Diamond Hill Investment Group DHIL
January 11, 2007 - 1:02pm EST by
tim321
2007 2008
Price: 87.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 196 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Diamond Hill’s rapidly growing hedge fund is going to recognize over $5mm in incentive fee revenue for this fourth quarter which will help double fourth quarter earnings from last quarters 61 cents a share to an estimated $1.20. This potential short term catalyst is backed up by a solid long term investment thesis that includes a reasonable valuation (7% base case free cash flow yield) on a business where assets under management have grown from $523mm in 2004 to an estimated $5.4 billion in 2007. My contention is that a 7% yield that has been conservatively estimated (i.e. no 2007 hedge fund incentive fee revenue) AND that is rapidly growing will not hold up in a 5% risk free rate of return environment.
 
There are many appealing aspects to this story and I will try and briefly touch on the important ones.
 
 
Potential Catalyst:
 
Besides advising a series of seven mutual funds, Diamond Hill manages several long/short hedge funds that all run the same strategy. They recently engaged a third party marketing firm and have recently seen a significant growth in assets – from $177mm to $314mm in just the last quarter. The hedge fund returns, which have been taken from a hedge fund database, are up close to 9% net for the fourth quarter. I have estimated a 0% return for December since it hasn’t been released yet. My rough estimate is $5mm in incentive fee and the rest from the management fee (1.5% and 20% with a 5% hurdle – accrued quarterly). For what it is worth, I don’t think others have put 2 and 2 together here (analogous to the GROW incentive fee – it takes some digging since it is not reported directly by the company and you have very few institutional shareholders who own the stock).
 
 
 
Hedge Fund Incentive Fee Calculation
 
3/30/2006
6/30/2006
9/30/2006
12/30/2006E
 
 
 
 
 
 
 
 
 
 
Total Incentive
$1,613,228
$896,647
$0
$5,000,000
Total Hedge Fund Fees
$1,801,229
$1,122,518
$280,649
$5,348,712
 
 
 
 
 
DHIL Q Net Return
6.41%
3.34%
-0.41%
8.6%
 
 
 
 
 
Assets under Management ($mm)
117
150
177
314
 
 
 
 
Long term buy as well:
 
The chart below is the reason why Diamond Hill’s stock went up from 31 to 84 this past year.  Fortunately, total AUM is still under $4 billion so there is plenty of room for future growth. I have estimated that the company ends 2007 with $5.4 billion in assets (1/3 the growth rate of 06) and will later describe how I arrive at this number.
 
 
Diamond Hill Assets Under Management
 
2004
2005
2006
2007E
Mutual Funds
237
907
2518
3598
Managed Accounts
265
513
875
1281
Private Partnership
21
110
314
500
 
 
 
 
 
Total AUM
523
1530
3707
5379
YOYG
 
193%
142%
45%
 
 
Stock Price
87.75
S/O
     2,239,245
 
 
Market Cap
 196,493,749
Cash
   19,319,145
 
 
EV
 177,174,604
 
 
07 Earnings
 $11,749,787
 
 
07 Yield to EV
6.6%
 
 
 
Diamond Hill is best know for their $1.2 billion long/short mutual fund which is largely considered one of the most viable long short mutual fund options around. It was ranked 3rd in its category according to Morningstar in 2006 with 17% performance and 1st in 2005 with 22% performance.
 
The growth of the long short asset base is central to my thesis that, despite recent price appreciation, the equity is still mispriced. If reality proves my 2007 estimates to be conservative, I think this long/short chart will be one of the main reasons why. The higher fee paying, long short strategy assets (1.55% for the mutual fund) have not only been growing rapidly on an absolute basis but also relative to the other lower fee producing products. The long/short strategy assets represented 29% of total assets at the end of 2005 and more than 45% at the end of 2006. This should significantly improve revenue per incremental net inflow.
 
 
12/31/2005
12/31/2006
 
 
 
Long/Short
451
1674
Total AUM
1531
3708
 
 
 
LS as % of AUM
29%
45%
 
 
Strong and stable flows:
 
Of the $1.6 billion mutual fund asset increase in 2006, only $300mm was due to performance. Not only have the new money flows into DH been strong, but they have also been stable.  In fact, my research suggests that only three weeks of the entire year showed negative flows. Net mutual fund flows averaged $25mm a week in 2006 and this is what I have modeled out for 2007. It should be noted that the first week of 07 started off well despite negative performance from energy exposure – $35mm in new money.
 
 
So why the strong inflows?
 
Performance:
 
Morningstar needs a 3 year track record and the financial advisors want to see a 5 year track record before they make a fund recommendation. Diamond Hill has finally hit this length requirement on many of their products which combined with good performance has led to inflows. Go to Morningstar.com to see the performance on their individual mutual funds.
 
Distribution:
 
One of the reasons inflows have been strong is because of a strong distribution platform. There are three ways money comes in a) ira and financial planners b) regional wirehouse distribution and c) 401K platforms. Management indicated that 70% of funds today come from A and B but that they are aggressively working on improving their 401K platform distribution – the stickiest assets of all.
 
Morningstar:
 
Unlike U.S. Global, this 800 pound gorilla likes Diamond Hill. They have given five stars to the long/short fund and high marks to the both the small cap fund (which is closed to new investors) and large cap fund. There is a great report for subscribers of Morningstar on the long short product that goes into depth as to why they like Diamond Hill. I would not be surprised to see them get fund manager of the year sometime down the road.  
 
Management:
 
I like the CEO of Diamond Hill Rick Dillon. He is a nose to the ground, Midwestern worth ethic kind of guy who loves Buffett (always a good sign on all sort of fronts) and talks about investing in way that makes sense.
 
Past letters to shareholders:
http://www.diamond-hill.com/shareholderLetters.asp
 
He was recently interviewed by Joe Kernan for those interested:
http://www.cnbc.com/id/15840232?video=16...
 
 
 
 
 
 
 
 
 
 
My 2007 Estimates:
 
 
 
 
 
2005A
2006E
2007E
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
Mutual Funds
 
 
 
     3,510,324
       13,571,154
   23,927,333
Managed Accounts
 
 
 
     2,731,058
        5,841,410
     9,360,715
Private Partnership
 
 
 
     2,941,285
        8,006,196
     6,375,000
 
 
 
 
 
 
 
Total Revenue
 
 
 
     9,182,667
       27,418,759
   39,663,048
 
 
 
 
 
 
 
Operating Expense
 
 
 
 
 
 
 
 
 
 
 
 
 
Compensation
 
 
 
     6,877,929
       18,512,859
   24,987,720
Legal
 
 
 
       105,591
           207,454
        300,096
G&A
 
 
 
       573,348
        1,178,943
     1,705,419
Sales and Marketing
 
 
 
       247,972
           401,334
        580,556
 
 
 
 
 
 
 
Total Operating Expense
 
 
     7,804,840
       20,300,589
   27,573,790
 
 
 
 
 
 
 
As % of Revenue
 
 
 
 
 
 
Compensation
 
 
 
75%
68%
63%
Legal
 
 
 
1%
1%
1%
G&A
 
 
 
6%
4%
4%
Sales and Marketing
 
 
 
3%
1%
1%
 
 
 
 
 
 
 
Net Operating Income
 
 
 
     1,377,827
        7,118,170
   12,089,258
 
 
 
 
 
 
 
Operating Margin
 
 
 
15%
26%
30%
 
 
 
 
 
 
 
Mutual Fund Admin
 
 
 
         16,487
        2,020,061
     4,769,784
Investment Return
 
 
 
       594,777
        1,403,287
     1,500,000
 
 
 
 
 
 
 
Income Before Tax
 
 
 
     1,377,828
       10,541,518
   18,359,042
 
 
 
 
 
 
 
Income Tax Provision
 
 
 
     1,661,675
       (3,803,152)
    (6,609,255)
 
 
 
 
 
 
 
Net Income
 
 
 
     3,039,503
        6,738,367
   11,749,787
 
 
 
 
 
 
 
EPS
 
 
 
             1.83
3.02
4.93
 
 
 
 
 
 
 
Shares Outstanding
 
 
 
     1,660,930
        2,231,247
     2,383,334
 
 
I’m happy to go into detail into my 2007 estimates in the Q&A but let me address a couple key assumptions:
 
1)      I assumed zero hedge fund incentive fee
2)      $25mm weekly inflows into the mutual fund
3)      19bps per quarter as assumption to derive revenue from average quarterly mutual fund assets (i.e. 76 bps on total AUM). There should be significant upside to this number if the long/short as a % of assets trend holds.
4)      30% operating margin for 2007. This is the number management always talks about as their bogey once they reach scale. They have reached scale so this is the number I’m using. However, according to Capital IQ data, industry comps suggest that this 30% target is too easy. The only other asset management firm that has a larger compensation as a % of sales is Epoch holdings, a firm which is still in build out mode. The mean is 40%, GROW is near the bottom at around 20% (top line is same as bottom line for GROW’s incentive fee unlike DHIL) and Diamond Hill is way above most at 68%. The fact that management has indicated that they don’t need a big staff going forward also lends support to this argument.
 
 
Risks:
 
Market downturn – Despite the fact that Diamond Hill has less hot money than some other funds (think GROW) and the fact that the bulk of their money is in a long/short offering, value will still be impaired if we have a major market correction. Additionally, the fund has significant exposure to energy which is one of the reasons performance has started off negative this year.
 
Management gets greedy – There is the possibility that management puts more in their pockets than I have modeled into on my estimates. Self interest (management owns over 20% of the stock) and the fact that they adhere to Buffett helps mitigate this concern.
 
 

Catalyst

Incentive fee
Earnings growth
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