Investment manager Westwood Holdings Group (NYSE:WHG) has $14 billion in AUM.

The majority of the company’s offerings are active strategies and mutual funds that are provided to institutions and high-net-worth individuals. Since the beginning of time, active money managers have had net withdrawals, and WHG is no exception, having experienced organic net outflows in 11 of the last 15 years (and 9 of the past 9).

WHG’s inability to modify its cost structure, which is primarily made up of employee remuneration, in order to maintain profitability compounds the issue. Even though the company’s costs have been cut, its margins have completely collapsed.

Long-term challenges for WHG are not anticipated to go away, and the company has not been able to adjust. The majority of share buybacks at WHG are issued as share-based compensation, and the dividends are only marginally covered.

At this pricing, the company is not an opportunity.

Enterprise Description

Industry challenges: The emergence of passive investment vehicles has had a significant negative impact on the active public investment management sector.

These instruments encompass more than just straightforward trades like long S&P 500 and short Treasury bonds. Selecting sectors, market sizes, regions, styles, and other factors, enable institutions and individual investors to allocate more complicated combinations. Additionally, for a fraction of the price and with results that are very similar to those of their active strategy or mutual fund equivalents.

WHG has not escaped this trend, with organic net outflows occurring every year since 2014 and in 11 of the last 15 years. The business has attempted to combat this by acquiring additional capital, but the organic trend is too powerful.

Self-inflicted injuries: Although the corporation could have seen this trend earlier and shifted its focus to more secure sectors (like real estate or private equity), it chose to do so only in 2022 with the acquisition of Salient Partners.

But, in order to maintain profitability, the corporation might have to cut back on either its staff or the salary it provides to them. I recognize that given that investment manager typically have high operational leverage, this is easier said than done (on the upside and the downside).

Solid balance sheet: Throughout its highly profitable (30% operating margin) business phase, the corporation built sizable cash and investment reserves. These reserves still belong to the firm in part.

Dividends paid from capital: The corporation has given shareholders exceptional dividends that are not covered by earnings and are consequently a return of capital. These payouts shouldn’t be seen as ongoing. As of FY22, the company’s operating results are not sufficient to cover its dividend.

Cash flows don’t fare any better: The business boasts significantly higher FCF than net income. Nonetheless, stock-based remuneration and the integration of changes in securities as part of the CFO are the main factors that account for the variance (usually goes into cash from investing).

However, the company’s share repurchases primarily serve to offset stock-based pay, resulting in a stagnant share count overall. Even the large purchase in 2020 only resulted in an 8% reduction in the number of shares.

Valuation

Moving on to substitutes: It is true that public business is declining. By paying $33 million for Salient Partners, an alternative investment firm with an AUM of $2.7 billion, the corporation has now ventured into the world of real estate and alternative investments.

Private equity, real estate like wind farms, and a commodities trading division are among the services offered by Salient. Given that there are still challenges facing active managers, this shift is beneficial but does not ensure increased profitability.

The alternative investments market is likewise cutthroat, and it may have only experienced rapid growth during the past 15 years thanks to QE and low-interest rates. As an illustration, Salient, which handled $27 billion as recently as 2015, was sold while barely managing $2.7 billion.

Multiples: In 2020 and 2022, WHG had net losses, which they partly attributed to investment losses and the sale of its European operations.

But during those two years, they also experienced operating losses. Consider that we exclude 2020 impairment costs ($3.5 million) and acquisition costs from the Salient deal ($7 million over a $33 million deal, high). In that situation, our operating profit estimates for 2020, 2021, and 2022 are $1 million, $6 million, and $2 million, respectively.

One indicator of profitability may be the typical $3 million. Of course, we’re ignoring the costs we haven’t included and the losses on our investments.

Market capitalization for Westwood is $95 million, or 32 times the adjusted average operating income. It seems extravagant for a business that continually faces significant industry headwinds.

Therefore, a very little increase in revenue can result in a considerable increase in operating income due to WHG’s fixed cost structure. The issue, in my perspective, is that earnings must be sustainable, which is not assured given the industrial backdrop, and that growth must be significant to deliver even a 10% earnings yield (including taxes, which we avoid when using the multiple on operating income).

Conclusion

Since its business has been afflicted, WHG has struggled to grow organically for a large portion of the past 15 years.

The business expanded through acquisitions but was unable to buck the larger trend and advance into alternatives. Salient’s acquisition by the company last year may not have been sufficient to revive the business, especially if interest rates continue to rise in the alternative investing sector.

The price of the stock, not the situation or the business, is the issue. The corporation trades at a huge multiple of adjusted operating earnings at its current levels.

Given the operating leverage, that price assumes not only a material increase in profitability (at least a quadrupling of operating profits or an increase in revenues of 10%) but also the durability of those profits, which the context in no way guarantees.

Hence, in my opinion, WHG is not a good investment at these prices.

Featured Image: Pexels @ Tima Miroshnichenko

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