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Morningstar | Weak Flows and Adverse Currency Overshadow Invesco's 2Q Results; Lowering FVE to $38 per Share

We've lowered our fair value estimate for narrow-moat Invesco to $38 per share from $40 after updating our assumptions about assets under management, revenue, and profitability following the release of second-quarter results. The company closed out the June quarter with $963.3 billion in managed assets, up 12.2% year over year and 3.1% sequentially. Excluding the impact of the Guggenheim and Source acquisitions, which added $26.0 billion and $38.2 billion in ETF AUM in the third quarter of 2017 and second quarter of 2018, respectively, the firm's managed assets were up 4.8% compared with the second quarter of 2017 and up 0.3% sequentially.

Net long-term outflows of $6.5 billion were better than our forecast for $8.5 billion in net redemptions, but adverse currency exchange decreased total AUM by $13.8 billion, which was worse than our forecast for the period. Equity outflows of $6.0 billion during the second quarter, and talk of more outflows to come, have led us to stretch out the recovery in the firm's equity flow recovery story, increasing the likelihood that organic growth will be more flattish to slightly negative this year and next as opposed to slightly positive, leaving average annual organic growth during 2018-22 closer to the lower end (as opposed to the midpoint) of our 1%-2% five-year forecast.

With average long-term AUM up 10.2% year over year and the firm's realization rate (on a GAAP basis) declining to 0.432% from 0.476% in the prior year's period, the company reported a 4.0% increase in second-quarter management fee revenue and an 8.5% increase in total revenue, aided largely by an uptick in other revenue. First-half top-line growth of 11% is well above our forecast for mid- to high-single-digit revenue growth this year. As for profitability, adjusted GAAP operating margins of 24.0% during the first six months of 2018 were 190 basis points lower year over year, at the lower end of our forecast range of 24%-26% for the year.

As we've noted on several occasions since the start of the year, the market tends to reward organic growth and operating profitability, which explains why BlackRock, with a projected 4.4% annualized rate of organic growth during 2018-22 and operating margins of 40% on average the next five years (relative to the rest of the U.S.-based asset managers we cover at around 30%), and T. Rowe Price, with a projected 2.0% annualized rate of organic growth and operating margins of 44% on average over the next five years, have historically traded at 15%-plus premiums to the group. The flip side to all of this is that the market punishes firms that fail to live up to organic growth and profitability expectations, which is some of what we've seen with Invesco this year.

On the organic growth front, Invesco had generated a 1.8% annualized rate of organic growth during 2013-17, with a standard deviation of 1.6% around those results. Only BlackRock (1.5%) and T. Rowe Price (1.4%) have had lower standard deviations around their organic growth the past five years. So, for Invesco, which we continue to believe will generate 1%-2% annual organic growth over our forecast period, to put up a negative 0.3% annualized rate of organic growth during the first half of the year has been frustrating (especially since it looks like things might not improve all that much in the back half of the year). That said, we're still forecasting total end-of-year AUM of between $900 billion and $1.1 trillion, with the lift Invesco should have gotten from the inclusion of Guggenheim's ETF operations in its AUM this year being washed out by weaker markets and organic growth, as well as adverse currency.

During the second-quarter conference call, management once again touched on the trajectory of is revenue yield, which will be affected by both industrywide fee compression pressures (which will mainly affect large-cap active equity offerings) and shifting product mix (as the growth rates for lower-fee-generating AUM, like ETFs and other passive products, are significantly higher than other product sets), noting that the back half of 2018 will likely be in a 39.5-basis-point to 40-basis-point range (down from 40 basis points previously), with 2019 looking to be closer to 39 basis points on average. We were already at those levels and lower in our forecast for this year and next, which we've gone and notched down once again (preferring to stay on a more conservative tack than management), which ultimately leaves us at the bottom end of the range for forecast revenue and earnings.

We tend not to talk too much about Invesco's net revenue yield, which is based on non-GAAP financials, preferring to stick with its realization rate, which is basically the annualized result of the management fees the firm earns in each period divided by its average AUM. The realization rate we use tends to be higher because the management fees we are using include distribution and servicing costs, as well as some other adjustments that Invesco makes to its top line, but ultimately ends up being more comparable with other firms. During the past five calendar years, Invesco's realization rate averaged 0.494% (or 49 basis points) and was 0.472% (or 47 basis points) during 2017. Compare this with the company's average net revenue yield of 0.436% during 2013-17 and 0.416% during 2017.

At the start of the year, we had revised our forecast for the company's realization rate to 0.449%, down 4.8% from 2017, which inferred a net revenue yield of 40 basis points (below management's guidance for 41 basis points during 2018). After Invesco updated its full-year forecast to 40 basis points (during the company's first-quarter earnings conference call) we notched our forecast down once more, with our realization rate expectations for 2018 moving to 0.445%, which implies a net revenue yield of 39.5 basis points, equivalent to a 5.5%-6.0% decline in fee rates. Following Invesco's second-quarter earnings conference call, we have taken the realization rate for 2018 down to 0.4425% (with a net revenue yield of 39 basis points), and currently have 2019 at 0.426% (with a net revenue yield of 38 basis points), so continue to stay ahead of management on fee rates.

What gets lost sometimes in this discussion is the fact that Invesco's fee compression is a function of two different issues: (industrywide fee compression pressures and shifting product mix. As to the former, the company has control over where and when it initiates fee cuts, with much of what we have seen the past several years affecting large-cap active equity offerings, which are far more exposed to the growth of low-cost index-based passive products--namely, index funds and ETFs. That said, reductions to fees in areas where there is greater competitive pressure have been measured (as there is no point in cutting fees dramatically and not gaining additional flows), but the downside remains that cuts to higher-fee-generating active funds can have a greater impact on profit margins.

It should be noted, though, that a far greater proportion of the shift in the company's realization rate lately has been a function of shifting product mix, with greater growth of low-cost passive and other offerings driving down the firm's net revenue yield, while at the same time having a neutral to positive effect on margins (especially as the firm garners greater scale in these lower-fee-generating products). While it is true that operating margins are down this year, a lot of that is coming from higher distribution and other costs, much of which can be tied to the deals it's done this past year. Our current forecast has margins coming in at the lower end of our forecast range of 24%-26% during 2018, but then improving gradually to 25%-27% as the firm continues to scale up in lower-fee-generating products that come with significantly lower cost profiles.

From a valuation perspective, we continue to like Best Idea Invesco on both a price/earnings and price/fair value basis. The company is currently trading at 9.4 times and 8.7 times (and 9.8 times and 9.2 times our own earnings estimates) the consensus earnings estimates for this year and next, respectively, well below the group at 12.4 times and 11.6 times. During the past five (10) calendar years, Invesco's shares have traded at an average of 15.8 (16.7) times trailing earnings, and a slight discount to the group. Our revised fair value estimate of $38 per share, which is equivalent to a price/fair-value multiple of 0.68 times, implies a price/earnings multiple of 14.4 times our 2018 earnings estimate and 13.5 times our 2019 earnings estimate, with the group as a whole trading at a slight premium to Invesco's shares.