Impact of ETF Price War, Active Fund Outflows On BlackRock’s Revenues Likely To Continue

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The intensifying price war among incumbents in the global ETF industry and the continuing trend of investors shifting cash from actively-managed funds to low-cost funds had a notable impact on BlackRock’s (NYSE:BLK) results for the first quarter of the year – resulting in lower-than-expected revenues for the quarter. [1] The asset management giant managed to report an earnings beat, though, thanks to its focus on keeping costs under check and also due to a one-time $81-million tax gain for the period. We believe that the results for this quarter are representative of the long-term growth issue currently facing BlackRock.

While BlackRock is the undisputed leader in the global ETF industry, with a market share in excess of 30%, it has had to slash fees for its core ETF offerings on several occasions in recent years in order to safeguard its market share from a range of competitors including industry majors Vanguard and State Street (NYSE:STT), as well as new entrants like JPMorgan (NYSE:JPM) and Goldman Sachs (NYSE:GS). As a result of this, BlackRock’s total revenues from ETFs have grown at a much slower rate than its ETF assets under management – a trend that we believe is unlikely to change going forward.

That said, BlackRock enjoys significant economies of scale compared to its other competitors thanks to its industry-leading assets under management of $5.4 trillion, as well as due to its diversified geographical presence. The lower-than-expected operating costs for Q1 reinforce our belief that the company can improve its profits in the long run by keeping a close watch on expenses. We stick to our price estimate of $400 for BlackRock’s shares, which is slightly ahead of the current market price.

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BLK_Ear_PBTDiff_17Q1

The table above summarizes the factors that aided BlackRock’s pre-tax profit figure for Q1 2017 compared to the figures in Q1 2016 and Q4 2016. Strong improvements in valuation across asset classes coupled with extremely strong inflows into ETF and passively-managed funds helped BlackRock’s investment advisory fees for the period, although these gains were mitigated to an extent by a reduction in performance-related fees compared to the previous quarter. Revenues from BlackRock’s advisory platform (“Aladdin”) also nudged lower compared to Q4 2016.

Notably, BlackRock’s headcount has remained constant around 13,000 over the last four quarters, because of which all changes in compensation expenses have been almost entirely from performance-linked payouts. It should be noted, though, that the first quarter of the year sees seasonally higher compensation expenses for the company due to the payout of bonuses. Taking this into account, the sequential increase in these costs looks justified. At the same time, BlackRock did well to report a reduction in non-compensation costs compared to Q1 2016 as well as Q4 2016. Overall, this helped BlackRock’s operating margin (adjusted basis) improve from 41.6% in Q1 2016 to 42.6% in Q1 2017. You can see how changes to BlackRock’s operating margin affects our price estimate by making changes to the chart below.

BlackRock Reports Net Inflows Across Its Offerings, Except For Active Equity Funds

BlackRock offers a complete range of investment products, including actively-managed as well as passively-managed (indexed) equity and fixed income funds, ETFs (iShares) and multi-class asset funds, in addition to currency, commodities, and other alternative investment funds. The company witnessed strong inflows for nearly all its fund classes over Q1 2017, with its long-term funds roping in more than $80.3 billion in net new cash. Inflows continued to be led by BlackRock’s extremely popular iShares offerings, which reported net inflows in excess of $64.4 billion. Equity iShares added almost $45 billion, followed by fixed income iShares with more than $20 billion.

The equity market rally and the impending fiduciary rule by the Department of Justice had a positive impact on inflows for BlackRock’s passively-managed equity and debt funds as well, which reported inflows of $6.3 billion and $11 billion, respectively. In sharp contrast, BlackRock’s actively-managed funds lost cash for yet another quarter – an industry-wide trend. As active equity funds demand much higher base fees (roughly 0.6% of assets for BlackRock) compared to indexed equity funds (around 0.05% of assets), and as they also attract sizable performance-related fees, this has been the single biggest drag on BlackRock’s top line over recent quarters. We expect these outflows to continue in the near future – negatively impacting BlackRock’s revenues.

The strong overall inflows in Q1 along with improvements in market valuation of securities helped BlackRock grow its total long-term assets to over $5 trillion for the first time in Q1 2017. Taken together with cash management fund assets of just under $390 billion, BlackRock’s total assets under management now stand at a record $5.42 trillion.

BLK_Ear_LT_AUMDiff_17Q1

The chart below captures the proportion of BlackRock’s assets under management distributed across its various offerings. Notably, BlackRock’s iShares offerings now account for almost 26% of its total asset base compared to a figure of 23% in Q1 2016. At the same time, actively-managed funds are now down to 19% of total AUM from almost 22% in Q1 2016.

BLK_Ear_AUMSplit_17Q1

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Notes:
  1. Q1 2017 Earnings Release, BlackRock Investor Relations, Apr 19 2017 []