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Blackrock: Related Weakness
in Share Price Could Represent a Good Entry Point for Investors

BlackRock, Inc. (NYSE: BLK) is the world leader in Exchange Traded Funds (ETFs) through its iShares brand. Most ETFs are passive index funds that are content to accept returns equal to the indexes they mimic, but with much lower fees than active funds. The ETF industry has created scores of indexes targeting specific industries, countries, and investment characteristics (like growth or value) in addition to broad indexes like the S&P 500 or the Nasdaq 100, says Douglas Gerlach, editor of the award-winning Investor Advisory Service,

BlackRock is a broad-based investment manager. It manages equities, fixed income, and balanced funds, along with “alternative” investments like hedge funds, pools of hedge funds (known as “funds of funds”), and funds that invest in currencies, commodities, and real estate. About 58% of its $5.8 trillion in long-term assets under management (AUM) consists of equities. Another 32% are in fixed income, 8% in balanced funds, and 2% in alternative investments. It also manages $457 million in cash management products.

Between iShares and privately-managed index funds for institutional investors, index products comprise 71% of BlackRock’s AUM. The downside is that index funds don’t pay as well as actively-managed funds. BlackRock receives annual fees averaging 0.14% for its index funds while its active funds pay more than twice as much, 0.32% plus performance-based fees in many cases. Two thirds of its actively-managed funds are on behalf of institutional investors such as pension funds and endowment funds that typically receive much lower pricing than retail mutual fund investors. Retail investors also face additional expenses beyond the costs of investment management, such that the total expense ratio is higher than BlackRock’s fee.

BlackRock also offers a technology platform called Aladdin which provides wealth managers and custodians with data and tools to develop fund portfolios for clients. Technology revenue is 5% of total company revenue, but also helps place client assets in BlackRock products.

BlackRock’s scale gives it impressive cash flow even at these seemingly-low fee rates. Free cash flow is approximately 30% of BlackRock’s revenue. BlackRock uses its free cash flow to pay dividends (a 2.3% yield), acquire other investment management firms, and buy back stock.

In the second quarter, BlackRock’s EPS rose 27%, about half due to operational growth and half due to a lower corporate tax rate. Revenue increased 11%, adjusting for a new standard for revenue and expense recognition that had no impact on profits.

Organic asset growth rose at an annualized rate of just 1.3% in the quarter, a marked deceleration from recent quarters. Organic asset growth refers to net new assets gained, which overlooks market price fluctuations and foreign currency translation. The figure has typically run in the 4%-5% range. BlackRock says that institutional investors in particular have reduced their equity allocations in response to global volatility. Institutional investors also reduced their investments in non- ETF equity index funds in the first quarter, although this worsened significantly in the second. Retail investors sold off stock funds in the second quarter and reduced how much they put into BlackRock bond funds. This is a part of an industry-wide pattern that emerged in the second quarter. We expect it to be temporary because mutual funds and ETFs are the overwhelmingly popular way for individuals to invest. Related weakness in BlackRock’s share price could represent a good entry point for investors.

We believe that BlackRock can maintain double-digit EPS growth with 3%-5% net cash inflows, and 5%-7% market growth between stocks and bonds. Profit margins have gradually expanded, and this should continue.

BlackRock should also experience an EPS boost from share buybacks if it doesn’t find something even more profitable to do with its free cash flow, such as acquisitions. We believe it can grow EPS by 12% annually.

Five years of 12% growth could result in EPS approaching $45. A repeat of the average high P/E ratio of 20.5 may lead to a stock price as high as 920. Adding in dividends, the total return could be 15% per year. The downside risk appears to be 27% to 369, the product of the average low P/E of 14.5 and EPS of $25.46 over the past twelve months.

BlackRock’s low return on equity (ROE) is caused by intangible assets on its books. While these intangible assets are indeed valuable assets judging by the cash flow they produce, BlackRock’s balance sheet is a mix of acquired assets marked up to full market value when they were acquired plus its original assets at their historical costs. ROE may not be a useful measure for this company. Blackrock is a buy up to $512.

Editor’s Note: Published continuously since 1973, the Investor Advisory Service is one of the nation’s top-performing investment newsletters. Each month 3 stock recommendations are featured along with in-depth profiles of recommended companies and economic and market trends. Download a FREE sample issue at www.InvestorAdvisoryService

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