|Shares Out. (in M):||7||P/E||0||9.4|
|Market Cap (in $M):||776||P/FCF||0||0|
|Net Debt (in $M):||193||EBIT||0||146|
|TEV (in $M):||969||TEV/EBIT||0||6.6|
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VRTS is no stranger to VIC. However, since the last writeup, the company has made significant progress against its prior challenges, and last week closed a transformative merger which nearly doubles the firm’s AUM and EBITDA (post conservative cost synergies). The company also took out its 24% holder (BMO) at a bargain price, and in doing so reduced its excess cash position (for which the market gave the stock no credit). I will refer readers to former writeups and threads for more robust discussion of the business and its history. But here is a short refresher:
Having spun out of Phoenix Life in early 2009, this formerly captive asset manager flourished as it grew by selling various institutional asset management products through wirehouses and other channels. Retail distribution is their specialty, and they have accumulated a mix of managers across asset classes. Along the way, they caught some shooting stars, developing several $5-10+ billion products out of thin air. However, a quant strategy flamed out (AlphaSector) following the exposure of marketing improprieties committed by its sub-advisor, and an emerging markets juggernaut lost its star manager (Rajiv Jain). These setbacks precipitated an extended period of significant net outflows, and if one thing is clear, the market hates asset managers with outflows. VRTS bought back a significant amount of stock during the dark days as it continued to generate ample free cash flow and had no better use for it, substantially reducing shares outstanding from a peak over 9m in 2013 to just under 6m at the end of 2016.
Today, the AlphaSector debacle is behind the company, with most assets having left the building and the SEC investigation resolved. Meanwhile, fallout from the emerging markets funds in the wake of Jain’s departure to launch his own boutique has not been so bad, and flows have stabilized. In Q1, open-end flows were close to flat, and overall flows (including separate accounts, institutional, etc.) turned positive.
As a result, combined with favorable markets, standalone AUM has stabilized and begun to recover:
The previously underappreciated cash-rich balance sheet has been put to use through attractive share repurchases and the recent acquisition. And the recently closed merger with RidgeWorth Capital Management results in a scaled, diversified, tax-advantaged VRTS with much brighter prospects. As the market digests the pro forma numbers, I expect the stock to re-rate appropriately.
I will keep this brief. RidgeWorth seems highly complementary in terms of products (more diversification, and more products less likely to be threatened by the trend toward passive management) and sales channels (more institutional channel focus adds balance to VRTS’ retail channel expertise). Scale and manager diversification should also result in more efficient operations and less volatile flows, respectively. We no longer have managers overseeing a third of the company’s assets… historically a good problem to have as these managers had grown exponentially to become such a large piece of the pie, but nevertheless a situation that often led to volatile AUM and earnings. For a more detailed overview of the deal’s commercial logic, see this helpful presentation on the company’s IR site.
First we will examine how the capital structure has changed pro forma the merger. The company ended up financing the deal with a mix of debt, equity and mandatory convertible preferred (MCP) – roughly half debt, a quarter stock issued at $110, and a quarter preferred which mandatorily converts in 2020 between $110 and $132, depending on where the stock trades (and may be converted before then at $132). This was frustrating to those holders who would like to see a more ambitious capital structure – the company had arranged a credit facility which could have financed virtually the entire transaction – but they opted to go a more conservative route, which has always been their m.o. when it comes to capital structure. I count the preferred as debt for now as it is out of the money, and I deduct the 7.25% preferred dividend in cash (which is how the company has begun to satisfy the dividend, as opposed to letting it accumulate in principal) before arriving at earnings / free cash flow to common.
The current adjusted balance sheet looks something like this:
The income statement may look something like this, pro forma the merger:
Typically, the sell side has been slow to adjust numbers and models, and management seems to offer them limited assistance. There are several elements of the deal and recent financings that make the pro forma moderately tricky.
Key considerations in capital structure include how to treat the preferred (I leave it unconverted for now), and how to consider that while the final purchase price was reduced by $38m to account for client approvals not yet obtained on $3.75 billion in AUM, there was also a $21m increase in the fair market value of certain RidgeWorth investments. I assume that all client approvals are obtained within six months (causing the final $38m to be paid out ultimately), while treating the $21m adjustment for an increase in RidgeWorth’s investments at closing as a wash (neutral to cash and investments).
More importantly, impacting cash generation, as part of the transaction VRTS acquired $420m of intangible assets that it will amortize straight-line over 15 years. This $28m annual amortization is fully tax-deductible, providing a valuable tax shield going forward of almost $11m a year. I add back this non-cash amortization while retaining the tax benefit to show “cash” earnings. This hardly seems aggressive, but analysts so far are generally not highlighting VRTS’ true cash earnings power, if they are making adjustments for the merger at all. It should however become clear over the course of the year that VRTS is currently set to earn $11-12 a share in cash earnings, with potentially meaningful upside from (any) revenue synergies or additional cost synergies (initial estimate is unassuming given substantial duplicative corporate costs).
Ultimately, VRTS should trade at a much higher valuation. They are experiencing stable/positive AUM trends and can pursue significant potential revenue synergies, yet the company trades near the bottom of the barrel:
As the company’s new earnings power, scale and diversification become more apparent to the market over the coming year, I would expect VRTS to trade materially higher.
Another way to value VRTS is to consider its private market value in a SOTP valuation. It is worth noting that VRTS has $6.8 billion of closed-end funds. While fees are only a little above average, this is essentially permanent capital and deserves a much higher valuation. When asset managers are bought, they trade on EV/AUM. The ratio reflects quality of assets, fee profiles, diversification and growth potential. I think one can assume that VRTS would conservatively trade around 1.5% of AUM to reflect its pro forma mix of roughly 44% fixed income (including some more exotic stuff), 45% equities, and 11% alternatives and other (incl cash mgmt.) However, I would probably value the closed-end funds between 3-5%. Buyers also assign value to cash, investments and seed capital where the market may not. Here is what it looks like (with preferred now in the money):
If you don’t like splitting out the closed-end funds and think 1.0-2.0% for the whole firm is generous enough, then knock off about $19 / share at the midpoint. If you don’t like giving them value for the seed capital, then knock off another $15, but now you’re being unreasonably stingy. Seed investments may seem like working capital, but they are easily liquidated. The seed program drives growth in the business, but probably is not necessary for revenue maintenance, as VRTS is an attractive platform and has found new managers and products to replace dying products outside of the seed program. I think of the seed program as a place to park capital to drive growth. And if you choose the low end of the range (1% of AUM with no bump for closed-end assets), this is where distressed firms change hands. JNS was recently bought by Henderson for around 1.6% of AUM, and Janus had not exactly been killing it. But even at 1% of all AUM, and even with zero value for the seed capital, we are still north of $80. Seems like a very good risk/reward.
Main risks are market risk (obviously) and current, often justifiable trends toward passive management… and reliably terrible communication from management (who is actually fairly aligned and pro-shareholder, if conservative, in their decision-making). Both market risk and passive management risk are able to be hedged through shorting other asset managers (I don’t have any specific recommendations to share, but I would look for comparable asset classes and distribution channels). Frustrating management is more of an impediment than a risk, but it is harder to hedge and must be tolerated in order to own the stock. Their track record is much more impressive than anything they say, so I have chosen to follow their actions more closely than their words.
2017 - Market digests recently closed acquisition of RidgeWorth, and estimates begin to reflect new capital structure and earnings power.
2018-2019 - Management achieves some revenue synergies and grows the business.
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