|Shares Out. (in M):||150||P/E||0.0x||0.0x|
|Market Cap (in $M):||6,070||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||960||EBIT||0||0|
Oaktree Capital Management (Oak) was previously written up by trev62 on December 2010. Share price was $36 then and the fact that shares were not listed on major exchanges was identified as main reason for mispricing. Oak had an IPO last month and shares are now trading on NYSE. What's the current price? $35.49. I believe this is an opportunity to buy a great business at great price (adjusted P/E about 9).
I will be brief here. Oak is a LA-based asset manager led by Howard Marks and Bruce Karsh. The company currently manages about $76 billion in assets across various funds and strategies, but with a focus on distressed debt. Howard Marks is one of the all-time greats in value investing. The company's past performances have been truly outstanding.
Some Clarifications and Assumptions:
Bear case: the scenario that AUM declines significantly from the current level
Base case: the scenario that AUM stays at current level
Bull case: the scenario that AUM grows meaningfully
AUM almost doubled since 2007
Assuming 30% effective tax rate, it was 26% for 2011
150 million shares to share economic interests
The industry average P/E is about 13
Oak generates revenue from three sources: management fees, incentive income and investment income. Management fees are calculated as a fixed percentage of the capital commitments or NAV of a particular fund. Incentive income is typically 20% of the investors' profits in certain funds, subject to applicable hurdle rates or high-water marks. Investment income is return on the company's own investments in various funds.
The company has been consistently profitable, with positive Adjusted Net Income for the last 16 years and 63 of the last 64 quarters (the exception being a segment loss of $6.9 million in the fourth quarter of 2008).
Management fee income:
As of December 31, 2011, OAK has management fee-generating AUM of $67 billion. The weighted average annual management fee rate is 1.11%.
The Fee Related Earnings for the past five years were:
5-year average is $271 million, 3-year average $326 million.
Bear case: use 5-year average number
$271 million is about $1.26 per share after tax, since management fee is quite stable, I assign a 15x multiple to it, so $18.97
Base case: use 3-year average number
$326 million is $1.52 per share after tax, give it 15x we get $22.82
Investments or Investment Income:
Current book value is $7.44 per share and the company has about $1 billion of its own capital invested in various partnerships.
There are two ways of evaluating this. The first approach is to simply deduct excessive cash and investments. I would argue this is conservative since managing by Oak, those investments will likely generate satisfactory returns over time. So the second approach is to treat company’s own investments as AUM, which generates no management fee but we shareholders get all investment returns. (actually shareholders own the investment principle as well, but since we are focusing on the earning power of the investments, to be conservative, I will ignore it for now)
Bear case: simply deduct excessive cash and investments
we need to make some adjustments since part of the book value might be used to run the business. To be conservative, cash and cash equivalents are discounted at 50%.
|50% of Cash and cash equivalents:||$149|
|U.S. Treasury and government agency securities:||$382|
|Investments in limited partnerships at equity:||$1,159|
|Total investments and cash:||$1,690|
|Net cash and investments:||$730|
With 150 million shares outstanding, this is about $4.87/share.
Base case: evaluate the earning power of these investments
I assume an annual return of 15% on these investments. I think this is reasonable since the company will probably invest its own capital only in the most profitable opportunities. With 15% rate of return, $1.16 billion invested will generate per share earning of $0.81 after tax. Use 12x multiple we get $9.72/share
Incentive fee income:
Incentive fee is generally 20% of profits (8% hurdle rate) and 40% to 55% of that is allocated to incentive fee-linked bonuses.
Bear case: use average incentive fee income for the past five years:
net of incentive compensation (mn)
2007 $332 $254
2008 $174 $109
2009 $175 $109
2010 $413 $254
2011 $304 $125
Average: $280 $170
Per share incentive fee earning is about $0.79 after tax, with 12x multiple we have $9.51
I would argue the bear case is conservative since for the past five years incentive creating AUM has grown from $15 billion in 2007 to $36 billion.
Base case: assume incentive generating AUM stays at the current level
We have to make some assumptions about future investment returns. Oak’s biggest strategy, distressed debt, has net IRR of 19% since 1988. The next two big strategies, private equity and US high yield, have average returns of 12% and 10% since 1994 and 1986. So I am comfortable to assume average return of 12% going forward.
|Incentive fee generating AUM:||$36 billion|
|Average annual return:||12%|
|Profit generated:||$4.32 billion|
|Incentive generated (20%):||$864 million|
|Incentive income after compensation:||$432 million|
|Incentive income per share after tax:||$2.02|
Sum of parts:
|Bear Case||Base Case|
|Management fee income||$18.97||$22.82|
|Sum of parts||$33.35||$56.74|
Oak also has $1.7 billion of “accrued incentives” ($1 billion after incentive related compensation). This is due to Oak's conservative accounting method. Unlike its peers, Oak only recognizes its incentive fees as actual earnings when capital is returned to investors at the end of a fund's life.
Since most of these accrued incentives will be realized over time, to avoid double counting, I did not include them in my calculations. The value of these accrued incentives will be reflected in the future incentive earnings.
Growth and New Opportunities
The bull case of this investment depends on two things: Oak continues to grow its AUM and Oak captures new distress opportunities in Europe and also some sectors of the US economy such as real estate.
Oak has a great asset raising track record (it's worst year ever being its first, when it "only" brought in $2.4B in 1995). AUM grew to $74.9 billion as of December 31, 2011 from $17.9 billion as of December 31, 2000 (CAGR of 13.9%). Over the same period, the portion of AUM that generates management fees grew from $16.7 billion to $67.0 billion, and the portion of AUM that potentially generates incentive income increased from $6.7 billion to $36.2 billion.
Given the operating leverage inherent in asset managers, Oak's long-term earning potential is substantial if it can continue to raise assets and generate strong returns.
Oak has an impressive roster of deep pocketed clients. It manages assets on behalf of many of the most significant institutional investors in the world, including 73 of the 100 largest U.S. pension plans, 39 states in the United States, over 350 corporations, over 300 university, charitable and other endowments and foundations, and over 150 non-U.S. institutional investors, including six of the top 10 sovereign wealth fund nations. As trev62 mentioned in his writeup, funds tend to flow to the largest managers since nobody gets fired for buying “IBM”.
Not only can Oak raise capital, it can raise capital in bad times when others cannot. It brought in between $12-$19 billion/year in 2007, 2008, and 2009. This counter-cyclical feature is very valuable, especially when Europe and many other major economies are in trouble. If/When things blow up, we will have Howard Marks acting on our behalf and taking advantage of the situation.
Management and Major Shareholders
Management and insiders still own approximately 70% of the equity interests and they also have full control of the company via Class B units. This does not bother me too much since as one of the best value investors ever, Howard Marks will most likely treat his shareholders fairly and make smart capital allocation decisions. The company currently pays dividend (6% yield).
A number of prominent funds are shareholders: Maverick Capital, Greenlight Capital, David Funds, just to name a few.
Performance deteriorates as AUM grows: This will happen at some point but I am less concerned now. On the contrary, I think the ongoing mess in Europe offers great opportunities in the next couple of years.
There are no clear catalysts. But I think the management will take proper actions if the share price is too far from intrinsic value.