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Morningstar | More Volatile Equity Markets Lead to Mixed Results in T. Rowe Price's 2Q; No Change to FVE

There was little in wide-moat-rated T. Rowe Price's second-quarter results that would alter our long-term view of the firm, and we are leaving our $116 fair value estimate in place. T. Rowe Price closed out the June quarter with a record $1.125 trillion in managed assets, up 4.0% sequentially and 7.7% year over year, despite more volatile equity markets. Net inflows of $2.5 billion would likely have been better had the equity markets not sold off in May, but they were still on par with the $2.3 billion quarterly run rate we've seen for flows at T. Rowe Price since the end of the 2008-09 financial crisis. Target-date funds continue to generate the bulk of the firm's organic growth, bringing in another $1.6 billion during the second quarter.

While average AUM was up 6.1% year over year during the June quarter, T. Rowe Price reported a 3.7% increase in revenue compared with the prior year's period, due to a 4.3% decline in administrative, distribution, and servicing fees, as well as a lowering of its overall effective fee rate to 0.462% from 0.469% during the second quarter of 2018. First-half revenue growth of 1.9% was in line with our call for low- to mid-single-digit top-line growth in 2019, driven by the equity market recovery during the first half, as well as easier comparables in the back half of the year.

As for profitability, adjusted operating margins of 42.2% during the first half of 2019 were 195 basis points lower than 2018 levels, as compensation and other expenses expanded at a much faster rate than revenue. While this was slightly better than our full-year forecast calling for operating margins of around 40%-41%, we'll hold back on altering our projections as the firm continues to make upfront investments in key regions and channels to help drive growth (and is likely to take advantage of the better margin picture to make additional investments).

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 out-performance, 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 June 2019, 69%, 80%, and 78% of the company's funds were beating peers on a three-, five-, and 10-year basis, respectively, with 86% of funds rated 4 or 5 stars by Morningstar, better than just about every publicly traded (and privately held) U.S.-based asset manager we cover. T. Rowe Price also maintained 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 over many of its peers.

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 (15%-20%) to the group of 12 U.S.-based asset managers we cover, the shares are only slightly undervalued (5%) 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, 3.3% standard deviation over the past 10 calendar 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 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 40%-42% on average. Our fair value estimate implies a price/earnings multiple of 15.0 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.