What Gross Hire Could Mean for Janus

We have increased our fair value estimate for narrow-moat-rated  Janus Capital Group to $15 per share. We adjusted our valuation model to account for the impact we expect Bill Gross' hiring to have on the firm's ability to attract and retain assets, especially on the fixed-income side of things. The potential exists for Janus to pick up a significant amount of fixed-income AUM in the near to medium term, given Gross' reputation as a bond fund manager, and the likelihood that PIMCO will see a meaningful amount of outflows tied to his departure. However, we would note that there are a few hurdles that could limit the amount of assets the firm ultimately picks up.

For starters, Janus is a much smaller player in the bond fund market, with just $31.4 billion in fixed-income AUM at the end of the second quarter. At PIMCO, Gross had an army of traders, research analysts, portfolio managers, and other specialists at his disposal. While additional resources will be committed to Gross' efforts at Janus, it may not be adequate to support a large influx of capital in the near to medium term. It should also be noted that Janus will be competing against some of the heaviest hitters in the fixed-income market when going after institutional business, with  BlackRock (BLK) , PIMCO, and  Legg Mason all having significantly more resources to bring to bear.

That said, we think that Janus does provide Gross with the perfect setting to re-establish himself as a fixed-income investor, allowing him to focus more on unconstrained product, while Gibson Smith tackles the more constrained parts of the portfolio. This should leave Gross in a somewhat better position in a rising interest rate environment, allowing him to drive stronger flows as long as his performance is top-tier. Combined with his mandate to build out the firm's global macro fixed-income strategies, we think that Gross' addition at Janus should allow the firm to more than double its fixed-income AUM during the next five years.

While that sounds impressive, it should be remembered that even at $80 billion in total fixed-income AUM at the end of 2018, Janus will still be much smaller than  Franklin Resources (BEN) and Legg Mason (both of which we see managing more than $400 billion in fixed-income assets by the end of our five-year projection period), and still have to face off with industry giants PIMCO and BlackRock (which will not only have close to $800 billion in actively managed fixed-income AUM, but also a nearly equal amount of AUM from passively managed bond index funds and ETFs). These firms have significantly greater resources than Janus, which we think will struggle to handle a sudden influx of capital in the near term.

Our understanding (based on commentary from our fund analysts) is that Gross has so far only requested one trader to assist him in the Newport Beach, California office that Janus will set up for him, as well as one client-facing person. This is likely to slow the influx of capital that could come into the firm following Gross' hiring, especially on the institutional side, where 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. Because these type of accounts benefit from careful due diligence, Janus and Gross will have to prove themselves before money starts flowing in the door.

We also don't think that all of the capital that is likely to leave PIMCO following Gross' departure is going to head directly to Janus. While we expect some investors to follow Gross, we think there is just way too much competition from better performing bond shops to draw investors that are leaving PIMCO away from Janus. BlackRock in particular has generated some stellar performance from its actively managed fixed income funds of late, and is being more aggressive about going after this business. We've also heard from some institutional investors that are planning to use the turmoil at PIMCO as an opportunity to reallocate their portfolios, trimming positions in fixed-income products that have been a bit overweight the last several years and increasing their exposure to alternatives.

Even with these headwinds, we still see Janus' fixed-income AUM more than doubling by the end of 2018. This level of growth in its fixed-income operations will lift Janus' organic growth into positive territory for the first time since 2009, with our forecast having the company's AUM growing at a 4%-5% rate organically over the next couple of years. The net result is a 2.5% CAGR for organic AUM growth during 2013-18. By the end of the final year of our five-year forecast, we expect Janus to have close to $80 billion in fixed-income AUM, accounting for 30% of its total assets (compared to 18% at the end of the second quarter). This forecast also assumes a relatively modest improvement in the firm's equity operations, which have been a big drag on overall results for much of the last five and a half years.

While the net result will be a reduction of Janus' realization rate over the next five years, given the much higher rate of growth we are expecting from its fixed-income funds, we still envision an improvement in overall revenue growth for the firm. Prior to Gross joining Janus, we had been forecasting annual revenue growth of 6%-7% over the next four years (following revenue growth of more than 8% in 2014), resulting in a 7.2% CAGR for revenue during 2013-18. Our new forecast (based on the growth of Janus' fixed-income operations) has revenue growing closer to 9% this year, with annual revenue growth averaging just over 9% the next four years, with the net result being a 9.1% CAGR for revenue during 2013-18.

With regards to profitability, Janus is now likely to close out 2014 with operating margins at the upper end of our 29%-30% range. For the time being, we have assumed that Gross will receive compensation from the company's compensation pool, similar to how other senior portfolio managers are paid at the firm, as opposed to some sort of revenue sharing agreement. We hope to get more information on this when Janus reports earnings later this month, but every indication so far has been that this will be the case. While we continue to believe that Janus will need to spend more on compensation and distribution in the near to medium term, in an effort to improve its performance and flows on the equity side of the business, we now believe that operating margins are likely to expand to the 31%-32% range over the next five years (compared with 30%-31% previously).

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