<THE RULE MAKER PORTFOLIO>
T. Rowe Surprise
By Matt Richey (TMF Verve)
ALEXANDRIA, VA (August 5, 1999) -- Almost exactly 1 1/2 years ago, the Rule Maker Portfolio bought shares of the Baltimore-based investment management firm T. Rowe Price (Nasdaq: TROW). To date, the stock has been flat -- almost to the penny -- versus a nearly 30% return for the S&P 500. Stock performance aside, I and my fellow port managers have grown doubtful of the company's standing as a Rule Maker. And thus, we haven't written much about the company. Check that, we haven't written about T. Rowe at all. Not only is that unFoolish of us, but we may be missing out on a company that offers more than meets the eye.
Today's report offers a thought-provoking analysis of T. Rowe Price by message board Fool Zeke2. Ironically enough, I was planning on doing a report on the company myself for today, but after seeing Zeke's impressive analysis, I immediately recognized that anything I could offer on the company would pale in comparison to Zeke's work.
Before going any further, here's a quick summary of the latest financial results from the company: On July 26, T. Rowe reported second quarter diluted earnings per share (EPS) of $0.41, beating estimates by a penny and up 20.6% year-over-year. Quarterly net income was $53.7 million on total revenue of $245.8 million.
In looking at the company's latest 10-Q, Zeke finds a highly profitable and growing company. He also points out some unique benefits of the asset management business, including economies of scale and a tight control of cash. In particular, take notice of Zeke's discussion of how T. Rowe has what is arguably the most efficient Flow Ratio of any of our Rule Makers.
What follows are excerpts from Zeke's work, broken down by topic. (I've occasionally added emphasis to certain key phrases that jumped out at me.)
"T.Rowe Price generally produces very simple financial statements, which is pretty much consistent with everything about the company. There's nothing fancy here, just consistent profitability within a very conservative and almost boring framework. Jumping right into it, on the balance sheet, cash on hand has increased from $283.8 million to $361.6 million in the six months from December 31 to June 30 of this year.
"Accounts receivable rose 7.7% from six months ago, to $108.5 million. This can be good or bad, depending upon what this means. If this means that asset management fees haven't yet been deducted from client mutual fund accounts, then rising accounts receivables for an asset manager is actually a strongly positive sign, which is completely the opposite of the other Rule Maker companies. This is because T. Rowe makes money by skimming a percentage of the asset balance every quarter, and this is then automatically deducted from the client's invested balance. Collection is therefore not an issue, and the accounts receivable represent fees which have not yet been deducted from the asset accounts. I'll have to ask the company about this, or somebody on this board who is more familiar with the company's financial statements.
"The Flow ratio is really not very applicable to T. Rowe's business model, since there is no danger of inventories piling up or in slow collections of asset management fees. T. Rowe's only current assets consist of cash, the aforementioned accounts receivable (which may not be bad at all), and other assets representing the 50% ownership of Rowe Price-Fleming International and other investments (which I take to be T. Rowe's investments for its own account). That's really it for the current assets. All of them seem to fall into the cash or investments group, so if you bought my above arguments about the accounts receivable, one could conclude that T. Rowe has no numerator for the Flow Ratio, which would give the company a perpetual Flow Ratio of zero. How 'bout that, Microsoft?"
"In any case, the salient performance metrics are the growth in sales and net income. Revenues for the quarter, consisting mostly of investment advisory fees, grew 10.5% over the year-ago quarter, from $222.3 million to $245.8 million. For the six months period, revenue growth was slightly higher, at 13.6%. In both comparisons, the overall growth in revenues from administrative fees and investment income was faster than the growth of the bread and butter advisory fees, which actually grew at 8.37% and 12.3% over the quarter and six month year-over-year periods, respectively.
"Expenses grew more slowly than sales, as one would expect. The beauty of the asset management business model is that in theory, the incremental cost of managing each additional dollar of assets should become progressively lower. In other words, it shouldn't cost that much more to manage $50 billion in assets than it does to manage $25 billion in assets. We can see that principle at work here, as expenses grew 6.9% for the quarter compared to the quarter last year, and 9.25% for the six-months period comparison.
"To calculate gross profit margin, I took revenues minus the compensation and related personnel costs, plus international investment research fees to simulate the cost of goods. This gives me a 61.5% gross margin figure for the six-month period, and 60.2% for the most recent quarter.
"Net income rose 19.7% quarter over quarter, and 24.3% year over year. Net margin was 21.8% for the six-month period and 20.5% for the latest quarter."
A Closer Look at the Business
"Total assets under management grew from $147.8 billion to $159.2 billion over the six-month period, which translates into 15% yearly growth.
"In any case, 74% of all assets under management are in equity funds, which makes us happy because that's where the highest investment fees normally are. International assets under management of Rowe-Price Fleming stood at $33 billion, of which only 50% ($16.5 billion) goes to T. Rowe. International equity management generally produces a higher profit than domestic equities, which in turn produce a higher profit margin than bonds. Adding that $16.5 billion gives us $175.7 billion in total assets. In the second quarter, the company got $324 million in net new asset inflows. This was composed of $799 million flowing into domestic stock funds (good), $219 flowing out of bonds and money market funds (which is not good, but is better than losing them from equities funds), as well as $256 million from those really profitable international stock funds, which hurts a bit. But hey, net inflow is good, and $324 million a quarter equals $1.3 billion a year in new assets. That's nice."
"I guess my main point, one that I don't want people to miss, is not that I am ragingly bullish on T. Rowe Price. My point is that I wanted to review the reasons why I bought the stock, check on the recent company performance, and then determine if I am still getting what I originally bought it for. My conclusion is that I am happy with the way the company is performing, and that I am not going to sell. It also means that if the stock price were to drift lower into the twenties, that I would give serious consideration to adding to my position.
"That doesn't mean that I am happy with the slowdown in net inflows of funds in the last year or so, and I would certainly be more positive on the stock if I knew that the company was actively taking market share.
"I do know that an asset management Rule Maker is not the same class of company as a Microsoft or an Intel, which has a stranglehold on 80% or 90% of the industry business.
"In that sense, T. Rowe is more like a Pfizer or a Schering-Plough. Those companies are competing in a game which, due to the industry dynamics, allows the profitable co-existence of 12 players, all of whom probably could qualify as Rule Makers (or get pretty close to doing so).
"Now, don't get me wrong. Asset management does have some barriers to entry, and does have some elements to it that makes customer switching inconvenient, but nowhere near that of the pharmaceuticals. T. Rowe doesn't have to be one of the top five or ten mutual funds in terms of net inflows or 401(k) monies to continue to be very successful, although it would be nice. The industry allows a number of very successful players to co-exist. There is no reason why 10 or 15 or 20 players cannot all continue to make profit margins of 20% and grow assets under management by 15% per year. As long as T. Rowe is successful at growing assets under management at a pace of 10%-12% per year, then EPS growth will continue unabated at 15% or better."
"The Holy Grail of investing, in my opinion, is to find great companies operating in industries which offer the following three characteristics:
1) High returns on the assets and capital that must be invested in the business, plus...
2) Rapid growth in the company's available capital to reinvest at those high rates, and...
3) The ability to sustain both 1 and 2 for an extended, and ideally, infinite period of time.
"I still think that T. Rowe is exhibiting all three of those characteristics. Point 1 is not in doubt; Point 2 is a concern but not critical just yet, and Point 3 is a question that can be debated.
"I will be looking at some of the competitors in the industry and will post anything of interest."
Again, the above were just excerpts of Zeke's complete analysis, which is available at the following two posts on the Rule Maker Companies board:
- A Mouthful about T. Rowe Price
- The Trouble with TROW
Zeke makes a strong argument that T. Rowe, even if not a Rule Maker, is certainly a company worth watching. What do you think? Click into our Rule Maker Companies board and share your thoughts.
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Day Month Year History R-MAKER +0.07% -2.01% 9.60% 38.03% S&P: +0.64% -1.13% 7.45% 32.94% NASDAQ: +1.02% -2.75% 17.02% 55.23% Rule Maker Stocks Rec'd # Security In At Now Change 6/23/98 68 Cisco Syst 29.21 61.50 110.58% 2/3/98 54 Microsoft 45.13 85.75 89.99% 5/1/98 82 Gap Inc. 23.05 39.88 72.97% 2/13/98 52 Intel 46.93 71.44 52.23% 2/3/98 66 Pfizer 27.43 33.56 22.34% 5/26/98 18 AmExpress 104.07 127.13 22.16% 6/3/99 11 *Delphi Au 17.19 18.06 5.08% 8/21/98 44 Schering-P 47.99 49.06 2.23% 2/6/98 56 T. Rowe Pr 33.67 33.13 -1.63% 2/27/98 27 Coca-Cola 69.11 60.88 -11.91% 2/17/99 16 Yahoo Inc. 126.31 128.38 1.64% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 82.19 27.75% 3/12/98 15 Chevron 83.34 95.44 14.51% 3/12/98 20 Eastman Ko 63.15 70.13 11.05% 3/12/98 17 *General M 61.28 61.00 -0.46% Rule Maker Stocks Rec'd # Security In At Value Change 6/23/98 68 Cisco Syst 1985.95 4182.00 $2196.05 2/3/98 54 Microsoft 2437.28 4630.50 $2193.22 5/1/98 82 Gap Inc. 1890.33 3269.75 $1379.42 2/13/98 52 Intel 2440.28 3714.75 $1274.47 5/26/98 18 AmExpress 1873.20 2288.25 $415.05 2/3/98 66 Pfizer 1810.58 2215.13 $404.55 8/21/98 44 Schering-P 2111.7 2158.75 $47.05 6/3/99 11 *Delphi Au 189.09 198.69 $9.60 2/27/98 27 Coca-Cola 1865.89 1643.63 -$222.27 2/6/98 56 T. Rowe Pr 1885.70 1855.00 -$30.70 2/17/99 16 Yahoo Inc. 2020.95 2054.00 $33.05 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 15 Chevron 1250.14 1431.56 $181.42 3/12/98 20 Eastman Ko 1262.95 1402.50 $139.55 3/12/98 20 Exxon 1286.70 1643.75 $357.05 3/12/98 17 *General M 1041.80 1037.00 -$4.80 CASH $255.59 TOTAL $33980.84
Notes: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.
*Although DPH is not a Foolish Four stock, it was spun-off from GM on June 3, 1999