HNNA - Hennessy Advisors: Getting A Bigger Share Of A Shrinking Market

2023-08-02 05:45:51 ET

Summary

• Hennessy Advisors is a mutual fund manager with a dividend yield of 7.85% and a strong balance sheet.
• HNNA assets under management have been falling over the past years, and I doubt this will change anytime soon due to the rising popularity of passive investing.
• In my view, Hennessy Advisors is becoming a value trap, and it could be best for risk-averse investors to avoid this stock.

Introduction

I've been looking for high dividend yield stocks in the microcap space and among the companies that popped up on my radar screen was Hennessy Advisors (HNNA). It's a US mutual fund manager with a dividend yield of 7.85% as of the time of writing but I'm concerned that the company has been struggling with falling assets under management ((AUM)) over the past few years and they are barely above $3 billion right now. Overall, mutual funds in the USA have been losing market share to passive strategies and ETFs over the past several years and the whole situation reminds me of a quote from the movie Other People's Money (1991):

We're dead alright. We're just not broke. And you know the surest way to go broke? Keep getting an increasing share of a shrinking market. Down the tubes. Slow but sure. - Larry "the Liquidator" Garfield, source

In my view, the dividend payments could be slashed in the near future and my rating on Hennessy Advisors is neutral. Let's review.

Overview of the business and financials

Hennessy Advisors was founded in 1989 by financial advisor Neil Hennessy and it launched its first mutual fund in 1996. The company was listed in 2002 and it currently has a portfolio of 16 domestic equity, multi-asset, and sector and specialty funds as well as an actively managed ETF focused on environmental, social and governance ((ESG)) and machine learning/artificial intelligence opportunities named Hennessy Stance ESG ETF. According to the corporate website of Hennessy Advisors, its AUM stood at $3.15 billion as of July 28, 2023. The company had 18 employees as of March 2023 and is still led by Neil Hennessy who acts as its CEO and Chairman.

Hennessy Advisors has been active on the M&A front over the past two decades and it has completed a dozen acquisitions, the largest of which was in 2013 when it got its hands on 10 funds ten funds previously managed by FBR Fund Advisers that boosted its AUM by $2.2 billion to $3.1 billion. Hennessy Advisors reached its zenith in FY16 in terms of AUM with close to $7 billion but its business has been in a steady decline since then, shrinking almost every single year despite several acquisitions made.

With AUM falling, revenues and earnings have been contracting rapidly as well and EPS dropped to just $0.30 for the first half of the company's FY23.

Looking at the latest available financial results, we can see that revenues from investment advisory fees and shareholder service fees dipped below the $6 million level for Q2 FY23 and this pushed down diluted EPS to just $0.15. This was barely above the $0.14 per share quarterly dividend that the company has been paying out since August 2019.

Turning our attention to the balance sheet, we can see that the situation looks good as cash and cash equivalents stood at $57.9 million as of March 2023. Considering the debt of Hennessy Advisors consists only of 4.875% notes due 2026, I think the company is in a good position to fund three or four small acquisitions over the coming years. Its latest purchase was announced in late April and includes two funds with AUM of about $70 million.

Looking at what to expect for the future, I think that Q3 FY23 revenues are likely to be above $6.5 million due to the improved AUM compared to the previous quarter and that diluted EPS could be around $0.17. Hennessy Advisors should release its financial results for Q3 FY23 in about a week. However, I'm less optimistic about the long-term prospects for the company and I expect that AUM will continue to fall over the coming years which should put pressure on margins and earnings. And as EPS dips below the quarterly dividend payment, I think that Hennessy Advisors could cut its dividend in late 2023 or early 2024.

You see, the mutual fund industry is in a secular decline as investors have been focusing on passive investment strategies over the past few years and it seems that the trend is unlike to reverse anytime soon. According to data from Morningstar , US equity mutual funds had net outflows of $926 billion in 2022 which is about $6 billion per day. Passive funds, in turn, had net inflows of $556 billion.

Well, what about the ESG and machine learning/artificial intelligence ETF of Hennessy Advisors? Surely that's a hot niche right now, right? Yes, but the issue is that Hennessy Stance ESG ETF has total assets of $45 million which is less than 1.5% of the company's AUM which means that it won't make much of a difference. In addition, it seems that this ETF is barely growing as it had assets of $43 million in December 2022 when Hennessy Advisors took it over.

Looking at the upside risks, I think that the share price of Hennessy Advisors could get a boost in the short term if the Q3 FY23 results are strong. In addition, the market valuation could rise if the company makes more acquisitions in the ESG and AI spaces in the near future which significantly increase its AUM. For example, Hennessy Advisors plans to fold the $70 million funds from the April purchase into the Hennessy Stance ESG ETF. This pivot into ESG and AI could also potentially attract more investors.

Investor takeaway

Hennessy Advisors has a strong balance sheet and a dividend yield of over 7% but mutual funds have been losing popularity in the USA for years now and it doesn't seem this is likely to change anytime soon. While I expect the Q3 FY23 financial results of the company to show an improvement compared to the previous quarter thanks to an uptick in AUM, I'm pessimistic about the financial performance of the business over the long term. And considering quarterly EPS have been inching close to dividend payments, I think that it's likely that the dividend will be cut in late 2023 or early 2024. While Hennessy Advisors has a TTM P/E of just 10.5x, a net operating margin of close to 30%, and a high dividend yield, I think that it's becoming a value trap due to the decline in AUM. In my view, it could be best for risk-averse investors to avoid this stock.

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