Lowering Our Allianz Fair Value

We are lowering our fair value estimate for  Allianz to EUR 122 from EUR 126 after Bill Gross' recent departure from PIMCO. We expect fund outflows at PIMCO, which we think could amount to as much as 5% to 15% of PIMCO's total assets of close to $2 trillion (or EUR 1.6 trillion) to weigh on commission income and performance fees for Allianz in the next three to five years. That said, our long-term view for Allianz remains positive, and our full-year profit projection for the company is relatively unchanged, believing that solid performance from Allianz's P&C business should compensate for any near-term weakness at PIMCO.

Getting an accurate read on the amount of capital that could ultimately leave PIMCO is a difficult task, but we have taken note of two high-profile departures of star managers that may offer some insight into what could unfold at the bond shop. In the first case, we looked at Jeffrey Gundlach's acrimonious departure from TCW in December 2009, which led to outflows of roughly $7 billion from TCW Total Return Bond fund (representing more than 50% of the fund's assets before Gundlach's exit). That said, the situation is not quite the same as Gross' at PIMCO, as Gundlach was outperforming at the time of his departure, and when he was forced out he ended up taking his entire team with him to start DoubleLine.

The second case involves Neil Woodford's departure from Invesco Perpetual, which recorded some $12 billion in outflows (or roughly 25% of the AUM that Woodford had been managing for the firm) from the announcement of his departure in October 2013 to his departure in April 2014 and ultimate launching of his own fund in June of this year. Woodford's performance was also stellar, he was on good terms with the management at Invesco, and there were several capable managers waiting in the wings to take control of his funds. We think that the latter case is more representative of what could happen with the funds Gross was managing at PIMCO.

To get to our projected range of outflows of $100 billion to $300 billion in the next three to five years, we had to break down PIMCO's total AUM to account for the assets that Gross was managing that are most likely at risk. As we noted above, PIMCO managed some $2 trillion (or EUR 1.6 trillion) in assets at the end of August 2014. Of this total, approximately 25% (or EUR 400 billion) represents separately managed accounts being run for Allianz, which we view as more permanent in nature (and unlikely to be contributing to the outflows). As for the remaining $1.5 trillion (or EUR 1.2 trillion), we estimate that Gross was directly responsible for around $600 billion (or EUR 470 billion), which is the main pool of assets that we feel are at risk of leaving PIMCO.

If we assume that 25% of these assets leave, much like we saw at Invesco Perpetual, the outflows would be in the $150 billion (or EUR 118 billion) range. In this scenario, the changes of leadership and investment processes weigh on investors' minds, but the firm continues to get credit for being a leading global fixed-income manager with broad, deep resources and some of the best investment professionals in the business. The outflows would be even lower if the talent that has been brought in to replace Gross generates better performance than he had been, winning the confidence of many of PIMCO's institutional clients. This would leave the outflows closer to the lower end of our forecast range. Internally, PIMCO is projecting $100 billion of redemptions related to Gross' departure.

Before we move on to the other scenarios, we should note that many of the separately managed accounts that PIMCO runs for large institutional clients are not going to go away overnight. These accounts are monitored by investment committees and advised by consultants who are deliberate in their consideration of manager changes and other material events. They typically put a manager on watch while they evaluate changes like this and look for potential replacements. It also takes time to open a business relationship with a new manager and to ultimately move the money, and when the money does move, it does so in an orderly fashion. Because these types of accounts benefit from due diligence, PIMCO will have the opportunity, in many cases, to prove itself with its new team in place.

If we assume that 50% of the assets (or $300 billion) that Gross was managing for PIMCO leaves the firm, much like we saw with Gundlach, then the outflows would be at the upper end of our forecast range. We find this forecast a bit more difficult to support, given that it is Gross alone who is leaving, with the army of traders, research analysts, portfolio managers, and other specialists that he had at his disposal remaining at PIMCO. These resources traditionally allowed Gross to get more and better information than any other bond investor, and we think that that advantage remains with PIMCO. What would make this scenario more likely is if the performance of the funds that Gross was managing deteriorates further, with investors losing confidence in their ability to recover.

A more likely upper-end outcome is that somewhere in the neighborhood of $200 billion (or EUR 160 billion) ends up leaving the firm in the next three to five years. Outflows at this level would equate to 33% of the assets that Gross was managing and represent approximately 10% of PIMCO's total AUM at the end of August. We get some support for this forecast from the most recent flow estimates that Morningstar has put together for  PIMCO's Total Return (PTTRX) fund, which saw $17.9 billion in outflows during September, with requests for another $5.6 billion to be withdrawn at the start of October. Together, these two figures represented 10% of PIMCO's Total Return AUM of $222 billion at the end of August. This was also better than the estimated outflows for  PIMCO Total Return ETF (BOND), which were $631 million in September, representing 18% of the $3.6 billion fund. That said, outflows in situations like this have a tendency to be heavier at the outset, with any further outflows dribbling out of a fund over time.

What makes this all the harder is the fact that the Total Return fund has been in net outflow mode for the last 17 months, prompted at first by the Federal Reserve's so-called taper tantrum but kept alive by the fund's uncharacteristically lagging performance. Based on data just released by Morningstar Direct, the fund's total AUM has dropped from peak levels of $293 billion in April 2013 to $202 billion at the end of September 2014, with outflows totaling $87 billion, or $5.1 billion on average per month. While we think some investors will be perfectly comfortable to leave their funds with PIMCO's new investment team, we think that the more mediocre performance of Gross' funds, along with the unproven track record of the team that is following him (even though they've invested alongside Gross for a long time) might give some investors reason to pause, prompting further outflows.

For valuation purposes, we prefer to remain a bit more conservative, having seen the impact that poor performance and a loss of investor confidence can have on flows in the aftermath of the 2008-09 financial crisis, when both AllianceBernstein and Legg Mason suffered through several years of debilitating outflows from institutional clients. As such, we have stuck to the middle of our forecast range ($200 billion) when thinking about the impact that Gross' departure could have on fee income in the near to medium term. Accordingly, we've lowered our fee income growth rate for Allianz this year to 4.5% from 5.0%, mainly to reflect the lower AUM levels at PIMCO. We then trim this fee income growth rate gradually to 3.5% next year, with the firm seeing more normalized growth rates for fee income by 2018. We also adjusted Allianz's P&C results upward to reflect our expectations for higher transaction volume in the commercial product line and price actions in European auto insurance, which should help compensate for the near-term weakness at PIMCO. Putting it all together, our revised fair value estimate for Allianz is EUR 122.

We should also note that Allianz has appointed Oliver Baete as the company's next CEO to succeed Michael Diekmann, who is scheduled to retire in 2015 when he reaches the retirement age of 60. Baete, a former McKinsey executive who led the European insurance and asset management practice, joined Allianz in 2008 as COO and was promoted to the CFO position after a year. He is intimately familiar with the firm's insurance and asset management operations and has been groomed by the senior management to take the top job when Diekmann retires. One of his biggest achievements was the successful turnaround of Allianz's P&C operations in France, Italy, and Turkey, where performance was hurt by poor underwriting results.

Given his extensive experience in operation improvement, we would not be surprised if Baete exerts tighter control over PIMCO's operations, a move that Diekmann did not fully support following Mohamed El-Erian's departure from PIMCO in January. Baete will continue as the head of global P&C business before he takes over as CEO next year.

While we are not surprised by the company's choice of Baete for its next CEO, we think the timing of the announcement is somewhat interesting, as Allianz typically handles matters like this at its annual general meeting in May. In our view, the early announcement was intended to send a clear signal to investors that the management team at Allianz is on top of the PIMCO situation. Baete's technical knowledge and background in insurance and asset management operations also gives us comfort in the firm's continued commitment to its core businesses in life, P&C, and asset management. In our view, this move is particularly important to the new management team at PIMCO, as the firm is currently under investigation by the SEC regarding the pricing of securities within its Total Return ETF.

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