisors operating in 240 offices.
·Typical customer is earning $40,000 - $100,000 per year and lives in rural areas or smaller metro areas not generally served by large asset management companies, and not coveted by large competitors. Average starting investment is $11,100.
·Company has 660,000 mutual fund customers with an average account balance of $36,000; 77,000 variable account customers with an average balance of $44,800. Currently, 85% of WDR mutual fund assets are in equity markets.
·WDR conducts investment seminars throughout the country to generate potential clients with an emphasis on long-term relationships rather than one-time sales
·Assets are managed with an equity focus and a growth at a reasonable price philosophy. Most funds are highly ranked by industry publications.
·Average customer maintains account for 11 years (4 years is mutual fund average); redemption rate for past 5 years was 7.7% or less than 1/3 industry average; dividend reinvestment rate is 87.7%; 53% of assets in are in retirement accounts; 13% of assets in annuities
·Average monthly direct deposit of $139; 64% of new funds flow into retirement accounts

Austin, Calvert & Flavin
·Acquired August 9, 1999: Purchase price was $30.5 million including $9.3 million in contingency payments made in subsequent years
·Purchase price ~2.2% of AUM at time of purchase (result of more contingency fees paid given market performance in 1999 and 2000)
·AUM at acquisition was $1.4 billion
·Based in San Antonio, Texas, with a focus on trusts, high net worth individuals, pensions, etc.

Legend
·Acquired March 31, 2000: Purchase price was $65.4 million with a $4 million contingency payment made in 2000 for performance goals (no contingency payment made in 2001)
·Purchase price ~2.5% of AUM at time of purchase
·AUM as of December 2000 was $2.8 billion
·Based in Palm Beach Gardens, Florida with a focus on serving employees of school districts and non-profit organizations
·90,000 clients with an average investment of $31,000/account.
·Legend has 290 advisors located in 22 offices throughout the eastern U.S.

Industry:

The asset management industry is made up of many companies (both public and private) and is highly competitive. However, the economics of the business are terrific once scale is reached. Typically, these businesses earn very high returns on capital (30%+ for WDR), are very predictable over long periods of time, and have very solid financial statements. Historically, pricing has been very stable among the various asset classes, and growth has been determined by financial market performance and favorable industry demographics (older Americans saving more for retirement, etc.).

The primary difference among competitors in the asset management industry is the asset mix (and thus pricing given the differences between equity vs. fixed income, and retail vs. institutional), and the cost (or profit in the case of WDR) of gathering assets. For various products, pricing across the industry is relatively similar. WDR has decided to build their business around the distribution of their product. As a result, WDR sacrifices the rapid growth of assets that may occur if they were distributed more widely in favor of a distribution profit. There is very little difference within the industry in terms of fund performance over long periods of time, so it is difficult to differentiate the business easily. WDR enjoys much lower redemption rates, and much higher reinvestment rates, as a result of their unique distribution system. They also have a favorable asset mix in terms of profitability with their focus on equity products sold to retail investors. WDR enjoys higher margins and returns on capital because of their ability to profit from distribution and from their asset mix relative to competitors. Compared to competitors, WDR’s distribution system also makes the business much more stable (redemption and reinvestment rates), predictable, and less risky over time.

Competitive Advantages:

Unique focus on middle-class Americans in smaller markets not saturated by competitors and difficult to enter for large asset management firms (costly to set up distribution compared to available assets).

Profitable acquisition of assets. WDR makes a small profit using its distribution channel to gather mutual fund assets. Though the margin is very small, it allows WDR to have better economics than other asset management firms who typically pay for distribution.

High reinvestment rates. WDR customers reinvest approximately 88% of dividends and capital gains. This high rate of reinvestment further lowers asset acquisition costs.

Low redemption levels. WDR experienced an 8% redemption rate in 2001, roughly 1/3 the industry average. This low redemption rate creates much higher margins (assets create more dollars of net income as they get older), and allows the company to reach high profitability levels without generating substantial sales each year.

Advisor retention. WDR has one of the largest proprietary sales forces in the mutual fund industry that would be difficult to replicate. 33% of advisors have been with the firm for more than 5 years, 22% more than 10 years.

Management:

Keith Tucker (CEO – 57) – been in current role since spin-out from Torchmark; held same role within Torchmark before WDR became public; been with company for 11 years

Henry Herrman (CIO – 59) – been with WDR since March 1987; considered by many to be a key person within the company based on interviews with current and former WDR personnel

John Sundeen (CFO – 41) – been with WDR since July 1999; prior experience at WDR from 1994 – 1999 was as head of fixed income portfolios

Thomas Butch (Marketing – 45) – been with WDR since November 1999; previously with Stein Roe & Farnham from 1994 – 1999; current role (and very important) is to develop other distribution channels -- 401(k) plans, wrap accounts, and sub-advisory services to other mutual funds

Valuation:

I've developed a detailed DCF model that is too bulky to post here. However, based on conservative assumptions (6% annual increased in S&P 500, 5.6% yield on fixed-income products which equates to current Lehman Aggregate yield, and modest growth for number of advisors and advisor productivity). I also used a 10% discount rate to arrive at an intrinsic value in the low-mid $30's. (I would be happy to share other assumptions if members are interested in my calculations).

Based on my calculations, I think it is highly probable that an investor will earn high-teens/low-20's returns annually at current prices over the next 3-5 years.

Recent Market Activity:

The asset management industry is currently out of favor with Wall Street. Obviously, as market prices decline, the ability for asset management companies to show increasing profits diminishes. For those companies with an equity focus (like WDR), earnings estimates have been cut recently. Given my time horizon, I prefer to invest in very attractive industries that are experiencing temporary difficulties. Despite low average assets under management, the Waddell & Reed franchise is still very much intact and adding value each year.

Catalyst

1. Valuation -- there is a wide gap between current market value and WDR's intrinsic value; WDR is increasing intrinsic value each year
2. Acquisition -- though I never invest with an acquisition needed to realize value, this is a distinct possibility in this particular case. Several prominent "value" investors (including Highfields) are large holders of the stock, and the private market value of this business is substantially higher than the current market price.