EUR 850.00 For Business Accounts Only

Morningstar | Fee Pressure Trumps Positive Flows in BlackRock's 2Q; Keeping Our $495 FVE in Place

There was little in wide-moat-rated BlackRock's second-quarter results that would alter our long-term view of the firm. We are leaving our $495 fair value estimate in place. BlackRock closed the June quarter with a record $6.842 trillion in managed assets, up 5.0% sequentially and 8.6% year over year, with positive flows, foreign-exchange gains, and market gains all contributing to assets under management. Net long-term inflows of $125.4 billion during the second quarter were fueled by $74.7 billion of active inflows (predominantly from BlackRock's fixed-income operations), $15.0 billion of inflows from the institutional index business (with most going into fixed-income strategies), and iShares (where the company's exchange-traded fund platform generated $35.7 billion in inflows). Although BlackRock's annual organic growth rate of 4.1% over the past four calendar quarters trails management's ongoing annual target rate of 5%, it was more in line with our long-term forecast for 3%-5% organic AUM growth annually.

Despite this, BlackRock reported a 2.2% decline in second-quarter revenue compared with the prior-year period, owing to a drop in its realization rate from 0.186% a year ago to 0.175% in the most recent quarter. The decline in base management fee rates was due more to product mix shifts than BlackRock reducing fees on any of its products. The company's first-half top-line decline of 4.4% was at the lower end of our expectation for a low- to mid-single-digit decline in revenue in 2019, but given the easier comparables in the fourth quarter, we are sticking with our forecast. While BlackRock reported a 260-basis-point year-over-year decline in second-quarter operating margin to 36.6%, we believe it will close the year with operating profitability in the 37%-39% range.

BlackRock reported inflows from each of its equity platforms--active ($0.5 billion in inflows), institutional index ($1.2 billion), and iShares/ETFs ($4.2 billion)--during the second quarter, which was a marked improvement over the outflows reported during the first quarter. Given the meaningfully higher fees that BlackRock charges for its active equity operations (55 basis points relative to 24 basis points for iShares equity offerings and 4 basis points for institutional index funds), any improvement in this part of its business (from a performance and flow picture) is beneficial to base fee growth. BlackRock closed the June quarter with 69%, 74%, and 84% of its fundamental equity funds above the benchmark or peer median on a one-, three- and five-year basis, respectively, compared with 59%, 78%, and 80% at the end of the second quarter of 2018. Actively managed systematic equity funds recovered somewhat in the near term, with 39%, 90%, and 93% of AUM beating their benchmark or peer median on a one-, three- and five-year basis, respectively, at the end of June 2019, but remain off the pace of the 86%, 82%, and 91% results posted in the year-ago period. Given that improvements in BlackRock's active equity operations have been more miss than hit for much of the past five years, we're not putting much weight behind a long-term recovery in this part of the firm's overall business. We believe management's goal is 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 migrate active equity portfolios over to more quantitative-based strategies (much as it did with 10% of the active equity platform in March 2017).

BlackRock's fixed-income operations (which accounted for 32% of firmwide AUM at the end of the second quarter) drove the majority of inflows during the second quarter, with the company generating $110.4 billion in inflows--active ($65.1 billion in inflows), institutional index ($13.8 billion), and iShares/ETFs ($31.5 billion)--from its bond funds during the second quarter. Near-term performance has been slightly better on the active side (which accounted for 14% of firmwide AUM), with 79%, 82%, and 86% 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 second quarter, compared with 78%, 71%, and 85% in the year-ago period. This has allowed (and should continue to allow) the firm to drive positive flows as long as investors are looking for actively managed taxable fixed-income offerings. On the tax-exempt side, near-term performance was much weaker, with just 26%, 75%, and 78% of active funds beating their benchmark or peer median on a one-, three- and five-year basis, respectively, at the end of June, compared with 78%, 77%, and 76% at the end of the second quarter of 2018. During the call, CEO Larry Fink noted that some of its institutional clients are finding it increasingly difficult to manage their fixed-income portfolios in house and are looking to firms like BlackRock, which can offer both active and passive solutions at cost-effective rates, to build deeper relationships with. This should be a net positive for continued fixed-income flows in the near to medium term.

We continue to expect iShares' fixed-income operations (which accounted for 8% of firmwide AUM at the end of the second quarter) to continue to grow at a higher rate organically than the equity iShares platform, as well as the remainder of its fixed-income platform. This is primarily because equity ETFs already account for 77% of the global ETF market (compared with fixed-income ETFs at 19%), and organic growth for the equity part of the business has been trending down toward the 8% average annual rate of organic growth we've seen from equity index funds historically (compared with the 15%-20% annual organic growth rate that fixed-income ETFs have put up the past couple of years). With 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 to grow organically at a low-double-digit rate on average annually the next five years, with BlackRock maintaining market leadership domestically (39% of the market) and globally (37%).

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 4% of the market domestically and 3% globally), it 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, in our view, is going to come from firms like Schwab, Fidelity, and JPMorgan Chase, which have their own built-in distribution platforms and have shown a willingness to offer index funds and ETFs with 0-basis-point fees, using other parts of their business to compensate for the lost management fees on their proprietary products. 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 product mix shift and the increased scale of iShares operations. That said, the 5.8% year-over-year decline in the firm's fee realization rate during the second quarter was well outside the 3.7% (4.0%) rate of decline we've seen on average the past five years (during 2018). As much of this was driven by mix shift, we're not going to alter our forecasts, which continue to call for 3%-4% annual fee declines for BlackRock during 2019-23.

While second-quarter (first-half) revenue was down 2.2% (4.4%) year over year, affected not only by the fee compression but also by 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 the fourth quarter of 2018), with annual revenue down low to mid-single digits during 2019. While BlackRock reported a 260-basis-point decline in second-quarter operating margin to 36.6% compared with the same period in 2018, we believe it will close the year with operating profitability in the 37%-39% range.
BlackRock spent $1.6 billion ($1.3 billion of which was done via a private transaction) on share repurchases during the first quarter, buying back an estimated 3.8 million shares, which was well above its targeted $1.2 billion ($300 million per quarter) share-repurchase plan for 2019. With its repurchase target for the year already met during the first quarter, management does not expect to make any more repurchases this year unless the market provides an opportunity to buy back shares at meaningfully lower levels than we saw during the fourth quarter of 2018 and first quarter of 2019 (where the shares traded at an average price of $415 and a low of $361). BlackRock increased its quarterly dividend another 5% to $3.30 per share at the start of 2019 (equivalent to a 2.8% dividend yield at today's share price), having raised it to $3.13 per share in the second quarter of 2018 and $2.88 per share (from $2.50 per share) at the start of last year.