VIRTUS INVESTMENT PTNRS INC VRTS
November 12, 2015 - 1:21pm EST by
shays
2015 2016
Price: 125.00 EPS 7.79 7.88
Shares Out. (in M): 9 P/E 9.4 9.0
Market Cap (in $M): 1,122 P/FCF 8.3 7.9
Net Debt (in $M): -445 EBIT 120 117
TEV ($): 677 TEV/EBIT 5.6 5.8

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Description

VRTS is a multi-boutique, multi-strategy asset manager that provides actively managed mutual funds to retail investors. Its core business is a recurring revenue, fee-based, capital lite business that has one of the best track records of growth within the asset management industry.  We believe VRTS is misunderstood by the market primarily for two reasons: 1) accounting complexity associated with its seeding program obscures the free cash flow generating capability of the core business; and 2) the company’s flows have been temporarily distorted by one family of funds shrinking significantly, a situation we believe will end in the near term.  We believe the shares could be worth ~$227 by the end of 2017, representing ~85% upside from the recent share price of $123.

Investment Thesis  

Fee-Based, Capital-Lite Business

VRTS offers actively managed investment strategies from a collection of internal affiliates and external subadvisors. It has been one of the fastest growing asset managers since the financial crisis, growing its assets under management (AUM) at a ~12% compound annual growth rate between 2009 and September 30, 2015, with the growth equally balanced between net inflows and market performance.

VRTS wholesalers are among the most productive in the industry due to strong, long-term relationships with financial advisors (its wholesalers have historically generated 30% more gross sales than industry peers).  VRTS has $48bn of AUM, which is comprised of ~60% equity, ~30% fixed income, and ~10% alternatives. By product category, AUM is comprised of ~60% open-end mutual funds, ~13% closed-end mutual funds, ~14% separately managed accounts, and ~11% institutional products.

Seeding Program Creates Accounting Complexity

Three years ago, VRTS significantly increased its practice of seeding new funds using capital from its balance sheet.  Due to this practice, VRTS has accumulated a significant amount of cash and investments. The company now has on its balance sheet no debt, and approximately $450 million of cash and investments, representing roughly 40% of its market capitalization today.

Seed investments also create complex accounting that obscures the free cash flow generation of the company.  Accounting rules require VRTS to consolidate its seed funds in their early years (when VRTS’ capital > 50% of the fund’s AUM).  As a result, investment purchases and sales of the seed funds are reported in cash flow from operations on VRTS’ cash flow statement, optically depressing VRTS’ reported free cash flow significantly. 

For example, in 2014, VRTS’ reported cash from operations was negative ($59) million, and free cash flow after ($2) million of capital expenditures appeared to be negative ($61) million.  However, when adjusting for purchases and sales of securities by VRTS’ seed funds, VRTS’ actual operating cash flow was $114 million, and free cash flow after ($2) million of capital expenditures was $112 million, which represents 11% of VRTS’ market capitalization today, or 19% of VRTS’ enterprise value when crediting the company for its cash and investments.

Flows Have Been Temporarily Distorted; We Believe The End is Near

In August, 2014, a third-party quantitative manager (“F-Squared”) that was sub-advising five funds (“AlphaSector”) for VRTS, received a Wells notice from the SEC for marketing back-tested results as actual performance.  VRTS subsequently terminated the relationship with F-Squared, but has seen significant outflows from these strategies.

While VRTS as a whole has seen net outflows for the past year, these outflows have been more than entirely attributable to Alphasector. VRTS’ funds excluding Alphasector have actually seen strong relative flows and performance.

Our view is that Alphasector is now a small enough portion of VRTS’ AUM that it can no longer affect VRTS’ total flows as significantly (now down to ~$3bn out of ~$48bn total AUM), and it is only a matter of time before VRTS’ total flows turn positive again. When that happens, we believe it could provide a catalyst for VRTS shares to re-rate.

We do not believe the F-Squared issues have meaningfully damaged VRTS’ relationships with financial advisors. We commissioned a survey of 127 financial advisors who responded that any SEC fine would have minimal impact on their desire or intention to offer VRTS products in the future. In addition, many of the survey participants expressed positive views of VRTS.  This survey, combined with the continued organic growth of non-AlphaSector funds over the past few quarters, reinforces our view that VRTS’ franchise is durable, valuable, and is likely to return to growth in the near term as the AlphaSector funds continue to become less and less meaningful to the company.

Furthermore, even if VRTS were to immediately lose all earnings and AUM attributable to AlphaSector, VRTS still trades at ~5.8x LTM EBITDA, an inexpensive valuation on both a relative and absolute basis.

 

The SEC does have an ongoing investigation into VRTS related to AlphaSector, but we believe any fine the company faces is likely to be manageable. F-Squared itself was fined $35 million, and we believe it highly unlikely that VRTS would be fined more than F-Squared, given that F-Squared committed the primary fraud.  On its Q3 earnings report, VRTS disclosed that it has reached an agreement “in principle” with the SEC to settle this matter. VRTS has reserved $11 million post-tax for the regulatory matter (and did not change the reserve when announcing it had reached the agreement with the SEC).  Given the late-stage nature of the negotiations, we expect this issue to be resolved within the next few months, and we don’t anticipate the final fine being materially different from what VRTS previously reserved.

Attractive Valuation

Excluding cash and investments, VRTS trades at just 5.3x EBITDA, 5.5x EBITDA – CapEx, and 9.1x P/E on our 2015 estimates.  Many analysts value VRTS on a traditional P/E basis, giving the company no credit for its cash and investments.  VRTS is a significant outlier in its industry with ~40% of its market capitalization in net cash and investments (as opposed to ~6% of market capitalization for the average publicly traded asset manager).  As such, we view Enterprise Value / EBITDA as a more appropriate valuation metric for VRTS, as the net cash and investments distort traditional P/E-based valuation methodologies.

It’s also worth noting that the company is returning a significant amount of capital to shareholders. We estimate the company will return more than 12% of its enterprise value to shareholders this year, between dividends and share repurchases. At the company’s Q3 earnings report in October, VRTS announced a very large, incremental share repurchase authorization, and now has an outstanding authorization representing more than 20% of the company’s shares. The scale of this new share repurchase should help to highlight the value of VRTS’ balance sheet.

Prior to the F-Squared Wells Notice, VRTS traded at ~9x forward EBITDA. As some of the dynamics we have identified play out (i.e., flows turning positive again, final resolution of the SEC investigation, share repurchases), the shares could return to their prior ~9x EBITDA valuation (~9x EBIT, as there is negligible capex in the business). This is a discount to VRTS’ longer-term historical average multiple of 10x – 12x EBITDA. 

At 9x forward EBITDA, we believe VRTS could be worth $227 per share by the end of 2017 on our estimates, representing ~85% upside and a ~33% multiyear IRR.

 

Conclusion

VRTS has a strong business that is profitable and growing. With the stock trading at 5.5x EV / EBITDA – CapEx, outflow issues at AlphaSector are more than priced in and have obscured healthy growth in VRTS’ other strategies. AlphaSector outflows will soon cease to be a headwind, and total AUM is well positioned to return to growth within the next few quarters. Regulatory issues with the SEC are likely to be resolved very soon with minimal monetary or long-term reputational damage.  The company has a significant amount of cash and investments on its balance sheet that is being ignored by analysts, continues to generate significant free cash flow, and is aggressively returning this cash to shareholders with a very large share repurchase program.  We believe that in the case of VRTS, misunderstandings over accounting complexity and a myopic focus on short-term flows are creating an extremely compelling opportunity to purchase a high quality asset manager at a significant discount to fair value.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Flow Inflection: As AlphaSector outflows decline, we estimate VRTS’ total AUM growth should turn positive again within the next few quarters, which could be a catalyst for re-rating

Accelerated Capital Return: With VRTS’ large new share repurchase authorization, we believe VRTS investors will begin to ascribe greater value to VRTS’ cash and investments

Regulatory Resolution: Final resolution of the outstanding SEC investigation will remove a key overhang on the stock. An announcement is likely to occur sometime in the next few months

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