T. Rowe Price: Patience Growing Thin With Continued Market Underperformance (NASDAQ:TROW) (2024)

Previous Coverage

In June 2022 I published my arguments for going long T. Rowe Price Group (NASDAQ:TROW), and despite having considered it a strong buy at that point, my position has been vastly underperforming the market during that period. In fact, during the past two years, TROW has delivered a total return including dividends of -8% compared to the total return of the S&P 500 just shy of 31%. Ouch! I always advocate for dollar cost averaging, so I’m a bit better off due to having built my position in tranches, but I’m still trailing the market vastly for this position. If my example serves for anything, it’s to be mindful of the concentration any single position represents in one’s portfolio.

I’ve for a while been impatient with TROW and having digested the latest quarterly performance of 26^th of July, I thought it was time to revisit the company. First however, I’ll revisit the baseline related to why I perceived it to be a good investment at the time.

Revisiting the Arguments

I remember sifting through the financial statements and historical valuation metrics for TROW having little doubt that this trade would turn out to provide solid returns. At that time, I build my case around some of the following arguments.

With a forward yield of 3.8% at the current price, you can lock in a yield well above the ten-year and five-year average, in fact, in the last decade there was only one other moment where TROW could be picked up at a similar yield, the Covid-19 crash.

Over the past decade, TROW has managed to grow revenue, net income and free cash flow, which are all paramount for a growing business and a secure dividend.

TROW is in possession of a rock-solid balance sheet with $2 billion in cash and only $320 million in debt.

With a payout ratio at 35% when measured on free cash flow, and enough cash on the balance sheet to cover it for almost two years, the dividend is very secure.

Previous article on TROW

Today, you can pick up TROW at a forward yield of 4.8%, revenue is starting to grow again YoY and the balance sheet is in an even better position with $2.7 billion in cash and only $376 million in debt, creating a strong net cash position.

Cash flow is not as stellar as the heydays of 2022, but it’s still north of $1.2 billion trailing twelve months, which is in line with the average seen over the past many years where ebb and tide play its role with a volatile business, causing fluctuations in free cash flow. Nothing out of the ordinary here.

In total, one could be so bold as to say the foundation is just as good as two years ago, if not even more so considering the starting yield and its security given the balance sheet and free cash flow situation. I would however highlight that the dividend hikes has been paltry in the last couple of years compared to the trend seen in a five- or ten year horizon.

However, the market doesn’t seem to agree, and investor patience has been tested plenty, and more likely than not, will continue to be tested.

Let’s have a closer look at business performance.

Financial Performance Q2-2024

TROW reported its second quarter performance on the 26^th of July and here are some of the highlights for the second quarter.

• Revenue of $1.73 billion, up 7.6% from $1.61 billion a year ago, however down 1% QoQ
• Earnings per share of $2.11, up 2.4% from $2.06 a year ago, however down 15.3% QoQ
• Expenses increased 8.5% YoY, but net income also increased 5.8% to $565 million
• Assets under management (AUM) was $1.57 trillion, up 12.1% YoY.
• Assets under management (AUM) grew $26.9 billion QoQ, which equates to a 1.7% growth.
• During Q1, management hiked the dividend for the 38^th consecutive year, increasing it by 1.6% from $1.22 to $1.24.

In essence, the performance of the second quarter of 2024 contained more positives than negatives also considering how the company continues to exhibit a very robust balance sheet, which will act as a bulwark should the economy turn for the worse at some point.

However, it should also be highlighted that TROW underperformed consensus estimated in the market. Revenue was $50 million short and adjusted EPS was $0.02 below. This was the first miss in the last year, and a small once as such, but it was a miss regardless and therefore dampened investor enthusiasm in the days after the results were published.

If we zoom out a bit and consider the complete six months of 2024 compared to the same period last year, then we see that revenue was up 10.6% to $3.48 billion and net income grew 16.8% to reach $1.07 billion. All well.

In total, TROW, at first sight, appears to be a well-functioning and profitable company.

The factor grades of Seeking Alpha, which compares TROW relatively to its peers also suggest that this is a company that has returned to growth, drives strong profitability while not disappoint on its revisions. Valuation could offer a better starting point, which should be viewed in the light that earnings has been depressed following the peak of 2022.

Similarly, the dividend grades of Seeking Alpha are all in green, which is a rare situation for a large cap company during an upcycle period of strong returns for the broader market and at a time of economic expansion in the global economy. Normally, it would be observed that profitability or growth was exhibiting a negative develop, which would be evident in the factor score and easily visible in the financial accounts. This is of course a comparison to peers, and I would argue the dividend growth score is a bit too favourable, but all in all this paints a picture you want as a dividend growth investor.

Given that financial performance has stabilized after the volatility in 2022, an obvious question arises.

Why Does The Market Have No Appetite For TROW?

First and foremost, earnings peaked in 2021-2022 and this weighs like a blanket on the stock, as EPS is lower, meaning that the “Earnings” in P/E ratio has decreased. However, I perceive there are other arguments that may be the prime culprit as to the underperformance and unfortunately, I don’t expect those to go away anytime soon.

Ever since inflation started spiking, we’ve been in an economic macro scenario where many economists were expecting a recession to be just around the corner. The likelihood of that was perhaps not elevated a lot, but it was talk of the town and showed itself in the market, in the shape of the famous magnificent seven driving the majority of the returns.

TROW thrives in times where liquidity is plenty and investor sentiment positive. As such, when liquidity is withdrawn from the market and nervousness is a constant theme, it dampens TROW’s financial performance as we’ve seen with negative flows of funds. Now, we never had the recession, but as has been the case in the past few months, the expectation that one is just around the corner remains as high as any other point in time over the last few years. And this concern, whether it becomes reality or not, means that investors are closer to the exit than the entrance when it comes to TROW.

There is simply too much ambiguity in terms of where the economy is headed.

Another point of interest, which is also frequently discussed in the earnings call between the management team and analysts who dial in, is the idea of a permanent shift in preference amongst customers towards products with lower fee’s, causing a compression in income potential for TROW in both the near- and long-term perspective.

Here is a snip from the latest earnings call, with Jen Dardis, CFO addressing the topic.

Looking at our income statement. Q2 adjusted net revenues were $1.8 billion, an 8.5% increase from Q2 2023, driven by higher average AUM. Compared with Q1 2024, adjusted net revenues were essentially flat as higher investment advisory fees were offset by a decline in accrued carried interest. Our annualized effective fee rate for Q2 2024 was 41.6 basis points, which is down from the prior quarter as client flows and transfers led to a mix shift in assets under management to lower fee products and asset classes

Jen Dardis – CFO – Q2-2024, earnings call transcript

Lastly, I’d highlight the effect of the combination above. Namely, that uncertainty in the broader economy and the gradual shift in customer preferences, also shows itself in the EPS and revenue outlook for the coming years.

With low single digit forecasted growth in the coming years for both top and bottom-line, there isn’t a whole lot to be enthusiastic about for the market.

Valuation And Conclusion

As an investor in TROW, nothing would make me happier than come away with a clear bull case conclusion. Unfortunately, I find it hard to construct one. If we compare the outlook above, to the mean historical valuation for TROW, there isn’t much justification for the stock to suddenly find itself in an upwards moving trajectory. As such, stock appreciation as a catalyst appears slim.

A thing I often consider, is the idea of mean reversion when it comes to yield. If we observe TROW’s yield over a prolonged time period, we can observe that it on average trades with a yield of roughly 3%. The last couple of years has been the exception, and we have to go back to the financial crisis of 2008 to find the last time, the stock traded with such an elevated yield.

From that perspective, a return to the long-term average starting yield of 3% would require a stock price of $164.4 – 59% higher than the current stock price. I don’t personally see that on the horizon anytime soon given the arguments I highlighted for why the market has no appetite for the stock, but given sufficient patience, the stock could climb quite a bit higher. At least from a mean reversion perspective. Question of course is, what sort of patience is required, as the yield, for the first time since 2008, has been trading with this unusually high yield for a long time, indicating the market has lost faith in TROW at the moment.

Considering the valuation in general, it’s important to consider the revenue and earnings outlook. Those expectations were low single digit growth, so there isn’t much upside to be had, even if we assume the stock should reverse towards it’s five- and ten-year mean P/E ratios. These have also been declining steadily over the last decade, a small red flag in its own.

My conclusion is that TROW is granted a hold rating. This is based on the arguments that the business is doing well and is very robust due to a rock-solid balance sheet. My observation is, that the stock is closer to its bottom than its peak, so downside should be limited granted that the financials have stabilized, but there just isn’t enough power to propel revenue and growth higher in a tempo that could drive capital appreciation. Point being, I don’t think my capital is at major risk here, so as I’m already invested, I’ll hold onto my shares.

The company is 87 years old and has weathered numerous recessions that buried lesser firms, but TROW still stands and has in addition hiked the dividend for 38 consecutive years. However, given the outlook both for the economy and the business in the coming years, I doubt we’ll see a strong rally in the stock, potentially resulting in continued market underperformance.

Early 30s 'buy and hold' investor trying to achieve financial freedom to the greatest extent possible.Main focus within dividend growth investing & value. I've been investing for 10+ years and worked across several industries including finance, logistics, oil and pharma. Holding a Graduate Diploma within Accounting and MSc within Business Administration & Supply Chain Management.I cover companies matching my focus as well as portfolio strategy