Hennessy Advisors (NASDAQ:HNNA) is an investment manager that offers domestic equity, sector, specialty, balanced and fixed income products.
Highly-accretive M&A strategy provides institutional-class infrastructure and significant earnings power
Although the M&A cadence has remained fairly steady since 2000 with the acquisition of 13 mutual funds (prior to 2012), the most recent acquisition was the largest ever. In June 2012, HNNA acquired a family of 10 FBR funds with $2.2 billion in AUM (at closing) for $38.9 million. Three of the funds were merged into existing Hennessy funds and the remainder were rebranded with the Hennessy name with no changes in the portfolio managers.
While this acquisition resulted in greater leverage (debt increased from $1.9 million in FY12 to $28.6 million in 2Q14), there are three mitigating factors. First, there is more than sufficient debt coverage due to the strong FCF (virtually all operating cash flow translates into FCF due to the minimal capex requirements), which increased >4x since FY12 to $7.8 million in the LTM. Second, the "acquired" operating income vastly exceeds the interest costs as shown in the chart below.
Third, the final balloon payment of $15.6 million is not due for more than three years (October 2017), which provides plenty of time to refinance into a low fixed rate before short-term rates increase.
Not only do these funds provide greater intra/inter asset class diversification (in fixed income with core/balanced funds and equities with utilities/financials funds) but the expanded marketing, distribution, client service, compliance and trading capabilities can be leveraged across the entire firm. As a result, HNNA now has an institutional-class infrastructure, which is just as important (if not more so) than performance.
The asset management industry is most suited to a growth through acquisitions strategy as the business model is highly scalable with the majority of fees from incremental AUM dropping directly down to operating income. This is reflected in the significant margin expansion shown in the chart below.
Specifically, HNNA only has 18 employees despite $5.4 billion in AUM. In the asset management industry, this extremely high profit per employee ratio is typically only seen at hedge funds or private equity firms (to which so many mutual funds are compared).
Moreover, by lowering the expense ratios of the acquired funds and improving performance (in some instances), HNNA is less vulnerable to the increasing competition from lower cost products.
As the debt from the FBR acquisition is gradually paid down, HNNA can continue to strategically acquire funds with its new status as the hunter rather than the hunted and greater borrowing capacity (its lender allowed the loan balance to increase from $1.9 million to $30 million). This should enable continued AUM growth regardless of market conditions. HNNA can be opportunistic in acquiring funds at attractive multiples (as a % of AUM) as many of its targets are highly incentivized to sell. For example, a smaller manager facing increasing compliance costs and wanting to retire has to sell in order to monetize his or her multi-decade track record*. The sale of the FBR funds highlights another buying opportunity, in which the seller decides to exit a non-core business.
*The manager would get nothing if he or she simply shut down the firm and gave investors their money back. The "downside" of having all of your assets go up and down the elevator every day is that there are no real assets to sell when they are gone (the office lease expires and the Bloomberg Terminal is returned).
Recent reversal of negative fund flows is masked by FBR-related AUM growth
Although the M&A strategy is a net positive, one drawback is that investors typically discount acquisition-driven AUM growth compared to organic inflows (market appreciation or investor contributions) as the contribution of the latter is often assumed to be much lower than it actually is. However, this is clearly not the case with HNNA as evident by the dramatic reversal in fund flows since FY12.
This growth continued in the most recent quarter as AUM increased 40% to $4.8 billion, which drove a 40% and 58% increase in revenue and net income, respectively, to $8.3 million and $1.8 million.
Going forward, inflows should be driven by the ongoing rotation by individual investors into equities from fixed income, the placement of its funds on additional mutual fund platforms (where a majority of funds are purchased) and a recent marketing program aimed at gaining more business from financial advisors.
CEO going "all in" is reassuring sign
No one is more motivated to increase shareholder value than CEO Neil Hennessy (who is also a portfolio manager) for three reasons. First, he owns 32% of the stock. Second, much like Richard Pzena and Mario Gabelli* his name is on the door. Third, a majority of his overall compensation is tied directly to company-wide profitability (the bonus is 10% of pre-tax profits; also similar to Mr. Gabelli).
As chairman of the now independent board, he is at least partly responsible for the six dividend increases since 2005 including the most recent 28% dividend increase in January 2014. The strong earnings power provides the ability for future increases as the current annual dividend of $0.16 per share (up from $0.09 in FY10) only costs $946,000.
*Although Gabelli Asset Management changed its name to GAMCO Investors in 2005, this still reflects the Gabelli name.
A decrease in AUM due to redemptions (which may increase if funds underperform their respective benchmarks) or market losses would reverse the positive operating leverage experienced since the FBR acquisition. HNNA is especially vulnerable to a downturn in the equity markets as fixed income only accounts for 7% of AUM as shown in the chart below.
There is industry-wide fee pressure due to competition from lower cost products such as index ETFs/mutual funds and smart beta strategies.
HNNA competes against much larger fund families with greater resources, especially in the critical areas of marketing and distribution that often trump performance in terms of fund flows.
There is exposure to rising interest rates as the prime rate (on which the loan agreement is based plus a 75 bp spread) follows short-term rates, which are expected to increase over the next year (e.g. there is a 60% probability that the Fed raises rates by July 2015).
There is key man risk given the dependence on Mr. Hennessy although HNNA is building out its bench of portfolio managers.
Any future acquisitions would result in higher leverage as they would most likely be funded with debt instead of equity although this would prevent dilution.
Valuation and price target
The fact that HNNA perfectly fits the profile for inclusion in the Hennessy Small Cap Financial Fund (see investment strategy; with the exception of the "conservative lending culture" part) means that it should be attractive to other funds looking for stocks with these same attractive fundamentals.
Although the stock may be off the radar for some of these managers due to the small size (on an absolute basis and relative to its peers) and lack of analyst coverage, this may change following the recent uplisting to NASDAQ.
As shown in the chart below, the 26% discount to the peer group P/E multiple and 43% discount to the market cap/AUM multiple overcompensates for any "lower quality" acquired earnings and ignores the recent turnaround in fund flows. HNNA even trades at a discount to the S&P 500 (P/E of 18.3x) even though its net profit margin is >2x higher (~10% for the S&P).
The fact that AMG (which grew by acquiring boutique managers) trades at a ~2x higher multiple presents two key takeaways. First, this reinforces the validity in the growth through acquisitions strategy. Second, AMG's 37% operating margin highlights the potential margin headroom for HNNA as AUM continues to increase.
The target price of ~$20.90 (a 40% return to be reached over the next 12-24 months; stop loss below the 50 DMA) is derived using a blended multiple, which consists of a 10% discount to the peer group median P/E and market cap/AUM multiples.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.