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Morningstar | Industrywide Flow Slowdown and Adverse Currency Affect BlackRock's Q2 Results; No Change to FVE

There was little in wide-moat-rated BlackRock's second-quarter earnings that would alter our long-term view of the firm. We are leaving our $600 per share fair value estimate in place. BlackRock closed out the June quarter with $6.300 trillion in managed assets, down 0.3% sequentially but up 10.7% year over year, with positive flows and market gains offset by adverse currency exchange during the period.

Net long-term inflows of $14.5 billion during the second quarter were a step down from the positive $66.2 billion quarterly run rate we'd seen from BlackRock during the prior eight calendar quarters but was not out of character with what has been reported so far from the other asset managers. Overall, there appears to have been an industrywide slowdown in flows during the second quarter, as investors derisked portfolios over concerns about an escalating trade war and potential slowdown in the U.S. economy.

BlackRock's iShares ETF platform continued to be its largest driver, picking up another $17.8 billion in AUM during the second quarter. The firm also saw positive flows from its retail ($5.5 billion) operations, which was offset somewhat by institutional outflows (of $8.8 billion). The company's organic growth rate of 4.3% over the past four calendar quarters is now more in line with our long-term forecast for 3%-5% organic AUM growth annually.

BlackRock turned year-over-year average long-term AUM growth of 13.4% into 10.4% base fee revenue growth during the second quarter, as mix shift and fee compression weighed on results. Total revenue was up 11.4% (13.6%) when compared with the second quarter (first half) of 2017, above our projections for high-single-digit top-line growth this year (with the company facing higher AUM and revenue hurdles in the back half of the year). As for profitability, BlackRock posted a 160-basis-point increase in first-half operating margins to 39.2% when compared with the year-ago period.

Looking more closely at the firm's flows, total equity outflows of $22.4 billion during the second quarter were driven by the firm's active ($4.4 billion) and institutional ($19.4 billion) platforms, offset slightly by $1.4 billion in positive flows from its iShares ETF operations. Equities remained BlackRock's largest category at the end of the second quarter, accounting for 53% of total AUM--spread across its active (5%), institutional index (27%) and iShares (21%) platforms. While the institutional outflows were less impactful to second-quarter results, given that the base fees for those index-based assets are around 4 basis points, they do serve as a reminder that these assets can move in large chunks when investment mandates shift during the year. Having seen improved flows over much of the past year, as investment performance has improved for the group overall, the jump in active equity outflows were also a setback.

Given the meaningfully higher fees BlackRock charges for its active equity operations (of 55 basis points relative to 27 basis points for iShares equity offerings and 4 basis points for institutional index funds), a continued improvement in this part of its business would ultimately be beneficial to base fee growth. BlackRock closed out the June quarter with 59%, 78%, and 80% of its fundamental equity funds above the benchmark or peer median on a 1-, 3-, and 5-year basis, respectively, compared with 62%, 78%, and 66% at the end of the second quarter of 2017. Actively managed systematic equity funds also put up a good showing, with 86%, 82%, and 91% of AUM beating their benchmark or peer median on a 1-, 3-, and 5-year basis, respectively, at the end of June 2018. The key to getting and keeping flows positive in BlackRock's active equity operations is having 3- and 5-year performance results that are consistently in the upper quartile. While the company continues to get closer to doing that on a sustained basis, positive flows may still be more difficult than in past periods, especially with the gatekeepers for retail-advised platforms placing a much greater focus on active managers' fees and investment performance when selecting funds for their platforms.

BlackRock's fixed-income operations (which accounted for 30% of total AUM at the end of June) benefited somewhat from the derisking that took place during the second quarter, but overall flows were not much better than what we saw during the first quarter of 2018. The company generated $26.4 billion in net long-term inflows from its fixed-income operations--spread across its active ($2.7 billion), institutional index ($7.8 billion), and iShares ($16.0 billion) platforms. Slightly weaker investment performance on the active side (which accounts for 13% of total AUM) could pose a risk to future flows, though, with 78%, 71%, and 85% of taxable fixed-income funds above the benchmark or peer median on a 1-, 3-, and 5-year basis, respectively, at the end of the second quarter, compared with 75%, 77%, and 88% in the year-ago period. That said, tax-exempt fund offerings are looking much better, with 78%, 77%, and 76% of active funds beating their benchmark or peer median on a 1-, 3-, and 5-year basis, respectively, at the end of June, compared with 53%, 54%, and 68% at the end of the second quarter of 2017. This should provide some stability to overall flows in BlackRock's active fixed-income funds.

Going forward, we expect iShares fixed-income operations (which accounted for 6% of total bond fund AUM at the end of the second quarter) to continue to grow at a somewhat faster rate organically than its equity iShares platform, due primarily to the fact that equity ETFs already account for 78% of the global ETF market (compared with fixed-income ETFs at 17%) and more and more institutional and retail investors are looking to ETFs to meet fixed-income exposure needs. We also expect iShares, which has generated close to $900 billion 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 $4.9 trillion at the end of the second quarter of 2018) to grow organically at a 10%-14% annual rate during the next five-plus years, with BlackRock maintaining market leadership both domestically (39%) and on a global (37%) basis.

Assuming mid-single-digit market gains, this should allow the market to double over the next five years--at the lower end of management's current forecast for the global ETF market to reach $10 trillion to $12 trillion in AUM by the end of 2023. While BlackRock has 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 five years now and has been capturing a greater percentage of the industry's flows. While total net inflows of $17.8 billion during the second quarter ran slightly behind the estimated $19.4 billion in inflows that Vanguard recorded, BlackRock's year-to-date inflows of $52.5 billion were meaningfully higher than Vanguard's estimated inflows of $42.9 billion during the first six months of the year. This leads us to believe that drastic pricing actions are less likely going forward, especially with Vanguard pulling back on ETF fee reductions the past year as it focuses on spending more to improve its back-office operations.

BlackRock's long-term net inflows of $330.2 billion during 2017 (which included $241.8 billion in iShares ETF inflows) were nearly twice as great as the company's average annual inflows of $171.3 billion during 2014-16, and reflective of 7.0% annual organic growth. Our expectations for 2018 and 2019 are not quite as robust, though, as we believe that a fair amount of ETF flows last year were driven by retail-advised platform adjustments related to the Department of Labor's fiduciary rule (which are unlikely to be repeated in future periods), with full-year organic growth expected to be closer to the upper end of our long-term forecast calling for 3%-5% annual organic AUM growth both years. While the headwinds posed by the markets during the first half of the year have lowered our expectations slightly for end of year AUM, which we now have in a $6.500 trillion to $7.000 trillion range (as opposed to $6.750 trillion to $7.000 trillion), we still see the firm generating high-single-digit revenue growth this year (and next), with operating margins hovering around 40%.

After 2019, we see the firm turning average annual organic AUM growth of 3%-5% into mid- to high-single-digit annual top-line growth, with the net result being a 6.3% CAGR for revenue during 2018-22. Our five-year forecast includes a continuation of the fee compression we've seen over the past several years, as well as expectations for a down year in the equity markets. And unlike most of the other firms in our coverage, we continue to project margin expansion for BlackRock during 2018-22, with the company's operating margins improving 50 basis points on average annually over the next five years (driven not only by the increased scale of the firm's operations but the efficiencies created by ongoing technology investments). This would leave operating profit margins at around 42% by the end of 2022.

This, along with the reduction in the company's effective tax rate to around 23% from 29% following the passage of the Tax Cuts and Jobs Act of 2017, should allow BlackRock to generate around $5.8 billion in free cash flow (defined as cash flow from operations less capital expenditures) annually on average during 2018-22 (equivalent to $28.9 billion overall during the five-year time frame). Our current projections have the company spending between $7.5 billion and $8.0 billion (or around one fourth of its annual free cash flow) on share repurchases during 2018-22. BlackRock spent $275 million per quarter on share repurchases during 2017 and expects to buy back $1.2 billion worth of shares (or $300 million per quarter) this year, having already spent $655 million on share repurchases during the first half of 2018.

As for the dividend, we have BlackRock returning around $11.7 billion to shareholders as dividends during 2018-22, with an average annual payout ratio of 45%. At the start of 2018, BlackRock increased its quarterly dividend 15% to $2.88 per share, which lifted its annual payout to $11.52 per share, equivalent to a 2.3% dividend yield at today's share price. We currently have the firm increasing the dividend by 15% again in 2019, 12% in 2020, and then 10% in 2021 and 2022, which would leave the annual dividend at $18.10 per share in 2022. That said, management did note back in June that it would be seeking board approval this month to increase the quarterly dividend from $2.88 per share to $3.13 per share (reflective of an 8.7% increase), which would raise the annual payout this year to $12.02 per share. We don't believe that this will exclude them from raising the dividend again next year during in the first quarter (which is the period when BlackRock has historically increased its dividend), it just means that the increase might be smaller than what we had been forecasting, with the annual dividend next year likely to be around $13.20 per share.

While BlackRock is looking fairly attractive right now on a price-to-fair value estimate basis (trading at around 85% of our $600 per share fair value), the shares remain elevated on a price/earnings basis, trading at 17.9 times this year's and 16.1 times forward consensus earnings estimates. This is reflective of premiums of 47% and 41%, respectively, to group multiples of 12.2 times this year's and 11.4 times forward consensus earnings. BlackRock has historically traded at 15%-25% premium, so the shares do appear to be a bit rich on that basis. That said, the group seems to have bifurcated this year into the "haves"--BlackRock, wide-moat rated T. Rowe Price and Eaton Vance, and narrow-moat Cohen & Steers--which have above-average organic growth profiles and/or above-average operating margins and the "have nots," which are lacking in one or both of these metrics, creating more attractive opportunities in some of the second-tier names in the group--with narrow-moat rated Invesco continuing to be our top-pick, trading at 64% of our $40 per share fair value estimate and 9.2 times this year's and 8.5 times forward consensus earnings, a deep discount to where the firm has traded historically.