BlackRock Continues to Impress

We continue to be impressed by

BlackRock's BLK ability to generate solid organic growth, especially considering the size of its operations. With $5.148 trillion in total assets under management at the end of 2016, BlackRock is the largest asset manager in the world. Unlike many of its peers, BlackRock is generating organic growth in its operations with its iShares platform, which is the leading domestic and global provider of exchange-traded funds, riding a secular trend toward passively managed products that began more than two decades ago. We recently increased our fair value estimate to $410 per share from $385 to reflect changes in our assumptions about AUM, revenue, and profitability since our last update.

BlackRock generated $141 billion in investor inflows with its iShares operations during 2016, better than closest rival Vanguard ($102 billion in inflows), marking the third straight year that iShares has captured the largest share (35%) of the organic growth generated by the ETF industry. With iShares, BlackRock has a platform that is growing organically at a high-single- to double-digit rate annually, compared with index funds growing at a high-single-digit rate and actively managed funds declining at a low-single-digit rate on average the past five years. This has helped the firm to maintain average annual organic growth of 3%-4% despite the ever increasing size and scale of its operations.

The firm could actually augment this organic AUM growth and improve top-line growth if its actively managed fixed-income and equity platforms--both of which generate higher fees than its passive offerings--outperformed on a more consistent basis. The company is already reaping some reward from the improved positioning of its fixed-income platform (with 78% and 88% of BlackRock's actively managed taxable bond funds beating their benchmarks on a three- and five-year basis, respectively, at the end of 2016), picking up $17 billion in inflows last year. While the payoff would be even greater if the firm were to get its active equity platform (where just 62% and 65% of funds were beating their benchmarks on a three- and five-year basis, respectively, at the end of 2016) back on track, given its higher fee rates, flows remain in negative territory and are expected to stay there the next several years.

Size, Scale, Brand, and Diversity Dig a Wide Moat
The publicly traded asset managers we cover tend to have economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage. Although the switching costs might not be explicitly large, the benefits of switching from one asset manager to another are at times so uncertain that many investors take the path of least resistance and stay where they are. As a result, money that flows into asset management firms tends to stay there, borne out by an average annual redemption rate for long-term mutual funds of around 30% during the last 5-, 10-, 15-, 20-, 25-, and 30-year time frames. We believe asset managers can improve on the switching cost advantage inherent in the business with structural attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong brands and entrenched sales relationships), which provide them with a level of differentiation.

Although the barriers to entry are not significant for the industry, it takes time and skill to gather the level of assets necessary to build scale. This provides large, established asset managers with an advantage over smaller players, especially when it comes to gaining cost-effective access to distribution platforms. Asset stickiness (the degree to which assets remain with a manager over time) tends to be a bigger distinguisher between wide- and narrow-moat firms, in our view. Companies that have shown an ability to gather and retain investor assets during different market cycles have tended to produce more-stable levels of profitability, with returns exceeding their cost of capital for longer periods. While more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been firms with both solid product sets across asset classes and singular corporate cultures dedicated to a common purpose that have tended to thrive. Asset managers offering niche products with significantly higher switching costs--such as retirement accounts, funds with lockup periods, and tax-managed strategies--have also been able to hold on to assets longer.

BlackRock, in our view, has a wide economic moat around its operations. The size and scale of its operations, the strength of its brands, and the diversity of its AUM by asset class, distribution channel, and geographic reach provide the firm with a leg up over competitors. BlackRock is the largest asset manager in the world, and its product mix is fairly diverse, with 51% of managed assets in equity strategies, 31% in fixed income, 8% in multi-asset class, 8% in money market funds, and 2% in alternatives at the end of 2016. Passive strategies continue to account for close to two thirds of BlackRock's long-term AUM, with the company's iShares ETF platform maintaining a leading share of the market on both a domestic (38%) and a global (37%) basis. Product distribution is weighted more heavily toward institutional clients, which by our calculations account for more than 80% of total AUM (based on an assumption that more than half of iShares' AUM is derived from institutional investors). These types of clients have traditionally been stickier than individual retail investors. BlackRock remains geographically diverse as well, with clients in more than 100 countries and more than one third of its AUM coming from investors domiciled outside the United States and Canada.

Another key differentiator for BlackRock has been its commitment to risk management, product innovation, and advice-driven solutions. Having been principally focused on institutional investors for much of its existence, BlackRock has had to be concerned about not only investment performance, but also the risks taken to generate those results, as most of its institutional clients come to the table with required levels of performance and volatility in their investment mandates. As a result, the company has developed tools to assess both security- and portfolio-level risks, which it not only uses internally but also offers to external clients for a fee. This has enhanced the firm's ability to roll out new products and to combine existing products to create outcome-based investment offerings.

We believe that asset managers with a single corporate culture dedicated to a common purpose--which is ultimately reflected in the level and consistency of investment performance, the rate of organic growth, the focus and importance placed on risk management, and the amount of employee turnover--tend to do a much better job of holding on to assets in the long run. Thus, we also highlight the success that BlackRock has had with its insistence on one common culture, focused on one shared vision and operating on one platform, even as it has made several transformational deals during the past decade. We also think the ability to generate more-stable cash flows than most of the other publicly traded asset managers has allowed BlackRock to continuously reinvest capital in its business (especially in regards to technology and new products), making it that much harder for smaller (and weaker) competitors to compensate.

Market Movements and Strategy Shifts Can Have Impact
BlackRock has staked its future on its ability to not only manage but market and sell both passive and active investment strategies. With more than 85% of annual revenue derived from management fees levied on its AUM, dramatic market movements or changes in fund flows can have a significant impact on operating income and cash flows. Shifts from active to passive strategies can have an impact as well, with management fees much lower for index funds and ETFs. Shifts among asset classes can also be problematic, with fees for actively managed fixed-income and money market funds lower than those for equity and balanced strategies.

BlackRock has been fairly prudent with its use of debt, especially when making acquisitions. Debt/total capital has averaged about 14% during the past decade. BlackRock entered 2017 with just under $5 billion in total long-term debt on its books. This left the firm with a debt/total capital ratio of just under 15%, debt/EBITDA at 1.0 times, and interest coverage of more than 22 times.

Management has historically returned the bulk of its excess free cash flow to shareholders through stock repurchases and dividends. The company is currently committed to spend $275 million per quarter on share repurchases, but would increase the allocation to buybacks if the shares traded at significantly lower levels (which management actually did during first quarter of 2016, buying back $300 million worth of stock). During the past 10 calendar years, BlackRock spent $9.9 billion on share repurchases. The firm did, however, issue $2.8 billion of common stock as part of the BGI acquisition in 2009 and continues to issue shares regularly as part of a stock-based compensation program.

During 2007-16, BlackRock returned $9.5 billion to shareholders as dividends, with the firm maintaining an average payout ratio of around 43%. The firm increased its quarterly dividend 9% in early 2017 to $2.50 per share, lifting the company's annual payout to $10.00 per share and leaving its payout ratio at around 47% of our current 2017 earnings estimate. Management continues to target a 40%-50% payout ratio as part of its ongoing dividend policy.

Stewardship Is Exemplary
Chairman and CEO Larry Fink's exceptional leadership has been the driving force behind much of the company's success. In an industry where acquisitions have not always worked out, Fink has overseen not one but two major deals--Merrill Lynch Investment Management (2006) and Barclays Global Investors (2009)--that transformed BlackRock, turning it into the largest asset manager in the world and leaving it with the widest moat in our asset management coverage.

Another reason that BlackRock has had success where so many have failed is that Fink has insisted on one culture at the company. BlackRock has epitomized our view that asset managers with a single corporate culture dedicated to a common purpose tend to benefit from much wider economic moats over the long run than companies operating with less-cohesive or inconsistent organizations.

We continue to be impressed by efforts the firm has made to broaden the scope of its senior management team and groom potential successors to Fink and president Robert Kapito by moving key personnel around into different management roles. While there is no indication that either Fink or Kapito is going anywhere soon, we think it is prudent for the board and senior management to take these steps. Strengthening the skill set of the company's wider management team supports our Exemplary stewardship rating for the firm.

That said, there have been some cracks in BlackRock's armor--like the poor performance of the firm's actively managed funds during the past decade. With close to $1.5 trillion in managed assets, BlackRock's active management operations are one of the largest in the world. This business generates 49% of the company's base management fees, despite accounting for 29% of total long-term AUM. Poor investment performance coming out of the financial crisis, which affected flows for both its active equity and fixed-income platforms, has left management working to put things right.

BlackRock started revamping these operations in 2012, bringing in new managers and introducing different ways of processing and organizing their investment teams. This has led to improved performance in BlackRock's actively managed fixed-income and equity platforms, which has put these offerings in a better position to generate positive flows. Results have been inconsistent, however. Getting these operations back on track would be a bonus for investors, in our view, as the fees that BlackRock generates on its actively managed operations are much higher than those it earns on iShares and institutional index fund business.