Janus Capital Group: When The Wrong Metrics Create A Value Opportunity

| About: Janus Capital (JNS)
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Janus Capital Group Inc (NYSE: JNS) manages mutual funds, and other investment products for individual and institutional investors. The company operates funds under the Janus brand as well as INTECH and Perkins, each specialized in different investment styles and disciplines.

As of September 30, 2011, the firm had $141 billion of assets under management. This is an important metric, as it drives revenues. As the company notes:

Revenues are generally based upon a percentage of the market value of assets under management and are calculated as a percentage of the daily average asset balance in accordance with contractual agreements with the Company’s investment products or clients. Certain investment products are also subject to performance fees which vary based on a product’s relative performance as compared to a benchmark index and the level of assets subject to such fees.

Given its importance, changes in AUM are followed closely and the market (and media) tend to place great emphasis on this figure. JNS’s AUM is down 18.7% in the last two quarters, which has spooked the market and sent its shares down a whopping 49.2% year to date (as of 11/1). Such a large decline gives the impression that customers are fleeing, losing faith in its investment managers.

Fortunately for the company, this is not entirely true. Of the $32.5 billion decline in AUM this year, just 8.2 billion (1/4) is the result of long-term (excluding money market accounts, which are short-term in nature) net outflow. The bulk of the decline is due to a decline in the value of assets under management. The company’s investment products have greater emphasis on equities than many of its competitors, and the equity market’s poor showing up to the end of the recent quarter (September 30) took a toll on the company’s AUM.

Taking a longer term view, one might be of the mindset that equity prices will rebound from September lows, carrying JNS’s AUM along for the ride. Indeed, October was one of the best showings in recent memory, and this should surely benefit JNS’s revenues this quarter.

The following chart shows the company’s aggregate assets under management over time, as well as the net long-term (excluding money market) investment flows per period.

Janus Capital Group Inc. - Assets Under Management, 2004 - 3Q 2011

Janus Capital Group Inc. - Assets Under Management, 2004 - 3Q 2011

Note that, despite the sometimes wild swings in AUM, the net investment flows is significantly smaller than the overall swing. This shows the relative importance of overall asset prices, and suggests that the amount invested with JNS is relatively sticky, which is to be somewhat expected, given that many people are passive investors, going through the unenjoyable process of selecting mutual funds and then rarely re-evaluating (“set and forget”).

On its face, this scenario seems well suited for a value investor. The market seems focused on the wrong metric (overall change in AUM) when a better metric for predicting long-term earnings (net investor inflows) exists that shows a much more mild scenario than that which first appears. Additionally, in focusing on the wrong thing, the shares have taken a beating.

But is JNS cheap? Free cash flows drive investment value, so it is worth looking at the company’s ability to generate free cash flows. Additionally, given the fluctuations in the company’s revenue (largely in line with overall performance, which is largely correlated with the market cycle), it is important to consider the company’s free cash flows over an entire business cycle, rather than cherry pick the best (possibly most recent) periods.

Janus Capital Group Inc. - Cash Flows, 1999 - 3Q 2011

Janus Capital Group Inc. - Cash Flows, 1999 - 3Q 2011

Here we see that, except for 2004, the company has had largely stable cash flows, and that, as expected given the nature of its business, capital demands are quite low, resulting free cash flows that are tightly coupled with cash flows from operations.

Over the last decade, the company has generated free cash flows that have averaged $236 million per year. This is also the average from the last five years, and coincidentally also the figure from last year. This compares to the company’s current (as of 11/1) market cap, which is $1.22 billion, resulting in a free cash flow yield of a whopping 19.3%!

Considering this figure has been sustained for a decade, it appears that the company is quite cheap. But before we make this determination, we should look for any red flags.

One possible red flag relates to the company’s debt load. Let’s look at its capital structure.

Janus Capital Group Inc. - Capital Structure, 1999 - 3Q 2011

Janus Capital Group Inc. - Capital Structure, 1999 - 3Q 2011

Here we see that JNS does carry a hefty debt load, but that it has been reduced dramatically over the last ten quarters. In fact, the company has repaid $513 million of debt in this period, or 46% of the total. Though the company’s debt to equity ratio is around 46% (far higher than I would normally consider), there are several reasons I am not concerned in this case.

First, as noted, the company is repaying its debt quite rapidly. Like other companies I’ve looked at, this can be an attractive feature, especially when purchasing at a relatively low enterprise value. As the debt is repaid and value shifts to equityholders, there can be the dual benefit of both increasing equity as a percentage of enterprise value, and an increasing enterprise value. Not a bad situation to be in!

Second, none of the company’s debt is due until 2014, and more than half isn’t due until 2017. Given the company’s free cash flow, there is little likelihood that it will be unable to pay this amount down before 2014, when it would be forced to repay or roll over. Not being at the whim of the credit markets to roll over the debt is a huge bonus.

Before we end, it is worth noting that the company’s free cash flow may be overstated due to the company’s use of stock-based compensation. Fortunately for investors at the current price (and perhaps unfortunately for employees!), a large amount of the company’s options are out of the money, thanks for the rapid decline in share price. The same is true for the company’s unvested restricted stock awards.

What do you think of Janus?

Disclosure: No position, but may initiate within 72 hours.