HNNA - Hennessy Advisors Trades At Low Multiples Because Its Business Is Declining

Summary

• HNNA is a fund manager. The company's business model is under threat because of the growth in passive investment strategies.
• From a record AUM of $6.7 billion in 2016, the company is managing $3 billion as of FY22. The trend will probably continue.
• HNNA's managers were conservative and started returning capital to shareholders years ago. Today, the company offers a well-covered 5% dividend yield.
• Further, HNNA's balance sheet is strong, with $20 million in net cash holdings ($60 million in cash, $40 million in debts).
• Although HNNA's P/E ratio of 11.5x seems low, it is high because the company's earnings present a declining trend that is industry based.

Hennessy Advisors ( HNNA ) is a mutual fund manager with some $3 billion in AUM as of September 2022.

The company has formidable margins, a strong balance sheet, and pays dividends yielding 5% at current stock prices that are well covered by earnings.

Unfortunately, the company's business model has been under attack because active investment strategies are out of vogue. Since 2007, the company has only had positive organic inflows above redemptions between 2013 and 2016.

With that in mind, I believe HNNA's current stock prices are not justified by earnings generation capacity.

Note: Unless otherwise stated, all information has been obtained from HNNA's filings with the SEC .

Business description

An industry under siege : Active mutual funds have been under siege from cheaper passive strategies and ETFs. Passive strategies, which represented 10% of AUM in the U.S. in 2010, today represent more than 40% of AUM . The picture is even worse at the organic inflow level (new money invested rather than growth generated by market returns); active strategies faced almost $3 trillion in outflows between 2005 and 2020, compared to $3 trillion in inflows for passive strategies .

HNNA has not been immune to this trend. After 2007, the company faced redemptions above organic inflows in 13 out of 16 years. The market appreciation of the funds offset part of the redemptions, and the company also acquired funds managed by other companies, but still, the effect was there.

After acquiring a series of funds in 2013 , HNNA more than quadrupled its AUM, from $900 million to $4 billion. Then another two years of net positive inflows elapse, which, coupled with market appreciation, led to the company's ATH AUM of $6.7 billion in 2016 . After that, the road was down, ending with the company managing $2.9 billion as of September 2022 ( FY22 year-end ).

Substantial margins : Still, asset management is a business with great economics. Particularly, the company does not require a gigantic structure to manage its business. HNNA had 19 employees in FY22 and enjoyed operating margins above 30%. Of course, these margins are affected by operational leverage, because the same employees (meaning more or less the same cost) can manage more AUM and generate more revenues, or conversely less AUM and less revenue.

Great capital allocation : A company facing a difficult industry can worsen things if management does not handle capital allocation intelligently. Fortunately, HNNA managers understood that the problem would not be solved by throwing more money into the business. They have returned funds to shareholders, in the form of consistent dividends and share repurchases.

Strong balance sheet : In October 2021, HNNA completed the offering of $40 million in 2026 notes paying 4.8% fixed. In hindsight, the rate ended up being cheap, although the use of those funds is not clear, given that HNNA does not have uses for those funds. Still, the company has those debts more than covered by $60 million in cash and equivalent holdings.

Valuation

Why am I not recommending HNNA if it has a strong balance sheet, high margins, and good management? The answer is price compared to income, coupled with growth prospects.

Multiples not expensive : With current AUM levels, HNNA can generate about $6 million in net income, more than covering its yearly $4 million dividend. The company trades at a market cap of $70 million, or a P/E ratio of 11.5x.

But the business is declining : This multiple would not seem excessive with a company showing stagnant profits, but HNNA's business shows a long-term negative trend. Moreover, with high interest rates, markets plummeting, and a looming recession, the short and medium-term outlook does not seem fantastic for HNNA's business either.

Use of the $40 million in debt : I commented previously that HNNA's managers did not squander company funds trying to fight against their industry's secular winds. However, at the end of last year, the company asked for a $40 million loan and has kept the proceeds unused.

In my opinion, the most obvious use of these funds is to leverage the company by paying a special dividend. The shareholders lower their acquisition cost, and the post-dividend company has a higher return on equity (considering that return on invested capital is higher than pre-tax debt costs). I would not speculate on this development, though, as it is impossible to predict.

Conclusions

I like many things about HNNA: A strong balance sheet, a well-covered dividend, conservative managers, and high margins. The stock also trades at what could be considered a low multiple to current earnings, on a general basis.

However, I do not recommend HNNA because it participates in a declining industry. The company has faced organic outflows in 13 out of 16 years since 2007. The trend was accelerated by the pandemic and will probably continue even if markets recover from the recent sell-offs.

Therefore, I ask for a much lower multiple before considering HNNA. The current trend implies that today's 11.5x is tomorrow's 15x, and so on, or conversely, that share prices will decrease in the future.

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