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Morningstar | Invesco's Purchase of OppenheimerFunds Will Enhance Its Scale, but the Price Tag Concerns Us. See Updated Analyst Note from 24 Oct 2018

We reduce our fair value estimate for narrow-moat Invesco to $28 per share from $35 after updating our assumptions about the company's assets under management, organic growth, revenue, and profitability following its announced purchase of OppenheimerFunds. While the combination, which will add higher-fee-generating AUM and the potential for some cost savings via the elimination of expense redundancies, looks additive to the firm's efforts, the issuance of 81.9 million shares of common stock (equivalent to 20% of Invesco's outstanding shares at the end of the second quarter) and $4 billion of 5.9% preferred stock to fund the deal leaves us less enthused. Our main concern is that Invesco is using its own undervalued shares--trading at less than 8 times this year's consensus earnings and less than 9 times our rolling estimate of EV/EBITDA--to pay a premium for assets that don't seem to offer much of the scale advantages we'd expect to see from a deal of this size.

Investors reward two things in U.S.-based asset managers--organic growth and above-average profitability levels--with Invesco historically falling short in one of these categories. During the past five (10) calendar years, its organic growth rate averaged 1.8% (1.7%) with a standard deviation of 1.6% (3.1%), making it one of the better AUM growers (with one of the lowest standard deviations) among the 12 asset managers we cover. Where the company has come up short has been on the profitability front, with Invesco's GAAP operating margins of 25.0% (22.6%) during the past five (10) calendar years below the group average of 29.9% (27.4%). While we expect the Oppenheimer deal to keep the firm's margins from deteriorating too much in the face of industrywide fee compression, as well as rising costs associated with improving investment performance and enhancing product distribution, it will lead to a weaker organic growth profile than we've been projecting for a stand-alone Invesco in the near to medium term.

Invesco's announcement on Oct. 18 that it had agreed to acquire OppenheimerFunds, a predominantly active equity manager (with a focus on global and international equity investing), has raised questions about what the deal means not only for the firm but for the future of active managers, which are currently facing stiff headwinds from the growth of passive investments to increased scrutiny over investment performance and management fees and greater regulatory oversight. The deal itself fits with our longer-term thesis for the asset-management industry, which calls for industry consolidation in the face of fee pressures (owing to the disparity that exists between management fees on actively managed funds and those charges by passively managed index funds and ETFs) and rising costs (as the industry has to spend more not only to improve investment performance, but also to cover some of the expenses associated with research and portfolio management and retail distribution that had historically been covered by retail investors).

[For more details on our views on industry consolidation, as well as the secular headwinds facing the U.S.-based asset managers, please see our report, "U.S. Asset Managers Still Facing a Difficult Future," published in late February 2017.]

We expect the majority of the firms we cover to consolidate internally where it makes sense, increasing the scale of individual funds under the direction of solid active managers that are more likely to provide them with the best chance to keep fee cuts to a minimum while still gaining access to third-party platforms. This can be a double-edged sword, though, as funds tend to underperform the larger they get in size, so managing that differential will be critical to long-term success. As for external consolidation, we view most of our U.S.-based asset manager coverage as being buyers rather than sellers. Unlike past rounds of consolidation, though, which involved buying up managers to either fill in product sets or expand distribution reach, we expect future deals to be done more for scale than anything else. In these types of deals, we envision midtier asset managers (those with $250 billion–$750 billion in AUM) acquiring small to midsize firms (those with $25 billion–$250 billion in AUM), in order to increase the scale of their operations.

As long as these external deals are priced appropriately, and asset managers recognize that they could potentially lose 5%-15% of the acquired firm's AUM as they consolidate funds/portfolios into their own, deals like this should help offset some of the fee and margin compression we are forecasting longer term for the industry, with the margins for the acquiring firms more likely to revert to where they were prior to the deal once the initial boost to the company's top line wears off. As we noted when Janus Capital Group and Henderson Group announced their merger in October 2016, the cost synergies created by these types of deals are likely to be eaten up over the long run by the rising costs associated with running the business, with much of the cost savings from combined operations needing to be reinvested back into efforts to produce better investment results and enhance product distribution, which has thus far been the case with Janus Henderson.

Looking more closely at the Invesco-Oppenheimer deal, the combined firms would have just over $1.2 trillion in total AUM were they to be put together today, with 52% of managed assets dedicated to equities, 24% in fixed-income portfolios, 5% in balanced funds, 12% in alternative strategies, and 7% in money market funds. It would also be predominantly an active manager, with just 21% of AUM dedicated to passive strategies and ETFs. The combination will make Invesco the 13th-largest global asset manager (behind Goldman Sachs but ahead of Wellington Management) and the sixth-largest manager in the U.S. retail channel (with more than $650 billion in AUM); Vanguard ($4.8 trillion in retail channel AUM), Fidelity ($2.2 trillion), BlackRock ($1.9 trillion), American Funds ($1.8 trillion), and State Street/SSgA ($750 billion) were the five largest providers in the retail channel at the end of July 2018.

More importantly, Invesco will end up with top-10 fund offerings (on an AUM basis) in 10 of 15 different U.S. retail asset categories--U.S. Core Equity (eighth largest), U.S. Value Equity (eighth largest), Global Equity (third largest), International Equity (seventh largest), Emerging Market Equity (second largest), High-Yield Munis (second largest), Non-High-Yield Munis (seventh largest), Banks Loans (second largest), MLPs (largest by AUM), and Real Assets (eighth largest)--following the acquisition. The combination will also improve the overall positioning of the firm with the top 10 U.S. wealth managers, with its five largest relationships each holding more than $30 billion in client assets, and expand its product portfolio into higher demand, alpha-persistent AUM, including global, international, and emerging-market equity funds, as well as income-focused alternatives (like high-yield muni bond and bank loan strategies) that can capture both institutional and high-net-worth business.

While the acquisition does increase Invesco's exposure to active equities, increasing the amount of AUM the firm would have dedicated to actively managed equity strategies to 37% of managed assets (from 29% currently), Invesco is gaining a large collection of global, international, and emerging-market equity funds that tend to have better performance profiles and are currently facing less fee compression (despite charging higher fees than U.S. equity funds on average). For some perspective, close to two thirds of Oppenheimer's equity AUM (and 47% of its managed assets overall) come from global, international, and emerging-market equity funds, while just 10% of Invesco's equity AUM (and 6% of its managed assets overall) are dedicated to foreign-stock-focused funds. The two firms are strongly positioned in foreign equities as well, with 75% of Invesco's rated funds and 66% of Oppenheimer's funds being Morningstar Medalists (having been awarded a Bronze, Silver, or Gold medal by our fund analysts due to their belief that these funds will likely outperform their category peer groups and appropriate benchmarks on a risk-adjusted basis over the next five years).

Unfortunately, the absolute flows being generated by each firm's international equity funds during the past year (with Invesco at negative $2.6 billion and Oppenheimer at positive $2.4 billion since the end of September 2017) have not been enough to offset the outflows from their U.S. equity offerings (with Invesco bleeding $8.9 billion in AUM over the past year and Oppenheimer seeing $3.8 billion walk out the door). From a medalist perspective, Invesco had 45% of its rated U.S. equity funds with medals at the end of the third quarter, while Oppenheimer had just 43%. Even more damning is the relative performance of Invesco's U.S. equity fund AUM, with just 50% of its U.S. value funds beating their benchmark and their peer group on a three- and five-year basis at the end of September 2018; just 40% of its U.S. growth equity AUM ahead of the benchmark on a three- and five-year basis; 56% and 36%, respectively, beating peers over the same time frames at the end of the third quarter; and less than 15% of the firm's U.S. core equity funds beating either the benchmark or peer group at the end of September.

As such, it will be critically important for Invesco to retain as many of Oppenheimer's international portfolio managers and analysts as possible once the deal closes (given the stronger performance and flow contribution from these operations). That said, our North American manager research group has already raised concerns about the previously announced March 2019 departure of Rajeev Bhaman, who has run Oppenheimer Global (a $10-plus billion fund) since 2004, generating three-, five-, and 10-year annualized performance results of 14.0%, 9.8%, and 10.1%, respectively, at the end of September 2018, which outstripped not only the Morningstar world large-stock category (at 12.4%, 8.2%, and 8.3%) but also its benchmark, the MSCI All Country World Index ex USA (at 10.0%, 4.1%, and 5.1%). Thus, we want to make sure that his departure (while unrelated to the acquisition) is not the start of an exodus of talent.

For some perspective, after Invesco acquired the Van Kampen family of funds from Morgan Stanley in late 2009, the company quickly merged some of the redundant offerings that existed between the two fund firms (and rationalized some of its own funds as well), but still managed to retain most of the investment talent that was associated with the affected funds. That said, it is a completely different environment now than it was 10 years ago when Invesco was merging Van Kampen into its own operations, and we would expect a tighter labor market, as well as the pursuit of better performance by most asset managers (even if it means carving out teams from other shops), to challenge Invesco's retention rate, which has been about average relative to the rest of the industry the past five years.

Even though there is relatively little overlap among the U.S. equity fund offerings of both firms, we would be encouraged to see Invesco make an effort to shutter some of the underperforming offerings (where it makes sense), realizing of course that the best course of action may be to keep running these funds in what amounts to run-off mode, accepting the annual outflows as the price to be paid for garnering fees off an asset base that is likely to move with the U.S. equity markets. That said, some of these underperforming active equity funds could see 5%-10% annual reductions in management fee rates in each of the next five to 10 years, depending on where their management fees are relative to the median price point, so there will come a point at which fund consolidation will make even more sense for funds that are tangentially related in order to offset the fee and margin compression.

While we believe there are reasons to like the deal strategically, this does little to abate the challenges the two firms face in an industry that is facing stiff headwinds posed by the growth of passive investments, as well as increased scrutiny over investment performance and management fees and greater regulatory oversight, and a 10-year bull market that looks like it is running out of gas. Given these headwinds, we think that management's expectations for 1%-2% annual organic AUM growth following the combination may prove challenging. Prior to the deal, we were forecasting 0%-2% average annual organic AUM growth for Invesco on a stand-alone basis during 2018-22, but our attitude has changed following the company's third-quarter earnings, where Invesco put up a negative 5.3% annualized organic growth rate overall. This put a big damper in our organic growth forecast for 2018 of between 0% and negative 1%, which is now looking to be closer to negative 3% overall, with results for 2019-22 for Invesco now looking to be weaker than we had previously forecast.

Some of this is due to the deteriorating positioning of Invesco's domestic-equity funds, which will lead to a longer and larger extension of the outflows from the firm's equity operations than we had previously been forecasting, and some of it will be due to merger-related outflows following the Oppenheimer acquisition. On top of that, Invesco is basically doubling down on its commitment to active equities and the retail channel, the two areas of the market we expect to be pressured more by an increased focus on fees and investment performance in the near to medium term. As a result, we have moved our five-year CAGR for organic growth during 2018-22 from positive 0.5% to negative 1.5%, with the bulk of the outflows occurring during 2018-20 (with the last year of that period seeing a 20% decline in equity markets as well). While Invesco is "conservatively" predicting outflows of around $10 billion (or 4% of Oppenheimer's AUM) in the year following the close of the deal, our forecast is looking for something closer to 5% of acquired AUM being lost to merger-related outflows.

As for fee compression, we had previously forecast a 15% reduction in Invesco's annual realization rate from the end of 2017 to the end of 2022. We are now projecting only a 13% reduction, primarily due to the inclusion of some $250 billion in AUM generating fees of around 56 basis points relative to Invesco's overall fee rate of 47 basis points at the end of last year. We still believe that active asset managers that have greater scale, established brands, solid long-term fund performance, and reasonable fees, and which are perceived to be safer from a regulatory and legal standpoint, will have a leg up over their peers over the next five to 10 years. Part of that process will require managers to adjust their management fees annually in order to ensure that they are properly positioned relative to the median price point for the categories where they compete (assuming, of course, that their fund performance can justify the fees they are charging).

With very little overlap between the product offerings of the two organizations, we're left wondering where exactly management expects to derive its estimate of $475 million in annual cost synergies (which it expects to be fully realized in 2020). While management highlighted cost-cutting efforts, associated primarily with the streamlining of operational and technology platforms at the two firms, and increased scale advantages as being the drivers of these cost savings, we fail to see where much of this will come from. For some perspective, when Invesco acquired Morgan Stanley's retail fund operations back in 2009, this same management team was projecting $70 million worth of projected synergies (or around 3% of the combined expense base of the two firms) off of $119 billion in acquired AUM. In this deal, management is projecting close to 7 times more in projected synergies (equivalent to about 14% the combined expense base of Invesco and Oppenheimer) off of acquired AUM that is just over 2 times larger than the Van Kampen deal.

Our new fair value estimate of $28 per share assumes that the deal closes midway through 2019, adding around $250 billion to Invesco's AUM. We expect this deal to not only offset some of the fee compression we'd been forecasting for a stand-alone Invesco but to slightly enhance profit margins, given the infusion of higher-fee-generating AUM to the overall mix, as well as some cost savings coming to fruition. While we believe that the $475 million in annual cost synergies that management is forecasting are unlikely to be fully realized, we are still forecasting expense savings more on par with what the company had forecast for the Van Kampen deal (despite the lack of fund consolidation opportunities), which is producing more than half of the improvement in margins.

That said, by issuing 81.9 million shares of common stock (equivalent to 20% of Invesco's outstanding shares at the end of the second quarter), the deal is creating a fair amount of dilution for existing shareholders. Management is also taking on a longer-term dated obligation--$4 billion in perpetual, noncumulative preferred stock (with a 21-year noncall period--at a higher coupon rate (5.9%) than its existing long-term debt (with a weighted average coupon rate of 4.0%), most of which is due by the end of the first quarter of 2026. And at a purchase price of $5.7 billion overall, the acquisition of Oppenheimer seems to be a bit rich to us for a scale-driven deal that is unlikely to produce a lot of the scale-driven enhancements that we would expect from a deal of this size. The plus here is that Invesco's board has authorized a $1.2 billion share-repurchase program, with $400 million in buybacks likely to take place in the near term.

On a separate note, we find it interesting that Oppenheimer's reported $1.4 billion in annual revenue, and operating margins of 40%, works out to just under 10 times EBITDA (on an EV/EBITDA basis, assuming that Oppenheimer, much like other asset managers, has no more than 2% of revenue tied up in depreciation and amortization). This was in line with data from Sandler O'Neill and Partners, which at the end of 2017 showed that asset manager valuations in mergers and acquisitions remained around 10.0 times median run-rate EBITDA during 2017-17. If we were to assume GAAP operating margins of closer to 34% (more in line with comparable firms in our coverage), then the deal price works out closer to 11.5 times EBITDA, which is what this feels like to us.

We also don't take much encouragement from comments from management on the call about being "all of two hours into this," and needing to "work with our colleagues at Oppenheimer and over the next months [to] create a plan" when legitimate questions were raised about plans for some of the high-demand strategies, especially in the institutional channel. And when more than one analyst asked about how much of Oppenheimer's AUM and annual revenue is tied to MassMutual--which is not an out-of-bounds question, given that the French insurer AXA (through AXA Equitable Holdings) currently holds a 65% economic interest in AllianceBernstein, with AXA and its subsidiaries also being one of AB's largest clients, accounting for as much as 35% and 22% of institutional and retail AUM, respectively, and 28% of institutional client revenue and 4% of net retail revenue the past few years--to have management state "the level of detail that you're asking for now, we're not in a position to share that" is borderline unacceptable.