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BlackRock Shares Are Still Undervalued

Investment thesis

Investment management companies perform well when the global economy is growing as investors tend to flock to equity securities. Generally, such investments bear higher costs than fixed income or passive investment solutions, enabling asset management companies to earn higher fees that result in profit margin expansion. Considering the global economy grew steadily in the decade following the financial crisis of 2008, it doesn't come as a surprise that many of the leading companies in this industry have provided stellar returns to investors.


The share price performance of major investment management companies in the last 10 years.

The industry, however, is going through dynamic changes. The secular growth of passive investment products, which have lower fees, is proving to be an obstacle for many companies, but not for BlackRock Inc. (NYSE:BLK). The company certainly is the leader of this space and enjoys significant competitive advantages.

Even though shares have appreciated 123% over the past decade, there is still upside potential. The stock was trading with a dividend yield of 2.7% at the market price of around $497 on Friday.

Company profile and business strategy

BlackRock is an asset management company providing a suite of investment products and solutions to institutional, corporate and retail clients. At the end of the first quarter, the company was ranked number one in regard to assets under management.

Top 10 asset managers by AUM (as of March 31, 2019)

Source: ADV Ratings.

One of the primary reasons BlackRock has been so successful is because of the extensive products and solutions offered, which represent various asset classes, styles, regions and markets.

Product categories

Source: Company website.

The global footprint of the company has been another factor in its success. The rising income levels of emerging markets, such as the Asia-Pacific and Latin America regions, created a demand for wealth management products in the last several years, which was addressed by BlackRock because of its reach in these regions.

Over the last five years, the company has focused on diversifying its business operations. As a result, the company now provides investment management, risk management solutions and portfolio construction software tools. To integrate all these operations into a single ecosystem, the One BlackRock model was introduced. These changes indicate that offering all-in-one solutions to clients is one of the company's primary business strategies.

Global offices

Source: Company website.

Keeping up with technological advancements and providing a streamlined experience to clients is also a business objective of BlackRock, as confirmed by the management in the third-quarter earnings conference call.

Distributing wealth to shareholders through buybacks and dividends has always been a priority as well, which the management expects to continue indefinitely.

Industry analysis

The asset management industry is at a crossroads. Historically, companies focused on providing active investment products in a bid to help clients generate alpha returns. However, in the last decade, passive investment products have garnered unfathomable attention and investors have poured trillions of dollars into such solutions. A paper drafted by four Federal Reserve System governors in September confirmed that this shift will change the financial systems for many years:


"The shift from active to passive investment strategies has profoundly affected the asset management industry in the past couple of decades, and the ongoing nature of the shift suggests that its effects will continue to ripple through the financial system for years to come."



Benjamin Phillips, a consultant with Casey Quirk, believes passive investment assets under management will soon overtake that of active investments.

Source: Bloomberg.

Companies that have failed to address this new development are falling behind the early adopters of such strategies. BlackRock was one of the first to address this shift and, as a result, has a market share of 20% currently.

Source: Bloomberg.

Companies that continue to provide innovative and thematic passive solutions will likely generate economic profits in the next 10 years.

PricewaterhouseCoopers projects a huge increase in assets under management in 2020, and a shift in the investor base. The volume of investable assets is expected to grow faster in South America, Asia, Africa and the Middle East in comparison to developed regions such as North America and Europe. Therefore, investment management companies with a solid presence in these regions will be in a better position to exploit the available growth opportunities.

Technological developments will also be at the heart of the industry in the next five years. The growth of robo-advisory solutions is one such aspect that needs to be addressed by industry participants. According to data from Backend Benchmarking, $440 billion in assets is currently being managed by automated investment solutions providers. Companies with a strong balance sheet and a healthy cash position would be able to either acquire small companies providing these types of services or develop a platform to roll out automated products in the future. Addressing this growing shift early would be key to staying relevant in the changing industry.

Finally, the industry is seeing an increased level of regulation from governing authorities, so failing to comply with these standards might result in significant losses. However, Morningstar analysts predict that smaller-scale companies might find it difficult to absorb this pressure from regulators in the short term, which could be beneficial for industry leaders.

Financial performance

The performance of equity markets has been stellar in the last 12 months. However, there has been some significant volatility at times as a result of trade tensions between the U.S. and China, geopolitical uncertainty and unstable oil prices. Over this same period, however, BlackRock has generated approximately $350 billion (5%) of total organic growth. This is an indication of the effectiveness of its business structure.

In the third quarter, the company reported net inflows of $84 billion, supported by $51 billion of inflows to the company's passive investment solutions.

Source: Company filings.

The company's operating profit margin has declined at a steady rate, from 40.83% in 2014 to 38.51% in the trailing 12-month period. This doesn't come as a surprise considering the growth of low-fee-generating passive products. At the end of the third quarter, active products represented only 27% of total assets under management, but generated 47% of base fees. This is a clear indication that these products have better margins. Based on these factors, it's fair to conclude that margins will compress further in the future. Management is optimistic, however, that this compression will partly be offset by the growth of assets.

Source: Third-quarter earnings presentation.

BlackRock's debt maturities are well-staged, which is an indication of the high-quality capital management practices being deployed. In the next 11 years, there are four years in which no maturities occur, leaving ample time for the company to prepare its finances to honor upcoming repayments. This reduces the company's refinancing risk.

Source: Company filings.

According to data from GuruFocus, BlackRock's debt-to-equity ratio is 0.19, which is indicative of a strong balance sheet position.

BlackRock is generating organic growth even under volatile market conditions, and analysts predict mid-single-digit revenue growth for the next five years as well. The company continues to repurchase stock on the open market, reducing the number of shares outstanding. This will help per-share earnings figures in the future. Dividends, on the other hand, have grown steadily since the third quarter of 2017.

Amid slow growth, the company will deliver attractive returns to its shareholders in the coming years, based on its ability to pounce on market opportunities. According to Gregory Warren, the Morningstar analyst covering BlackRock, the company has a wide economic moat resulting from the significant switching costs of changing wealth from one investment manager to another. This moat will help generate alpha returns as well.

Outlook

BlackRock is investing to enhance its product offering to capture long-term returns from developing trends in the industry. For instance, the iconic iShares exchange-traded fund offering has been refreshed, with new funds addressing higher-growth segments such as factor investing, sustainable investing and megatrend funds. As these themes gain traction, just like high-tech investing did over the last couple of decades, BlackRock will be the go-to investment solutions provider for clients. Capital expenditures have increased in the last three years as the company has started developing the necessary infrastructure to roll out new fund categories and will likely remain elevated over the next several years as well.

Despite several reports by the International Monetary Fund and the World Bank, the Federal Reserve believes the American economy will continue to grow over the next several years. In the third quarter, the Americas contributed to 66% of base fees, and continued economic growth in the U.S. will positively impact BlackRock's earnings..

Trade tensions, on the other hand, are expected to subside as the two nations will eventually come to an agreement. A couple of weeks ago, Chinese officials confirmed to the South China Morning Post that a trade deal is likely within the next several months. This will be a tailwind for BlackRock since a continuation of the current bull market would lead to higher net inflows.

BlackRock is addressing the threat posed by robo-advisory services as well. The acquisition of FutureAdvisor in 2015 is finally set to pay dividends as investors embrace automated investing solutions.

The outlook for the company is positive and BlackRock will likely benefit from the industry-wide developments, while some of its peers might struggle. This is a result of the company's careful planning to invest in technologically advanced solutions and competitive advantages.

Valuation

BlackRock is a mature company that continues to grow at steady rates. A discounted cash flow model was used to derive an intrinsic value estimate for its shares, considering growth could last several years before slowing down.

The below table shows the revenue estimates for the company through 2023.

Fiscal year ending

Revenue estimate

December 2019

$14.34 billion

December 2020

$15.35 billion

December 2021

$16.45 billion

December 2022

$17.52 billion

December 2023

$18.57 billion



Source: Reuters Eikon and author's estimates.

The Ebitda margin has remained above 40% over the last five years, and an average of 41% was used in the model. Other major assumptions used are listed below.

  • Capital expenditure to average 1.2% of total revenue.
  • Net working capital to average 2.8% of total revenue.
  • Tax rate of 21%.
  • Cost of capital of 9.5%.
  • Ebitda multiple of 11.9 to calculate the terminal value.



With these assumptions, the intrinsic value estimate per share comes to $542, which indicates an upside of 11% from the market price of $497 on Friday.

Risks

The possibility of a global economic slowdown is the biggest risk of investing in BlackRock. If this risk materializes, fund flows will turn negative as investors park investable assets in their cash accounts as opposed to higher-fee-generating investment products. This will compress profit margins, leading to earnings erosion.

A further appreciation of the U.S. dollar against emerging market currencies is another risk for investors as this would negatively impact the company's total revenue.

Conclusion

BlackRock is one of the leading asset management companies in the world. It is benefiting from the secular trend of investors embracing passive investment solutions. Even though fees of these products are lower than that of actively managed peers, the sheer size of the assets under management is helping BlackRock generate sufficient returns. For this reason, shares deserve to trade at higher multiples than its rivals and are currently trading below my intrinsic value estimate. The dividend yield of 2.7% provides an additional source of income to investors.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.