BlackRock, Inc. (BLK) Q3 2013 Earnings Report, Transcript and Summary

Good morning. My name is Brent, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the BlackRock, Inc. Third Quarter 2013 Earnings Teleconference. Our host for today's call will be Chairman and Chief Executive Officer, Laurence D. Fink; Chief Financial Officer, Gary Shedlin; and General Counsel, Matthew Mallow. [Operator Instructions] Thank you. Mr. Mallow, you may begin your conference.

Thanks very much. Good morning, everyone. I'm Matt Mallow, the General Counsel of BlackRock. And before Larry and Gary make their remarks, let me point out, as I do in each of these calls, that during the course of this call, we may make a number of forward-looking statements. We call your attention to the fact that BlackRock's actual results may differ from these statements. And as you know, BlackRock has filed reports with the SEC, which list some of the factors that may cause the results of BlackRock to differ materially from what we say today. Additionally, BlackRock assumes no duty and does not undertake to update any forward-looking statements. So with those formalities out of the way, let's begin the call.

Thanks, Matt. Good morning, everyone. It's my pleasure to be here to present our third quarter results. Before I turn it over to Larry to offer his comments, I'll review our quarterly financial performance and business results. I'll be referencing selected pages from our earnings supplement, which has been posted on the BlackRock Investor Relations website, and discussing primarily as adjusted results. BlackRock delivered third quarter EPS of $3.88, up 12% compared to 2012. Operating income was $978 million, also 12% higher. Excluding the impact of fund launch costs in the year ago quarter, operating income was up 9% on a year-over-year basis. Nonoperating results reflected a $23 million increase in the market value of our seed and co-investments, largely driven by private equity, real estate and distressed credit and mortgage investments. Recall that non-operating income in the second quarter of 2013 reflected a $39 million pretax gain relating to PennyMac's IPO. Our GAAP tax rate for the quarter was impacted by a noncash revaluation of our deferred tax liabilities based on various U.K. and domestic state tax law changes, which we exclude from as adjusted results. The third quarter as adjusted tax rate was approximately 30%, consistent with a 31% annual run rate, which remains in appropriate intermediate term planning assumption based on what we know today. In the third quarter, we saw approximately $25 billion of long-term net new flows, representing an annualized organic growth rate of 3%. We, again, demonstrated the consistency of our highly diversified multi-client platform, with retail and iShares driving our organic growth this quarter, more than offsetting the outflows we saw in our Institutional business. We've raised approximately $124 billion of long-term net new business over the past 12 months, representing a 4% organic growth rate. Because 86% of these net flows were…

Good morning, everyone. Thanks, Gary, and thanks for joining the call. The current market environment remains challenging. Uncertainty is high and fundamentals are taking a back seat to policy decisions. The narrative in Washington that's running the debt ceiling debate is reducing the confidence in investors and business leaders, leading to a short-term focus and risk adversion. Rather than investing in new equipment or job creation, CEOs are focused on increasing stock buybacks and dividends, which does little to drive long-term economic growth. Even with a deal to avoid a default, the damage has been done by the fact that we have had a debate, questioning whether the U.S. will pay its bills, and the impact will be a slowdown in economic growth. In the face of this market uncertainty, BlackRock diverse platform continues to perform. We saw a $25 billion of net inflows this quarter, driven by positive flows in all major product categories and in all regions of the world. The flows we're seeing today and the stability of our platform are the result of investments we made in the business over the past few years. After acquiring BGI in 2009, BlackRock went through a period of integration that led many clients and consultants to take a wait-and-see approach. Could BlackRock marry active and passive investing that created more holistic solution for our clients? We addressed these challenges, emerging 2 organizations, performance issues and certain products and creating a single cultural identity. During this time, we never lost our focus of -- on identifying and focusing and attending to the needs of our clients. We rededicated ourselves to: One, the pursuit of alpha generation, leveraging our risk management and analytic capabilities to better advise clients and create solutions; two, we built our brand; and three, strategically position BlackRock…

[Operator Instructions] Your first question comes from the line of Matt Kelley with Morgan Stanley.

So you mentioned modeled portfolio. I just wanted to dig a little bit deeper there because that's something we've heard a lot about on our end. So can you help us size this in your mind and how important building modeled portfolios with advisories are in terms of getting increased penetration for iShares in the channel?

I have Rob Kapito here. Rob, you want to come over and answer? Rob is spending a great deal of time working with these channels, especially with the Morgan Stanley channel, related to models and how that impacts our active and our iShares.

So clients are now looking for a more holistic solution to their clients' portfolios, and they're looking for more asset allocation. And we are finding that clients have both active and passive in their portfolios. And what they're requiring now is for us to build model portfolios that they could use our products in them or use other products in them. So iShares is certainly a significant part of that asset allocation. So we think by providing these models to the advisors that, that will stimulate our -- their use of our products in their portfolios and that should help the growth of iShares, as well as our other passive and active portfolios.

Matt, one of the thing that we're trying to do, and we're not there yet, is making sure that we can use some of the Aladdin capabilities on the retail side, too. So that's something we are studying, we are in dialogue with many different distribution platforms. And so the first component of really adding value to our -- to the retail side is these model portfolios, which we're developing, but also can there be some analytical support in addition.

Okay. That's helpful. And then maybe this one is a little bit more for Gary, but you mentioned the fee rates in some of the iShares products and how there's a little bit of a tailwind now that your back in what we have see in the fourth quarter, there's been a lot of focus from investors on EEM. So I'm hoping you can give us a little bit of -- maybe help us size a little bit better both the impact on fee rate and sec lending fees from the shift that you saw during the third quarter and now into the fourth quarter, if there's anything incrementally you can give us?

Well, Matt, I would make the following observations. I mean, I think, as we enter the third quarter, we saw really 3 different dynamics that basically created a little bit of headwinds for us since we came into the quarter. One, obviously, as I mentioned was that our spot assets under management at the end of the second quarter basically ended up being below the average for the second quarter. And that obviously was one element. Two, is we saw some clear outflows in iShares, particularly around EEM in the latter part of the second quarter, as we mentioned. And the third element was overall beta mix, which I think is very important, where we basically saw significantly worse beta performance in markets like the emerging markets, natural resources, the world index which, obviously, is relevant because we have some of our higher-fee products in those markets. As it relates to the third quarter, as we basically get through the third quarter, we basically saw all of those trends reverse. So we basically end up actually having a spot AUM at the end of the third quarter, as you can see in the tables, about 3% higher than our average for the quarter. We, obviously, benefited from strong inflows in iShares in September at the latter part of the quarter, as you know some of that was driven by EEM. And then finally, we actually saw beta improvement in those markets that are at higher fee products, completely opposite of what we saw in the second quarter. So that all sets us up well to basically enter the fourth quarter with a better run rate. On the other hand, on securities lending, as you mentioned, which as you know is part of our base fee line, we did see meaningful compression and spreads. And so while we saw our average on loan balances go up roughly by about 7% year-over-year, we did see significant spread compression primarily around the lability spreads where we saw those spread declined a little over 30%. And I would say that, that's obviously created the drag.

Can I just -- let me just add one more thing, Gary, on that. So sec lending is a result of a need for people to borrow stock, whether it's a hedge fund or our people were -- and generally you see a lot of activity around mergers and some type of corporate event. And we all know the merger market, corporate event market has been rather low compared to other years. And hedge fund behavior has predominantly been more of a derisking type of strategy this year, as evident of what our hedge fund results relative to the S&P. And so the sec lending liability spreads have come down quite a bit. And whether this is a seasonal issue or secular issue, we'll find out. But unquestionably, sec lending volumes are down quite a bit in terms of the fees.

So Matt, just to finalize on that. I would just basically see that, as Larry said, that's driven primarily by the special collateral mark. And I would say that unless we see a meaningful change in the conviction of hedge funds around their trading activity, change in leverage or change in, basically, the M&A environment, I don't think we would expect to see a major change in that in the coming quarter.

Okay. Great. And then I'll just -- one quick follow-up for me, it's just on the OFR report. Larry, you mentioned, and I know there's a lot to still to be determined there, but just -- can you give us a sense for what your conversations have been with the regulators kind of coming into that, going out of that? Any steps you've already take to satisfy any requirements from them or anything else you can give us incremental will be helpful.

A, we had no conversation with any of the regulators prior to the publication. That would have been considered lobbying under Dodd-Frank, and so we did not have any dialogue. And we read the results, we read the results simultaneous with everyone else. We are now with the publication. We are in dialogue with the different regulators, the different participants in the FSOC. And all I could say is the conversations are good, they're robust. Our letter will most probably be public when we submit it in November 1, but it's just a process and we are very comfortable with the dialogue and the process that the regulators are putting forth.

Your next question comes from the line of Kenneth Worthington with JPMorgan.

This is actually Alex Kigel, in for Ken. Ken apologizes he's not able to join us today. We, basically, just wanted to know about your fixed income business. It seems like June was, in part, an inflection point for the fixed income investors. What are your thoughts about 3Q sales as an indication of fixed income investor behavior, as we continue to see rates potentially move higher at some point? Can we look at BlackRock solid fixed income sales for 3 -- for the third quarter as an indication of your resilience of the fixed income franchise? As we see it, potentially, rates start to rise?

Well, a, I think that activity in Washington is going to probably mute. The fixed income rate rise for some time, so I'm just going to -- I disagree with your proposition right off the bat. I think we're in a lower rate environment, a lot of people suggest today. And I do believe -- as I said, I do believe the behavior in Washington is dragging our economy down. And I actually believe the Federal Reserve is probably more reserved in terms of any movement related to tapering and there's going to be a lot more -- they're going to probably pause waiting to see if indeed the economy is impacted by Washington's behavior. It is our view that we are well positioned, as I said. We are very well positioned in fixed income because of performance. We are very well positioned because our position in unconstrained fixed income. And we are well positioned because of our solid performance in credit and high yield. So you put all those things together, if there is going to be flows, if there's rotation, I think we're very well positioned for that. And as we saw in the third quarter, we did see people look to us as -- in terms of adding fixed income exposures. And I would say, very clearly, the dialogues we're having with clients related to fixed income are more active than they have been in years for us. And so if the dialogue we're having with clients worldwide institutionally retail, if that's an indicator of forward growth, then I think we're going to be -- we're going to have consistent growth in the future.

Great. And just as a follow-up, can you please update on the progress you feel you're making in teaching fixed income ETFs to institutional investors, i.e., particularly banks and financial institutions, and as well as institutional investors and actively managed short-term fixed income products?

We continue to have -- as I said, when I've got a dialogue in fixed income, it does translate also to dialogue in iSharesBond. It's not just the active fixed income unconstrained side. It is, as I said in my prepared remarks, iSharesBonds, we have our first bank client, we have many conversations going on now and our new ETF product has been near, which is a low-duration type of product, for those who are frightened of the longer-duration products. So I think -- as I said, we have consonant whether they are in ETFs, ETF bonds and/or our active products.

Your next question comes from the line of Brennan Hawken with UBS.

So quick question, maybe hoping you could give some color on how you guys positioned the money funds given everything going on, the potential U.S. default, and not only maybe avoiding technical issues that can arise, but also maybe some of the knock-on effects that could come about as well?

Well, let me just state overall. We have dozens of teams working on contingent plans throughout the organization. Our job is to be a fiduciary and our job is to focus on even the unanticipated risk associated with any default. So beyond our money market funds, I think it would be incorrect to think that that's all we're focusing on related to default, there are many municipal bond market to collateral management of swaps to working with the custodians. You'll have to understand, the rating agencies, even if only one treasury bond, this is a coupon payment, definitionally, the entire sector then is considered a defaulted security. And so we have to be prepared for all the contingencies, whether they're T-bills or any other bond, U.S. bond, instrument. And so, I think, we're doing a very good job without getting in, in any of the details to making sure that we're anticipating those unanticipated problems associated with this type of event. As we all know, when you think back about the Lehman Brothers result, everybody thought that Lehman Brothers was it. But then when the reserve fund had that Lehman Brothers exposure, that's when I believe that we really fell off a cliff 5 years ago. And so our job is having these task teams working towards all the unanticipated possibilities that would occur in terms of collateral management, in terms of clearing, in terms of what is considered good collateral and bad collateral. So in addition to our money market funds, where we're obviously very focused on, we're focused at across all different of our platforms.

Okay. And then a question on the regulation, you had mentioned that you guys had started up a really active dialogue with the regulators here on the back of this OFR report. Just kind of curious, it's the one thing that I'm trying to struggle to get my head around is, if there is some kind of city designation for a large asset manager, what -- how does that manifest itself, like what does it mean? Does it just mean enhanced supervision? Does it mean capital? In your dialogues, do you have any sense of that or can you give us any color...

No. But let me just step backwards, I think you're aware we have capital set aside for operational risk, that was a condition we had with our U.K. and U.S. regulators. So unlike many other asset managers, we are already in that position. We are already regulated because of PNC's 20% ownership with us by the Federal Reserve. We are regulated by the control of the currency because of our bank trust division that we bought when we acquired -- when we bought BGI. So we have -- we're a firm that is very heavily regulated across region and across all the different regulators. So your question is a good question, but I can't answer it. But I can say we have -- we are -- we have regulatory oversight by many of those regulators that other firms, if they were a SIFI, do not at this present time. And it's a good question, what does that mean? Because the OFR did state, we are not a bank, we're a fiduciary, we're an agent. And OFR stated that these are not our assets, we're not levered, so I honestly don't know what it would mean if they designated a bunch of firms as SIFIs. And that's why my comment was very specific related to one of the ways that we've read into the OFR is that maybe they are going to regulate specific products like money market funds. But they may begin some type of supervision over, let's say, all types of products that have some x amount of leverage. So that would incorporate leverage type of hedge funds and other types of products like that. So we're not -- this is too early in the dialogue, too early, I believe, in the regulatory reviews of what they're going to do. But I think the OFR report was a very fair, in my mind, a very just report about what asset managers are and adjustly cited some risks associated with some of the types of businesses that asset managers are in. And so we are working alongside with regulators in responding to their questions as best we can.

Your next question comes from the line of Mike Carrier with Bank of America Merrill Lynch.

Larry, maybe -- first on flows, you give a lot of detail and the teams like, maybe current quarter, there's been some different trends than what we've seen kind of year-to-date. If I look at just the disclosure you guys give, iShares retail, you've been gaining some momentum; institutional has been more subdued and you guys have talked about that being a little bit more mature. But when I look at iSharesBond and I look at the, say, $45 billion of flows year-to-date, if you segmented that into sort of the retail population or the retail channel versus the institutional, like where is that kind of breaking up? And particularly in terms of -- because if I look at your retail equity flows, they've been more subdued but that's more on the active side, but it seems like the momentum is still there. So I just wanted to get some color on the iShares penetration in the 2 channels and how that would shift to flows for retail versus institutional?

Let me give this to Rob because Rob is working very closely with the whole team.

Yes. So basically, we have been focused on a few areas of iShares penetration. The first is, is still in the education mode. So there are a lot of institutional clients that are first learning how to use iShares in their portfolios for liquidity reasons and for access to markets, before they actually find an active manager to manage those assets. They also are looking for asset allocation from the iShares, and that's primarily on the institutional side. And we have very good penetration in there, but it's a process that's really just at their early stages. So if you think that iShares is actually grown already, we think that it's just the early stages of the growth of iShares institutionally. On the retail side, again, it's a larger education process but a lot of the FAs, who managed these particular portfolios, are using iShares more and more in their asset allocation models that I talked about before. And we are very focused on what we call a Core Series, which goes directly at what we think retail clients are looking for. And already this year, we have raised $9 billion in the Core Series. And these are more of the buy-and-hold type of retail investors, which is a segment that we have begun to spend a lot of time focusing on. The other thing is that, since I mentioned to you that we believe that clients have both active and passive strategies in their portfolios, we have combined our sales forces and we will now have the largest sales force of any asset manager going out and educating both the institutional and the retail advisors on how to use iShares. And then last, we're building up our distribution because being in the iShares business or the ETF business, it's really capturing the flag and providing the largest funds that have the transparency and the liquidity. And of course, you recognize some of those -- the partnerships that we have established, one most recently being with Fidelity, and we're seeing really good results early on from that relationship, and we have several other relationships as well. So we are seeing continued growth in iShares, continued ideas for the use of iShares. And specifically, because we're going into markets where a lot of liquidity concerns are emerging, certainly, iShares will help in providing liquidity in the markets where there may not be as much liquidity as in the past.

Okay. That's helpful. And then just as a follow-up. Gary, you gave some helpful color just on the fee rate and the -- you know how to frame the outlook. If I combine that with AUM up around 6% in the quarter, just going into the fourth quarter, it seems like it's setting up from -- for some decent operating leverage. Anything on the expense side that's more seasonal that would offset that or it is just, seasonally, you're going to have more momentum heading into the fourth quarter, just want to make sure there is nothing else that we should be thinking about?

Yes. I think, frankly, on -- well, I mean, before we talked a lot about compensation on the variable side and direct fund expense, which we've talked about, I think if you look at the, obviously, performance fees will drive relative changes in compensation levels. But beyond that, on the G&A spend, I would say that if you compare kind of the second and the third quarter sequentially and then you saw a little bit of a dip in the third quarter based on marketing spend going down, which is really all of the difference. And I think as we've been fairly consistent in our statements, that marketing spend is going to vary quarter-to-quarter. We would naturally see probably a lift up in the fourth quarter versus the third quarter. But beyond that, in SG&A, I think with the exception of that, I think the run rate is pretty well established.

Your next question comes from the line of Bill Katz with Citi.

In terms of my questions, on the Core Series having just phenomenal success that you highlight some very good organic growth. Just sort of curious, as that portfolio builds, would there be any natural internal pricing pressure for the remainder of the business to maybe reset pricing lower, just given will it likely be a pickup of liquidity in the Core Series?

I don't think so. I think this is just another leg to stand on here, where there are specific clients and we're looking at a segment that's called the buy-and-hold segment. And that, typically, has lower fees than those that look for more trading. And we're seeing both, i mean, it's pretty much equity spread. So it's really different segments of the markets and this is actually a new segment for us, so I don't really think an impact the other fee segments in the iShares business.

Yes. Bill, I would add one more thing to that. If you think about the manner in which investors buy the buy-and-hold in the Core Series, these are much stickier assets, so you're going to have much greater dollar amount and still have a much lower amount of liquidity in transactions because of the nature of the investor. So unless we saw a mixed change of investors on the Core Series, which would then lead you to think maybe there would be some cannibalization of the other ones, I don't -- we're not seeing any evidence of a migration from that. I would say that the investors are looking for more liquidity into the Core Series.

Okay. That's helpful. And then my follow-up. You didn't even talk about too much this quarter, I'm sort of curious, and maybe an update of demand in positioning in the scientific portfolio?

Our share performance is really good and it's -- we are having more dialogue, but we have not seen any real pickup in demand in that one area. But we do have, in one of the scientific areas, is our fixed income global opportunity fund, which we closed midyear, and there's a possibility we will reopen it. It's been a very, very successful fixed income hedge fund and we will probably think about opening it next year. And that had about a $400 million of this quarter in terms of growth. But it was a scientific equity where we saw that one outflow internationally. And that was just one client looking to move out of that asset category. So now I would -- I'm disappointed that we're not seeing more opportunities because we really do have a great track record in that area. And it's an asset category that is going to, really, just take more time to have the investors come back into the platform. And I -- and keep in mind, I think investors are now using more and more beta products instead of scientific, and they're using beta as alpha. And I think that's one of the outflow of interchanges in mix and the mix and style that, maybe 5, 6, 7 years ago, people are using quant strategies. And today, they're just -- and more and more of those investors are going to just be beta strategies, but actively managing their beta strategies.

Your final question comes from the line of Marc Irizarry with Goldman Sachs.

Larry, on the fixed income active inflows, can you give just a little more color on -- do you think what saw this quarter was a function of more manager replacement and manager sort of rotation amongst the competition? Or is this sort of more of a rethinking going on given the sort of the outlook for rates from institutional investors?

So on the institutional side, I don't think it was -- I think it was -- I think some of it was just -- I don't know if it was a rotation out of all other fixed income managers. I think it was more just a -- the clients, these institutional clients were just generating more and more cash because of their operations. And we're winning these new assignments as they generate more balance sheet because of our performance and our long-term relationship. Some of these clients we won are existing clients with other products, so they did some form of RFPs. And because of our performance and our position, we won. On the retail side, I do believe some of it is rotation into BlackRock and so -- and I believe it's just the beginning, very strongly.

Okay, helpful. And then maybe this is a question for Rob on the alternative business. I'm particularly interested on outside the U.S. just in terms of -- it looks like, this quarter, you saw an uptick in inflows and alternatives first quarter, and several that you've seen inflows there. Maybe you could give us an update on sort of the retail build out of alternatives and sort of what you expect for that business?

So we're very bullish on providing alternative investments to the retail investor. And it's all been about providing the appropriate wrapper in order for the retail investors to get involved in the -- in that area. So we have the alternative investments. And as you know, for a period of time, people have been separating alpha and beta, and getting their beta from passive and iShares, and their alpha from more alternative investments. And we've had those products and have been able to do that allocation for institutional clients. And what held us up on retail is providing the wrapper for them. Now within the 40 Act companies in the U.S. and also in outside the U.S., we have the wrappers and have been very successful in finding investors to go into those. Unfortunately, we have track records in those products, as well, that are long term. So it's pretty -- I think it's going to be pretty exciting to watch, especially in the long/short credit, where we have significant expertise and the track records. And in this particular environment, that gives people a lot more opportunity for yield, which is what they're looking for. So this will help us provide the retail investor with the same alpha/beta separation as we're doing the institutional, and I would look for significant increased sales in those particular areas because it make sense for the client.

I would add one other thing, Marc, our single strategy hedge fund have done quite well in terms of performance. And our objective, just like building our brand in retail, we are aggressively trying to build our brand in alternative space, too. And that's going to be an important component of our future growth that we identified, not just as a passive manager in an active equity and fixed income, but we're identified as a strong solution for alternative needs. And importantly, we have a very big forward calendar in terms of commitments in our illiquid products. So we are -- we're seeing more and more dialogue with our investors in the alternative space. Rob talked about the retail side, but the institutional side is quite robust, too.

Yes. I was just going to ask along those lines. I know the pipeline is something you guys don't necessarily disclose much, but could you give some -- maybe some color on sort of what the composition of the pipeline would look like across the firm?

I just got kicked by my General Counsel. We've determined that it's just -- we don't talk about that forward, or about our forward calendar anymore or forward commitment, but we're fine. But on the -- I'll leave it at that, I'm being kicked again.

This concludes our teleconference, Mr. Fink, do you have any final remarks?

I just want to thank everybody for the commitment they have. This was a truly differentiated quarter for us. I'm very happy with the results, especially with all the debates that are going on in Washington. And as I said in my formal comments, I think we're very well positioned due to the platform that is unparalleled in terms of active, passive platforms with our overlay of risk management, and that continue to drive these unique dialogues that we have with our clients. And I look forward to talking to everybody after the fourth quarter. And hopefully, everyone has a very good end of the year.

Thank you. This concludes today's teleconference. You may now disconnect.