Invesco's Morgan Stanley deal raises questions

Analyst Note
We're placing Invesco under review while we assess the full impact of the firm's acquisition of Morgan Stanley's retail fund operations, which include the Van Kampen family of funds. At first glance, the deal, which will add $119 billion to Invesco's assets under management (AUM), could increase our fair value estimate for the firm by as much as $2 per share. This is based on the $1.5 billion deal price ($1.0 billion of equity and $500 million in cash), integration costs of $100 million-$125 million, and synergies of around $70 million. While Invesco expects the deal to be accretive in the first full year after it closes in mid-2010, we continue to have reservations about the firm doing a deal of this size right now. With its poor record of integrating past acquisitions, which has kept the firm from reaping the full benefits of the size and scale of its operations and left its operating margins well below its peers, we'd much rather see Invesco working on putting its own house in order rather than making such a major acquisition.

The terms of the deal satisfy Morgan Stanley's desire to have an equity stake in whatever organisation acquires its retail fund operations. While it is a smaller stake (9.4% of Invesco's current shares outstanding), given the amount of cash Invesco has on hand, which was enhanced by a $400 million secondary offering in May, we believe it is likely that Morgan Stanley's stake could rise over time as Invesco uses some of its excess cash to repurchase shares.

As for the impact that the acquisition will have on Invesco's AUM, the company's asset mix will change very little, although it will end up with a higher level of retail investors and clients domiciled in the United States. As of September 30, Invesco had $417 billion in AUM, made up of equity (39%), balanced (10%), fixed-income (18%), and money market (23%) funds. The combined firms will derive 41% of their AUM from equity, 10% from balanced strategies, 18% from fixed income, and 17% from cash management. With retail exposure rising from 47% of AUM for Invesco to 57% for the combined firms, and the company increasing its reliance on US-domiciled clients (which rise from 61% of AUM to 67%), we expect Invesco to lose some of the diversification it has had in its managed assets.

At 1.3% of AUM, the deal is somewhat more expensive than BlackRock's purchase of Barclays Global Investors in June, but looks more reasonable on a price/sales (2.4 times) and price/EBITDA (7.7 times) basis. We were somewhat surprised to see how low the realisation rate was for the funds that are being acquired, which at 0.40% of AUM is much lower than the 0.57% we expect Invesco to earn on its average AUM this year. That said, with operating margins above 30%, the funds Invesco will be acquiring are far more profitable than its current lineup and could help the firm get its operating margins more in line with its peers.

Thesis (last updated October 1, 2009)
Despite its size and diverse product portfolio, Invesco was not immune to the bear market.

The firm's AUM dropped more than 25% during 2008 and were down slightly during the first quarter of 2009 (helped mainly by a large inflow of cash into Invesco's money market funds). With the fees earned on fixed income and money market funds lower than those for equities, the company's lower level of AUM and adverse mix shift has had a negative impact on revenue and profitability this year. The recent rally in the equity markets, however, has boosted the market value of Invesco's equity and balanced funds and increased flows into its equity and fixed-income strategies and out of its money market funds. This should help reverse some of the damage inflicted by the bear market, allowing Invesco to return to its main focus--unifying its disparate collection of businesses into a more cohesive and profitable global organization.

Invesco has many of the attributes we look for in wide-moat asset managers: a diverse mix of assets, broad distribution by channel and geography, and solid fund franchise. The company's product diversification is fairly balanced, with 36% of AUM at the end of the second quarter coming from equity offerings, 18% from fixed income, 9% from balanced products, 12% from alternative investments, and the reminder in money market funds. Invesco's client base is weighted more toward institutional clients (53% of AUM), which tend to be stickier than retail investors (43%) and private clients (4%). More than 35% of the firm's AUM comes from outside the United States, with Invesco being a market leader in Canada and the United Kingdom and servicing clients in more than 100 countries.

If there has been one major weakness in Invesco's ability to carve out more than just a narrow moat, it has been the positioning of its funds. The firm has done well with its Perpetual, Trimark, and Invesco banners in the UK, Canada, and Asia, respectively, but has faced an uphill battle with its AIM brand in the US. While a good deal of this was due to the decentralised nature of the firm's operations, which impeded its ability to support all of its funds, Invesco's involvement in the market-timing scandal earlier this decade did little to help its efforts.

Since Marty Flanagan took the helm in 2005, Invesco has been focused on improving the performance of its AIM brand, as well as the firm's ability to support its products. Invesco has also expanded its lineup of alternative investments through the acquisition of WL Ross, a manager of distressed assets, and PowerShares, a provider of exchange-traded funds. With some of these moves starting to bear fruit before the firm was impacted by the bear market, we think it is only a matter of time before Invesco gets its groove back and starts posting the type of results we believe the firm is capable of generating over the longer term.

Valuation
We've increased our fair value estimate for Invesco to $21 per share from $18 to account for changes in the global equity markets since our last update. The rally in the equity markets since the beginning of March has helped the company improve its AUM and reverse some of the damage inflicted by the bear market. We expect Invesco's revenue to decline around 15% this year, which is a marked improvement over first- and second-quarter results where year-over-year revenue growth was negative 40% and negative 33%, respectively. After 2009, we believe a more normalised level of market returns will result in 8% annual revenue growth over the projection period. With Invesco continuing to successfully manage its expenses in relation to a depleted revenue base, we expect operating margins to settle in at around 17% of sales this year. Over time, we expect operating margins to trend back up to 25% of sales, in line with where the company was at the end of 2007. We use an 11% cost of equity. Our fair value uncertainty rating remains at medium for Invesco.

Risk
With 80% of annual revenue coming from management fees earned on its AUM, dramatic market movements or changes in fund flows can have a significant impact on operating income and cash flows. Shifts away from equity strategies can have an impact as well, with management fees lower for fixed-income and money market funds. Invesco is also exposed to cultural, economic, and political risks through its operations and investments in overseas markets.

Strategy
While Invesco has not shied away from acquisitions--AIM Management (1997), LGT Asset Management (1998), Trimark Financial (2000), Perpetual (2000), Pell Rudman (2001), PowerShares (2006), and WL Ross (2006)--to expand its operations, the firm has not been able to fully capture the benefits of having increased its size and scale. Since coming on board in August 2005, CEO Marty Flanagan has focused on unifying the firm's disparate collection of businesses into a more cohesive and profitable global organisation.

Management & Stewardship
Marty Flanagan has been president and CEO of Invesco since August 2005. Rex Adams has been the firm's nonexecutive chairman since April 2006 and a member of the company's board of directors since November 2001. Flanagan was lured away from Franklin Resources, where he had been serving as co-CEO with Greg Johnson, the grandson of the founder of that firm. Invesco has a long history of squandering its competitive advantages, but things have improved somewhat since Flanagan took the helm. Aside from cleaning up the clutter that had kept the firm from being anywhere near as profitable as its peers, Flanagan spearheaded the acquisition of PowerShares and WL Ross in 2006. The company moved its primary stock market listing from the London Stock Exchange to the New York Stock Exchange in December 2007 after it lost its foreign private issuer status in the US. Invesco also shifted its domicile from the UK to Bermuda in order to avoid significant tax charges that would have resulted from a move to the US. While minimising the tax bill was a prudent move, shareholders may have fewer rights of redress with a firm domiciled in Bermuda.

Profile
Invesco provides asset-management services for institutional and individual investors. The firm's investment products are marketed under the Invesco, Invesco AIM, Invesco Perpetual, Trimark, and Atlantic Trust banners in more than 100 countries. At the end of the second quarter of 2009, product offerings included equity (36% of AUM), fixed-income (18%), balanced (9%), alternative (12%), and the remainder in money market funds.

Growth
While Invesco's turnaround efforts produced double-digit growth in revenue and AUM during 2006 and 2007, the company hit a wall last year. Given the dramatic decline in the global equity markets and corresponding decline in Invesco's AUM, we expect revenue to decline this year.

Profitability
While Invesco has made great strides toward improving its operating margins, which expanded from 14% in 2005 to 25% in 2007, it continues to lag the industry by a wide margin. With the bear market ravaging the firm's revenue and profitability, it might take years for Invesco's operating margins to return to the levels seen in 2007.

Financial Health
Invesco closed out 2008 with $1.2 billion in debt and more than $700 million in cash and other short-term investments on its books. While the firm's financial flexibility may be limited this year, given the impact that the bear market will have on its operations, we do not perceive any serious issues with its financial condition.

Bulls Say
1. With around $400 billion in AUM and a fairly diverse product offering, Invesco has both the size and scale necessary to remain a top competitor in the rapidly changing asset-management landscape.

2. With a diverse mix of assets under management, Invesco has a more complete portfolio, allowing it to sustain its AUM even when market fluctuations or investor demand turn against one asset class.

3. Invesco's product distribution is weighted more toward institutional clients (53% of AUM), which tend to be stickier than retail investors (43%)--especially in periods of prolonged market weakness.

4. More than 35% of Invesco's AUM comes from outside of the US. The firm is a market leader in both Canada and the UK and services clients in more than 100 countries.

Bears Say
1. The dramatic decline in equity markets has fuelled massive outflows from funds. With more than 40% of its AUM derived from retail investors, Invesco has not been immune to this phenomenon.

2. Invesco's AUM dropped more than 25% in 2008, from $500 billion to $360 billion, with the assets managed in its equity and balanced portfolios seeing the largest decline, dropping 45% year over year.

3. Despite the improvements in revenues and profitability since Marty Flanagan took over as CEO, Invesco's operating margins remain among the lowest of the asset managers that we cover.

4. Though by no means overleveraged, Invesco carries more debt on its balance sheet than the typical asset manager. This could hamper the firm's financial flexibility at a time when it needs it most.

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