Brooke’s Note: As I saw Envestnet gaining IPO momentum over the spring and into summer, I tried to write about the factors that might have caught the imagination of Wall Street in 10 reasons why the Envestnet IPO filing is for real But I had a feeling that the really sizzling reasons – the kind that help investors connect the dots and buy on an IPO’s opening — hadn’t been captured in what I had to say. Now I understand better what those reasons are. The Morgan Stanley report covered in this RIABiz story does the job of rolling the business prospects of Envestnet into a nice readable package that may result in that aha moment for industry observers.
Investors don’t appreciate Envestnet Inc. because they don’t understand the company’s potential to bring over assets in giant chunks in two different ways, according to a report published yesterday by a senior Morgan Stanley analyst.
The Chicago-based outsourcer of technology and investment solutions to independent advisors can expect to bring on significant numbers of advisors and their assets from “conversions” and by rolling up competitors, according to Celeste Mellet Brown in her report entitled: “Buy for Independent Trend, Stay for Conversions.”
Morgan Stanley was a lead underwriter of the Envestnet IPO.
The report outlines some of the factors that could derail Envestnet, including the fact that it takes a great amount of effort for any company, large or small, to outsource technology, and that Envestnet could handle those transitions ineffectively. Envestnet is vulnerable to a market downturn, because about 73% of the company’s sales are asset-based, and the risk of increasing competition from competitors going after the same acquisitions that are key to Envestnet’s growth. There is also the potential for channel conflict. For example, the firm largely depends on selling its platform through RIA custodians and some of them may want to sell some of the same services. [I am scheduled to discuss this report with Bill Crager, president of Envestnet today.]
Morgan Stanley estimates the Envestnet share price, which closed at $10.25 is more fairly priced at $15. After the report was made available to investors today, shares leaped 8.48% or 89 cents to $11.38.
The report concludes that the Chicago-based company will succeed wildly in the marketplace of independent advisors for the following reasons:
1.) The Fundquest deal completed earlier this year is a template for how conversions can add rapidly to Envestnet’s size. Just because of it, Envestnet expects assets under administration on its technology platform to increase by approximately $13 billion, the number of advisors served to increase by approximately 6,200 and the number of accounts on its platform to increase by approximately 90,000, according to its S-1 filing. “As the FundQuest deal illustrated, Envestnet benefits from other firms wanting to outsource their technology infrastructure for economic or capability reasons,” the Morgan Stanley report states.
“We reflect [in our estimates] Envestnet gaining $8 billion of client assets in the fourth quarter of 2010 and $11 billion in 2011 from conversions, which we think is only a portion of the company’s pipeline. There are likely opportunities beyond 2011 that we do not reflect in our model.”
The report adds: “We believe these conversions are already signed and locked in, with risk related to timing rather than completion...While there is more risk to 2011 conversions than those in the fourth quarter of 2010, we believe our estimates represent only 50-60% of the company’s high potential pipeline.”
Morgan Stanley says the company is likely to succeed in winning valued conversions because: “Envestnet has the scale and expertise with its technology platform. If you’re a broker-dealer and don’t want to spend a lot of time and money building proprietary technology, it’s cheaper/less painful to outsource this aspect of your business. In addition, for [RIA] custodians, it’s easier to create an open architecture platform and allow advisors to benefit from other companies improving their products rather than build it and maintain it alone.
2.) Envestnet is well positioned to grow by acquisition, according to the Morgan Stanley report. “While we don’t model the benefit of acquisitions in our base case estimates, we believe Envestnet is in a unique position to drive additional growth by rolling up the industry and/or acquiring new capabilities.” The company will be aided by the $45 million of proceeds it received from its July IPO [that Morgan Stanley accords a $32 million discounted value] and the fact that it has no debt on its balance sheet, which would aid its efforts to borrow cash for deals, according to the report. The company’s annual free cash flow of $25-30 million will also make it a strong acquirer, the report adds.
“While Envestnet has many larger competitors (e.g. custodians, SEI, Morningstar), given competitors’ platform positioning, we believe the companies Envestnet could acquire may not be attractive to the competition,” the report says. The most recent acquisition by Envestnet, B-Ready Outsourcing Solutions Inc., a Landis, N.C.-based company that hosts Schwab Performance Technologies’ PortfolioCenter may be a good example of a valuable company that only Envestnet could love. See: Envestnet buys a company to gain an edge with Schwab RIAs
3.) Envestnet effectively differentiates itself from the competition – and its service is an overlooked aspect of its ability to separate itself from the pack, according to the Morgan Stanley report. “Envestnet’s three groups of competitors are 1.) Other TAMPs 2.) Single product service providers and 3.) Custodian platforms. We believe Envestnet differentiates itself by its full integration of products, multi-custodian technology and open architecture independent platform. In addition, Envestnet clients talk glowingly about its customer service,” the report says. Envestnet has 1,100 investment solutions from 250 separate account managers and 28 third-party investment strategists – and its internal investment management group. It works with 14 third-party custodians.
4.) Envestnet may in fact be better positioned for client asset growth than Schwab and TD Ameritrade, according to the Morgan Stanley report. Brown also covers those companies for Morgan Stanley. “Envestnet is a much smaller company than Schwab and Ameritrade but [it] has the leverage of a very attractive technology platform and growing of a smaller base. We believe Envestnet can outgrow others, benefiting from the trend to independence as it is also benefiting from a technology-outsourcing trend,” she writes. [Yesterday, Envestnet reported a new deal. See: As Black Diamond deal starts to click, small custodian gets another hot partner
5.) Envestnet is addressing a fast-growing market, with research firm Cerulli estimating that RIAs, IBD reps and hybrids will control 37% of the market in 2012, up from 31% in 2008. These independent channels are all served by Envestnet. Bottom line: $130 billion of assets are entering Envestnet’s market each year from advisors turning independent and bringing their books of business with them.
6.) Envestnet has one of the best cracks of any company at capitalizing on the trend of advisors turning independent and looking for ways to scale up their practices, according to the Morgan Stanley report. “We recommend investors buy Envestnet because it allows one to own a pure play on the independent advisory trend though with a higher growth than the independent market – driven by the second lever of technology outsourcing. In addition, Envestnet benefits from technology-related operating leverage. [In other words, it doesn’t have to hire as many people to grow as other companies] New assets have virtually no additional costs, except upfront bonuses to sales[people] and additional customer service. For assets under administration, we believe new assets have 75%-plus gross margins, with an incremental 5-10% of revenue as operating costs related to additional service staff and sales costs.”
7.) There is a significant opportunity for Envestnet to sell more through existing enterprise clients, according to the Morgan Stanley report. Enterprise clients like Northwestern Mutual, National Financial Partners, National Planning Corp. and Russell Investments allow Envestnet to pitch their clients, the report says. Among its top three enterprise clients, Envestnet didn’t sell to more than about 36% of clients. Supporting this belief that more can be sold though existing partner firms is data showing that advisors using Envestnet’s platform expand their relationship over time. New standalone advisors have on average 14 asset-under-administration accounts on the platform and 2.25 AUM accounts. After three years, on average, advisors have 28 AUA accounts and 4.4 AUM accounts. AUM accounts are ones that show the advisor has taken full fiduciary responsibility. AUA accounts do not assume this full responsibility and can include: proposal generation, reporting solutions and other back-office support.
8.) The broad-based implementation of the fiduciary standard could be another big booster for Envestnet. Not only would it spur more brokers to become independents, but also Envestnet’s due diligence capabilities and careful processes could help make it easier for advisors to comply with fiduciary standards. The issue is hanging in the balance with an SEC study on the topic expected to be reported in January. See: Old foes in the fiduciary debate join new battle to sway SEC’s six-month study