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Morningstar | 1Q Market Rally Lifts T. Rowe Price's Near-Term Outlook; Increased FVE to $116 per Share

We've increased our fair value estimate for wide-moat-rated T. Rowe Price to $116 per share from $106 following slightly better first-quarter results than we were forecasting. T. Rowe Price closed out the March quarter with $1.082 trillion in managed assets, up 12.4% sequentially and 6.7% year over year, driven primarily by stronger equity markets. Net inflows of $5.4 billion were a marked recovery from the $8.4 billion in outflows that the company saw during the fourth quarter, as investors started moving off the sidelines after a volatile December quarter. Target-date funds continue to account for the bulk of T. Rowe Price's organic growth, generating $3.0 billion in positive flows during the first quarter (on par with the $2.6 billion quarterly run rate during the past decade).

While average AUM was up 1.8% year over year during the March quarter, T. Rowe Price reported a 0.1% decrease in revenue compared with the prior year's period, due to a 4.1% decline in administrative, distribution, and servicing fees, as well as a lowering of its overall effective fee rate to 0.464% from 0.471% during the first quarter of 2018. Our revised forecast for 2019-23, which includes a market correction midcycle, has T. Rowe Price generating low- to mid-single-digit AUM growth on average, with organic growth averaging close to 2% annually and revenue expanding at a positive 1.1% CAGR compared with a negative 0.3% CAGR previously.

As for profitability, adjusted operating margins of 40.1% during the first quarter were 385 basis points lower than 2018 levels, as compensation and other expenses expanded at a faster rate than revenue. That said, this was slightly better than our forecast of 38% to 40% for the year, and as a result we've increased our projections, with this year looking to be a year with margins of around 40%-41% and our five-year forecast calling for margins of 39%-41% on average.

For more details on our outlook for the U.S.-based asset managers, which includes a more in-depth look at our top two picks in the group, wide-moat-rated BlackRock and T. Rowe Price, please see "New Era for U.S. Asset Managers: Shifting Balance of Power With Distributors and End Clients Has Narrowed Moats of Most Firms," published March 15.

In an environment where active fund managers are under assault for poor relative performance and high fees, we believe T. Rowe Price is the best positioned among the U.S.-based active asset managers we cover. The biggest differentiators for the firm are the size and scale of its operations, the strength of its brands, its consistent track record of active fund outperformance, and reasonable fees. T. Rowe Price has historically had a stickier set of clients than its peers, as well, with two thirds of its assets under management derived from retirement-based accounts. At the end of March 2019, 68%, 79%, and 82% of the company's funds were beating peers on a three-, five-, and 10-year basis, respectively, with 60% of funds rated 4 or 5 stars by Morningstar during the past five years, better than just about every other U.S.-based asset manager. T. Rowe Price also had a much stronger Morningstar Success Ratio--which evaluates whether a firm's open-end funds deliver sustainable, peer-beating returns over longer periods--giving it an additional leg up.

While T. Rowe Price will face headwinds in the near to medium term as baby boomer rollovers affect organic growth in the defined-contribution channel, we think the firm, and defined-contribution plans in general, have a compelling cost and service argument to make to pending retirees, which should mitigate some of the impact as they work more closely with these end clients. We also believe T. Rowe Price is uniquely positioned among the firms we cover (as well as the broader universe of active asset managers) to pick up business in the retail-advised channel--an area of the market the company has not focused too heavily on in the past--given the solid long-term performance of its funds and reasonableness of its fees, exemplified by deals during the past two years with Fidelity Investments' FundsNetwork and Schwab's Mutual Fund OneSource platform.

While the firm is currently trading at a premium to the group of 12 U.S.-based asset managers we cover, the shares are slightly undervalued relative to our $116 per share fair value estimate. The market tends to reward both organic growth and operating profits in the U.S.-based asset managers, which explains why T. Rowe Price (with a 2.3% CAGR for organic growth, with a 3.3% standard deviation, the past 10 years and annual operating margins of 44.0% on average) and wide-moat-rated BlackRock (generating a 3.6% compound annual growth rate for organic growth, with a 3.1% standard deviation, during 2009-18 with operating margins averaging 37.4% annually) have tended to trade at premiums 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 0.9% during 2009-18, with a standard deviation of 7.6%, and operating margins of 29.6% on average annually.

With T. Rowe Price likely to generate low- to mid-single-digit AUM growth on average going forward (driven by 1%-3% annual organic growth in a forecast period that includes a 10%-plus decline for equity markets), we see top-line growth expanding in low- to mid-single-digit range annually in most years, with operating margins of 39%-41% on average. Our fair value estimate implies a price/earnings multiple of 16.0 times our 2019 earnings estimate and 15.7 times our 2020 earnings estimate. For some perspective, during the past five (10) calendar years, T. Rowe Price's shares have traded at an average of 16.3 (20.1) times trailing earnings.