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Morningstar | BlackRock Benefited From 1Q Positive Flows and Market Gains; We're Increasing FVE Slightly to $495. See Updated Analyst Note from 16 Apr 2019

While there was little in wide-moat-rated BlackRock's first-quarter earnings that would alter our long-term view of the firm, we expect to raise our fair value estimate for the firm slightly to $495 per share to reflect a stronger first quarter than we were projecting. BlackRock closed out the March quarter with a record $6.515 trillion in managed assets, up 9.0% sequentially and 3.1% on a year-over-year basis, with positive flows, foreign exchange gains and market gains all contributing to AUM during the period.

Net long-term inflows of $59.0 billion during the first quarter were fueled by $14.0 billion of active inflows (primarily from BlackRock's fixed-income operations), $14.4 billion of inflows from its institutional index business (with fixed-income inflows also offsetting equity outflows during the period) and iShares (where the company's ETF platform generated $30.6 billion in inflows despite seeing its first quarterly outflows from its equity ETF offerings since the first quarter of 2016). Although BlackRock's annual organic growth rate of 2.2% over the past four calendar quarters trails management's annual target rate of 5%, its annualized rate of 4.3% (based purely on first-quarter results) was more in line with our long-term forecast for 3%-5% organic AUM growth annually.

BlackRock reported a 6.6% decline in first-quarter revenue when compared with the prior year's period, as a 1.0% decline in average long-term AUM combined with a 3.9% decline in the firm's fee realization rate and meaningfully lower performance and distribution fees to impact the company's top line. With regards to profitability, while BlackRock reported a 160-basis-point decline in first-quarter operating margins to 36.8% of revenue when compared with the same period in 2017, we still believe that the firm will close out the year in a 38%-40% range (as the first quarter tends to have higher compensation costs than the remaining three quarters of the year).

Looking more closely at the firm's flows, BlackRock reported outflows from each of its equity platforms--active ($9.5 billion in outflows), institutional index ($15.0 billion) and iShares/ETFs ($1.6 billion)--during the first quarter as there was a continuation of some of the derisking activity that marred the fourth quarter of 2018 despite the market (as represented by the S&P 500 TR Index) rising 13.7% during the March quarter. CEO Larry Fink noted that more money was coming off the sidelines and going into fixed income as opposed to equities during the first quarter, a trend that he does not expect to continue as the year progresses. The outflows from iShares was the most troubling, as they represented BlackRock's first quarterly outflows from its equity ETF offerings since the first quarter of 2016, when the markets were much more volatile than we saw this March quarter. Even more troubling was the fact that peers like Vanguard (with an estimated $9.7 billion in equity ETF inflows), Schwab ($5.0 billion) and Invesco ($2.5 billion) posted positive equity ETF flows during the quarter. Despite the outflows, equities remained BlackRock's largest category at the end of the first quarter, accounting for 52% of total AUM--spread across its active (4%), institutional index (26%) and iShares (22%) platforms.

Given the meaningfully higher fees BlackRock charges for its active equity operations (of 55 basis points relative to 25 basis points for iShares equity offerings and 4 basis points for institutional index funds), any improvement in this part of its business would be beneficial to base fee growth. BlackRock closed out the March quarter with 63%, 73%, and 83% of its fundamental equity funds above the benchmark or peer median on a one-, three- and five-year basis, respectively, compared with 66%, 77%, and 78% at the end of the first quarter of 2018. Actively managed systematic equity funds stumbled, though, during the quarter with just 27%, 87%, and 87% of AUM beating their benchmark or peer median on a one-, three-, and five-year basis, respectively, at the end of March 2019, compared with 84%, 89%, and 90% in the year-ago period. Given that improvements in BlackRock's active equity operations have been more miss than hit much of the past five years, we're not putting much weight behind a long-term recovery, expecting the firm to basically run the unit for the cash flows (all while taking fee cuts annually to make sure its active funds don't lose placement on retail platforms) and occasionally migrating active equity portfolios over to more quantitatively based strategies (much as they did with 10% of the active equity platform back in March 2017).

As we noted above, BlackRock's fixed-income operations (which accounted for 28% of firmwide AUM at the end of the first quarter of 2019) more than offset the negative flow picture emanating from the firm's equity operations during the March quarter. In fact, BlackRock reported inflows from each of its fixed-income platforms--active ($18.3 billion in inflows), institutional index ($29.4 billion) and iShares/ETFs ($32.2 billion)--during the first quarter. Despite weaker near-term performance on the active side (which accounted for 13% of firmwide AUM), with 61%, 83% and 85% of taxable fixed-income funds above the benchmark or peer median on a one-, three- and five-year basis, respectively, at the end of the first quarter, compared with 83%, 72%, and 90% in the year-ago period, the firm is still well positioned to drive positive flows as long as investors are looking for fixed-income offerings. On the tax-exempt side of things, near-term performance was weak as well, with just 28%, 78% and 76% of active funds beating their benchmark or peer median on a one-, three- and five-year basis, respectively, at the end of March, compared with 63%, 58% and 74% at the end of the first quarter of 2018. With fixed-income looking like it was a stepping stone out of cash during the first quarter, management expects flows to be weaker, though, as we move through the remainder of 2019.

That said, we do still expect iShares' fixed-income operations (which accounted for 7% of firmwide AUM at the end of the first quarter) to continue to grow at a higher rate organically than its equity iShares platform, as well as the remainder of its fixed-income platform. This is due primarily to the fact that equity ETFs already account for 78% of the global ETF market (compared with fixed-income ETFs at 18%) and organic growth for this part of the business has been trending down towards the 8% rate of annual organic growth we've seen from equity index funds historically (compared with a 15%-20% annual, organic growth rate for fixed-income ETFs the past couple of years). With more and more institutional and retail investors looking to ETFs to satisfy their fixed-income exposure needs, we do not expect the higher organic growth rates being generated by fixed-income ETFs to wane much in the near to medium term.

We also expect iShares, which has generated more than $1 trillion in inflows for BlackRock since the firm closed the deal to buy Barclays Global Investors in late 2009, to continue to be the primary driver of organic growth for the firm. We expect the global ETF market (which stood at $4.8 trillion at the end of 2018) to grow organically at a 10%-13% annual rate during the next five years, with BlackRock maintaining market leadership both domestically (40% at the end of last year) and on a global (37%) basis. Assuming mid-single-digit market gains, this should allow the market to double over the next five years. While BlackRock has historically seen stiff pricing competition from Vanguard (which holds 25% of the U.S. ETF market and 19% of the global market) and Schwab (with just 3% of the market domestically and globally), the firm has held its market share steady for more than six years and has been capturing a greater percentage of the industry's flows. With most plain-vanilla large-cap index-based equity ETFs priced more in line with institutional index funds, we don't envision massive fee cuts from here. The bigger challenge for the industry, though, is going to come from firms like Schwab, Fidelity, and JPMorgan Chase that have their own built-in distribution platforms and have shown a willingness to offer up index funds and ETFs with zero-basis-point fees, using other parts of their business to compensate for the lost management fees on their proprietary products.

On the fee front, we continue to see compression in BlackRock's active and ETF management fees, with the former being more conscious and the latter tending to be driven by the increased scale of iShares operations. That said, the 3.9% year-over-year decline in the firm's fee realization rate during the first quarter was in line with the 3.5% (4.0%) rate of decline we've seen on average the past five years (and during 2018). While first-quarter revenue was down 6.6% year over year, impacted not only by the fee compression but meaningfully lower performance and distribution fees, we expect top-line results to recover some during the rest of the year (especially in the back half of the year as BlackRock laps the near-bear market seen during 2018), with annual revenue down just low-single digits during 2019. With regards to profitability, while BlackRock reported a 160-basis-point decline in first-quarter operating margins to 36.8% of revenue when compared with the same period in 2017, we still believe that the firm will close out the year in a 38%-40% range (as the first quarter tends to have higher compensation costs than the remaining three quarters of the year).

As for capital allocation, BlackRock spent $693 million on two acquisitions last year: $393 million for Tennenbaum Capital Partners, a middle-market credit and special situation credit opportunities manager (with about $9 billion in AUM at the end of 2017), and $360 million for Citibanamex's asset management business (with some $34 billion in fixed-income, equity, and multiasset AUM at the end of August 2018). And followed this up with a $1.3 billion deal for eFront, a leading end-to-end alternative investment management software and solutions provider, in March of this year. While the firm also continues to commit additional capital to seed investments, it has generally passed the bulk of its free cash flow on to shareholders. BlackRock spent $2.1 billion on share repurchases during 2018, reducing its shares outstanding by nearly 3%, and management had expected to spend at least $1.2 billion (or $300 million per quarter on share repurchases this year). The firm blew right through that number during the first quarter, spending $1.6 billion ($1.3 billion of which was done via a private transaction) buying back an estimated 3.8 million shares. With the company's repurchase target for 2019 already met, management does not expect to make any more purchases this year, unless, of course, the market provides BlackRock with an opportunity to buy back shares at meaningfully lower levels than we saw during the fourth quarter of 2018 and first quarter of 2019. As for the dividend, BlackRock increased its quarterly dividend 15% to $2.88 per share at the start of 2018, and then increased it again during the third quarter of last year to $3.13 per share, before taking it up once again during the first quarter of 2019 to $3.30 per share (equivalent to a 2.9% dividend yield at today's share price).