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Industry Margins Almost Back to 2008 Levels - With Assets Down

by Eric Daugherty

Last month I wrote about the industry earnings rebound. Now that earnings are in for all the publicly traded asset managers, what do they tell us about the state of the industry?

kasina Revised Forecast for Industry Operating Margins

Firms included: Alliance Bernstein, BlackRock, Calamos, Gabelli Asset Management, Pzena, Affiliated Managers Group, Legg Mason, Franklin Templeton, Invesco, TRowePrice, Eaton Vance, Janus, Waddell & Reed, Cohen & Steers.

Here are some observations gleaned from the latest earnings:

Retrenchment has worked - while we are not all the way back to 2008 operating margins on a full year basis, it's likely that 4th quarter number for 2009 will be even stronger than 2008 figures. Fairly rapid cost cutting and prioritization have combined with the market recovery to land firms in very strong shape financially. Psyches may not have healed yet, but balance sheets have.

It is too early for complacency - our prior forecast was for 3rd quarter operating margins of 31.6%. Actuals were 27.5%. What changed, primarily, was that 3rd quarter operating expenses for these firms were up 6% from the 2nd quarter. With a closer look, this $200M expense increase was mostly driven by three firms, and half of it derives from higher revenue-based costs (e.g. commissions). Another 20% of it appears driven by one-time severance and legal settlements. So, this increase is not cause for alarm, but it is worth watching, as a 6% increase per quarter is clearly unsustainable.

Size matters - we have been talking about the importance of scale for the last six months, and believe it will matter greatly in the future. One notable aspect of the industry financials is that the biggest firms have the same margins as other firms. We know that the biggest firms sell product for lower costs, so they must be leveraging size to effect lower unit cost structures as well, which makes sense. When I split the group into the largest four (Monsters), middle five (Mediums), and smallest five (Minis) by assets, there is little difference in operating margin. The largest firms are just making these healthy margins on a much larger base of assets, creating huge profits.

Not all are thriving equally - among all sizes, there are winners and losers. Of the fourteen public firms, three have operating margins less than 20%, and two have operating margins greater than 40%. These firms' performance persists from quarter to quarter.

Look for more M&A activity - everyone suffered in the downturn. Firms are now returning to thinking about the future. With the industry experiencing improved financials, those firms still underperforming will stand out, and may look for white knights. Given our maturing market and the challenges associated with organic growth, firms with strong balance sheets and a desire to grow will look to prey upon the laggards, particularly those with healthy brand names.