Affiliated Managers Group (AMG) Q4 results

Affiliated Managers Group reported Q4 earnings yesterday that were not as disastrous as feared. Unfortunately, the most appropriate word for this quarters result is "messy". On a GAAP basis, AMG lost $1.73 per share, but made $1.24 in pro-forma cash earnings. The delta was mostly driven by a non-cash impairment charge on two affiliates (but mostly on Value Act). There was also a net non-cash gain of $.06 from the repurchase of some trust preferreds at $.35 on the dollar, offset by the accelerated amortization of options expense due to management forfeiting them (strange accounting rules if you ask me). Even worse, management announced some changes to what they add back to get their cash earnings number. That was the noise.

Just to get this off my chest, I'm really surprised they decided to add another add-back item to get Cash Earnings. The reality is that the AMG story is already complicated and it hurts valuation. Increasing the complexity level seems like a bad idea to me. The only thing I can come up with is that management thinks they are already being penalized for the complexity, so they are making a change now that will increase cash earnings in the future, and there will come a time when investors do not shun complexity like they do now. When that happens, the stock will get an undiscounted multiple on a higher earnings number. I don't know if that was the rational, but either way, I don't like it. I still like this stock, but I disagree with the change to pro-forma presentation.

Fundamentally, times were tough. Net new flows at their affiliates was a negative $3.3 billion. This is actually a meaningful improvement from very recent quarters but is still negative. The markets were down significantly as we all know which hurts revenue at the affiliates and subsequently for AMG shareholders. The holding company still has $200m in cash as well as access to another $120 via a forward equity sale they entered last year (they can sell about 1.2 million shares for about $95 per share).

The assumptions going into the 2009 guidance were modified, which was probably an attempt to distract investors from the fact that AMG will earn a lot less than we thought they would even six months ago. Having said that, the guidance is very conservative in order to give management a very good chance of beating (if you lower the bar enough…). The 2009 guidance was $3.75 - $4.30. Both ends of the range assume no market appreciation from yesterday, but the upper end does assume some modest performance fees and some modest organic growth. For the sake of easy math, I’ll use $4 as the midpoint. Consider that AMG’s revenue grows for three main reasons: market appreciation of AUM, net new inflows (or subtract outflows), and accretion from new acquisitions. A $4 estimate for 2009 assumes that two of the three drivers will be non-existent and that the third (organic growth) will be very modest. So in my mind $4 will end up being too low. I think this business model should trade at 15x bear market earnings, so I get $60 even if two and a half of three drivers are turned off. Bottom line, I think this stock continues to have meaningful upside.

Last thing: I was reminded again this quarter that management is very astute at capital management. When the market cooperated, they raised convertible debt that had very low after-tax interest expense. Before the market really dropped, they sold equity forward which looks brilliant now. Most recently, as market participants are scared and afraid of complexity, they bought back some of that convertible debt at $.35 on the dollar. These are smart guys running the show.

Choosing our scars

I was at an industry conference in September that featured a speaker on generational differences. These talks generally don't sit well with me. There are several things that I don't like about them but I'll focus on one today. The whole generational discussion rests on the idea that the environment we are exposed to, especially when we are younger, can impact our behavior and thought process for the rest of our lives. I think this is probably right and I don't like it. The problem of course is that the lessons learned in one environment may not be the right lessons to apply to the rest of our lives.

I have been thinking about this all week, wondering what lessons we are collectively learning from the current financial crisis and recession. I am a big believer in trying to learn from our experiences, but I think we have to be very careful to either assign lessons to a specific set of circumstances, or make sure the lessons apply to other time periods and circumstances. For example, US treasuries have been about the only asset class to have positive returns in 2008, but I don't think the lesson is that we should all keep 100% of our portfolios in US treasuries for the rest of our lives. That example is obvious, but I think others are more subtle.

I wonder if a whole generation of investors will be overly risk-averse, rather than trying to add or reduce risk exposure based on the environment. Will there be a long term distrust of quantitative models? Has a whole generation "learned" that corporations are bad and can't be trusted? Some will almost certainly "learn" that debt is bad because they were kicked out of their home; others will "learn" that they do not have to live with the consequences of their dumb decisions because they were bailed out. The millions that were laid off may "learn" that that loyalty to an employer is not reciprocal, or that playing politics is necessary to survive. What have we "learned" about the role of government?

All I know that is I have been trying to identify the lessons I am "learning" from the current traumatic time period and deciding which I want to keep and which I need to resist (or at least assign to a specific set of circumstances). Think about it.

Time to put some money into equities

In my first posting I talked about putting money to work over the next six months in three "slugs" when the market is at least 5% off a recent high. The S&P 500 is 11% off its recent high as I write this. As I continue to talk to investors, the dominant theme continues to be fear. I would buy some stock today.

As an aside, my account finally transferred to Schwab and I bought some NDAQ and GFIG yesterday.

NASDAQ OMX (Ticker NDAQ) - My next purchase

My accounts are currently in limbo as I move them from my former employer, but I think NASDAQ will be the next stock I buy.

Nutshell Thesis:
I think NASDAQ is the Wal-Mart of the market structure industry. Their mantra is “extreme efficiency against massive scale”. They are trying to leverage their world-class technology for execution and clearing across multiple asset classes and geographies. My investment thesis is that they will be successful in their expansion efforts largely because they have a proven track record in US equities, which I consider one of the most competitive and commoditized markets. The markets they are trying to enter are much less competitive and commoditized. I like the management team, their business model, and the price.

Not the NASDAQ you remember:
Most people think of NASDAQ as the start up US equity exchange from 2000. They are much more diversified now. NASDAQ allows customers to trade stocks listed on NYSE/Archa, AMEX, or NASDAQ. They earn revenue from execution fees as you would expect, but also from listing fees, market data fees, broker access fees, and corporate services to their listed companies. That is just US equities. Through a series of acquisitions, they also offer execution of US options, Nordic equities and derivatives, and carbon and emissions derivatives in Europe. Additionally they are trying to expand into several new areas, often with a JV partner. Examples are the Dubai Exchange, AgoraX (ag OTC derivative platform in partnership with FC Stone), IDCG which is a clearing platform for OTC Interest Rate Swaps, and a multilateral trading facility in London to trade European equities.

Link to NASDAQ investor presentation for revenue breakdown: http://files.shareholder.com/downloads/NDAQ/508718992x0x258427/7df22b22-5ed8-4217-988c-9653c65030f1/Goldman%20Sachs%20121108%20Conference.pdf

Catalysts:

-The most likely catalyst is a surge in Nordic equity volumes. NASDAQ has an MOU with EMCF (a European Clearing firm of which they own 22%) to become the central counterparty for OMX equity transactions. Believe it or not, the Nordic equity markets are bilaterally cleared which has almost certainly limited volume growth. NASDAQ is improving the execution platform and adding a central counterparty, which should open the door to new participants.

-If NASDAQ reports meaningful market share gains on its London MTF, that market is big enough that investors would bid up the stock.

-An announcement of equity partners in IDCG would also excite investors given the size of that market.

-Incremental synergies from their OMX, PHLX and Boston exchanges. Management has indicated that total synergies will likely exceed the $150m they originally targeted.

Price:
I really liked NASDAQ under $23 when the markets were 15% lower. The stock is flirting with $23 again now so I would buy the stock. Consensus EPS for 2009 is about $2.20, so at $23 you get a solid company with real growth potential for just over 10x forward estimates.

Word of caution:
Although US equity execution fees only account for about 16% of total revenues, reports about US equity volume are likely to be the biggest contributor to short term volatility in the stock. I think predicting volumes is almost impossible and I don’t bother trying. Just be aware that volume data will move the stock around. This is not a trade, it is a stock I want to own for several years.

Still Positive on Equities after Unemployment Data

The S&P 500 was down 3% yesterday largely in reaction to the release of ADP's unemployment number. ADP estimates that the US non-farm economy shed 693 thousand jobs during the month of December. The data on ADP's website only goes back to December 2000, but this was the worst monthly decline in that time period. I also looked at the data from the Bureau of Labor Statistics covering the same time frame. Of note, the US non-farm economy started shedding jobs in December of 2007 (one year ago). If we assume the BLS number coming on Friday is the same as the ADP number, the US will have shed 2.829 million jobs since December 2007. That is equivalent to all the job gains over the preceding 23 months. I am just trying to frame the magnitude of current news flow.

Here is the link to the ADP Employment Report: http://www.adpemploymentreport.com/

Also yesterday, oil futures for February delivery dropped 12% on news that the inventory of oil rose more than expected. I don't think anyone attributes the rise to a sudden increase in production. The implication here is that demand for oil is weaker than expected given the economic recession.

Horrible unemployment data plus signals from the oil market that the economy is very weak only pushed the market down 3% yesterday.

One of the hardest questions to answer as an investor is "What is priced in?" This is even a hard question in retrospect, but consider the context again. The S&P 500 hit a low on November 20th and was up 24% before yesterdays "sell off" of 3%. Even shorter term, the S&P 500 was up 7% since Christmas Eve.

Yesterday's market gave me even more conviction that I need to be buying equities on the dips. The worst jobs number in over nine years only shaved 3% off the market that has been moving higher. I will also point out that in an earlier post I mentioned I would try to buy when the market is 5% of a recent high. So yesterday's move doesn't even qualify as a short-term entry point in my opinion.