Overview – Hennessy is the culmination of a roll up of mutual fund assets over the past 10 years. Most of the fund management is outsourced in one way or another – through formulas, such as the “Dogs of the Dow” theory and various quantitative screens (The basic strategies are outlined on Page 11 of the 10K, they are mostly value oriented although apply a small amount of technical indicators) or through sub-advisor agreements where the funds are actively managed. This is a low cost model within an industry that already requires quite low levels of capital. Most of its funds have expense ratios below 1.00%, but the company still boasts strong margins. With the huge downturn in markets during 2008 and 2009, assets under management (AUM) shrunk and profits plummeted as they are derived primarily from AUM. The stock market has returned to higher levels, but the stock has not. At the corporate level, the balance sheet remains strong and the company is proving opportunistic with a buyback, which should result in surprisingly high EPS and will prove a catalyst in realizing a higher share price.
What can go wrong –
1. Morningstar ratings a major selling point of mutual funds. There is a degree of reflexivity from a business perspective here because as the Morningstar rating goes lower, there can be an outflow of funds and remove the sole driver of profit. The median ranking of their funds is 3 stars. Hennessy has had net outflows over the past few quarters, although they have attracted some new money and the rise of the market has helped them.
2. If the buyback is fully executed, management and board will control greater than 50% of the stock. With an underleveraged balance sheet, they can lever up the company and take it private. They would not be the first C-suite to rip off shareholders in history.
Valuation –
Shares Outstanding: 5,800,000; Current Price: $2.50; Market Cap: $14,500,000;
Net Cash: $5,200,000; EV: $9,300,000; AUM(’10): $900,000,000; EV/AUM: 1%
AUM for 2010 should average $0.9 billion. Hennessy has bought asset managers for between 2-3% EV/AUM, and most asset managers trade around 2% EV/AUM, which overall appears undervalued due to the aversion to equities in the current environment (premium managers trade at higher valuations). Even at this level, trading at 2 or 3% EV/AUM would result in a gain of 100-200%. The use of an illiquidity discount and giving it a valuation of 1.5% EV/AUM would result in a 50% gain.
Earnings power has been low due to the volatility of the stock market. Even in the 08-09 turmoil, HNNA only posted a slight loss and now earnings should rebound. The company did just under $6 million in revenue for 2009 and $9 million in 2008, earning -$195,000 and $1,611,000 respectively. This shows how much revenue can flow from the top to the bottom line. Debt repayment has reduced interest expense, and AUM has come off its lowest levels. There are fixed costs in the business, but they are low and give the business a lot of leverage on the upside. The company should be solidly profitable for 2010 in a variety of scenarios:
Low end - Net profit margins for the first 6 months of 2010 have been 10%, and during the bull market they were closer to 25%. A 0.7% expense ratio of AUM of $900 million would yield revenue of $6.3 million, and a 10% profit margin would result in $630,000 or $0.10 per share. Net cash, this is about 15x earnings. The downside case would be about 10x earnings net of cash, a price of $2.00 per share.
Annualized – On an annualized basis, the company is doing about $7 million in revenue with 10% margins. This would translate into $700,000 net profit or $0.12 per share. At the current rate, a large part of revenue would flow straight to the bottom line.
Upside – If the company has been able to buyback enough stock to move the needle on the share count (low volume definitely slows down the pace), EPS could end up being higher. Lower interest expenses could contribute another cent to earnings. Their Japanese funds have 4 star Morningstar ratings and may be able to attract more assets and they have expense ratios greater than 1.00%. Any combination of the market rising since March, stemming outflows, and increasing AUM in their higher rated funds (they also happen to have higher expense ratios) could boost earnings further.
Buyback and dividend – Somewhat ironic in regards to their mediocre investment returns is how astute management is at increasing shareholder value. They authorized a buyback in August to repurchase 1,000,000 shares. This represents 17% of the company and is covered by cash on the balance sheet. This is encouraging due to the size of the buyback relative to size, and management’s awareness that the shares are cheap. Part of their expansion strategy has been to roll up other funds, but at current valuation their own company is a nice acquisition. And a quick note on the dividend, it has been an annual $0.09 for the past several years. With the upcoming changes in taxation, the company is essentially paying their 2011 dividend in 2010 so that it is taxed at a lower rate. While the record date on receiving the dividend has passed, simple yet very astute acts like this are evidence for confidence in management’s ability.
Management – The reason the buyback and dividend seem to represent the desired scenario of alignment of interests between management and shareholders is because it truly exists. The Hennessey family (one is CEO, another is an exec) own 37.4% ($5.4 million) of the company, and the board of directors own (excluding the Hennessey’s) 7.6% ($1.1 million). The CEO makes $180,000 and 10% of pretax profit. He didn’t receive a bonus in 2008 or 2009, although the 10% deal is essentially a performance-based incentive. Even though he has an incentive to drive profits, it should be done smartly since it is unlikely he will want to dilute his ownership, which vastly outweighs his salary including10% of profits.
Acquisitions – Any acquisition would be instantly accretive to earnings since the cash balance is earning nothing and the company already possesses the infrastructure to manage the funds. Management has not been overly aggressive in the past with acquisitions and they have all contributed to the growing the top and bottom line. They might utilize leverage in a deal, but the balance sheet is debt free and the company would not be putting itself in danger by taking on debt. It would also help the company grow since the market has been neutral and means AUM aren’t going to increase through a rising market.
Opportunistic buyout – Management could theoretically use their huge stake in the company and the debt free balance sheet to buyout the company. Cannell Partners, which as been an activist in small-cap companies (they have filed 13-D’s on many firms, including MEDW, VVTV, SLRY – takeaway: someone will speak up if things get out of hand), has a 7% position, which should act as a spokesperson for the rest of shareholders. This decreases the likelihood of shareholders getting robbed if management gains a controlling stake in the company.
Major Catalyst – Their quarterly results up through the March 31st quarter were released in August. This delay creates a huge knowledge gap between the current state of the company and what is publicly available. The main driver of profits is AUM. The stock market has buoyed around current levels for a while and is higher than they were for most of 2009. Revenue should come somewhere between $7-8 million and EPS could surprise on the upside if the buyback has been executed. HNNA is a small fish in a big pond and could be a takeover target – much as the smaller companies they have gobbled up have been to them – and the private valuation on it is substantially higher than the market price.
Disclaimer - Assume the above is the culmination of a chimpanzee locked in a room with a typewriter. Do your own research. I own shares in the company.
No comments:
Post a Comment