T. Rowe Price (TROW): A Quality Dividend Aristocrat Trading at a Discount

Asset management is a great business, given that the stock market has historically risen by a 9.1% CAGR since 1871.

 

In other words, the assets from which management fees are derived are generally rising, allowing for exponential growth in earnings and cash flow – the building blocks of any great dividend growth stock.

 

Of course, those same giant pools of money can create conflicts of interest between management and shareholders, in which employees of the company end up trying to enrich themselves with the kinds of giant bonuses that Wall Street has become legendary for.

 

This is why shareholders need to be very selective, only buying shares of time-tested, shareholder-friendly asset managers, such as T. Rowe Price.

 

With a dividend yield nearly 50% above its long-term average and a forward P/E multiple of just 15.1, TROW’s stock could be a timely opportunity to consider.

 

Let’s take a closer look at this venerable dividend aristocrat, which has 30 consecutive years of growing dividends under its belt, to see if T. Rowe Price is an appealing long-term investment for a diversified dividend growth portfolio.

 

Business Description

Founded in 1937 in Baltimore, Maryland, T. Rowe Price Group is one of the world’s largest investment managers with offices in 17 countries on four continents.

 

The company uses fundamental and quantitative analysis to create and manage equity and bond mutual funds, which have historically beaten their indexes and thus attracted consistent inflows of investor money.

 

Today T. Rowe Price has a record $813 billion in assets under management (AUM), having marked net asset inflows of $2.2 billion in the first three quarters of 2016.

 

Stock and blended asset portfolios account for 77% of T. Rowe Price’s total asset mix, with fixed income portfolios accounting for the remaining 23%. U.S. mutual funds account for 64% of the firm’s assets.

 

Business Analysis

As you can see, the track record of actively managed funds beating their benchmarks over the long-term is downright abysmal. This explains the rising popularity of passive investing, such as index funds and exchange traded funds (ETFs).

 

 

Fortunately, T. Rowe Price is one of the few investment managers that has actually earn its fees, with 81%, 84%, 82%, and 88% of its mutual funds beating their benchmarks over the last one, three, five, and 10 years, respectively.

 

Not surprisingly, the majority of T. Rowe Price’s mutual funds are rated four or five stars by Morningstar, well above the industry’s averages.

 

 

This kind of impressive outperformance makes T. Rowe Price one of the most trusted and respected names in asset management, giving it a wide moat that insulates it from most of its competitors.

 

Better yet, with about two-thirds of its AUM tied up in retirement and annuity funds, the company’s asset base is less prone to volatile asset outflows. This creates more stable fee revenue, earnings, and cash flow with which to pay investors a generous and highly secure dividend (more on this later).

 

In recent years, T. Rowe Price has been able to further widen its competitive advantage by launching a series of target date retirement funds. These are funds that automatically re-adjust asset allocation between bonds and stocks based on the changing risk-tolerance of a client who will need to retire by a certain date.

 

In fact, over the past five years T. Rowe Price has seen its target date fund AUM triple from $60 billion to $178 billion (22% of firm-wide AUM), according to Morningstar.

 

With the rapid aging of the U.S. population and growing concerns about retirement security, analysts expect retirement dated funds to become increasingly popular. T. Rowe Price is well-positioned to benefit from this trend.

 

Thanks to its strong track record created by a long-term performance focus and excellent brand equity, T. Rowe Price has been able to record net asset inflows in 30 of its last 40 quarters, resulting in steadily growing revenue, earnings, and free cash flow (FCF).

 

 

Management’s impressive balancing act between attracting and retaining top fund manager talent, while avoiding the kind of obscene compensation seen elsewhere on Wall Street, has helped the company generate strong, consistent, and growing margins during this time. T. Rowe Price’s strong profitability is also helped by the recurring revenue its business enjoys and its relatively low capital requirements (the company’s core asset is its research team).

 

 

In fact, compared to its peers, T. Rowe Price generates far better margins and returns on investor capital, showing the superiority of its unique management style.

 

Company	Operating margin	Net Margin	FCF Margin	Return On Assets	Return On Equity	Return On Invested Capital
T. Rowe Price	38.8%	26.7%	23.8%	18.6%	23.5%	23.5%
Industry Average	23.4%	15.8%	NA	1.1%	9.1%	NA

Source: Morningstar

 

Rather than having a single person calling the shots, T. Rowe Price has a management committee that collectively guides, implements, and reviews major policy changes and initiatives. This further reduces the company’s business risk profile.

 

Combined with a deep bench made up some of the best and most experienced money managers in finance, this creates a very stable and enduring investor-friendly corporate culture.

 

In fact, from 2011 through 2015, T. Rowe Price paid out 96% of EPS to shareholders in buybacks and dividends. The company has proven itself extremely dedicated to long-term shareholder wealth creation.

 

Key Risks

While T. Rowe Price has proven itself an excellent long-term dividend growth stock, there are a few risks to be aware of.

 

First, a large part of its fees are based on daily AUM, which means that financial results can be lumpy, especially during times of negative market volatility. The company does not do well during bear markets.

 

In addition, over the past few years T. Rowe Price’s rate of organic AUM growth (net inflows) has slowed:

 

 

The decrease in growth is due to T. Rowe Price’s sheer size (the biggest institutional investors have concentration limits in any given fund) and the rising popularity of passive investing (T. Rowe Price does not have any meaningful passive presence). Since December 2008 passive funds have attracted $1.6 trillion in assets, while active funds have seen outflows of $400 billion.

 

The chart below from Bloomberg is enough to instill fear in any active manager, and it makes T. Rowe Price’s sluggish growth above look decent compared to the rest of the industry.

 

 

Management has responded by gradually reducing its management fees (passive funds usually have much lower fees than active funds), as well as offering more retirement focused services and expanding internationally. There are a number of unique strengths possessed by T. Rowe Price to help it overcome the challenges posed by the rise of passive investing.

 

The good news is that because T. Rowe Price’s average mutual fund expense ratio has usually been below that of its rivals, the amount of fee compression has been minor. But going forward, the increasingly competitive asset management industry means that there is likely to be ongoing pressure to lower fees in order to continue to attract and retain more assets.

 

 

Investors should also be aware that 75% of T. Rowe’s AUM is tied up in funds with exposure to U.S. equities. This means that the company faces severe geographic risk, in that a sharp decline in U.S. markets will both result in a fall in fee revenue, as well as potentially large fund outflows as investors panic and withdraw their capital from the American market.

 

Management is working hard to diversify abroad. However, this will take time and there is no guarantee that the company will be able to replicate its success in the U.S. in other countries, which have different cultures and investor expectations.

 

Finally, it’s worth noting that several key executives are retiring from the company. In a business built on trust and performance, it never helps to lose highly visible leaders.

 

Brian Rogers, T. Rowe Price’s chairman and chief investment officer, is set to retire at the end of March. The company’s CFO recently announced he will retire in 2017 as well, and investors will recall that T. Rowe Price’s current CEO took over only at the end of 2015. That’s a lot of change.

 

Additionally, the company’s investment team has more than doubled in size since 2005. Such growth comes with cultural changes that could meaningfully help or hurt the company over time.

 

The good news is that the company’s key investment personnel have been with the company for a very long time, hopefully helping T. Rowe Price continue delivering steady results like it has for decades. As seen below, the company’s portfolio managers have been with the firm for an average of 17 years.

 

 

Dividend Safety Analysis: T. Rowe Price

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

T. Rowe Price has a Dividend Safety Score of 86, meaning it has a highly secure and dependable dividend. This is primarily a result of three factors.

 

First, despite the occasional lumpiness of its financial results, which can cause spikes in its payout ratios, T. Rowe Price has generally had its dividend very well covered by both earnings and free cash flow over the years.

 

 

In fact, the payout ratio for both metrics is generally well under 50%, allowing the dividend to not just remain highly secure during economic and market downturns, but continue growing as it did during the 1990-1991, 2000-2003, and 2008-2009 recessions.

 

T. Rowe Price’s dividend also scores well for safety because its business model does an excellent job of generating free cash flow each and every year. The asset management business benefits from high margins and low capital intensity. Free cash flow is the sign of a healthy business and is needed to pay dividends without having to issue shares or take on debt.

 

 

The other important safety factor is the company’s fortress balance sheet, which has no debt and a significant amount of cash.

 

As you can see, not only does T. Rowe Price’s current ratio indicate that the company has no challenges paying its liabilities with current assets, but the $1.4 billion in cash is enough to pay the dividend for five quarters.

 

 

This pristine, debt-free balance sheet means that, in a worst case scenario, management could choose to cover any insufficiency between the dividend and free cash flow with borrowed funds.

 

However, since T. Rowe Price would first tap its cash, this would only need to be done after a very protracted downturn in the economy, stock market, and industry.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

T. Rowe Price has a Dividend Growth Score of 77, meaning that income investors can expect much better dividend growth going forward than the 6.1% median payout growth provided by the S&P 500 over the past 20 years.

 

As seen below, T. Rowe Price has increased its dividend by 15.3% annually over the last decade.

 

 

However, be aware that given the growth headwinds the company is facing, especially in terms of slowing organic AUM growth, as well as long-term downward pressure on its fees, investors shouldn’t expect the same impressive 15% payout growth going forward (TROW’s last dividend increase was a 4% raise in early 2016).

 

That being said, in the coming years T. Rowe Price should be able to maintain around 5% revenue growth. When combined with increasing economies of scale and steady buybacks, it’s not unreasonable to assume the company could grow EPS by 9% to 10% annually.

 

Over the long term, T. Rowe Price’s dividend should grow at the similar pace, providing solid income growth.

 

Valuation

The stock market is nearing the 9th year of an epic bull run, which has left stocks trading at a historically high 26.1 times trailing EPS.

 

Fortunately, T. Rowe Price is currently trading at a far more attractive valuation, both on an absolute basis as well as relative to its historic norm.

 

P/E	13-Year Median P/E	Yield	13-Year Median Yield
16.8	20.8	2.9%	2.0%

Source: Gurufocus

 

Of course, we can’t forget that earnings growth is likely to be slower in the coming years for several reasons previously discussed – the continued shift to passive management, secular pressure on management fees, and potentially lower returns from the relatively pricey stock market (makes AUM growth harder to achieve).

 

However, even adjusting for lower growth expectations, T. Rowe Price shares appear to be reasonably priced. This is especially true given that TROW’s dividend yield is nearly 50% above its historic median and the stock’s forward P/E multiple is just 15.1, a discount to the broader market’s valuation despite T. Rowe Price’s strong business quality.

 

I believe T. Rowe Price can continue to moderately grow its business over the long term. There will always be a need for active managers, and T. Rowe Price has the performance track record, economies of scale, distribution relationships, and fee structure needed for long-term survival.

 

While the stock’s valuation looks appealing for long-term dividend investors, it’s worth pointing out that TROW’s stock will almost certainly underperform during the next meaningful market correction given the nature of its business. That would be the most ideal entry point for new investors, in my view.

 

Closing Thoughts on T. Rowe Price

T. Rowe Price has proven itself one of the best investment managers on Wall Street. More importantly, the company’s corporate culture is among the most shareholder-friendly in its industry, with a strong and consistent dedication to long-term dividend growth.

 

With shares trading at a seemingly reasonable price, something that can’t be said for most quality dividend growth stocks, T, Rowe Price is definitely one dividend growth blue chip that deserves consideration for any income growth portfolio. We own the stock in our Top 20 Dividend Stocks portfolio.