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It’s been said there’s more money to be made investing in mutual fund companies than investing in actual mutual funds.

That may be the case for Waddell & Reed Financial, Inc. (WDR ), unless you bought it at the wrong time; the stock has taken quite a plunge in the past year. This drop in price, combined with its history of consistently growing earnings, gives WDR a place on the Buffett Munger screener at GuruFocus. The following chart shows the company’s share price (green line) and its EBITDA (earnings before interest, taxes, depreciation, and amortization):

Waddell & Reed is a diversified mutual fund company with three distinct lines of business, and a history that makes it one of the first (and one of the few survivors) in this sector of the financial industry.

History

1937: Chauncey Waddell and Cameron Reed start a new firm in the then pioneering mutual fund and financial planning industry. The firm begins with less than $125,000 in assets under management and two mutual funds.

1958: In an innovative move, it opens a branch in a Buffalo, New York department store.

1969: Continental Investment Corporation buys the company.

1981: Liberty National Insurance Holding Company (later renamed Torchmark Corporation) buys the company from Continental Investment Corporation.

1998: Torchmark spins off Waddell & Reed, and the company goes public on the New York Stock Exchange.

2013: Sells its Legend group of subsidiaries, which focused on employees of school districts and other not-for-profit organizations.

2014: WDR fund families get several top ten rankings in the Barron’s annual ranking of the best mutual fund families for 2013.

Comments: A company with a long pedigree in the mutual fund industry, but also one saw several owners before going public in 1998. Inclusion in the Barron’s list suggest competent analysts and fund managers.

Waddell & Reed’s Business

This is a mutual fund company, one of the first established. Current operations involve three separate channels, or segments (as described in the company’s 10-K for 2013):

• Wholesale: retail funds are distributed through third-parties such as other broker/dealers, registered investment advisors, and various retirement platforms,
• Advisors: funds sold through a sales force of independent financial advisors.
• Institutional: investment advisory services sold to institutional investors, either directly or through consultants.

It derives its income from investment management fees, underwriting and distribution revenues, commissions derived from sales of investments and insurance products, and shareholder service fee revenues.

This graphic from the Investor Day Presentatio n, June 25, 2014, outlines the contributions to revenue made by each of the channels:

In addressing the issue of competition in its 10-K for 2013. WDR cites Investment Company Institute figures showing 9,500 open-end and closed-end funds available to some 93-million fund investors. These funds are created, sold, and distributed through hundreds of fund families and other entities.

As in many other industries, technology has had a disruptive effect by challenging existing structures and by empowering consumers. It has given consumers many more options and greater transparency, from what was once a comfortable, old-boys network.

Yahoo! Finance lists WDR’s competitors as AllianceBernstein L.P. (privately-held), Eaton Vance (EV), and The Jones Financial Companies, L.L.L.P. (privately-held). It also competes with asset management giants such as Blackrock, with its $56 billion capitalization, 15 times greater than Waddell & Reed’s.

Other information

Waddell & Reed Financial, Inc. is incorporated in Delaware, and headquartered in Overland Park, Kansas.

$130+ billion assets under management; it takes an active management approach to its funds.

Underwrites and distributes 86 registered open-end mutual fund portfolios in the Advisors Funds, Ivy Funds, Ivy Funds VIP and InvestEd.

Committed to doing its own “rigorous, proprietary fundamental research”.

Comments: A mid-sized financial services company specializing in mutual funds; it has three separate streams of income, and a significant amount of competition for each stream; although it is far from the largest in its field, it does have a multi-revenue model that has stood it in good stead in recent years.

Opportunities, Risks, & Growth

Opportunities

In its Investor Day presentation. the company identifies several areas of potential growth:

In the Wholesale Channel, it sees opportunities to tweak its existing structure to put more emphasis on the most profitable markets and to gain market share through new and deeper relationships; continued diversification of its sales efforts, reduced dependence on sales of the top-selling funds; and international expansion, with a strategic approach.

For the Advisors Channel, WDR sees careful growth in the number of advisors; adding practice management resources; and providing tools that help field managers focus on growing their offices.

Initiatives in the Institutional Channel include: Increasing the consultant community reach; and marketing with a clearly defined, differentiated, and recognizable brand.

More than half of its assets under management are now distributed through the Wholesale Channel, rather than the traditional Advisors Channel, and the former has higher redemption rates.

If investors redeem their holdings on short notice, both revenues and earnings could be adversely affected.

Its investment advisory and broker/dealer businesses are heavily regulated, mainly at the federal level (USA).

Dependence on the overall economy; more prosperous consumers buy more mutual funds, and vice versa.

It depends on the continuing good health of the securities industry, particularly on the state of the American stock market; a declining market leads to increased redemptions and reduced inflows of new capital.

Poor performance by the company’s funds could also lead to lost revenue and earnings.

Risks review based on issues listed in the 10-K for 2013 .

The following chart shows how WDR has grown its revenue (blue line) and EBITDA (green line) since going public in 1998:

As noted above, the company has plans to continue growing in all three channels. This excerpt from its Investor Day Presentation shows its plans for the biggest revenue contributor, the Wholesale Channel:

Analysts followed by Yahoo! Finance expect slightly lower earnings for this year and next: $3.37 for 2015 and 3.65 for 2016, compared with a preliminary 3.71 for 2014.

Comments on opportunities, risks, and growth: Waddell & Reed sees opportunities for incremental gains in strategic areas; risks listed by the company are quite real, but there are no immediate overarching concerns; and, although it had a rough year in 2014, there’s no reason it should not be able to maintain its competitiveness over the long haul, given its articulated plans to continue growing.

WDR by the Numbers

Comments: WDR’s share price is well below its 52-week high; it pays a dividend of 3.4% and that should be safe given the 37% payout ratio; the company bought back almost 2% of its shares in fiscal 2014; and it had an ROE of more than 42% last year (by comparison, Eaton Vance 36.73% and American Express 29.3%).

Management

Chief Executive Officer & Chairman of the Board: Henry J. Herrmann, age 71, a Chartered Financial Analyst, joined the firm in 1971 as a senior investment analyst covering the technology industries.

Senior Vice President, Chief Financial Officer: Brent K. Bloss, age 45, joined the company as Assistant Vice President and Assistant Treasurer in 2002; before that, he held the position of Senior Audit Manager at KPMG LLP.

President, Portfolio Manager: Michael L. Avery, age 61, joined Waddell & Reed in 1981 as an investment analyst following the healthcare industry.

Board of Directors: A board of eight, made up of Chairman Herrmann and seven independent directors. The independents have experience or expertise in energy, transportation, insurance, consulting and investments, banking, accounting, investment banking, and finance.

ISS Governance QuickScore. Receives a score of 8, on a scale which ISS describes this way, “A decile score of 1 indicates lower governance risk,while a 10 indicates higher governance risk.” It receives four red flags, for: Board Practices, Takeover Defenses, Meeting & Voting Related Issues, and Termination. It receives two green starts, for: Use of Equity, and Other Issues.

Comments on Management: Given the age of CEO Herrmann, we would expect a change at that position in the near future. The board appears suitably diverse and independent. The ISS QuickScore unveils several issues, including Takeover Defenses.

Ownership

Gurus: Nine of the name investors followed by GuruFocus hold positions in Waddell & Reed. Largest among them is Ken Fischer, with 2,122,331 shares, while Chuck Royce (Trades. Portfolio ) has 733,791 shares, and Jim Simons (Trades. Portfolio ) has 571,400.

Institutions: Institutions owned just under 83% of the outstanding shares, valued at $3.3 billion, according to nasdaq.com:

Short Interests: GuruFocus puts the shorts at 3.14%, which is roughly in the middle of the range within which it’s moved in recent years:

Insiders: People with ties to the company own about 2% of its shares, according to GuruFocus. Yahoo! Finance lists CEO & Chairman Herrmann as the single largest holder among insiders, with 1,151,610 shares (as of December 31, 2013); CFO Brent Bloss owns 80,684 shares.

Comments on Ownership: The senior officers own a major stake in the company, particularly CEO Herrmann. Major holdings among gurus and institutional investors, and low interest among shorts, suggest this company enjoys the long-term confidence of the market.

Financial Condition

The GuruFocus automated system gives WDR 6/10 for Financial Strength and 9/10 for Growth & Profitability:

The first red flag that catches our eye comes from the Cash to Debt ratio, which does not look good when compared to its own history. Yet, as the following chart shows, its ratio is in line with its peers:

Since there’s also a second red flag referencing debt, Interest Coverage, let’s take a look at the company’s debt and its ability to service it:

As we can see, the company took on a load of debt in the early 2000s, and has since reduced it a bit. Turning to the servicing side, let’s see if we can gain some perspective with a chart of the company’s revenue (blue line), EBITDA (the green line), and long-term debt (red line):

Waddell & Reed has maintained or improved its long-term debt level for more than a decade. At the same time, it has substantially increased both its revenue and its EBITDA.

And, let’s take a look at the company’s free cash flow:

Note that while the debt level has come down in the past decade, free cash flow is more than two and half times greater (by the end of fiscal 2013).

Comments on financial strength: While the automated system generates some warning flags, we’re comfortable with the level of WDR’s debt, and its ability to service that debt.

Valuation

WDR earns a place on the Buffett Munger screener because it has a high predictability rating, and is considered either under valued or fairly valued.

Let’s start with the predictability factor: it earns a 4-Star (out of 5) rating for the consistency of its earnings. To see why, let’s look at a GuruFocus chart of its EBITDA (green line) and net income (EBITDA plus interest, taxes, depreciation, and amortization — blue line):

Since coming out of the financial crisis of the last decade, its EBITDA growth has been robust and consistent. That five years of performance earns it a high (but not the highest) predictability rating at GuruFocus.

The other big piece of the Buffett Munger screen is the PEG ratio (also referred to as PEPG). That shows the relationship between the P/E ratio (based on one year of earnings data) and the growth of earnings over the past five years. Put another way, it shows us the relationship between the current stock price and the growth of earnings over the past five years, rather than one year.

On February 26, 2015, Waddell & Reed had a PEG ratio of .72, which indicates it is undervalued (anything below 1.0 is considered under valued, anything between 1.0 and 2.0 is considered fairly valued, and anything over 2.0 is thought to be over valued).

Legendary mutual fund manager Peter Lynch was an advocate of the PEG ratio; interestingly, since the sharp pullback in the share price last year, the company meets the criteria for being a Peter Lynch value stock (the price — blue line — is below the 15 times P/E — green line):

Among the analysts covered at Yahoo! Finance, the consensus median price is $50.00, close to the current price of $49.75 (February 27, 2015), with a high target of $64.00 and a low target of $39.00.

Comments on valuation: This stock has found a place on two important screens: Warren Buffett (Trades. Portfolio )’s and Peter Lynch’s. That reflects the mostly downward action of the price, while the earnings lines have continued their upward trajectory. As always, with these kinds of value stocks, we have ask ourselves if this really is a bottom for the share price.

Conclusions

With modest expectations for earnings growth this year and next, we might also have modest expectations for the share price as well.

However, we can’t ignore the solid 3.4% dividend yield, and the continuing quest among conservative investors for alternatives to bonds and other fixed income vehicles.

For investors who want a combination of income and potential capital appreciation, Waddell & Reed may make the case for buying the fund company and not the funds.

About the author:

Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks. He’s currently exploring two potential routes to an income portfolio: First, to combine dividend challengers, contenders, and champions with covered calls, and second, to combine more volatile stocks with collars.

As a writer and publisher, Abbott explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald’s Profits. the first of a series of booklets on this subject, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

In an eclectic career, Robert Abbott was a radio news writer and announcer, a newsletter writer and publisher, a farmer, a telephone operator, and a construction worker. When not working, he has been a busy volunteer, which includes more than a decade of leadership roles at the Airdrie Festival of Lights, one of North America’s leading holiday light displays. He lives in Airdrie, Alberta, Canada.