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Morningstar | Institutional Derisking Outflows Mar BlackRock's Solid 3Q Results; No Change to $580 FVE

There was little in wide-moat-rated BlackRock's third-quarter earnings that would alter our long-term view of the company. We are leaving our $580 fair value estimate in place. BlackRock closed the September quarter with a record $6.444 trillion in managed assets, up 2.3% sequentially and 7.8% year over year, with positive flows, market gains, and the inclusion of the assets under management from the acquisitions of Tennenbaum Capital Partners and the asset-management business of Citibanamex offset by adverse currency exchange during the period.

Net long-term inflows of $10.6 billion during the third quarter were a step down from the positive $67.8 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 other asset managers. It appears that the industrywide slowdown in flows we saw during the second quarter crept into the third quarter as investors continued to derisk portfolios, with BlackRock in particular reporting $30.7 billion in institutional equity index outflows as a result of increased uncertainty about global monetary policy and trade. The company also noted that it experienced large outflows ahead of and during last week's equity market sell-off, which will probably blunt our full-year organic growth forecast down to 2%-3% (from 3%-4% previously).

BlackRock turned year-over-year average long-term AUM growth of 9.5% into 3.7% base fee revenue growth during the third quarter, as mix shift and fee compression weighed on results. Total revenue was up 1.9% (9.4%) compared with the third quarter (first half) of 2017, leaving the company well positioned to generate mid- to high-single-digit top-line growth for the full year. BlackRock posted an 80-basis-point increase in year-to-date operating margins to 39.1% when compared with the year-ago period, at the lower end of our 39%-40% full-year target.

BlackRock's total equity outflows of $17.3 billion during the third quarter were driven by the firm's active ($7.7 billion) and institutional ($30.7 billion) platforms, offset by $21.2 billion in positive flows from its iShares exchange-traded fund operations. Equities remained BlackRock's largest category at the end of the third quarter, accounting for 54% of total AUM--spread across its active (5%), institutional index (27%), and iShares (22%) platforms. While the institutional outflows were less impactful to third-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 and allocations shift during the course of a year.

Given the meaningfully higher fees BlackRock charges for its active equity operations (53 basis points relative to 25 basis points for iShares equity offerings), any improvement in this part of its business would be beneficial to base fee growth longer term. BlackRock closed the September quarter with 66%, 70%, and 80% of fundamental equity funds above their benchmarks or peer medians on a one-, three-, and five-year basis, respectively, compared with 59%, 80%, and 69% at the end of the third quarter of 2017, so we are seeing gradual improvements in overall performance. Actively managed systematic equity funds also put up a decent showing, with 74%, 85%, and 92% of AUM beating their benchmark or peer median on a one-, three-, and five-year basis, respectively, at the end of September 2018.

The key to getting and keeping flows positive in BlackRock's active equity operations, though, will require the firm's three- and five-year performance results to be 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 29% of total AUM at the end of September) benefited somewhat from the derisking that took place during the third quarter, but overall flows were still not much better than what we saw during the first and second quarters of 2018. During the period, the firm generated $22.9 billion in net long-term inflows with its fixed-income operations, spread across its active ($1.2 billion), institutional index ($8.8 billion), and iShares ($12.9 billion) platforms.

Slightly weaker near-term investment performance on the active side (which accounts for 13% of total AUM) could pose a risk to future flows, though, with 66%, 72%, and 84% 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 third quarter, compared with 78%, 78%, and 89% in the year-ago period. That said, tax-exempt fund offerings are looking much better, with 74%, 74%, and 78% of active funds beating their benchmark or peer median on a one-, three-, and five-year basis, respectively, at the end of September, compared with 55%, 51%, and 53% at the end of the third quarter of 2017. This should provide some stability to overall flows in BlackRock's active fixed-income funds as we move forward.

We expect iShares fixed-income operations (which accounted for 6% of total AUM at the end of the third quarter) to continue to grow at a somewhat faster rate organically than the equity iShares platform, primarily because equity ETFs already account for 79% 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 more than $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 $5.1 trillion at the end of the third quarter) to grow organically at a high-single- to double-digit annual rate during the next five-plus years, with BlackRock maintaining market leadership both domestically (39%) and on a global (37%) basis.

This should, assuming mid-single-digit market gains on average, allow the market to nearly double over the next five years--at the lower end of management's projection for the global ETF market to reach $10 trillion-$12 trillion in AUM by the end of 2023. While BlackRock has seen stiff pricing competition in the past 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 2% share globally), the firm has held its market share steady for more than five and a half years now and has been capturing a greater percentage of the industry's flows.

BlackRock's total net inflows of $34.1 billion during the third quarter were once again greater than Vanguard's (estimated inflows of $24.7 billion), with year-to-date inflows of $84.4 billion from iShares topping the estimated $68.0 billion in inflows produced by Vanguard's ETF operations. While this leaves organic growth for BlackRock's ETF operations closer to 7% so far this year, relative to something closer to 9% at Vanguard, it does hint at the fact that pricing has stabilized somewhat in the industry, especially with Vanguard pulling back on more dramatic ETF fee reductions the past year as it has focused on spending more to improve its back-office operations.

It should also be noted that the weaker organic growth we are seeing so far this year is due to the industry (which has generated just 8% organic growth so far in 2018) lapping really strong results in 2017. For example, BlackRock's ETF net inflows of $241.8 billion last year were nearly twice as great as iShares' average annual inflows of $121.1 billion during 2014-16 and reflective of 18.8% 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 for iShares likely to come in closer to 7% this year and then rebounding to around 10% during 2019.

As for full-year organic growth, we're now looking at full-year results in a 2%-4% range overall for BlackRock (compared with 3%-4% previously), with the headwinds posed by the markets keeping AUM in a $6.500 trillion-$6.750 trillion range. Even so, we still see the firm generating mid- to high-single-digit revenue growth this year with operating margins of 39%-40%. We're not expecting the industry headwinds to ease all that much over the next several years, but we still envision BlackRock generating positive flows (driven primarily by the strength and positioning of its iShares ETF platform), with organic growth averaging around 3.0% annually during 2018-22, despite our forecast calling for a 20% decline in equity market values midway through our five-year projection period.

With that in mind, and with fee compression continuing to be an issue for all market participants, we forecast only a 2.6% compound annual growth rate for revenue for BlackRock during 2018-22. Unlike for most of the other asset managers we cover, we project slight operating margin expansion for BlackRock during 2018-22, with margins expected to improve 15 basis points on average annually, driven not only by the increased scale of BlackRock's operations but the efficiencies created by ongoing technology investments. This should leave operating margins at 39%-40% by the end of 2022 (up from 38.6% in 2017), despite dipping below 37% during the year we forecast an equity market decline.

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 $5.6 billion in free cash flow (defined as cash flow from operations less capital expenditures) annually on average during 2018-22 (equivalent to $28.1 billion overall during the five-year time frame). Our current projections have the company spending between $7.5 billion and $8.5 billion (or around 30% of its annual free cash flow) on share repurchases during 2018-22. BlackRock spent $275 million per quarter on share repurchases during 2017, and while it had expected to buy back $1.2 billion worth of shares (or $300 million per quarter) this year, management has already spent $1.1 billion on share repurchases during the first nine months of 2018, taking advantage of weaker stock prices during the second and third quarters to ramp up the company's repurchase activity.

We have BlackRock returning around $10.5 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 and then increased it again during the third quarter to $3.13 per share, lifting its annual payout to $12.02 per share, equivalent to a 2.9% dividend yield at today's share price. We currently have the firm increasing the dividend by midsingle digits on average during 2019-22, which would leave the annual dividend at $15.21 per share in 2022. After the share repurchase and dividends have been covered, BlackRock should have around $9.4 billion left to commit to seed capital and other investments, more than the rest of the companies in our coverage list combined.

With the shares trading off some on third-quarter results as well as concerns about organic growth going into the fourth quarter, BlackRock is looking really attractive, trading at 70% of our $580 fair value estimate and 14.8 times this year's consensus estimate and 13.5 times next year's consensus estimate. Our fair value estimate implies a price/earnings multiple of 20.6 times our 2018 earnings estimate and 18.7 times our 2019 earnings estimate. For some perspective, during the past five (ten) calendar years, the shares have traded at an average of 20.0 (20.8) times trailing earnings.

We recently added BlackRock to our Best Ideas list, noting its discount to our fair value estimate as well as the fact that the market tends to reward both organic growth and operating profits in the U.S.-based asset managers. This explains why BlackRock (generating a 3.3% CAGR for organic growth, with a 3.3% standard deviation, during 2008-17 with operating margins averaging 36.2% annually and reaching 38.6% during 2017) and wide-moat-rated T. Rowe Price (with a 2.6% CAGR for organic growth, with a 3.3% standard deviation, the past 10 years and annual operating margins of 43.6% on average, closing out 2017 with margins at 44.2%) have tended to trade at a premium to the group.

As a reference point, the group of 12 U.S.-based asset managers we cover had an average annual organic growth rate of 0.8% during 2008-17, with a standard deviation of 6.2%, and operating margins of 27.4% on average the past 10 years. Our expectation is that BlackRock will continue to generate above-average organic growth (3.0% annually during 2018-22, with a standard deviation of 1.9%), with operating margins of 39%-40% on average the next five years, a period that includes a 20% decline in equity market values midway through our projection period.