2023-03-28 05:15:34 ET
Summary
- Westwood Holdings Group is an investment manager with $14 billion in AUM. The company focused on publicly traded instruments (mutual funds and institutional strategies).
- The business has been fundamentally decaying, with organic net outflows in most operating years since the GFC and every year since 2013.
- In 2022, WHG acquired an alternative asset manager to diversify its revenue sources to more protected markets.
- However, there is no guarantee alternatives will perform as well as in the past decade. The alternatives boom was partly tied to historically low-interest rates and easy money.
- Against a decaying industry and an uncertain future, WHG stock asks for a substantial multiple of earnings. It does not represent an opportunity.
Westwood Holdings Group ( WHG ) is an investment manager with $14 billion in AUM.
The company's products consist mostly of mutual funds and active strategies offered to institutions and high-net-worth individuals. Active money managers have suffered net outflows for decades, and WHG is no different, with organic net outflows in 11 out of the past 15 years (and 9 of the past 9).
Adding to the problem, WHG has been unable to adjust its cost structure, mostly composed of employee compensation, to protect profitability. The company's costs have been reduced, but still, the company's margins have collapsed.
WHG's long-term headwinds are not expected to disappear, and the company has been unable to adapt. WHG's dividends are poorly covered, and most share buybacks are re-issued as share-based compensation.
The company is not an opportunity at these prices.
Note: Unless otherwise stated, all information has been obtained from WHG's filings with the SEC .
Business description
Industry headwinds : As mentioned in my article about Hennessy Advisors ( HNNA ), the active public investment management industry has been severely damaged by the proliferation of passive vehicles.
These vehicles do not cover only simple strategies like long the S&P 500 or short Treasury bonds. They allow institutions and retail investors to allocate more complex combinations, choosing sectors, market caps, geographies, styles, etc. Further, at a fraction of the cost and substantially similar returns as the mutual fund or active strategy counterparts.
WHG has not been immune to this trend, with organic net outflows in 11 out of the past 15 years and every year since 2014. The company has counteracted this by acquiring other funds, but the organic trend is too strong.
Self-inflicted wounds : The revenue fall is a reality, although the company could have perceived that trend earlier and moved towards more protected realms (like real assets or private equity), only doing so in 2022 with the acquisition of Salient Partners.
Still, the company could have reduced its workforce or the compensation that it pays to that workforce to protect profitability. I understand this is easier said than done because investment managers generally have significant operational leverage (on the upside and the downside).
Strong balance sheet: The company accumulated significant cash and investment reserves when it was a very profitable (30% operating margin) business. Part of those reserves is still with the company.
Paying dividends out of capital : The company has paid extraordinary dividends to shareholders that are not covered by earnings and therefore are a return of capital. These dividends should not be considered recurrent. As of FY22, the company is not covering its dividend with operating earnings.
Cash flows are no better : The company boasts much better FCF than net income. However, the difference is mostly explained by stock-based compensation and the incorporation of changes in securities as part of the CFO (usually goes in cash from investing).
Further, the company's share repurchases are only useful to cover the stock-based compensation, with the overall share count remaining stagnant. Even the big purchase of 2020 only decreased the share count by 8%.
Valuation
Moving to alternatives : The declining public business is a reality. The company has now entered the realm of alternative investments and real assets by acquiring Salient Partners, with an AUM of $2.7 billion, for $33 million.
Salient has offerings in private equity, real assets like wind farms, and a commodities trading arm. This change is healthy, given that the headwinds against active managers have not disappeared, but does not guarantee profitability growth.
The alternative investments industry is also competitive and may have grown fast only under the protection of QE and low rates for the past 15 years. For example, Salient managed $27 billion as close as 2015 but was sold while managing only $2.7 billion.
Multiples : WHG generated net losses in 2020 and 2022, partly fueled by losses on their investments and the sale of their European subsidiaries.
But they also generated operating losses in those two years. Suppose we remove acquisition costs from the Salient deal ($7 million over a $33 million deal, high) and impairment expenses in 2020 ($3.5 million). In that case, we arrive at $1 million in operating profit for 2020, $6 million for 2021, and $2 million for 2022.
The average of $3 million could be considered a measure of profitability. Of course, ignoring the expenses we have not added and the investment losses.
Westwood trades at a market cap of $95 million, or a 32x multiple of adjusted average operating income. For a company suffering consistently from strong industry headwinds, it seems excessive.
Of course, WHG's fixed cost structure can significantly increase operating income by a relatively small increase in revenue. The problem, in my opinion, is that growth should be substantial to return even a 10% earnings yield (considering taxes, which we avoid when using the multiple on operating income) and that those earnings should be sustainable, which is not guaranteed given the industry backdrop.
Conclusions
WHG has suffered from its industry's ailment, unable to grow organically for much of the past 15 years.
The company grew through acquisitions but could not act against the bigger trend and move earlier into alternatives. Last year's acquisition of Salient may not be enough to revitalize the company, particularly if the alternative investment industry suffers from high interest rates.
The problem is not the context or the company but the stock's price. At current prices, the company trades at an enormous multiple of adjusted operating profits.
That price incorporates a significant improvement in profitability (at least quadrupling operating profits or growing revenues by 10% given the operating leverage), but also sustainability on those profits, something that the context does not guarantee at all.
Therefore, I believe WHG is not an opportunity at these prices.
For further details see:
Westwood Holdings Group Is Too Expensive For A Threatened Business