Oaktree Capital Group (OAK) – Strong as an Oak ?

oaktree-logo

Oaktree Capital is an US-based listed asset manager specializing in alternative assets and more specifically in “distressed” securities. Co-founder Howard Marks became quite famous and is one of the most intelligent people in the investment industry. I had reviewed his book 5 years ago and read everything he writes with great interest.

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Oaktree is clearly one of the “Highest quality” names in Alternative Asset Management with a very good long-term track record. A reader mentioned Oaktree in the “ideal company post” and as I had them on my list anyway I decided to make this my first analysis for 2017.

Looking at the stock chart we can easily see that the stock has seen better days and trades now significantly  below the IPO price of USD 43 from 2012 when the company went public:

oaktree

 

The company has a market cap: 5,8 bn USD. Due to its complex accounting (LP/GP structures, lumpy incentive fees etc.) GAAP Earnings are very volatile and not really representative of the underlying profitability. These were the GAAP EPS for the last 5 years (Bloomberg):

Year EPS
2015 1.450
2014 2.970
2013 6.350
2012 3.830
2011 -4.230

Incentive fees:

The driver of this volatility is the so-called “incentive fee”. For the classical “PE style” closed end funds, (around 33 bn of the 100 bn total AUM), Oaktree charges a percentage of the returns above a certain threshold. In most cases they charge a 20% profit share on top of a minimum return which usually is in the range of 6-8% p.a. Half of the profit share then goes as bonus to employees, the rest to the shareholders. To make things even more complicated, those fees have to be “accrued” first at fund level based on the actual performance and are only “earned” when money is actually paid out to investors. This makes those incentive fees highly volatile and usually, the time period when they are realized in GAAP is often several years later than when they were actually “created”.

This is how this looks for Oaktree based  on the numbers I compiled from the annual report:

2015 2014 2013 2012 2011
Incentive AUM 31,9 33,9 32,4 34,0 36,2
Incentive Fee created (shareholders) -66,4 24,2 549,5 493,0 -14,0
in % of Incentive AUM -0,2% 0,1% 1,7% 1,5% 0,0%
Avg 0,59%
Incentive fee earned GAAP) 122,0 259,6 593,8 238,5 124,8
in % of incentive AUM 0,38% 0,77% 1,83% 0,70% 0,34%
Avg 0,81%
Delta “Incentive created” to GAAP -188,4 -235,4 44,3 254,5 -138,8

We can easily see that the GAAP numbers are much smoother than the “real” numbers and over those 5 years GAAP looks a lot better than the true value creation. This is not  a surprise as Oaktree, as a distressed investor did create a lot of value after the financial crisis by snapping up distressed assets on the cheap. A lot of the performance within the fund then was already realized in 2009 and 2010 but then got distributed (and earned in GAAP) in the following years.

When assuming a “normalized” level of incentive earnings, I would use the underlying numbers and disregard the trailing GAAP numbers.

Usually when valuing Asset Managers in M&A transactions, incentive earnings get a lot lower valuation multiples than ongoing earnings from regular fee income.

Pro/Cons

As always I start my analysis with reading the underlying documents, in this case the 2015 annual report  and then I try to compile a pro/con list adding stuff I know from elsewhere.

Pros:

+ Howard Marks, clear investment philosophy (counter cyclical)
+ diversified (loans, real estate etc.), not a one trick pony
+ “alternative” assets have a strong underlying trend
+ 17 USD per share “hard” asset value (plus stake in Doubleline)
+ hard to value (incentive fees, complicated statements)
+ counter cyclical nature of the business
+ 2016 looks much better than 2015

Cons:

– Founders seem to be going into retirement (Marks is only Chairman)
– operational profitability declined 5 years in a row
– listed shares have only 1/10 of voting rights (A/B share structure)
– increasing competition in core business
– reporting focused on “adjusted” numbers which are not much better than GAAP numbers
– filings really hard to comprehend
– analysts are still optimistic

Operational profitability

Something which they do not report very well but “sprang into my eye” is the fact that the “ordinary” part of the business, i.e. the normal fee income vs. the normal cost seems to be in pretty serious decline.

Asset management as such is quite easy business: You charge a fee and you have to pay salaries and cost. This is a table of P&L lines I compiled myself from the annual report which I think is relevant in looking at Asset Management business:

2015 2014 2013 2012 2011
Fee income 753,8 762,8 749,9 747,4 724,0
Compensation -404,4 -379,4 -365,3 -329,7 -308,1
Equity based compensation -38,0 -19,7 -3,8 -0,3
G&A -120,8 -127,9 -117,4 -102,7 -94,7
Depr. -10,0 -7,3 -7,1 -7,4 -6,6
EBIT 180,6 228,5 256,3 307,3 314,6
Cost Income Ratio 76,0% 70,0% 65,8% 58,9% 56,5%
AUM bn USD 78,9 78,1 71,9 66,8 67,0
Fee in % of AUM 0,96% 0,98% 1,04% 1,12% 1,08%

We can see that headline fee income increased a little bit over the past 5 years, but especially compensation increased much more, resulting in a significant drop  in the underlying profitability. We also see some fee pressure but overall this part still looks Ok.

But a drop from a Cost/Income ratio of 56,5% to 76% is quite dramatic in my opinion.

Increasing competition for Alternative Assets

This is from the annual report:

“The increasing number of investment managers dedicated to our markets and the increasing amount of capital available to them have made it more difficult to identify markets in which to invest, and this could lead to a decline in our returns on investments. “

A pretty clear statement. What we see at the moment is a bifurcation of the Asset Management industry: On one side, cheap ETFs (plus quant strategies) and on the other side Alternative Assets with higher fees. Everyone in between has to go one direction or the other. For many players, the Index/ETF world is not an option, so almost all “classical” Asset Managers try to push into alternatives. Cleary Oaktree has the advantage of the track record, but things will clearly get more tough. This will impact further fee levels and potential returns. Plus, I guess that part of the increase in compensation is a defensive move to keep key people in the group. Good for the star employees, less good for the shareholders.

Valuation

I liked the way the Brooklyn Investor tried to value Oaktree,  a sum of parts valuation with 3 parts: The regular fees, the incentive fees and the NAV.,

This is how it looks based on “gut feeling” assumptions (12x EBIT multiple for normal fees, 6x EBIT for incentives, Doubleline at 1,5% of AUM, other NAV at book):

mn USD Per share
2015 EBIT ex Incentive 180,6
Multiple 12
Value 2.167,2
Per share 14,0
Avg Incentives 5 year 189,5
Multiple 6
Value 1.137,2
Per share 7,3
NAV Investment Q3 2016 per share 17,1
Doubleline value p.s. 1,7
Total value per share 40,1
Current price 37,6
Upside 6,8%

Under those assumptions, the stock looks fairly valued. Now one could of course discuss any of the assumptions (averages, multiples etc.) in order to move the value up or down. However my experience is that my first “gut feeling” approach often turns out to be pretty good.

So at this stage we can clearly see that although Oaktree is an interesting company, but they do have issues and the stock price does not indicate a significant undervaluation which I would need in this case. For me this is (again) a stock for the watch list which I would consider toi buy at a lower price, in this case at least below 30 USD per share (all other things equal).

Summary:

For the time being, I will remain a loyal reader of Howard Marks’ comments but not invest into Oaktree. The good times seem to be over and the company is facing some operational issues. At a significantly cheaper price, the stock would be more interesting.

 

12 comments

  • I would add another negative to your initial pro/con list being the potential for a rising rate environment. The major push into alternatives by the large institutional players (insurance companies, pensions and sovereign wealth funds) has largely been driven by the low rate environment. If we are seeing a secular turn in interest rates, it would be a hefty long-term detractor from the alternative asset management sector.

    Also, having recently been employed with one of the largest global alternative managers, I would stress the importance of Oaktree going after custom mandates rather than pooled closed-end products. I imagine they are aware of the importance, but hearing them clearly communicate the business direction would be important to me.

    Lastly, as a positive, Trump has indicated his interest in rolling back regulation. Should this occur, they should see some drop in G&A. I can’t guess what the dollar figure of this impact would be, but it’s something worth considering.

    Thanks for posting, looking forward to more in 2017.

  • It should be noted that OAK did their IPO very timely – they knew they were overearning and hence got a good valuation.
    I pretty much agree with your valuation overall and I don’t think we are looking at a great bargain right now. This will become a bargain, when we got a hiccup in the financial system and bargains become avaliable that will drive growth in incentive fees.

    It also should he noted that the owners are on the way out and thay includes Howard Marks. Since investment management is a people business, this warrant a durther discount on OAK’s intrinsinc value.

  • Interesting post. I looked at Oaktree (and Fortress Investment Group) a couple of weeks ago and came to the same conclusion as you. I would like to buy but not at the current price…

  • I see OAK a bit differently. If one believes cycles will continue to exist they might be a worthy addition to someone’s portfolio. Could you also explain why you think Doubleline should be valued the way you did so? I see it both on DL’s AUM and the earnings or dividends it pays to OAK.

    Quick back of the napkin: Over the last 8 years, we see a very lumpy (ranging from $405-984mm) but average distributable earnings (which is the more conservative metric and lower than both ANI and ENI) of $592 million/year. That’s $3.87/share. Throwing out the 2 outlier years, it’s $3.64/share. SO:

    Book value of cash and investments at $1.7 billion or 11.68/share
    +Accrued incentives of $5.63/share
    +Doubline at $800 million or $5.22 share
    =$22.53

    Today’s price is $38.50, so the ongoing business is valued at $15.97/share ($2.4 billion) or ~4.2x the more conservative distributable earnings. That looks cheap for the ongoing business.

    • Rob,

      as I said, one can discuss the assumptions. However I would make one comment: It looks like that the “core business” seems to struggle structurally. So just using averages (even with taking out outliers) is in my opinion very optimistic.

      Could happen but is not the base case in my opinion. Plus I think adding the accrued incentive looks like doublecounting when you have included incnetive fees in the distributable earnings. they can only be distributed once 😉

      mmi

      • Thanks for the response. I’m thinking hard about the double counting…and I don’t think it is. Accrued incentives as presented above are past tense as the (ed) suggests. These are already earned and we’re buying them as such. If we look forward and believe the company can perform over future business and credit cycles hopefully, more incentives will accrue to replace those already earned thus driving DE to be similar to the past levels. I don’t think I’m saying that we should distribute yesterdays accrued incentives, then distribute them again tomorrow while also earning more.

        • Hi Rob,
          of course you can do it one way or the other, I just think that using distributed earnings in your multiple and adding accrued is not 100% consistent. In any case, even if you add accured I would assume a haircut as they ccan also shrink (like in 2015….).

          However I think there is a bigger issue with adding the NAV in a sum-of-parts valuation:

          Oaktree has the regulatory requirement for instance for CLOs to invest a certain percentage of the fund from own (shareholders) money. So as long as the run the business, a certain amount of the NAV is locked in and not distributable similar to the NAV of an insurance company. When you value an insurance company, you don’t add the NAV to the NPV of the future earnings because it is required to run the business.

          So I do think that one would actually need to “haircut” Oaktree’s NAV to adjust for the regulatory required capital and really only add true “excess” to the valuation. However they do not disclose this.

  • A very timely post. I quickly bought and sold this yesterday.

    +
    Howard Marks himself owns a meaningful position i.e., 11% of the company.
    The management (all together) own around 37% of the company.


    they are slowly liquidating their position (?) i.e., they used to hold 50% of the stocks in 2013 and 42% in 2015. So, approximately 4% of the shares are being sold by the management every year (so far).
    The interests rates are very low for a while now. And that makes for strange asset prices and expectations. I don’t feel comfortable enough to buy people who invest in bonds when the interest rate is surely going to go up (increasing inflation and decreasing bond prices). Even though I am sure that they know of this possibility and have probably planned for it, I can’t get myself comfortable enough with the investment.

  • Great post!

    Thinking about the fee/earnings drivers, I assume that the mid-/long-term outlook should be dependent on the credit cycle. With increasing risk premiums and default rates, the distressed investment strategies (both trading and loan-to-own) might potentially see more promising opportunities than as of today. Current availability of debt funding might eventually change someday… But that is a bit dependent on makro topics and difficult to forecast.

    Frohes Neues BTW.

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