Schroders: Secure 5.4% Dividend, Potential Mid-Teens Annualised Upside (OTCMKTS:SHNWF)

Schroders: Secure 5.4% Dividend, Potential Mid-Teens Annualised Upside (OTCMKTS:SHNWF)

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Introduction

We initiated our Buy rating on Schroders (OTCPK:SHNWF) in March 2019, focusing on the non-voting stock (Bloomberg ticker SDRC LN) trading in London as offering the best value. Since then, shares have returned 16.9% (in GBP), mostly in dividends, far out-performing the FTSE All-Share index:

In this article, we review our Buy case after H1 2020 results last week, reduce some of our estimates but re-iterate our Buy rating.

Buy Case Recap

Our original Buy case in March 2019 was based on the belief that the U.K. asset management sector has a natural tendency to grow earnings faster than GDP, and that Schroders represents the “best of breed”. We believed its earnings will resume its long-term mid-to-high-single digit growth after 2019, from:

  • Positive Assets Under Management (“AUM”) net flows to resume, after outflows we attributed to a cyclical market downturn and other one-offs.
  • Revenue margin compression trends to remain steady, more than offset by a natural 3-4% asset price appreciation to provide an 1-2% revenue growth
  • Profit margin to be flat or improving, due to natural operational leverage, compensation discipline and technology-based cost savings
  • Dividends to continue at least on their existing level
  • Valuation multiples to re-rate upwards, driven by the resumption of positive AUM flows

After the start of the COVID-19 outbreak and market correction, we revisited our Buy case in March 2020, lowered our expectations but still concluded with a Buy rating, based on our belief that:

  • The market correction merely brought the AUM back to its 2019 average, and 2020 EPS would likely be no worse than 5% lower than 2019
  • The dividend would remain well-covered
  • In our Base Case, AUM would grow with a CAGR of 3-4% (from natural asset price appreciation), revenue and EPS would grow with a CAGR of 1-2%. Including the 6% Dividend Yield, the annualised return would be 7-8%
  • In our Upside Case, initiatives like the Lloyds JV would add 2% to AUM growth, AUM CAGR would be 5-7%, revenue and EPS would grow with a CAGR of 4-6%. Including the 6% Dividend Yield and a re-rating up to 13x P/E (as seen in late 2019) over 2 years, the total return would be 30-40%

We will re-examine each of our assumptions below, in light of H1 2020 results.

Positive AUM Flows Remains Unproven

During H1 2020, group AUM rose to £525.8bn, 5.1% higher than at 2019 year-end and 18.3% higher year-on-year (mostly thanks to the market rebound in H2 2019). This means that, since 2018 year-end, group AUM has grown by 29% (£118.7bn) in 2.5 years. However, £74.1bn of this is from the new Lloyds (LYG) joint venture, and £30.6bn is from the market (including currency). While these shows the strength of asset price appreciation in Schroders’ business model and the strategic value of its franchise to potential partners, net inflows of only £7.4bn in this period was disappointing:

The key headwinds are in the Mutual Funds and Institutional segments, both of which had showed negative flows in all but one year since 2016:

During Q1 2020, COVID-19 and market turmoil contributed to outflows by encouraging “risk off” behaviour among investors, but flows only showed a marginal improvement during the Q2 rebound, with flows remaining negative:

Schroders Net New Business – Mutual Funds & Institutional (Last 6 Quarters)

Source: Schroders results presentation (H1 2020).

Schroders had much better flows in Private Assets & Alternatives, Multi-asset (i.e. Solutions), and Wealth Management, with all showing fairly consistent inflows over the past few years (even excluding the AUM from Lloyds):

Management now has a stated goal of focusing on growth from these three segments, which currently account for 54% of group AUM (from 35% in 2016) and 44% of group revenues (from 29%). Even if problems in the more “traditional” Institutional and Mutual Funds were to continue, their impact would shrink in relative terms over time.

For now, Schroders’ ability to resume positive AUM flows remains unproven, though that is to be expected during the COVID-19 outbreak.

Revenue Margins Broadly Stable in Each Segment

Schroders’ revenue margins remain broadly stable in each segment, though with some impact from COVID-19 and some one-off distortions. A comparison of revenue margins between 2019, H1 2020 and 2020 guidance is below:

Private Assets & Alternatives retains a stable margin, while other segments are down 1-2 bps, somewhat more than usual due to COVID-19’s impact on business mix. Solutions margin was distorted by the huge influx of low-margin AUM from Lloyds, while Wealth Management margin was impacted by a lower Net Interest Margin (after rate cuts in the U.K.). 2020 guidance on revenue margins remains broadly unchanged from that in March 2020, slightly worse in some areas due to the same reasons stated above.

Revenue margin compression is a longstanding but manageable trend in asset management (partly due to mix), and H1 showed no major acceleration:

Schroders Op. Revenue Margin by Segment (Since 2013)

NB. “Institutional” and “Intermediary” segments no longer exist from 2019.

Source: Schroders company filings.

Successes with Overseas Joint Ventures

One key positive in H1 2020 results is the success of Schroders’ joint ventures, which are not reported in the group AUM except for Schroders Personal Wealth (“SPW”). For example, the China JV with the Bank of Communications (“BoCom”) (OTCPK:BKFCF) had £9.1bn of Net New Business in H1 2020 and grew its AUM to £68.7bn, while the India JV with Axis Bank had £2.1bn of Net New Business and grew its AUM to £15.3bn:

Schroders Joint Ventures Overview (H1 2020)

Source: Schroders results presentation (H1 2020).

Schroders’ group share of profit from these JVs nearly doubled to £27.6m in H1 2020, or 9.0% of group Profit Before Tax.

Compensation Costs Disappointed

Management raised the compensation cost ratio to 45% in H1 2020, from 44% in the prior year, and also re-emphasized the 45-49% long-run target, citing the increased headcount due to acquisitions:

“In terms of the comp. ratio we’ve been below our 45% to 49% target range for quite a few years now … Our staff numbers have increased largely to acquisitions. When we looked at that we got to retain our talent and therefore we’ve increased our accrual rate to 45% … it’s something we need to look at, yes, in the second half of the year. But that’s our best expectation at the moment.”

Richard Keers, Schroders CFO (H1 2020 Earnings Call)

This represented an increase vs. guidance in March and is a disappointment:

In terms of comp, no change … So, 44% this year, 44% in 2020.

Richard Keers, Schroders CFO (2019 Earnings Call)

Higher compensation costs will be a headwind to earnings in 2020.

13% EPS Decline in H1 2020

The result of the different dynamics described above can be seen in the H1 2020 P&L below. Management fees fell 2.9% year-on-year, as the 18.3% year-on-year growth in period-end AUM was offset by the decline in fee margins. Net Income fell 2.8%, mainly driven by the decline in management fees, despite the higher profit from JVs. Negative operational leverage was created by Operating Expenses still growing 0.8% while revenue declined, with the cost ratio worsening by 246 bps, including 100 bps from compensation costs, so Profit Before Tax fell 10.0% and EPS fell 13.0% year-on-year:

Schroders Key Financials (H1 2020)

NB. H1 2020 net Income includes £25m reduction from SPW adjustment.

Source: Schroders results releases.

H1 2020 period-end group AUM of £526bn is higher than the 2019 year-end AUM of £500bn, but more than £70bn of this is likely in low-margin AUM from Lloyds. Unless there is a major jump in asset prices or Net New Business in H2, revenues are also likely to be lower year-on-year. With the compensation cost ratio guided to be 45% for 2020 (100 bps higher year-on-year), and non-compensation costs implied to be higher as well (£465m vs. 2019’s £461m), we now expect 2020 EPS to be 10% or more lower than 2019 (vs. 5% before).

Dividend Remains Well-Covered

Schroders declared a 79p dividend for H1 2020, flat year-on-year; last-twelve-month dividend of 114p represents a 70% payout ratio on reported EPS. Schroders has a progressive dividend policy with a target payout ratio of 50% (on reported EPS), and management has a track record of paying a rising or at least flat dividend, even during 2008 and 2009:

Schroders Dividends Paid vs. EPS (Since 2007)

Source: Schroders company filings.

Valuation

At 2,100p, Schroders non-voting shares are trading at a P/E of 10.5x relative to 2019 earnings and a P/E of 11.1x relative to last-twelve-month earnings. The Divided Yield is 5.4%.

Illustrative Returns Calculations

Our illustrative returns calculations are below. For our Base Case, we keep mostly the same assumptions as before:

  • 2020 EPS now to show a 12.5% decline year-on-year, vs. 5% before
  • 2021 EPS to show a 6.5% rebound, thereafter EPS grows at 1.5% (the mid-point of our previous 2-3% range)
  • Dividend to be flat in 2020, and thereafter grows roughly in line with EPS
  • 2023 P/E of 10.5x (equivalent to a 6.2% Dividend Yield)

At the current share price 2,100p, the exit price of 2,424p and dividends imply a 4.9% annualised return and a 15% total return over 3.5 years:

Illustrative Schroders Returns – Base Case

Source: Librarian Capital estimates.

For our Upside Case, we use the same assumptions as the Base Case, except with the changes below, again mostly unchanged from March:

  • 2021 EPS to show a 11.5% rebound, thereafter EPS grows at 5.0% (the mid-point of our previous 4-6% range)
  • 2023 P/E of 13.0x (equivalent to a 5.0% Dividend Yield)

These assumptions give a 14.7% annualised return and a 52% total return over 3.5 years:

Illustrative Schroders Returns – Upside Case

Source: Librarian Capital estimates.

Conclusion

Schroders shares have returned 16.9% since our March 2019 initiation, significantly outperforming the FTSE All-Share index.

With disruption from COVID-19, Schroders’ ability to resume positive asset flows remains unproven, but trends in revenue margins are stable.

Management disappointed in H1 by raising compensation cost margin 100 bps to 45%; we now believe EPS could fall by 10% or more in 2020.

At 2,100p, we have a mid-teens annualised return in our Upside Case; the Base Case carries little downside and the 5.5% Dividend Yield is secure.

We continue to believe Schroders shares will outperform the FTSE All-Share and offer a good risk/reward balance, and reiterate our Buy rating.

However, within U.K. asset management, we prefer Hargreaves Lansdown (OTCPK:HRGLY) for its stronger business model; within global finance, we believe U.S. banks such as JP Morgan (JPM) and Bank of America (BAC) offer more upside.

Note: A track record of my past recommendations can be found here.

Disclosure: I am/we are long BAC,JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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