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Morningstar | Outflows Continue to Mar Waddell & Reed's Results in 3Q; No Change to $20 FVE

There was little in no-moat-rated Waddell & Reed's third-quarter results that would alter our long-term view of the firm. We are leaving our $20 fair value estimate in place. The company closed out the September quarter with $79.5 billion in assets under management, up 1.1% sequentially but down 1.7% year over year. Net outflows of $2.0 billion continued the trend of improving organic growth (which had been interrupted during the second quarter), but the firm remains a long way away from generating positive organic growth. Given the weakness in the equity markets since the start of the fourth quarter, with a lot of investors looking to derisk their portfolios in a bull market that seems to be on its last legs, we think it will be difficult for Waddell & Reed to generate positive organic AUM growth the next several years (a period where we also forecast a bear-market decline).

Despite average AUM being down 1.3% year over year and the company seeing a decline in its overall realization rate (from 0.667% to 0.651%), higher underwriting and distribution fees year over year allowed the firm to produce a 2.0% increase in third-quarter revenue. Year-to-date top-line growth of 2.9% was above our forecast for flat revenue growth this year, but given the movement of equity markets so far during the fourth quarter, as well as ongoing fee compression, we're sticking with our forecast. Adjusted operating margins of 20.1% represented a 165-basis-point improvement over the first nine months of 2017, but given our longer-term forecast for not only fee and margin compression (as active managers like Waddell & Reed need to narrow the fee gap with low-cost passive products while spending more to enhance investment performance and distribution) but also a 20% decline in the equity markets midway through our five-year forecast period, this may prove to be a high point for profitability.