<THE BORING PORTFOLIO>
Continuing with UAM
By Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (June 30, 1999) -- On Wednesday, I started to look at United Asset Management (NYSE: UAM), a money management firm holding company. Some excellent responses to the first part of the analysis of the company were posted to the Boring Portfolio message board.
WJD10 submitted the following: "...having purchased a piece of this business in early 1996 and sold it in two steps over the past year, I thought I would give my take on the company. By way of background my introduction to UAM came from an interview in the OID [Outstanding Investor Digest, www.oid.com] of 11/21/95 with the principals of Schwerin Boyle Capital Management. In a small nutshell, the appeal of the company to me was that it appeared to be a gross revenue royalty business that required literally no capital to grow. The operating affiliates were responsible for covering their own expenses so the parent company just took in its share of management fees, which it used to pay dividends, buy in its own stock, and acquire more money management companies."
So I went to our prized collection of OID back issues and checked out what Bob Schwerin and Dan Boyle had to say about the company back in 1995:
"UAM... [is] kind of like the advertising companies Buffett bought in the early 1970s. Norton Reamer founded UAM based on two successful models: Marsh and McLennan -- which bought insurance brokers and allowed them to continue operating independently -- and the Interpublic Group -- a holding company that has successfully owned advertising agencies. He realized that money managers were service businesses, too, and don't require capital to grow. And he came up with a brilliant way of structuring acquisitions of those money managers with revenue sharing -- which is exactly what you want -- where expenses go with the firm, but you get a piece of the revenue. Again, a gross revenue royalty can be a helluva business. And that's exactly what UAM has."
The capital needs issue is what I was getting at the other day. When you look at the amortization of what is essentially goodwill, you have to ask if that needs to be replaced as it is "consumed." The value of capital traded for acquired firms is chalked up to "costs assigned to contracts acquired," which means the value of the company is relationship between UAM's affiliated firms and their clients. The contract between affiliated firms and their clients, which are mostly fund management and marketing firms, can generally be terminated with 30 days notice.
So you have to ask whether that puts those assets in jeopardy. Would the termination of a contract kill the earning power of the firm? Unless you're talking about a contract severance that came about through malfeasance, which would likely affect other contracts, the answer to that would be negative. No one client represented more than 4% of affiliated firms' revenues in 1998. The value represented by the intangibles might be chalked up to contracts, but the asset that is really acquired is the earning power, reputation, and abilities of affiliated firms. It's not really specific contracts, economically speaking.
The maintenance of these assets is what you want to assess and decide whether they pass over into being UAM's intangibles as they get charged off the balance sheet or if they end up evaporating into the ether as time goes on. On $113.3 million of amortization of these intangibles in 1998, $18.5 million in cash was disbursed and assigned to "contracts acquired," which is the intangible that comes from acquisitions of money management firms. Now, there's a big difference between capital expenditures that are necessary to maintain a company and expenditures that are necessary to grow a company. The former is deducted from operating cash flow (not EBITDA, because working capital changes are an important element of operating cash flow) to get at free cash flow while the latter is not deducted from net cash from operations to get at free cash flow per share.
That's because free cash flow is the amount of cash that could be distributed if the company were to stop growing today. Discretionary expenditures to expand the business are taken out of free cash flow or financed with new equity, equity equivalents, or debt. So that's an important distinction in figuring out the financial aerodynamics of the company -- whether cap. ex. is truly discretionary or really required to maintain the company's current condition. If you look at a company's free cash flow deducting all cap. ex. rather than just maintenance cap. ex., the NPV indicated isn't going to be any different than the NPV of free cash flow calculated by deducting just maintenance cap. ex.. But I think the distinction is important from the standpoint of examining the current profitability of a company.
In this case, I would agree with Bob Schwerin and Dan Boyle. The financial aerodynamics of the company are attractive. There isn't a lot of drag from maintenance cap. ex. and there isn't even that much drag from discretionary capital disbursements necessary to grow the business. Net cash from operations before working capital changes for 1998 was $211.4 million, a slight amount of cash was generated from working capital changes, and thus net cash from operations in 1998 was $212 million.
One place where I would make a major adjustment to the financial statements is in the definition of invested capital and return on invested capital. By doing so, I think we'll get closer to the real return on capital economics of the company, its ability to grow shareholder value going forward, and see why it's priced at a cash P/E of 7 and an enterprise value-to-NOPAT (net operating profits after tax) of 9.47. That's on Friday and we'll also continue things on the Boring board.
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