Janus Henderson - Markets Helping, Upgrade To Bullish

Summary

• JHG reported another quarter of net outflows in 2Q21, but earnings were boosted by strong markets and performance fees.
• Investment performance versus peers is an area of concern and should be carefully watched.
• With valuation supported by higher AUM, and a positive assessment of management, I upgrade to Bullish.
• Investors concerned about an equity market correction should be mindful of JHG’s market leverage.

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In A Nutshell

Janus Henderson Group (NYSE:JHG) reported strong 2Q21 earnings and announced a $200m buyback program. The group is in good shape from a financial perspective, but operational trends are somewhat underwhelming. In this note I will highlight a few interesting aspects of the 2Q21 result. I also revisit my fundamental valuation of JHG, full details of which are set out below.

Net Flows – Stubbornly Negative

Readers of my previous work on JHG will be well aware of the historical problems with JHG’s Quantitative Equities (Intech) segment, and so it was no surprise to see continued outflows from this AUM bucket, with a net -$1.3bn going out of the door in the three months to 30 June 2021. A net outflow of -$1.9bn in Equities was the other key driver of the total group net outflow of -$2.5bn. Flows in Alternatives were strong, with an impressive sales outcome, but unfortunately this is a relatively small component of overall group AUM.

Source: JHG 2Q21 Results Presentation, slide 18

CEO Dick Weil’s comments suggest that management expects net outflows to continue in Quantitative Equities, and that the focus remains on getting flows in the other buckets back into positive territory. Whilst it is good that the CEO is upfront about the Quantitative Equities challenges, it is somewhat disappointing that the goal on flows isn’t to get back to positive numbers inclusive of the impact of the Quantitative Equities headwind.

• “Next, as I’ve told you in prior quarters, our path to organic growth starts with net flows going positive outside of our Quant Equity business. We are aiming for consistent growth, which we achieved in the fourth quarter last year, but in the first and second quarter of this year we’ve fallen short, and that's not okay with us. However, the underlying trends and the pipeline make us confident that we have a good chance to deliver our goal of more consistent positive flows outside of the Quant Equity in the second half of the year.” Source: JHG 2Q21 Earnings Call Transcript, Seeking Alpha

Stepping back from the quarterly numbers and taking a longer-term perspective, net flows have been in negative territory since I started covering JHG in late 2018. The chart below plots net flows by quarter, expressed as a percentage of each quarter’s opening AUM. Note that these percentages are quarterly rates, not annualized rates.

Source: Created by author using data from JHG financial reports

A bullish take on the chart above is that the trend is broadly positive, with the rate of net outflows moderating over time. A bearish interpretation of the data is that consistent net outflows are a sign that the underlying AUM franchise is not in a healthy state. Irrespective of how the data is interpreted, annualized net outflows of around -2% pa represent a material drag on revenue.

AUM Driven Higher By Markets

For fund managers battling extended periods of net outflows, strong markets can come as a big relief. Despite the negative story on flows discussed above, JHG’s AUM has risen from $378.1bn as at 3Q18 to reach $427.6bn at 2Q21, an increase of 13.1%. Looking at things in a slightly different way:

• Over the 11 quarters to 2Q21, cumulative net flows were -$66bn.
• Over the 11 quarters to 2Q21, cumulative market/FX impacts were +$100.7bn.

The tables below highlight the very material benefit that JHG’s AUM has received from market movements over the quarter and half-year to 2Q21. It is not realistic to expect the contribution from markets to have such a major influence on AUM movements over the medium term, but the higher AUM base is obviously good news for investment management fee income.

Source: JHG 2Q21 10Q, page 27

Investors should also keep in mind that the market influence on AUM can easily go into reverse. Looking back at 4Q18, AUM fell in one quarter from $378.1bn down to $328.5bn, with -$41.2bn of the fall due to movements in markets/FX.

With a very direct link between AUM and profit, this serves as a reminder that earnings streams generated by fund managers are not annuity-like in nature. Timing markets is a next-to-impossible challenge in my view, but if an investor feels that markets are overstretched and ripe for a correction, they’d be well advised to consider very carefully how much market leverage they want to take on via exposure to investments in listed fund managers such as JHG.

Performance Fees – A Monster Quarter

JHG generated $77.4m of performance fees in 2Q21, well above anything that the group has achieved in recent years. To put that number in context, 2Q21 base investment management fees were $494.5m. Expressed as a percentage of the base investment management fee total, the 2Q21 contribution from performance fees of 15.7% is not sustainable in my opinion. To illustrate this point further, the chart below plots JHG’s annualized performance fees by quarter, expressed as bp of AUM.

Source: Created by author using data from JHG financial reports

Performance fees are virtually impossible to predict or forecast with confidence. Note that the 2Q21 outcome was high due to seasonality and most likely a material benefit from outperformance relative to absolute return targets (driven by strong markets) for several product sets. The average performance fees over the last 12 quarters to 2Q21, expressed as an annual run rate have been $69m pa. If we exclude the very strong 2Q21 outcome, the average over the prior 11 quarters is $47m pa. Looking at performance fees relative to AUM, the average performance fees over the last 12 quarters to 2Q21 is 1.79bp pa. If we exclude the very strong 2Q21 result, the average over the prior 11 quarters is 1.29bp pa.

For valuation purposes, I have historically assumed a low level of performance fees. Having taken a fresh look at the data for the analysis above, in my latest update (set out further below) I now factor in a higher level of sustainable performance fees.

Investment Performance – Not Where It Needs To Be

Consistently strong investment performance is foundational to success in the asset management industry. Distribution reach and quality are important factors, but even highly skilled, well-resourced and motivated sales operations will struggle to sell underperforming products. Similarly, the slickest client relations team can’t do much to prevent AUM redemptions if the investment management teams are generating poor returns.

In a previous Seeking Alpha note on JHG, I set out my concerns regarding the negative drift in the group’s investment performance metrics, particularly the peer-relative numbers. As shown in the table below, broadly speaking, peer-relative numbers have deteriorated slightly further. Given that the Equities bucket represents 56% of group AUM, and also carries a relatively high investment management fee rate, the soft numbers for both 1-year and 5-years are slightly worrying.

Performance versus peers (% of mutual fund AUM in top 2 Morningstar quartiles):

Source: JHG 2Q21 Results Presentation, slide 25

Updated Fundamental Valuation

In the calculations and discussions below, I put forward a simple P&L model for JHG that can readily be flexed to consider a number of scenarios. Note that the calculations are in line with the “adjusted” results that JHG’s management presentations refer to (as is the analysis presented above).

The starting point for revenue is AUM. Consistent with previous valuations, I make downward adjustments to AUM to capture anticipated outflows in Quantitative Equities and also in regard to historical Dai-ichi related AUM. My Base Case valuation AUM is $412.5bn (3.5% below reported 2Q21 AUM).

For the Bear Case, I have allowed for a 5% reduction in AUM from the Base Case level. In the Bull Case, I’ve assumed AUM 5% higher than used for the Base Case.

A key valuation assumption required is the investment management fee margin. The 2Q21 investment management fee margin was 47.1bp, and I adopt this for the Base Case valuation. For the Bear Case, I have allowed for a 5% reduction in the investment management fee margin. In the Bull Case, I assume the same investment management fee margin as used for the Base Case.

For performance fees, I have increased my assumption to 1.0bp pa (up from 0.6bp pa).

For the compensation ratio, I continue to use a Base Case assumption of 43%. For the Bear Case valuation, which assumes a reduction in AUM, I have set the compensation ratio to 46%. I assume 42% for the Bull Case.

For non-compensation operating expenses, I have inflated the FY20 expense base at 5%, in line with management FY21E guidance of a “mid-single digits” increase.

In regard to investment income generated on JHG’s balance sheet cash and investments, I have adopted earning rate assumptions based on medium-term expectations rather than expected near term conditions. I note that investment income is not a major driver of group earnings.

I have assumed an effective tax rate of 24%, being the mid-point of management’s expected normal range of 23% to 25%.

Source: Created by author using data from JHG financial reports

Risks – Upsides and Downsides

JHG’s business mix is heavily weighted to equities. It follows that JHG’s earnings are highly sensitive to both upward and downward movements in equity markets. Investors who are currently concerned about an equity market correction should be aware of the market leverage risk.

Ongoing industry-wide investment fee pressure is a downside risk to JHG’s earnings, and the company may be less successful in future at offsetting this fee pressure with beneficial changes in business mix.

Further deterioration in investment performance versus peers may act as a headwind on product sales, and trigger increased redemptions. This represents a notable source of downside risk for JHG. New product launches in the ETF space, discussed at length in the 2Q21 analyst Q&A, have the potential to generate positive sales momentum, offering modest upside risk potential on net flows.

Continued net inflows in the higher fee Alternatives space represents an additional, modest upside risk.

With new COO James Lowry joining in October 2021, there is the potential for a major review and restructure of JHG’s operational systems to be announced in coming months. This is a source of both upside and downside risk. A successfully implemented efficiency program would be positive for JHG, however, restructure costs and disruption/distraction impacts must also be considered.

Conclusion – Valuation Appeal Outweighs Concerns

At ~$41.11 per share (assumed ex dividend price), my valuation scenario framework indicates that JHG is trading at a PE of between 9.9x and 13.6x, with a Base Case of 10.9x. My “fair value” benchmark for a fund manager is a PE of around 12x. On that basis, JHG looks to be approximately 10% cheap.

Downside risks associated with weakness in both net flows and peer-relative investment performance must be considered. On the other side, I continue to regard JHG as a solid business, run by capable and sensible senior management.

In regard to management and JHG’s corporate culture, a couple of comments in the 2Q21 Earnings Call Transcript are worth highlighting. These Q&A responses are consistent with what I have come to expect from JHG’s management – a pragmatic approach, with a strong focus on sustainable outcomes.

CEO, Dick Weil, in response to a question about near term and medium-term opportunities.

• “But like a farmer, you need to plant for different reasons. And so you want to do things that are paying today and you want to do some things that are planted today and hopefully pay tomorrow in the medium and then in the long-term. So we are trying to act across time frames both to do things that are more immediate, but also think that lay the foundation for future success.” Source: JHG 2Q21 Earnings Call Transcript, Seeking Alpha

CEO, Dick Weil, in response to a question about M&A appetite:

• “But like always, when we talk about inorganic opportunities, it's hard to find a culture match. It's hard to find compensation that fits. It's hard to find people who want to be part of an organization as opposed to be in their own little self directed area. And so finding the right fit is a nontrivial exercise, it's difficult. It's especially difficult probably in alternatives these days with very high prices for a lot of different parts of that business.” Source: JHG 2Q21 Earnings Call Transcript, Seeking Alpha

Given the strong share price appreciation over recent months, at ~$41 per share, JHG’s dividend yield is running at around 3.7% pa. Whilst this is a bit lower than the 4%+ that has been observed in the past, it still represents a healthy income yield in the current environment.

Based on an updated fundamental valuation framework, a solid balance sheet, a fresh $200m buyback program, and continued comfort with management, I upgrade my view on JHG from Neutral to Bullish.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This writing is for informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. This article is not an investment research report, but an opinion written at a point in time. The author's opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. Any and all opinions, estimates, and conclusions are based on the author's best judgment at the time of publication, and are subject to change without notice. Past performance is no guarantee of future returns.