StepStone Group: Not Stepping Up Here (NASDAQ:STEP)

In May of last year, I concluded that it was time for a small step for shares of StepStone Group (NASDAQ:STEP). This came after shares had seen quite a big pullback while operating momentum remained strong, yet I was aware of the fact that this is a cyclical business. Despite some question marks, I believed that shares were looking interesting, as I contemplated taking a small position, which I ended up doing.

A Recap Of The Thesis

StepStone is a global private market investment firm, focusing on investor solutions which includes advice, data services and other services for its client base which includes insurance companies, pension funds and high net worth individuals, among others.

The basic promise of the product and service is that StepStone develops private market portfolios across various private asset classes, such as private equity, infrastructure, debt and real estate. The company oversaw $300 billion worth of assets in 2020, although the value of assets under management was substantially lower than the assets under administration.

Coming out of the pandemic rally, StepStone went public at $18 per share in September 2020, translating into a $1.7 billion equity valuation. The business model of StepStone is comprised out of fixed fees, but also a huge and variable incentive revenue stream (carried interest), creating huge volatility in the financial performance of the business.

The company generated $264 million in revenues in 2018 on which it posted operating earnings of $86 million. Revenues fell to $256 million in 2019 as operating profits fell to $62 million. Revenues for 2020 (ending in March that year) fell to $235 million, yet earnings rose to $132 million.

The real impact of the pandemic was seen in the first quarter result for 2021 as the company posted a huge loss on the back of a reversal of carried interest amidst valuations coming down during the pandemic, but markets at large quickly showed a recovery at the time.

Shares ended up rising to $55 in November 2021, as 2021 revenues rose 6% to $787 million as operating earnings rose to $338 million, with earnings power pegged at $2 per share. These were great times as valuation multiples were expanding, leaving me questioning the huge momentum run as conditions were pretty much ideal already in 2021, as I am typically wary of high profits being awarded higher valuation multiples.

By May 2022 shares were back to $25 already despite continued strong momentum as earnings were pretty much trending around $4 per share, while assets under administration and management kept rising as investors were pricing in a correction in the markets and the impact on the business of course. Given that reasoning I did not automatically see appeal at 5-6 times earnings, given the cyclicality of the business and a complicated shareholder ownership structure. Nonetheless, I was happy to initiate a small position, yet I failed to have conviction to initiate a position in size.

Stabilizing

Since May shares have been trading in a $25-$30 range, currently exchanging hands at $26 per share, leaving no gains over pretty much the past half a year. In May the company posted its 2022 results, marking another spectacular 73% increase in sales to $1.37 billion with income before taxes up 52% to $513 million and reported earnings coming in at $3.84 per share following a huge minority interest. The company ended the year with $570 billion in assets under management and ownership.

First quarter sales for the fiscal year 2023 revealed a $77 million negative revenue number on the back of a huge reversal in carried interest, with carried interest payments payable to staff coming down as well. Despite the pullback in the valuations, total assets managed or administered rose to $588 billion in the meantime. The reversal in carried interest trend actually worsened during the second quarter, with a negative $158 million revenue number being reported.

Given the flexible cost base and minority interest, net losses to the firm were modest at $40 million, or about $0.66 per share, for the first six months of the fiscal year 2023. With fixed fee revenues on the rise, amidst total assets rising to $602 billion, investors should not focus too much on the volatile carried interest profit or loss contribution.

With the balance sheet being quite de-risked, the focus is on the valuation. There are no major causes of concern here from that point of view as the inflow of assets, or at least stabilization of assets under administration and management is quite comforting. That is comforting as the market developments in the fourth quarter of 2022 provide few reasons to become upbeat on the results for the third quarter of the fiscal year of the company. Given all of this, I am working with a current $1.50 per share stable fixed fee income (based on the results so far this year), accompanied by wild swings in carried interest, although these should be positive on average.

Concluding Remark

Given the discussions held above, I see no reason to alter the small stake which I have held in the business. The first and second quarter results were worse than I feared as no quick recoveries in sight, but on the other hand the fixed fee component of the business continues to do quite well. Given all these moving parts I remain upbeat in the long run, yet I see no reason to alter a modest long position at this point in time.