Diamond Hill Investment Group: Dividend Continues At 8%; 7x P/E And 41% Net Cash Make Company A Value Buy

Summary

• 8% Dividend Yield which is extremely attractive.
• 4Q20 Net Inflow of $900mn into Diamond Hill’s funds.
• Reported EPS in 4Q20 up 13.8% YoY.
• As of 2020, net cash directly held by Diamond Hill was 41% of market cap.
• Stock repurchases of 5% of shares outstanding in 2020.

8% Dividend Yield, 7x ex-cash P/E, 9% FCF Yield

The Diamond Hill Investment Group (NASDAQ:DHIL) is an active asset manager, with a 20-year history, $26bn in AUM and a value investing philosophy. They had a mixed set of 4Q20 results, which despite a decline in revenues was however offset by higher investment income, leading to a net income attributable to common shareholders gain of +7.1% YoY. Our buy recommendation on the stock is predicated on its consistent fund performance, significant cash on the balance sheet, ability to generate robust free cash flows, attractive and inexpensive valuations. 2020 net cash to market cap [at current prices] stands at 41% and the company generated an estimated 2020 FCF yield of 11.9%.

DHIL Equity Fund Performance [Source: 4Q 10Q]

We have updated our model following the full year 2020 results [see attached], and looking ahead, in 2021/2022 we expect Diamond Hill’s FCF yield to be at 9.3%/9.8%. Given this, a low P/E in 2021/2022 of 12.1x/11.2x, and 2020 expected dividend yield of 8.2%, we think the stock offers a favorable risk-reward scenario for investors. Importantly, ex-cash P/E [after deducting related interest income after tax], looks very attractive for the company and stands at 7.3x and 6.8x for 2021 and 2022 respectively.

DHIL Fixed Income Performance [Source: 4Q 10Q]

$200.00 Target Price Implies 41% Potential Upside

Diamond Hill’s stock has performed well and is up 25% since our initiation in July 2020. We now value Diamond Hill at an ex-cash P/E of 12x, using our 2021 EPS estimate, and add it to current net cash per share [after deducting related interest income after tax] to arrive at a target price of $200.00. This represents a potential upside of 41% from current stock levels. At the $200.00 target price, implied P/E is 16.5x.

Higher Inflows Highlight of 4Q20

Diamond Hill reported 4Q20 numbers with a significant quantum of inflows. For the quarter, net client inflows totaled $900mn, and stood at $1.5bn for the year ended 2020. With this, Diamond Hill’s AUM as at end December 2020 was $26.4bn, though average AUM for the year was meaningfully lower at $21.9bn because of the market downturn in 1Q20. For the year ended 2020, net client inflows have come to fixed income strategies.

AUM [Source: 4Q 10Q]

Revenues for 4Q20 fell 2.4% YoY as the mix of AUM tilted towards lower fee-paying strategies. Reported net operating income too declined by 32.5% YoY on higher operating expenses. A 79.9% YoY jump in investment income led to the 7.1% YoY increase in net income attributable to common shareholders. EPS attributable to common shareholder for 4Q20 was $4.54 against $3.99 in 4Q19. For full year 2020 however, Diamond Hill reported a 24.8% YoY drop in EPS attributable to common shareholders on lower revenues, operating margins and investment income.

Commenting on the results, Heather Brilliant, CFA, President and CEO said:

Operating results were negatively impacted by the severe market downturn in response to the pandemic, as well as a mix shift into lower fee strategies. However, we believe our higher assets under management at year end and positive client flows speaks to the quality experience our investment team and associates deliver for clients.

Brandywine Global to Acquire Diamond Hill's Fund

In February 2021, Diamond Hill had announced that Brandywine Global would acquire the company’s High Yield and Corporate Credit Funds, Brilliant added. The company is now looking to “develop new, long-term oriented investment offerings that meet client objectives and align with their investment principles”. This includes planned 2021 launches in large-cap and micro-cap strategies as well as securitized bond strategies.

AUM Further Breakdown [Source: 4Q 10Q]

Dividends, Special Dividends and Share Repurchases

In 2020, management returned $56.6mn to shareholders in the form of a $12.00/share dividend and a buyback of 5% of stock outstanding which amounted to $18.6mn. Currently, the company pays dividends in the form of special dividends, however, from January 2021, management has instituted a regular quarterly dividend of $1.00/share and at the end of each year, the board will decide whether to pay an additional special dividend. Cash and investments held directly by the company equaled $58.08/share, a 2.2% YoY improvement and representing 41% of market cap.

Catalysts

Attractive dividend yield

Even though the company pays out only a special dividend, this number has been growing steadily over the last five years and represents a very promising dividend yield of 8.2% in 2020. We expect this dividend to at least remain at current levels given the strong cash balance of the company.

Free cash flow

Diamond Hill has been a significant generator of free cash flow over the years with 2019 and 2020 free cash flow yield of 11.7% and11.9% respectively. Looking ahead, we expect free cash flow to continue growing [taking aside that 2020 will be negatively affected by the short-term COVID impact]. Our free cash flow yield estimates for 2021 and 2022 stand at 9.3% and 9.8% respectively.

Significant net cash per share

Diamond Hill has a large net cash per share on its balance sheet [including investments] that is directly held by Diamond Hill Capital Management as at end 2020. This net cash per share amounts to $58.08 in 2020 and represents 41% of the current market cap. This gives us comfort on the balance sheet as well as dividend payments.

Risks

Risk of Passive Management

The flow of funds to passive investment products, such as index funds and ETFs, is perhaps the single biggest risk for the entire global asset management industry. This is a topic which has seen a great deal of press and visibility and is a focus for all institutional investors and professional fund managers/analysts.

Poor investment performance and outflow of AUM

The company’s financials are primarily driven by fee income, which is a function of AUM. AUM’s will be negatively impacted by poor investment performance. This could result in negative growth for Diamond Hill. Additionally, weak investment performance as well as negative economic and market sentiment can result in investor outflows from Diamond Hill’s funds.

Pressure on fee income

Any downward pressure fee income from investor demand for passive funds will likely negatively impact Diamond Hill’s financials and business outlook.

Loss of key personnel

Diamond Hill depends significantly on its experienced team of portfolio managers, research analysts and management who have specialized expertise in their areas. Additionally, other than the CEO, employees do not have employment contracts with the company and can terminate their employment at any time. Departures of key personnel from the company can affect fund performance and investor confidence.

Competition

Competition from other investment products and firms like asset managers, mutual funds, ETF’s, hedge funds, brokerages, etc. remains high and is a key risk for Diamond Hill.

Cut in dividends

Diamond Hill doesn’t pay out a regular quarterly dividend, preferring instead to only pay out annual special dividends. Any reduction in the dividend per share of $12.00 could negatively impact the company’s stock price.

Conclusion

Despite mixed latest quarterly results, the company still looks to be very attractive on its fundamentals. Diamond Hill’s AUM of $26.4 bn at the end of December 2020 was much higher than the AUM at the beginning of the year, with additional higher investment income to add. From a valuation standpoint, metrics look to be very robust. The company has a 7x ex-cash P/E, significant net cash per share of 41%, and FCF Yield Of 9%. On top of this, the company has been returning its capital to shareholders, with an 8.2% dividend yield and a 5% share repurchase. This will buoy investor confidence and make this stock much more attractive in the long-run.

Our DHIL Model for your reference...

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.

Comments

[mavsfan99]

How can I make sure I get the special dividend? When should I buy shares? What date? Thank you.

[Value Investment Principals]

@mavsfan99 You should buy before 11/26/2021 in order to make sure you get the $19.00 special dividend.

[mavsfan99]

@Value Investment Principals Thank you!

[mavsfan99]

I just bought 50 shares at $165. Hope it was a good time to buy in.

[Wolverine78]

Asset managers like this are fairly simple to value. 2x revenue plus net cash. Just look at all acquisitions that follow that formula and even what they sold there own funds for. As such they should trade right around $150. As aum and revenue increase, so will the fair value. Hopefully they can see value come back in favor and also seed some funds with the cash to attract more aum at the right time. Good company at a very fair price that will return a good chunk of cash and hopefully catch some new aum. Keep the practice clean and simple and probably expect a boring 10-15% annualized return rate over next 10 years.

[sjm- cfa]

@Wolverine78 EV/R of 2X seems low to me, as EV went for over 3X and current valuations are higher with more traditional asset managers at ~2.8X and alternative asset managers at ~4.8X. Using some of the cash balances is a great point.

[sjm- cfa]

Appreciate the analysis. I like the stock and think it mis-priced although your valuation work is more optimistic than mine (my FV target currently $165). DHIL looks to be selling w/in mean/median valuation range of peers that I follow AB, BEN,BLK,FHI,VCTR & TROW w/DHIL having a superior balance sheet and profitability profile. Offsetting the superior financials is the fact that DHIL has limited liquidity and no stock coverage by the Street.

Its hard for me to see the end game for DHIL. Most small shops become part of larger organizations, either being acquired or buying other organizations to gain scale to leverage distribution, technology and/or compliance. There seems to be a strong appetite by others to purchase asset managers but the performance track records go up & down the elevators. Without a transaction, I am content to own a disciplined asset manager with great financials and their stock that is reasonably mis-priced.

[parity]

@sjm- cfa Why are they carrying so much cash? SOP valuation incl large cash balance discounts are very hard to narrow and a high dividend or buybacks rarely do the job unless you are willing to hold 5+ yrs to realize the discount.

[sjm- cfa]

@parity don't have much of a perspective on the reasons for the large cash balances. Perhaps institutions that place money with DHIL are more comfortable with a company with a very strong balance sheet given the volatility we have seen the last 20 years? I agree a valuation discount can take a long time to narrow and amortize the valuation premium/discount over 3-5 years when looking at return potential of a stock.

I do take some comfort that DHIL, at its core, has a disciplined intrinsic value approach to investing and appears unlikely to get caught up in the fad-du-jour (such as GME) that could blow up a co. (or hedge fund). As DHIL's revenues & profits are tied to equity appreciation/depreciation, it is comforting to me as an investor, to have a balance sheet that can weather a pretty big storm. You may want something different.

Good luck investing.

[Wolverine78]

@parity it’s not dead cash, I think you have some investing going on as well. It’s super valuable for when demand picks up to be able to seed a new fund. Maybe start 2-3 new funds and use own capital. This cost very little and then may attract new aum plus the money can grow at investment rates. Beauty of compounding And attracting aum that compounds which you get fees on. Just need to be patient for right time and right clients before you sees the funds. Lots of liquidity is name of game for them and huge value.