T. Rowe Price (TROW) did well in a tricky environment in their 1Q16 earnings report yesterday with the company putting up decent net new asset raises in a quarter where the S&P 500 dove -11% to start the year to then rebound by just as much to end the period. Normally that type of volatility shakes investors out of the market however the company was able to take in net new assets of +$5.1 billion or organic growth of +2.7%, offsetting market related losses of -$3.6 billion. While the bulk of the inflow was target date funds subscriptions of +$4.2 billion, the +$900 million of non target date inflow was a solid respite from the consistent downward trajectory that has persisted since 2013.
While we applaud the new fish on the deck in the quarter, the TROW boat is still being weighed down by substantial margin degradation with new hiring expenses and the build out of non U.S. distribution. Operating margins hit 41.3%, their lowest level since 3Q09 as the company blew through the 6,000 employee mark for the first time in it's history. The $1.04 per share in earnings reported was in line with a lowered Consensus estimate but was down -8.2% year-over-year and validates that Street estimates are way too high for the out year and that the company has put in its high water mark in profitability (in 2013 with operating margins over 48%).
With ending assets-under-management only -1% off of their all-time high from 2Q15, the company is barely putting up earnings over $1 per share and thus with the Street at over $5 per share in the out year (2017), we continue to put out the stock as better on the Short side. Our fundamental, intermediate term thesis continues to outline the pervasive shift in Large Cap strategies from mutual funds to passives and that the firm's important Target Date fund product suite is materially slowing. The +10% annualized organic growth in Target Date flows in the quarter was the lowest 1st quarter growth rate in the history of the product and with deliberate 1H seasonality raises the risk that trends will decelerate throughout the year. Outside of the positive quarter for fund raising, the TROW enterprise is still heavily dependent on the market to increase its billable assets with market returns since 2009 responsible for $4 out of every $5 raised by the company (market returns since '09 have tallied $409 billion compared to $77 billion in organic net new asset growth). With margins compressing and intermediate term trends still outlining substantial share gain by passives, we maintain our Short view on shares.
Both sides of the House including Target Date and Non Target Date contributed to a positive first quarter in fund raising for the firm:
However Target Date growth rates on a rolling 4 quarter moving average are now well below double digits at +8% growth with the rest of the franchise still averaging a decay or negative growth rate:
And margins are dropping substantially to new cycle lows as the company continues to add employees and distribution which raises the stakes that the market will have to continue to perform to keep TROW AUM and earnings stable:
Our fundamental, intermediate term thesis outlined in our recent Black Book is unchanged and rests on the following:
The shift from active to passive continues to accelerate and 67% of passive inflows are going to Large Cap strategies. TROW has the largest percentage of Large Cap product of any public mutual fund manager and when including SMAs, TROW's Large Cap exposure goes to over 40% of total assets-under-management:
2.) The firm's Target Date franchise is its go to source of growth, however the oldest Baby Boomers turned 65 in 2011 and now three Series of TROW target date products are in redemption. The hump gets worse in the distribution into the 2020 series which is the second biggest pool of TD assets for the manager. Target date is the only source of growth currently in the overall complex.
3.) TROW is once again at peak margins and profitability and after setting a new high water mark in 2013 at over 48% operating margins, results are set to recede. TROW will also be bumping up against a break point in fees at over $500 billion in mutual fund AUM which won't help margins. We have earnings at $4.06 for 2017, -17% below the Street before considering that the stock's multiple should also contract against the group.
TROW Best Ideas Short Call - Paddling UpStream
Please let us know of any questions.
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA