U.S. Global Investors: JETS Ownership Is Worth 2x Its Value, And You Get The Rest For Free

Summary

  • The earnings announcement last week was the first time the management team clearly outlined a strategy to double down on the highly profitable ETF business.
  • No one is more incentivized to generate value for shareholders than CEO Frank Holmes, who owns ~17% of total shares outstanding.
  • Ownership of JETS presents an extremely high-quality revenue stream worth between $160M and $320M of market capitalization (depending on the assumptions outlined below).
  • Why invest now? This quarter, management announced an exploration of strategies to unlock shareholder value and has $20M of cash on the balance sheet (or >20% of market capitalization).

Exchange traded fund concept. A bull and bear besides the golden text ETF.

aprott/iStock via Getty Images

We believe that U.S. Global Investors (NASDAQ:GROW) is deeply undervalued due primarily to ownership of the U.S. Global Jets ETF (JETS), which is worth as much as 3x the company's current market capitalization. A renewed focus on the ETF business from management and announcement this quarter of exploration to unlock shareholder value are likely catalysts that will play out in the coming months ahead.

This article is a summary of due diligence calls with current and former employees of BlackRock iShares, Goldman Sachs ETF desk, WisdomTree ETF desk, and Roundhill Investments on ETF economics. Seeking Alpha analyst Josh Klein has done a great job overviewing and highlighting the value of the rest of the GROW platform (see here and here). If you are unfamiliar with this story, please review his articles before reading further.

ETFs Are A Fund Manager's Dream

The revenue and earnings quality of ETF management fees stand in stark contrast to those of mutual funds. Unlike mutual funds, there is a very clear flywheel effect for innovative ETFs that creates a sustainable moat. See an example below with JETS:

  1. U.S. Global JETS ETF is launched as the first ever airline ETF. U.S. Global Investors has a novel, differentiated product in the market that benefits from first-mover advantage and begins to build its brand value.

  2. Investors who wish to gain passive exposure to this group of airlines invest, and assets under management begins to increase.

  3. As assets under management of the ETF increase, the liquidity of the product improves meaningfully. The increased liquidity attracts market makers, option traders, and institutional investors.

  4. The ETF becomes the de facto measure of the airline stocks (acting as a proxy index), and the publicity from this adds to brand power attracts increasing investor flow.

  5. Investor flow increases assets under management, which brings further liquidity, which introduces further Assets Under Management, bringing increasing brand recognition and driving additional inflows.

The end result of the flywheel effect above is a highly defensible revenue stream due to a captive asset base:

  • Sustainably achievable value proposition: Investors choose JETS to get direct exposure of a basket of stocks, and pay 0.6% management fee for this exposure. The investor is not expecting active management related to this basket of stocks, they are paying for diversified and liquid exposure.

  • Real switching costs: Retail investors have few if any ways to get direct exposure to the portfolio of underlying stocks (other than buying and balancing these stocks by themselves), and institutional investors, market makers and option traders need the liquidity that JETS has created to do their job.

  • Very high barriers to entry: Even if a bigger ETF player tried to recreate JETS, they would not benefit from the same first mover advantage. The only way to capture market share would be to lower fees, which makes the already challenging proposition of breaking into the established market even harder. The investors that were most excited to gain exposure to airlines already have the exposure they need with JETS. Because the value proposition of the ETF to customers is exposure instead of performance, first-mover advantage has a lasting role in market structure.

  • Earnings quality: The completely passive nature of ETFs means there are very low fixed costs for business operations. Our diligence with industry participants suggests margins as high as 90%. The proof is in the pudding: Roundhill Investments, a private ETF provider founded in 2018, has 8 ETFs with 11 employees on their LinkedIn. GROW has 3 ETFs with 42 employees on their LinkedIn (a quick search through LinkedIn would show you that the majority of these employees are mutual funds related).

Assuming a range of assets under management between $3B and $4B (JETS's AUM today is roughly $3.5B), 90% gross margin, and 10-15x earnings multiple, the market capitalization value of JETS is between $160M and $320M. This asset on its own is worth more than 170% stock price appreciation at the midpoint:

Model

Valuation Methodology

Internal Analysis - Excel

Comparable companies support this 10-20x earnings multiple:

Chart

Active vs. Passive Investing: Passive is a Clear Winner

JETS is a true gem, but it is just the start. The company announced a third ETF launch, and we expect more ETFs to be announced in the future as the organization becomes more passive focused. A more diversified stream of tremendously high margin ETF management fees will be critical for GROW, and the board of directors should be entirely focused on this OKR if it is serious about creating value for shareholders over the next 1-3 years.

The trend to passive vs. active investing has accelerated since 2015, with passive investing vehicles now accounting for the majority of U.S. domestic equity funds with over $6.2 trillion dollars in assets under management:

Chart

Passive vs. Active Investing Assets Under Management

Bloomberg Terminal

The debate of active vs. passive investing has dragged on for over a decade, and perhaps the most high-profile outcome was Warren Buffett's $1 million dollar bet with active investor Ted Seides, co-founder of Protege Partners. The takeaway is abundantly clear: For the average investor (and even professionals like Seides), passive investing is likely to generate better returns.

We recognize the immediate irony in highlighting the bullish trends around passive investing while advocating for an active investment in U.S. Global Investors, but it is critical in understanding why the company is at a key inflection point. GROW has two businesses: a new, passive ETF business with a growing number of ETFs under management, and a legacy, active mutual fund business with shrinking AUM and aggregate performance well below the S&P 500.

In the past, GROW management chose to consolidate the ETF and mutual fund business together for reporting purposes. This has been a clear mistake in our opinion, because these revenue streams couldn't be any different.

Mutual funds require performance in order to attract assets. If performance declines relative to similar mutual funds, investors will move their money elsewhere. Investors are fickle and if performance does not exceed peers, assets under management suffer. This makes the fee structure of mutual funds volatile - fees are not recurring, not sticky, and require continued outperformance.

Fund managers recognize this, and to entice investors to remain invested, mutual fund fees continue to see pressure:

Chart of Mutual Fund Fees

Investment Company Institute, Trends in the Expenses and Fees of Funds Mar-21

Investment Company Institute

GROW is not immune to this trend. The company's mutual fund business has been a melting ice cube of more than a decade of poor performance and outsized fees:

Mutual Fund Table

GROW Mutual Fund Performance

US Global Investors

Unlike ETFs, mutual funds are also required to hire active stock pickers, with a typical fund requiring a portfolio manager and a number of investment analysts on salary. When performance is good, salaries increase - but when performance declines they are still required to be compensated. And when revenue is volatile and expenses are variable, it leads to doubly bad earnings quality.

It should be obvious: Charging 1%-3% for average annual performance since inception below the S&P 500 cannot generate sustainable economic profit. It is for this reason that investors value mutual fund fee revenues at a significantly lower multiple than ETF management fee revenues. It's also why CIR views management's signaling this quarter to double down on ETFs as a critical first step to unlocking shareholder value.

As for next steps, this is what we would do to create value for shareholders and make clear to the market that there is deep value in the stock:

  1. Full divestiture, sale or spinout of mutual fund business: Show the market the full earnings potential of the ETF business.
  2. Further doubling down of ETF business: Launch more ETFs in less time. Roundhill Investments has launched 8 ETFs in the past 3 years, with far fewer employees.
  3. Key hires on management team with deep ETF expertise: Leverage industry expertise in building a sustainable ETF business, and hire an in-house IR team to help send a better message to the market.
  4. Act on comment of "reviewing strategies" to unlock shareholder value and buy back $10M-$20M of stock: The most undervalued investment opportunity is the company's stock itself.

Conclusion

We believe that GROW is extremely undervalued and that no one stands to benefit more from long-term stock appreciation than CEO Frank Holmes, who owns 17% of the stock. While options are relatively inexpensive versus the 2x-3x implied upside based on ETF revenue alone, it's difficult to predict the timing of any buybacks or special dividends the company is exploring, which is the key catalyst for a repricing of the stock. We therefore recommend ownership of GROW stock itself as the company reprices over the next six to 12 months.

This article was written by

Professional investing for almost a decade with passion for recurring revenue streams and defensible business models. Learned to invest and think about businesses from time in the trenches of the analyst class of Wall Street. Deep value investing, preference for dividends, and always studying all-time-great Stanley Druckenmiller, shlita. Primary investing framework is convexity, and leveraging options-thinking whenever possible.“You’ll do better if you have passion for something in which you have aptitude. If Warren had gone into ballet, no one would have heard of him.” - Charlie Munger
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Disclosure: I/we have a beneficial long position in the shares of GROW either through stock ownership, options, or other derivatives. 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.

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