Description

U.S. Global Investors has been written by TheEnterprisingInvestor exactly 1 year ago and the thesis has worked out beautifully generating 156% return since. Despite these share price gains, GROW remains one of the most undervalued stocks currently on the market - trading at absurd 5x earnings, vs 15x peer valuations.

The company has some minor investments in the crypto industry and the market seems to view GROW as some kind of a proxy for crypto - with its share price fluctuating in line with the crypto moods. However, its stabilized, high operating margin (45%-50%) and highly cash generative ETF management business alone supports 100%+ upside from the current share price levels, but this seems to be left completely ignored by the market and likely somewhat hidden behind the crypto veil.

CEO Frank Holmes owns 16% of the stock, which likely constitutes the majority of his net worth after a run-up in GROW share price. I do not think that the past issues of minority shareholder interest misalignment are relevant today - as CEO should be more interested in seeing the appreciation of the stock price than draining the company through increased management compensation. Given the successful (or lucky) strategic/operating moves over the last year, the company seems to be well-positioned to unlock the value for minority shareholders.

The overall investment thesis and attractiveness of the company has been well put (maybe just a touch too enthusiastically) by the CEO (FY Q3'21 call):

“So, I remain very committed, bullish and we are going to educate investors why we are undervalued at trading at less than 5 x of earnings. I think we should be trading closer to 20x earnings and that means that GROW is huge on the upside, huge potential. [...] And so, I think that of the opportunity when we sell-off, then investors are not really capturing and why we are trading at such a good multiple. The huge embedded value of the ETF business we are in and I think that going forward, this is going to be unlocked.”

Operating business

GROW used to be an under-scaled investment manager (mutual funds and ETFs), founded in 1968 and since 1989 led by its CEO Frank Holmes (65 years). For several decades the company has done very little in terms of shareholder value creation and its market cap stood below $20m until it accidentally stumbled upon two major gold mines (figuratively speaking) - airlines and crypto.

The company has a number of non-operating assets on its balance sheet (detailed in the next section), however, the majority of value and share price upside comes from the fund management business. At the moment its portfolio GROW has a total of $4.5bn of AUM split across several funds, the largest one being $3.9bn JETS ETF:

• 8 tiny mutual funds (natural resources, precious metals, emerging European markets, etc.) - together called USGIF. Till recently admin fees from these mutual funds used to be the company's primary source of revenue. In 2016-2018, the company faced significant shareholder redemptions on its mutual funds, which resulted in AUM deterioration from $700m to around $300m (COVID peak). Lately, AUM has somewhat rebounded to $500m alongside post-COVID market recoveries. Management fees amount to 0.76%-0.97% of AUM plus additional performance fees for equity funds.

• 2 ETFs - US Global Go GOLD (GOAU) and US global JETS (JETS). GOAU is a precious metals focused ETF launched in June'17, whereas JETS was launched in Sep'16 and, as the name suggests, focuses on the airline industry. Both ETFs saw an extremely positive effect from the COVID - GOAU AUM increased from $15m (mid'19) to $100m, whereas JETS has exploded with AUM going from $70m (mid'19) to $3.9bn. Currently GROW charges 0.60% management fee for both ETFs and covers their hard costs. Needless to say, this drastic increase in AUM has made a very material impact on the company's financial performance.

• There is also a newly started airline ETF in Europe with a $0.7bn AUM. The chart below as well as the total AUM calculations exclude this new fund so far as it is not clear how exactly the economics of it will look like (launched in partnership). Any management fees received from this fund would provide additional upside to my base case scenario.

Average AUM chart:

Historical financial performance:

A few notes on the table above:

• Fiscal Q2’21 operating profit decline reflects a one-off $1.8m compensation bonus for the sale of HIVE stake.

• Significant increase in net income for the fiscal Q2’21 and Q3’21 is mostly attributed to one-off realized and mark-to-market investment gains in HIVE. 

• Total operating revenues are calculated based on 0.6% management fees for ETFs, which amounts to annual fees of $24.6m, and then another $4.5m from the mutual funds (in line with the latest quarter run-rate). 45% operating margin is applied to calculate Q4’21 estimated operating profit.

Overall, the company has finally made a major profitability breakthrough and reported 53% operating margin for fiscal Q3'21. Excluding the performance bonus, fiscal Q2'21 operating margin also would've been around 45% (CFO, latest conf. call):

So, I know a lot of people are curious about why there was a decrease for that December quarter and I do want to remind people that that really is related to a bonus that was paid in that quarter related to realizing on investments about $1.8 million. [...] So, if we remove that bonus from our operating expenses, then the operating margin for December would be approximately 45%.

I expect that with the stabilized ETF AUM, the company will continue to operate at similar margin levels going forward.

Worth noting that the company now aims to expand the geographical presence of its ETFs and over the last quarter has already cross-listed JETS fund on Mexico Stock Exchange and launched the above-mentioned new airline ETF in Europe with a listing on London Stock Exchange and AUM already at $0.7bn. The economics might be different for the newly launched ETF on LSE as it was done in partnership with HANetf, which will probably take a cut of the fees - but this shows that there is still potential for further growth in AUM.

Unlike the company’s legacy business of managing mutual funds where customer redemptions materially reduced the fee-earning-asset base, the ETF business is way more stable, and decline in AUM might happen only with the drop share prices of airlines or large misalignments between ETF NAV and its price in the market (could happen in market panics). Otherwise, the number of ETF units in issue should remain relatively stable. 

Crypto luck

Aside from the operating business, the company also invests in its own mutual funds (USGIF) and has made several small equity investments in some riskier industries - some of which seem to have worked out pretty well so far (crypto, gold exploration, entertainment industry). The most prominent one was/is the investment in HIVE Blockchain - a publicly-listed Ethereum miner, which operates in Canada, Switzerland, and Iceland. 

GROW used to own 10m shares of HIVE with a cost basis of around $0.24/share. During the crypto run at the end of '20 HIVE shares appreciated from $0.30/share to around $2/share, valuing the investment at $20m compared to $80m GROW market cap at the time. The company used this opportunity and in Dec'20 sold its HIVE shares with $18.2m gains, but then in Jan'21, reinvested most of it into HIVE again purchasing $15m convertible debt (converts at $2.34/share) and 5m warrants with a strike price of C$3/share. As crypto, and especially Ethereum, has continued to be volatile in 2021, HIVE share price reached $5.40 (C$6.80/share) mid-February, causing the debentures and warrants owned by GROW  to skyrocket to around $50m at the peak.

Retail investors have obviously noticed this with multiple new articles and discussions on retail investor forums positioning GROW mainly as a "crypto play" through its HIVE stake. The result can be seen in the graph below - GROW became a simple crypto proxy - its stock is moving in line with HIVE and the general crypto market. When fiscal Q3’21 results came out and the company showed very strong performance and a major breakthrough in profitability, all of that was ignored and GROW share price started falling (in line with the broader crypto market) putting the operating business at absurdly low valuation levels.

GROW crypto assets are only a small part of the value compared to the fund management business so share price drift together with crypto is really puzzling. Moreover, the value of these crypto investments has a well-protected downside by the principal of debentures, which also include 8% annual interest rate paid monthly. HIVE has already started repaying the debentures and in the most recent quarter the principal value has declined from $15m to $14.3m.

The stake obviously has some remaining optionality - HIVE currently aims to up-list on NASDAQ - the application has already been approved (17th June) and the new listing should appear shortly. This could potentially result in some favorable developments in HIVE’s share price.

Valuation

ETF AUM has now stabilized at around $4bn. At 0.6% management fees this results in $24m.

USGIF average AUM has been fluctuating around $480m - $500m during the last 3 quarters, generating close to $1.1m+/quarter in revenues. Let's put it at $4.5m annually.

As the economics of the newly launched ETF in London are not yet clear, I am not counting any revenues from its $0.7bn in AUM.

At this rate, the total annual operating revenue for GROW will be c. $28m. In the two most recent quarters, the company has managed to reach 45% - 53% operating margins (excluding one-off bonuses). I think this should be sustainable given that some of the costs might actually come down a bit as various AUM growth-related costs (market maker fees for issuing new fund units) subside. Assuming 45% operating margin, the company should easily be able to generate $12.5m annual operating profit. Putting a 15x multiple on that, which I think is very fair (even conservative) for a stable high margin ETF management business, results in a $187m valuation for the operating business alone (vs $90m current market cap). 

The whole asset management business, or at least the ETF funds, could easily be worth much more to a strategic acquirer (e.g. one of the large ETF houses) who could eliminate most of the overheads. 

Aside from the operating business, the other assets on the balance sheet are:

• $7.8m - working capital surplus (mostly cash, excluding mutual fund investments);

• $7.2m - investments in USGIFs;

• $14.3m - remaining principal of HIVE debentures. At the current HIVE price these debentures are actually worth a bit more, however, if the company did not convert them at the peak in April, they probably won't do it at much lower prices. 

• $0m - HIVE warrants. Currently out of the money, but similarly to debentures have optionality on HIVE share price increase;

• $4m - 2.4% stake in publicly listed Thunderbird Entertainment Group (content production studio);

• $1.5m - stake in publicly listed GoldSpot Discoveries (gold exploration). The stake was valued at $0.5m at the end of March'21, but since then the share price has tripled.

• $2.9m - other investments, equity securities without readily determinable fair values;

These other assets sum up to $37.7m, putting the total value of GROW at $225m vs the current market cap of $90m (150% upside). I think that this is the base case scenario - although there might be some AUM fluctuations further down the road on or the management compensation could rise a bit more than expected, in a similar fashion one could argue that 15x multiple for the operating business is too low (especially in acquisition scenario), that there is optionality for further growth in AUM or from growth in HIVE and other assets.

CEO commented during the last conference call:

“That’s right, our PE ratio is extremely low. When you compare it, I’d like to do this classic example that Invesco, excellent fund family group, 40% of their assets are in the QQQ and they traded 15.4 times, Wisdom Tree is a 100% ETFs and they traded 21.3 and growth rates are 4.4 and 80% of our operating revenue comes from the ETF space. So, it’s I think that GROW has the potential for much more upside as we continue to show Q-over-Q and year-over-year growth in revenue, cash flow, and assets.”

Risks

• One of the key risks is that management ramps up its compensation and siphons away most of the newly found profits. I think at this point, this has already proven to be an exaggerated risk. Except for the bonus on the sale of HIVE stake, the compensation growth has been relatively controlled so far. CEO owns 16% of the company and has voiced the current undervaluation issue numerous times. This adds confidence that he would rather focus on lifting the stock price rather than receive relatively small incremental compensation increases.

• Another important consideration that is harder to handicap is capital allocation. There has not been any talk yet of the share buybacks or other types of capital return to shareholders despite the CEO stressing undervaluation numerous times and plenty of liquidity on the balance sheet. Management might waste all of the cash generated by the asset management business by throwing it into new business ventures. So far their investments have worked out really well, but it also might have been just pure luck. In the last conference call, the CEO has made comments that they are preparing to launch some kind of a new natural resources ETF and also seems to be of interested in crypto industry?: “Well, we are working on some – I think an excellent new product that fits up to our expertise in global natural resources. And we’d be the only product out there. So, we are fast-tracking the execution of that. So, we can also tell us the story and we think it’s a great product for investors for many reasons from retail to institutional and we can at least stay lean and mean.”

• Crypto market continues to trade down, dragging GROW share price with it. However, the only real exposure GROW currently has to crypto is its $14.3 debentures which even if not repaid at all constitute only a minor part of the total value of the company. Also, HIVE had over $140m in liquidity (mostly in bitcoin and etherium) as of the last quarter and, even if you cut that in half, there is still plenty of leeways to continue repaying the debentures.

Catalyst

• Time and accumulation of cash on the balance sheet.

• Buybacks with excess liquidity.

• Upcoming FY Q4'21 (June) earnings report should again show revenues north of $7m. Operating profitability should also continue to increase.

• AUM growth of the new European airline ETF.

• HIVE share price appreciation.

• A potential sale of JETS ETF.