Ares Management: With Great Reward Comes High Risk (NYSE:ARES)

Introduction

Ares Management (NYSE:ARES) is a global alternative asset manager that specializes in investment funds and financial solutions for small and medium-sized businesses.

As the Fed raises interest rates to 5%, the company will benefit significantly. Ares Management is also transitioning to a management fee-based company rather than a performance fee-based company in order to obtain earnings stability.

Its stock outperformed the S&P 500 in terms of total return. Ares’ average total return over the last ten years has been 19.2% per year, compared to 9.5% for the S&P 500.

Non-GAAP earnings per share are expected to rise significantly, but I believe investing in the company is risky due to its high debt load and reliance on interest rate levels. The stock could bode well for investors with a high risk tolerance.

Strong Third Quarter Earnings

Third-quarter results for Ares Management proved the company’s resilience in the face of challenging and uncertain market conditions, with AUM, management fees, and fee-related earnings all increasing by more than 20% year over year. Despite the difficult climate and the prolonged slowdown in primary market activity, the company’s AUM and fee-related earnings grew well.

Management fees, rather than performance fees, provide a reliable revenue stream for the firm. Management fees accounted for over 90% of overall fee revenues, and fees were directly responsible for 92% of realized income.

More than 90% of the firm’s debt assets are floating-rate, therefore it benefits from an increase in interest rate environments. Rate hikes are expected to be implemented this year in response to rising inflation, as discussed at the December FOMC meeting. Ultimately, this bodes well for Ares Management’s bottom line.

The firm is positioned for future growth by focusing on the asset classes and regions with the highest rates of expansion. Private equity does carry some risk, however, because of the possibility of financial or operational mismanagement. Real estate asset values are sensitive to macroeconomic and regulatory changes, as well as to fluctuations in the value of individual properties and rental income. Forecasts for the housing market indicate a downward trajectory in equity values this year. Both investments are illiquid and difficult to value. With great reward, comes high risk.

Dividends And Share Repurchases

The company currently pays a dividend of $2.44 per share, representing a dividend yield of 3.4%. The dividend per share has increased from $1.13 in 2017 to $2.44 in 2022 (16.6% annual increase on average).

A closer look at the cash flow statement reveals that dividend payout has increased significantly over the last five years, as has net income. Over the last few years, free cash flow has been declining. Because the company issued a large number of shares, the buyback yield is negative.

The issuance of new shares dilutes current shares, as shown in the graph below. The company’s outstanding shares were approximately 120 million in 2020; now, the shares outstanding are approximately 177 million. Dilution of shares is unfavorable for investors because it reduces earnings per share when earnings are equal. Earnings are currently growing rapidly and are expected to increase significantly in the coming years.

Valuation

Rather than using Seeking Alpha’s non-GAAP PE ratio, YCharts uses the GAAP PE ratio. YCharts puts the GAAP PE ratio at 82, while Seeking Alpha puts the non-GAAP PE ratio at 23.

From what we can tell from the graph, the GAAP PE ratio is rather high when compared to its historical PE ratio. Even though we think the stock is a bit overpriced, we anticipate rapid earnings expansion in the next years as a result of higher interest rates.

For the upcoming years, 6 experts have revised their earnings projections up, while 7 have revised them down. Earnings per share are anticipated to rise by 25% yearly, and revenue will grow substantially.

A low forward non-GAAP PE ratio of 14 for 2024 suggests the stock is favorably priced.

This stock may be interesting in the short term, but there are risks on the horizon in the long term. The company is vulnerable to earnings fluctuations due to its high increasing net-debt load and low interest coverage. Over the last few years, free cash flow has been steadily declining. When the Fed lowers interest rates, the company may be in rainy weather. Those who can sail the boat may see significant stock appreciation, but the stock is a hold for me.

Conclusion

The rising interest rate environment and rapid expansion of Ares Management’s AUM suggest that the firm will see increased profits in the years to come. AUM grew at a CAGR of 20% over the past decade, reflecting the firm’s success. Over 90% of total revenues are now generated by management fees, making the company more resilient to market fluctuations than it would have been had it relied on performance fees alone. Ares Management focuses on expanding its markets and sectors. Private equity and real estate are two examples. Due to their illiquidity, dependence on management success, and fluctuations in real estate prices, private equity and real estate investments could pose risks.

The stock’s dividend has increased by an average of 16.6% per year over the last five years. The company has recently issued many new shares, diluting the stock. The valuation of the company is currently a bit pricey, as shown by the YCharts GAAP PE ratio chart. However, thanks to the strong 25% annual growth in non-GAAP earnings expected in the coming years, the forward 2024 non-GAAP PE ratio is only 14. Ares Management is appealing due to the rising interest rate environment and increasing AUM, but there are still risks involved. An investor with high-risk appetite may consider an investment. But, with great reward, comes high risk.