BUY rating for Apollo Global Management LLC (NYSE: APO). Distributable earnings were down modestly in 3Q, hurt by lower realizations, but fee-paying assets continued to grow and, we believe, remain a key long-term driver for the stock. Management expects increased performance fees as it monetizes investments in its private equity Fund VIII.
The conversion will eliminate K-1 dividend forms (in favor of 1099s) and allow the stock to be included in a wide range of indices. The APO shares were added to the Russell 1000 index in 2Q.
In early November 2019, Apollo held an Investor Day, its first since 2014. Major themes included prospects for strong growth in AUM, favorable trends in the alternative credit market, and the expected resiliency of management fees during an economic downturn – due in part to the high 83% of AUM in permanent capital or long-dated vehicles. Management said that it was targeting AUM of $600 billion in five years, up from a then-current $315 billion, which we believe is achievable based on continuing strong flows into alternative investments; however, this has been made more difficult by the COVID-19 economic disruption. AUM grew at a 14.5% annual rate in 2014-2019, and the $600 billion target would represent slower growth of 9.1%. Management also noted three macro themes as tailwinds for growth: the global thirst for yield, the evolution of regulation, and the deleveraging of financial balance sheets.
With respect to current trends, we believe the outlook remains favorable. Capital deployment, which had been relatively light in recent quarters, jumped in 3Q to $20 billion, as market disruptions expanded the company’s investment opportunities. This should set the stage for improved realizations in future periods. Apollo had $46 billion of dry powder available for new investments as of September 30, reflecting strong inflows over the past year, particularly in the private equity segment, which has benefited from capital raised for APO’s ninth flagship fund. This fund has a 30% higher net minimum cash distribution than prior funds, and is expected to result in a significant increase in fee-related earnings.
Our positive view of the stock also reflects our expectations for continued strong distributions from current investments. We expect this to result in a distribution yield of nearly 7%, based on our forward four-quarter distribution estimate of about $2.54 and the current share price. The company has set a minimum distribution level of $1.60 per year that would yield 3.3% at current levels.
We also note that our distribution yield estimates for APO and its peers, generally in the 4%-5% range, are at or above the average yields of both REITs and utilities. In addition, relative to REITs and utilities, alternative asset managers have numerous methods of generating cash for payouts to unit holders. We believe that APO will generate strong returns over time from its contrarian investing style. However, we caution that the shares are appropriate only for risk-tolerant investors.
APO shares are down about 8% over the past year, versus a 7% gain for the broad market. The beta on the shares is 1.52.
On October 29, Apollo posted 3Q20 distributable earnings of $0.47 per share, down from $0.54 a year earlier and below the consensus of $0.49. Segment revenue was $521 million, up 8% from the prior year.
Fee-paying assets under management jumped 38% year-over-year in 3Q, to $336.1 billion, aided by the addition of $28 billion from a transaction with Jackson National Life Insurance. The company had $13.0 billion of capital inflows in the third quarter ($118.6 billion over the past year), with $20.9 billion deployed ($90.3 billion over the past year), and realizations of $1.7 billion ($10.7 billion over the past year).
Apollo declared a third-quarter cash distribution of $0.51 per share, up from $0.50 a year earlier. Trailing four-quarter distributions totaled $2.31 per share.
EARNINGS & GROWTH ANALYSIS
Inflows of $119 billion over the past 12 months have exceeded deployments of $90 billion. Fundraising has been strong, while 3Q20 represented a substantial pickup in deployment as investments began to meet the firm’s criteria. Fee-related earnings continue to surprise on the upside, as more assets become eligible for fees, and we expect this to continue. Market dislocations earlier in the year from the COVID-19 pandemic provided investment opportunities, but the duration of that downturn was not particularly long, with fiscal and monetary support so far offsetting the widespread need for infusion capital.
As of September 30, 2020, AUM totaled $433 billion, with 72% in credit, 18% in private equity, and 10% in real assets. In the credit segment, Apollo intends to take advantage of a push toward unconstrained credit as fixed-income investors seek better yields. It will also focus on new asset classes and partnership opportunities in new markets.
The private equity segment has benefited from a generally strong market environment. In this segment, the company has a value-oriented, contrarian approach to investing, and targets at least a 20% ROI. The focus is on corporate carve-outs, where businesses need a financial partner for growth; distressed-for-control, where Apollo is a leader in corporate restructurings and bankruptcies; and opportunistic buyouts, where it focuses on out-of-favor industries and geographic regions. Management expects performance fees to rise as it monetizes investments in its private equity Fund VIII.
In the credit segment, fee-related earnings have benefited from growth in management fees from permanent capital vehicles and fundraising. Athene Holding completed its initial public offering in 4Q16 and began trading on the NYSE under the symbol ATH. In late February 2020, the company closed a transaction with Athene that called for issuing 29 million Apollo Operating Group units, which increased the share count by about 7%, and acquired approximately 36 million additional shares of Athene Holding. Apollo also agreed to lock up all Athene shares for three years, which requires a mark-to-market discount due to a lack of marketability. At September 30, Athene had assets of $173 billion, all of which were counted as permanent capital.
In the real assets segment, Apollo is expanding its origination capabilities, raising capital, and broadening its geographic footprint.
At September 30, Apollo had carry-eligible AUM of about $130 billion, which is the basis of our management fee estimates. Of this amount, about $41 billion was not generating carry, as the underlying funds needed to appreciate before earning fees. Most of this nonearning carry was in the credit segment ($27 billion), where funds still needed an aggregate gain of 5% before generating carry.
In light of how its business has evolved, Apollo intends to emphasize fee-related earnings (FRE). It also believes that distributable earnings (DE) represent underlying operating performance better than its prior standard of economic net income (ENI). As such, it is now using DE as its primary earnings metric.
FINANCIAL STRENGTH & DIVIDEND
APO currently has no publicly traded, publicly rated debt.
In 2019, the company paid distributions of $2.35 per share, up from $1.83 a year earlier. Apollo’s policy is to distribute substantially all of its earnings after taxes. At the 2019 Investor Day, the company announced a new minimum distribution policy of at least $1.60 per share per year, implying a yield of about 4.4% based on the current share price.
In February 2016, Apollo initiated a $250 million stock repurchase program, with $150 million earmarked for share reduction and $100 million for equity-based awards granted under its equity incentive plan. Along with 4Q18 earnings, the company announced an additional $250 million buyback plan. Management plans to be opportunistic with share repurchases, and believes that the current share price does not capture the value of the franchise. APO’s diluted share count had been drifting higher in recent years due to stock-based compensation. Subsequent to the closing of the Athene transaction, Apollo’s share count increased about 8%, to 443 million.
In June 2019, Apollo issued $325 million of 4.77% Series A senior secured guaranteed notes due 2039, and $125 million of 4.872% senior notes due 2029. In December 2019, it issued $300 million of 4.95% fixed-rate resettable subordinated notes due 2050 to partly finance the Athene transaction.
MANAGEMENT & RISKS
Apollo is led by chairman and CEO Leon Black, who founded the company in 1990 to manage investment capital for a group of institutional investors, with a focus on corporate restructuring, leveraged buyouts, and minority positions in growth-oriented companies.
Beginning in 1Q15, the company began providing additional segment detail with respect to fundraising, capital deployment, realizations and performance, as well as other key statistics. This added transparency has allowed investors to better understand the flow of capital within each segment.
While there is a recurring management fee component that funds a good portion of cash distributions, the level of the distribution depends on Apollo’s ability to monetize investments. Furthermore, Apollo focuses on distressed and higher-risk credit-related assets that generate current income but that can be very illiquid in nature – even those that are publicly traded.
Private equity firms such as Apollo have relatively small publicly traded floats and the managing partners are in total control of the firm’s operations since they own most of the voting shares. Although Apollo’s founding partners are actively involved in the management of the firm and are the majority owners, they work for Apollo under employment contracts. The loss of any of these partners may impact the performance of Apollo funds that contain ‘key man’ clauses that would allow investments to be terminated with little notice.
Apollo thus has deep expertise investing across the capital structure, and often faces less competition by ‘avoiding the herd’ in traditional buyouts and traditional high-yield and investment-grade credit.
Alternative asset managers can be difficult to value. Economic net income, the company’s previous reporting metric, was volatile and difficult to predict since it included mark-to-market gains and losses on investments. Cash carry (realized gain) is also difficult to predict from quarter to quarter due to the timing of exits from investments. However, Apollo has a relatively steady component of its cash carry that adds to the stock’s value, in our view. Starting in 1Q19, the company began reporting distributable earnings (DE) as its primary earnings metric. The change should show a more stable earnings picture. With peers KKR & Co. and Blackstone Group also turning to primary DE reporting, we believe that a DE multiple approach is a good valuation tool.
Apollo currently trades at 20-times our 2020 DE estimate, an elevated historical multiple given depressed DE, but slightly below Blackstone (BX) at 23.5-times, and at 13.3-times our 2021 estimate, when we expect considerably stronger earnings. We think some of the discount compared to BX reflects Apollo’s relatively larger proportion of credit assets, but believe the multiple has room to expand. Alternative asset managers have received a substantial upward re-rating following their conversions to corporate status, partly reflecting the wider share ownership potential. Indeed, APO shares were added to the Russell 1000 index in 2Q20. We are maintaining our 12-month target price of $55, which values the shares at 20-times our 2021 DE estimate.