Description

Stilwell Financial, Inc. (NYSE: SV, $13.51) is currently an attractive opportunity based on its valuation, the special situation relating to the pending disposition of its 33% stake in DST Systems, and the recent emergence of a large activist shareholder. Stilwell primarily consists of a 98% stake in Janus and a 33% stake in DST Systems (NYSE: DST, $36.97). Janus accounts for 95% of revenues and the DST stake accounts for about 44% of Stilwell’s market value.

As VIC readers know, Janus is the growth-oriented mutual fund company whose name became synonymous with the technology bubble. If you haven’t looked at the company recently, you would probably assume that it is doing terribly. But, you would only be partially correct. Assets under management (AUM) peaked in 2000 at $350 billion and are currently $146 billion (now ranked the 6th largest equity manager, 14th largest 401(k) provider). Janus’ largest mutual funds have underperformed significantly, dropping more than 60% since the market peak. Surprisingly, most of the drop in AUM is related to market declines rather than redemptions. As evidence of the stickiness of mutual fund assets, Janus has had net redemptions of only $23.6 billion since the end of 2000. During the same time its client accounts have only dropped by 16% to 5.1 million. It is remarkable that a company can lose 60% of its clients’ money and still retain most of its clients.

Revenues and EBITDA for 2002 are expected to decline 26% and 31% from 2001, and decline 49% and 58% since the peak in 2000. Results are expected to stabilize going forward since Janus has probably already taken the hit from redemptions related to the crash. Janus’ results are still tied to the level of the market, but its portfolios are now less concentrated in technology/media/telecom and look more like the S&P 500.

The following are the main arguments for investing in the company right now:

1. Disposition of DST stake – Management has announced that DST is “non-core” and expects to complete a disposition in late 2002 or early 2003. The form of disposition is undecided, but the tax treatment is critical for valuation purposes and my thesis. SV could sell the stake outright which would trigger a corporate tax on the gain. Alternatively, SV could distribute the stake to shareholders via a spin-off and avoid the corporate tax. The market expects SV to go for the tax-inefficient approach so it can retain the proceeds within the company and reduce debt (see next point). SV’s debt/EBITDA is about 2x compared to the industry norm of 1x.

2. Incentive Problem – There is a major incentive-alignment problem related to the DST stake that may be corrected (see point 4) in order to create immediate value for shareholders. In April 2002 SV granted 6.2% of Janus’ shares to 180 key employees (Janus is structured as an LLC). The shares vest over 5-7 years with accelerated vesting based on performance targets. Employees do better under the tax-inefficient scenario of selling DST and paying down debt ($908 million of debt), because every dollar of debt reduction equals a dollar increase in the equity value of the shares into which the employees are vesting. If DST is sold and all the debt is repaid, the equity value of the company would increase by $3.95 per share (assuming the enterprise value stays the same). Employees don’t want DST to be spun-off because they are not yet major shareholders and they wouldn’t capture any of the value of the DST stake.

Just to be perfectly clear, here is how it works: Stilwell’s enterprise value is $3.8 billion, composed of the DST stake ($0.9 bn after tax), the Janus stub equity value ($2.2 billion), and net debt ($0.8 bn). Janus’ “stub” enterprise value is $2.9 billion ($2.2 bn of equity + $0.8 bn of debt). If DST is sold, proceeds are used to repay debt and $0.1 bn of cash is left over, so Janus’ equity value would be $3.0 billion, an increase of $0.9 billion, or $3.92 per share. When the employees vest, they will get 6.2% of this increased equity value. Alternatively, if DST is spun off, Janus is still stuck with the debt and the same equity value. Shareholders, however, would receive the pre-tax value of DST of $1.5 bn, or $6.54 per share, a much better deal.

Employees have an additional incentive to pay down debt because they have the right to put 50% of their vested shares to the company on scheduled liquidity dates. Accordingly, they want the company to pay down debt in order to ensure it is in good financial condition to honor the put.

3. Valuation – SV owns 39.7 million shares of DST, which is worth $6.54 per SV share pre-tax and $3.92 post-tax (assuming a corporate level tax of 40% and effectively zero basis). Accordingly, SV’s “stub” money management business is valued at $9.59 (SV share price – [39.7 x DST price]/224.4 million SV shares – 40% tax on DST gain) or about 12x consensus EPS of $0.77. The free-cash-flow yield for 2002 is 11% assuming $229 million of FCF and a market cap of $2.5 billion (FCF = $173 million of net income + $72 million of D&A – $16 million of capex).

Alternatively, if DST is spun-off to shareholders tax-free, shareholders would get an additional $2.62 per share due to forgone taxes. The stub money management business would effectively be valued at $6.97 per share today, implying a P/E of 9x and a 15% FCF yield, which is much more attractive. Comps including T. Rowe Price and Amvescap trade at 18-20x 2002 earnings.

4. Large Activist Shareholder – According to a November 22, 2002 13-D filing, a $5 billion Boston-based hedge fund, Highfields Capital Management, has recently taken a 7% stake in SV. The emergence of this firm on the scene is a catalyst for resolution of the incentive-alignment problem. Highfields was buying shares most recently on November 22 at $15.10 per share. Highfields has a good reputation as a value firm, having been started by a guy who is well publicized for returning 30%+ per year over 10 years while at Harvard’s endowment fund. The firm has been successful in similar activist situations before, including getting Reader’s Digest to remove its dual share class structure. Here’s what Highfield’s says about its intentions in its November 7 13-D filing:

“The Reporting Persons intend to review and consider the Issuer's further announcements and plans relating to the reorganization and the DST sale to determine whether such plan will achieve the highest values attainable for shareholders, or whether alternative transactions, including spin offs, recapitalizations, self-tender offers or sale of the Issuer, in whole or in part, should be proposed or pursued.”

Furthermore, on Monday Highfield’s hired the Blackstone Group “to put Stilwell's plans under the microscope and determine whether they are in shareholders' best interests,” meaning they are serious.

5. Solid Core Business – As you know, the fund management business is an extremely good one with high margins and operating leverage. As highlighted above, despite Janus’ terrible performance, it is still one of the leading mutual fund companies and it has only experienced mild redemptions. Today only 20% of assets are invested in aggressive growth and its relative performance in the last year has improved considerably. 75% of its funds are in the top two Lipper quartiles for the year ended September 30. Assets in November are actually up slightly for the month.

Catalyst

Catalyst:
1. Tag along as a large activist shareholder attempts to structure the pending disposition of DST Systems as a spin-off, avoiding $2.62 per share in taxes (i.e. 19% of the current share price).
2. The core business is undervalued relative to comps (P/E of 9x vs. 18x), including a 15% FCF yield.