|Shares Out. (in M):||54||P/E||0||0|
|Market Cap (in $M):||2,265||P/FCF||0||0|
|Net Debt (in $M):||-306||EBIT||0||0|
|Borrow Cost:||Tight 15-50% cost|
Financial Engines (FNGN) is a Registered Investment Advisor that focuses on the 401K market. The company has experienced tremendous growth over the past several years and operates a very scalable business model with very high returns on capital. However, I believe that the company will face headwinds going forward that will result in slower growth and cause pricing to eventually fall. I conservatively estimate that the stock is worth at most $29, for a 31% return versus the current price of $42.
Financial Engines operates as a Registered Investment Advisor and software platform that caters to the needs of 401K participants. The company partners with plan providers like Fidelity and Vanguard and then pitches large employers to offer services to their participant base. Plan participants are charged ~25 bps of AUM for an automated check-up and action plan, and for FNGN to execute on that action plan. Employers pay a fixed (recurring) platform fee to make the service available to employees.
FNGN offers four services:
· Professional Management. Discretionary managed account service. FNGN uses Monte Carlo simulation based on the participant’s answers to various questions along with the available funds within the plan to manage the retirement portfolio.
· Online Advice. Non-discretionary internet-based advice service designed for 401K participants who choose to actively manage their own portfolios.
· Retirement Evaluation. Periodic retirement readiness assessment.
· Social Security claiming guidance.
As of December 31, 2014, FNGN provides services to 602 plan sponsors and had $104.4 billion in assets under management ($894.9 billion in assets under contract).
FNGN operates a very scalable business model with compelling returns and incremental economics. The company essentially integrates with a plan provider, and then as employers want the service, they do some integration work and flip the switch to make it available to plan participants. Employers pay a platform fee in order to offer the service, and plan participants are either active or passive enrollees, as chosen by the employer.
Financial Engines has grown revenue 27% annually over the last five years and operating income 63% annually. The company’s operating margin has expanded from 6.3% in 2009 to 22.1% in 2014. Incremental operating margins are over 30%. Return on invested capital in 2014 was an outstanding 63.4% and should continue to grow. The company operates with no debt, has $300 million in cash on the balance sheet, and generated $60 million in free cash flow in 2014. The main revenue drivers are assets under management and the portfolio management fee. The main costs are salaries and benefits, R&D, marketing, and software development.
Despite this tremendous growth and compelling economics, I believe that the business faces several headwinds that will adversely affect growth and profitability going forward. FNGN operates in a huge market ($21 trillion in retirement assets) with lots of competition. FNGN’s biggest direct customers (plan providers) are also its biggest competitors. These customers have an incentive to push their own competing products, such as target date funds. FNGN generally acts as a sub advisor to the plan provider, so they have little direct contact with plan sponsors and participants. Organic growth of AUM (excluding market movement) has already decelerated from 25% in 2010 to 14% in 2014, and I expect this trend to continue.
Meanwhile, costs in the asset management industry are coming down quickly, with many index funds costing only a few basis points. Given the number of competitors and alternative products, I believe that FNGN’s Professional Management fees are likely to fall materially over time. Compounding this, as AUM grows, contracted thresholds trigger reductions in pricing. For similar reasons, I expect the fees that employers pay for access to the FNGN service to also decline, if not disappear entirely. The average platform fee per employer has already declined 26% since 2010. I can even imagine a scenario where FNGN has to pay employers for access to plan participants. It is unclear if FNGN would be able to reduce costs enough to offset these declines, as most of the costs are salary & benefits, marketing, and R&D.
FNGN currently trades at $42, ~58x LTM EPS and ~27x LTM EBITDA. My target price for FNGN is at most $29, ~31% below the current price. I arrive at this value using a 10-year DCF analysis.
AUM growth. FNGN has grown AUM 32.4% annually over the last five years. This has consisted of 20% annual organic growth and 12.5% annual market return. Organic growth has already begun to decelerate from 24.5% in 2010 to 14% in 2014. I assume that this trend continues and that organic growth averages 8.5% annually over the next ten years. I also assume that the long-term market return is 5% per year.
Professional management fees. Over the past five years, professional management fees have averaged slightly over 25 bps of AUM. Due to the headwinds mentioned earlier, I assume that fees decline gradually over the next ten years from 25 bps to 20 bps. This, combined with my AUM growth assumptions, results in professional management revenue growth of 11% annually over the next ten years versus 36% annually over the previous five years.
Platform fees. Sponsor growth has averaged 11% annually over the past five years and I assume this slows to 4.5% over the next ten years. Sponsor growth has already decelerated from 17% in 2009 to 9% in 2014. Meanwhile, platform fees have been shrinking from ~$77,000 in 2010 to ~$57,000 in 2014, or (7.5%) annually. I assume this trend continues over the next ten years due to the headwinds mentioned earlier. I think there is a very real possibility that platform fees ultimately go to zero. This results in platform revenue growth of (3%) annually over the next ten years versus 2% annual growth over the previous five years.
Total revenue. Total revenue has grown 27% annually over the past five years. My assumptions above result in total revenue growth of 10% annually for the next ten years.
Gross margin. Since 2006, gross margin has compressed from 67.5% to 60% in 2014. I assume that, given a flat fee structure, incremental gross margin is 60% going forward. However, the assumed fee compression discussed above results in gross margin compression to ~50% in 2024. This assumes that the company is unable to offset pricing reductions in the cost of sales line, as this is largely made up of salary and benefits.
Operating expenses. Operating expenses primarily consist of R&D, marketing, and G&A expenses. I assume that R&D expense remains constant at $30 million per year, marketing expense grows at half the rate of sales, and G&A expense gradually declines from 8% of revenue to 7% of revenue. This results in operating margin expansion of ~5% from 22% to 27% over the next ten years.
Free cash flow. As of December 31, 2014, the company had ~$163 million of federal NOLs and ~$59 million of state NOLs. FNGN has paid essentially zero cash taxes in the past, and I assume this continues for the next two years as the NOLs are exhausted. Following that, I assume the company pays taxes at a 35% rate. I also assume that capital expenditures remain flat at $10 million per year. These assumptions result in annual FCF growth of ~7% over the next ten years. I use a 10% discount rate and 3% terminal growth rate to arrive at my target price of $29.
Valuing the shares using both P/E and EV/EBITDA multiples yields similar results. At 15x my 2017 EPS estimate of $1.30, and adding the free cash flow generated over the next three years, the shares are worth $29. Similarly, at 8x my 2017 EBITDA estimate of ~$117 million, and adjusting for cash generated over that time, the shares are worth $27.
I think that upside risk is ~$50, for a reward/risk ratio of nearly 2x. If I assume that pricing remains steady at 25 bps, and that terminal free cash flow growth is 5%, the resulting DCF value is $50. 2017E EPS then becomes $1.50 and 2017E EBITDA becomes $132 million. At 20x and 12x, respectively, the shares would be worth ~$40.
Asset management stocks tend to trade on a percentage of AUM basis. With $104.4 billion in AUM as of December 31, 2014, FNGN currently trades at 2.2% of AUM. Peers currently trade between 0.9% and 7.9%, with an average of 2.9%. Excluding WETF, which has been growing AUM over 50% annually and earns an average fee of 50 bps on AUM, and BX, a best in class private equity manager, the group average is 2.0%. Given the headwinds mentioned throughout this report and the fact that FNGN acts as a sub advisor on a large majority of their business, I believe that the stock should trade below the group average. At 1% of 2017E AUM of $165 billion, the stock is worth $31. If it traded in line with the adjusted group average of 2% on 2017E AUM, the stock would be worth $60.
1. AUM growth accelerates. While organic AUM growth has already started to decelerate, as 401K plan participants gain greater awareness of these types of services, AUM growth could reaccelerate. The company has only penetrated ~12% of their assets under contract.
2. Strong market returns. Above average market returns will temporarily inflate AUM, causing the company to temporarily over-earn, and the market may apply a very high multiple to these earnings. Conversely, a down year in the equity markets will not only shrink AUM, and therefore portfolio management fees, but a sharp downturn could lead to 401K participants going to cash and withdrawing from FNGN’s portfolio management service.
3. Pricing holds steady. There is no evidence that pricing is falling and could hold steady despite competition and contracted price cuts.
4. The company is acquired. The company could be acquired by any of the large 401K plan providers as a way of differentiating their offering.
While FNGN operates an attractive business model with very high returns on capital, I believe the company will face headwinds going forward that will cause AUM and revenue growth to slow and results to fall short of investor expectations. I think the shares are worth at most $29 based on a 10-year DCF analysis, or a 31% return on the current price of $42, with additional downside if pricing or platform fees decline more than I assume, or the overall market declines significantly. With upside risk of $50 (18.5% loss), shorting FNGN offers a reward-to-risk ratio of nearly 2-to-1.