HENNESSY ADVISORS INC 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This report contains “forward-looking statements” within the meaning of the securities laws, for which we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. In some cases, forward-looking statements can be identified by terminology such as “expect,” “anticipate,” “intend,” “may,” “plan,” “will,” “should,” “could,” “would,” “assume,” “believe,” “estimate,” “predict,” “potential,” “project,” “continue,” “seek,” and similar expressions, as well as statements in the future tense. We have based these forward-looking statements on our current expectations and projections about future events, based on information currently available to us. Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at which, or means by which, such performance or results will be achieved. 30 Table of Contents Forward-looking statements are subject to risks, uncertainties, and assumptions, including those described in the section titled “Risk Factors” and elsewhere in this Annual Report on Form 10-K. Unforeseen developments could cause actual performance or results to differ substantially from those expressed in or suggested by the forward-looking statements. Management does not assume responsibility for the accuracy or completeness of these forward-looking statements. There is no regulation requiring an update of any of the forward-looking statements after the date of this report to conform these statements to actual results or to changes in our expectations. Our business activities are affected by many factors, including, without limitation, redemptions by mutual fund shareholders, taxes, general economic and business conditions, including those related to the COVID-19 pandemic, movement of interest rates, competitive conditions, industry regulation, and fluctuations in the stock market, many of which are beyond the control of our management. Further, the business and regulatory environments in which we operate remain complex, uncertain, and subject to change. We expect that regulatory requirements and developments will cause us to incur additional administrative and compliance costs. Notwithstanding the variability in our economic and regulatory environments, we remain focused on the investment performance of the Hennessy Funds and on providing high-quality customer service to investors. Our business strategy centers on (i) the identification, completion, and integration of future acquisitions and (ii) organic growth, through both the retention of the mutual fund assets we currently manage and the generation of inflows into the mutual funds we manage. The success of our business strategy may be influenced by the factors discussed in Item 1A, “Risk Factors.” All statements regarding our business strategy, as well as statements regarding market trends and risks and assumptions about changes in the marketplace, are forward-looking by their nature. OUR CONTINUING RESPONSE TO THE COVID-19 PANDEMIC We continue to monitor the effects of the COVID-19 pandemic on our business, particularly focusing on meeting the needs of our employees, our partners, and the Hennessy Funds and their shareholders. Since March 2020, we have remained engaged with key partners and service providers, strengthened our digital marketing and public relations programs, maintained an effective governance and internal controls program, and kept our employees up to date with trainings on relevant government and regulatory guidance impacting in-office work in order to ensure our continued success. We returned to work in the Novato, California office in August 2021, and continue to adhere to our Site-Specific Protection Plan, which we regularly update to reflect current local, state, and federal requirements. We remain committed to providing the same high level of services to the 16 Hennessy Funds and their shareholders, and we believe we have positioned the Company for long-term growth. OVERVIEW Our primary business activity is providing investment advisory services to a family of open-end mutual funds branded as the Hennessy Funds. We manage 10 of the 16 Hennessy Funds internally. For the remaining six funds, we have delegated the day-to-day portfolio management responsibilities to sub-advisors, subject to our oversight. We oversee the selection and continued employment of each sub-advisor, review each fund’s investment performance, and monitor each sub-advisor’s adherence to each applicable fund’s investment objectives, policies, and restrictions. In addition, we conduct ongoing reviews of the compliance programs of sub-advisors and make on-site visits to sub-advisors, as feasible. Our secondary business activity is providing shareholder services to shareholders of the Hennessy Funds. We derive our operating revenues from investment advisory fees and shareholder service fees paid to us by the Hennessy Funds. These fees are calculated as a percentage of the average daily net assets in each Hennessy Fund. The percentage amount of the investment advisory fees varies by fund. The percentage amount of the shareholder service fees is consistent across all funds, but shareholder service fees are charged on Investor Class shares only. The dollar amount of the fees we receive fluctuates with changes in the average net asset value of each Hennessy Fund, which is affected by each fund’s investment performance, purchases and redemptions of shares, general market conditions, and the success of our marketing, sales, and public relations efforts. 31 Table of Contents U.S. equities had positive performance for the one-year period ended September 30, 2021, with the S&P 500 ® Index returning 30.00% and the Dow Jones Industrial Average returning 24.15% for the period (on a total return basis). Equity prices advanced sharply during the period despite increased concerns over supply chain disruptions and elevated levels of inflation. The offset to this dynamic was the idea that economic growth has resumed as economies continue to reopen despite the lingering effects of the COVID-19 pandemic. After a 3.4% contraction in Real GDP in 2020, economic growth is expected to increase 5.9% in 2021, according to estimates compiled by Bloomberg. Over the past year, we have seen widespread availability of vaccines, and with that the ability of an ever-increasing number of people to travel, eat in restaurants, and return to work. The unemployment rate improved from 7.9% at the end of September 2020 to 4.8% at the end of September 2021. Long-term U.S. bonds declined meaningfully during the one-year period ended September 30, 2021, as the prospect of the Federal Reserve tapering its bond-buying activity and potentially raising interest rates as soon as 2022 prompted investors to sell bonds. As the U.S. economy reopens and some semblance of normalcy returns to the economy, investors’ attention has turned to the idea that inflation may continue to remain elevated, which may prompt the Federal Reserve to raise interest rates. While the Federal Reserve has indicated that they would like to see employment numbers return to pre-pandemic levels before raising rates, it seems that some investors are focused on the idea that any further inflationary pressures may force the Federal Reserve to act sooner. For the one-year period ended September 30, 2021, 10-year U.S. Government Bond yields rose from 0.68% to 1.49%. The Japanese equity market rose 20.61% (in U.S. dollar terms) for the one-year period ended September 30, 2021, as measured by the Tokyo Stock Price Index. Enthusiasm around Japanese equities has centered on the country’s recent surge in COVID-19 vaccinations as well as by the election of a new Prime Minister, Fumio Kishida, to replace Yoshihide Suga, who recently resigned. Against this backdrop, all of the 16 Hennessy Funds posted positive returns for the one-year period ended September 30, 2021. The longer-term performance numbers remain strong, with 14 of the Hennessy Funds posting positive returns for the five-year period ended September 30, 2021, and all 14 Hennessy Funds with at least 10 years of operating history posting positive returns for the 10-year period ended September 30, 2021. As always, we are committed to providing superior service to investors and employing a consistent and disciplined approach to investing based on a buy-and-hold philosophy that rejects the idea of market timing. Our goal is to provide products that investors can have confidence in, knowing their money is invested as promised and with their best interests in mind. Accordingly, we continually seek new and improved ways to support investors in the Hennessy Funds, including by providing thought leadership and other resources to help them navigate through this unprecedented market disruption due to the pandemic. We operate a robust and leading-edge marketing automation and customer relationship management (CRM) system, with a database of over 100,000 financial advisors in addition to retail investors. We utilize this technology both to retain assets and to drive new purchases into the Hennessy Funds. We employ a comprehensive marketing and sales program consisting of content, digital, social media, and traditional marketing initiatives and proactive meetings. In addition, our consistent annual public relations campaign has resulted in the Hennessy brand name appearing on TV, radio, print, or online media on average once every two to three days. We provide service to approximately 160,000 mutual fund accounts nationwide, including accounts held by shareholders who employ financial advisors to assist them with investing as well as accounts held by retail shareholders who invest directly with us. We serve over 14,000 financial advisors who utilize the Hennessy Funds on behalf of their clients, including over 800 who purchased one of our Funds for the first time during fiscal year 2021. Approximately 17% of such advisors own two or more Hennessy Funds, and nearly 550 advisors hold a position of over $500,000, demonstrating strong brand loyalty. Total assets under management as of the end of fiscal year 2021 was $4.1 billion, an increase of $0.5 billion, or 14.1%, compared to the end of fiscal year 2020. The increase in total assets during fiscal year 2021 was attributable to market appreciation. 32 Table of Contents The following table illustrates the changes in our assets under management over the past three years: Fiscal Years Ended September 30, 2021 2020 2019 (In thousands) Beginning assets under management $ 3,564,597 $ 4,873,839 $ 6,197,617 Acquisition inflows — — 194,948 Organic inflows 818,358 571,195 825,541 Redemptions (1,345,371 ) (1,771,127 ) (2,374,734 ) Market appreciation (depreciation) 1,028,338 (109,310 ) 30,467 Ending assets under management $ 4,065,922 $ 3,564,597 $ 4,873,839 As stated above, the fees we receive for providing investment advisory and shareholder service are based on average assets under management. The following table shows average assets under management by share class over the past three years: Fiscal Years Ended September 30, 2021 2020 2019 (In thousands) Average assets under management—Investor Class $ 2,394,194 $ 2,556,875 $ 3,357,813 Average assets under management—Institutional Class 1,595,106 1,541,529 1,826,929 Total $ 3,989,300 $ 4,098,404 $ 5,184,742 The principal asset on our balance sheet, management contracts, represents the capitalized costs incurred in connection with the purchase of the assets related to the management of mutual funds. As of the end of fiscal year 2021, this asset had a net balance of $80.6 million, unchanged since the end of fiscal year 2020. The principal liability on our balance sheet as of the end of our fiscal year 2021 was the net deferred tax liability of $12.4 million generated due to the continued write-off of our management contracts asset for tax purposes, which creates a book-to-tax difference. Following the end of our fiscal year 2021, on October 20, 2021, we completed a public offering of 4.875% unsecured notes due 2026 in the aggregate principal amount of $40,250,000. The 2026 Notes mature on December 31, 2026, and may be redeemed in whole or in part at any time or from time to time at our option on or after December 31, 2023. The 2026 Notes bear interest at a rate of 4.875% per year payable quarterly on March 31, June 30, September 30, and December 31. The 2026 Notes are direct unsecured obligations, rank equally in right of payment with any of our future unsecured unsubordinated indebtedness, senior to any of our future indebtedness that expressly provides that it is subordinate to the 2026 Notes, effectively subordinate to all of our existing and future secured indebtedness, and structurally subordinated to all existing and future indebtedness and other obligations of any future subsidiaries of ours. 33 Table of Contents RESULTS OF OPERATIONS The following table sets forth items in our statements of income as dollar amounts and as percentages of total revenue: Fiscal Years Ended September 30, 2021 2020 Amounts Percent of Total Revenue Amounts Percent of Total Revenue (In thousands, except percentages) Revenue Investment advisory fees $ 30,367 92.7 % $ 30,831 92.3 % Shareholder service fees 2,393 7.3 2,558 7.7 Total revenue 32,760 100.0 33,389 100.0 Operating expenses Compensation and benefits 9,078 27.7 8,820 26.4 General and administrative 4,754 14.5 4,961 14.9 Mutual fund distribution 485 1.5 477 1.4 Sub-advisory fees 7,332 22.4 7,573 22.7 Depreciation 232 0.7 239 0.7 Total operating expenses 21,881 66.8 22,070 66.1 Operating income 10,879 33.2 11,319 33.9 Interest expense — — 447 1.3 Other income (2 ) (0.0 ) (89 ) (0.2 ) Income before income tax expense 10,881 33.2 10,961 32.8 Income tax expense 2,979 9.1 3,120 9.3 Net income $ 7,902 24.1 % $ 7,841 23.5 % Revenues – Investment Advisory Fees and Shareholder Service Fees Total revenue comprises investment advisory fees and shareholder service fees. Comparing fiscal year 2021 to fiscal year 2020, total revenue decreased by 1.9%, from $33.4 million to $32.8 million, investment advisory fees decreased by 1.5%, from $30.8 million to $30.4 million, and shareholder service fees decreased by 6.5%, from $2.6 million to $2.4 million. The decrease in investment advisory fees was due to decreased average daily net assets of the Hennessy Funds. The decrease in shareholder service fees was due to a decrease in the average daily net assets held in Investor Class shares of the Hennessy Funds. Assets held in Investor Class shares of the Hennessy Funds are subject to a shareholder service fee, whereas assets held in Institutional Class shares of the Hennessy Funds are not subject to a service fee. We collect investment advisory fees from each Hennessy Fund at differing annual rates. These annual rates range between 0.40% and 1.25% of average daily net assets. Average daily net assets of the Hennessy Funds for fiscal year 2021 was $4.0 billion, which represents a decrease of $0.1 billion, or 2.7%, compared to fiscal year 2020. The Hennessy Fund with the largest average daily net assets for fiscal year 2021 was the Hennessy Focus Fund, with $1.1 billion. We collect an investment advisory fee from the Hennessy Focus Fund at an annual rate of 0.90% of average daily net assets. However, we pay a sub-advisory fee at an annual rate of 0.29% to the fund’s sub-advisor, which reduces the net operating profit contribution of the fund to our financial operations. The Hennessy Fund with the second largest average daily net assets for fiscal year 2021 was the Hennessy Japan Fund, with $844 million. We collect an investment advisory fee from the Hennessy Japan Fund at an annual rate of 0.90% of average daily net assets. However, we pay a sub-advisory fee at an annual rate between 0.35% and 0.42% (depending on asset level) to the fund’s sub-advisor, which reduces the net operating profit contribution of the fund to our financial operations. 34 Table of Contents Total assets under management as of the end of fiscal year 2021 was $4.1 billion, an increase of $0.5 billion, or 14.1%, compared to the end of fiscal year 2020. The increase was attributable to market appreciation. The Hennessy Funds with the three largest amounts of net inflows were as follows: Fiscal Year Ended September 30, 2021 Fund Name Amount Hennessy Japan Fund $ 42 million Hennessy Small Cap Financial Fund $ 35 million Hennessy Japan Small Cap Fund $ 13 million The Hennessy Funds with the three largest amounts of net outflows were as follows: Fiscal Year Ended September 30, 2021 Fund Name Amount Hennessy Focus Fund $ (339) million Hennessy Gas Utility Fund $ (134) million Hennessy Cornerstone Mid Cap 30 Fund $ (76) million Redemptions as a percentage of assets under management decreased from an average of 3.6% per month during fiscal year 2020 to an average of 2.8% per month during fiscal year 2021. Operating Expenses Comparing fiscal year 2020 to fiscal year 2021, total operating expenses remained relatively flat, decreasing by 0.9%, from $22.1 million to $21.9 million. The slight decrease in the dollar amount of operating expenses was due to decreases in many expense categories, partially offset by increases in compensation and benefits expense and mutual fund distribution expense. As a percentage of total revenue, total operating expenses increased 0.7 percentage points to 66.8%. Although the dollar value decreased slightly, operating expenses increased slightly as a percentage of total revenue because some of our operating expenses are fixed costs that did not decrease with decreasing revenue during fiscal year 2021. Compensation and Benefits Expense : Comparing fiscal year 2020 to fiscal year 2021, compensation and benefits expense increased by 2.9%, from $8.8 million to $9.1 million. As a percentage of total revenue, compensation and benefits expense increased 1.3 percentage points to 27.7%. The increase in compensation and benefits expense was due to an increase in incentive-based compensation during fiscal year 2021 resulting from our higher total assets under management, as well as an increase in salary compensation paid to our executive officers compared to our fiscal year 2020, which included five months during which our executive officers agreed to temporary 25% salary reductions. General and Administrative Expense : Comparing fiscal year 2020 to fiscal year 2021, general and administrative expense decreased by 4.2%, from $5.0 million to $4.8 million. As a percentage of total revenue, general and administrative expense decreased 0.4 percentage points to 14.5%. The decrease in general and administrative expense was due to lower director stock award expense, as well as a reduction in rent expense in our Novato office and a decrease in legal and accounting costs in the current period. Mutual Fund Distribution Expense : Mutual fund distribution expense consists of fees paid to various financial institutions that offer the Hennessy Funds as potential investments to their clients. When the Hennessy Funds are purchased through one of these financial institutions, the institution typically charges an asset-based fee, which is recorded as mutual fund distribution expense on our statement of operations to the extent paid by us. When the Hennessy Funds are purchased directly, we do not incur any such expense. These fees generally increase or decrease in line with the net assets of the Hennessy Funds held through these financial institutions, which are affected by inflows, outflows, and fund performance. In addition, some financial institutions charge a minimum fee if the average daily net assets of a Hennessy Fund held by such an institution are less than a threshold amount. In such cases, we pay the minimum fee. 35 Table of Contents Comparing fiscal year 2020 to fiscal year 2021, mutual fund distribution expense increased slightly by 1.7%, from $0.48 million to $0.49 million. As a percentage of total revenue, mutual fund distribution expense increased 0.1 percentage points to 1.5%. The increase in mutual fund distribution expense was due to slightly higher average daily net assets of the Hennessy Funds held at financial institutions in the current period. In the second quarter of the prior fiscal year, significant market depreciation, primarily resulting from the COVID-19 pandemic, caused a decrease in average daily net assets. Sub-Advisory Fees Expense : Comparing fiscal year 2020 to fiscal year 2021, sub-advisory fees expense decreased by 3.2%, from $7.6 million to $7.3 million. As a percentage of total revenue, sub-advisory fees expense decreased 0.3 percentage point to 22.4%. The decrease in sub-advisory fees was due to a decrease in average daily net assets of the sub-advised Hennessy Funds. Depreciation Expense : Comparing fiscal year 2020 to fiscal year 2021, depreciation expense decreased by 2.9% from $0.24 million to $0.23 million due to the write-off of fully depreciated assets. As a percentage of total revenue, depreciation expense remained flat at 0.7%. Interest Expense Comparing fiscal year 2020 to fiscal year 2021, interest expense decreased by 100% from $0.4 million to $0. The decrease in interest expense was due to the payoff in full of the remaining outstanding balance under our term loan agreement with U.S. Bank National Association on March 26, 2020. Income Tax Expense Comparing fiscal year 2020 to fiscal year 2021, income tax expense decreased by 4.5%, from $3.1 million to $3.0 million. The decrease in income tax expense was due primarily to lower net operating income in the current period. Net Income Comparing fiscal year 2020 to fiscal year 2021, net income increased by 0.8%, from $7.8 million to $7.9 million. The increase in net income was primarily due to decreased interest expense in the current period. LIQUIDITY AND CAPITAL RESOURCES We continually review our capital requirements to ensure that we have funding available to support our business model. Management anticipates that cash and other liquid assets on hand as of the end of fiscal year 2021 will be sufficient to meet our capital requirements for one year from the issuance date of this report, as well as our longer-term capital requirements for periods beyond one year from the issuance date of this report. To the extent that liquid resources and cash provided by operations are not adequate to meet long-term capital requirements, management plans to raise additional capital by either, or both, seeking bank financing or accessing the capital markets. There can be no assurance that we will be able to raise additional capital. Following the end of our fiscal year 2021, on October 20, 2021, the Company completed a public offering of its 2026 Notes in the aggregate principal amount of $40,250,000. The 2026 Notes mature on December 31, 2026, and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after December 31, 2023. The 2026 Notes bear interest at a rate of 4.875% per year payable quarterly on March 31, June 30, September 30, and December 31. The 2026 Notes are the Company’s direct unsecured obligations, rank equally in right of payment with any of the Company’s future unsecured unsubordinated indebtedness, senior to any of the Company’s future indebtedness that expressly provides that it is subordinate to the 2026 Notes, effectively subordinate to all of the Company’s existing and future secured indebtedness, and structurally subordinated to all existing and future indebtedness and other obligations of any future subsidiaries of the Company. Our total assets under management as of the end of fiscal year 2021 was $4.1 billion, an increase of $0.5 billion, or 14.1%, from the end of fiscal year 2020. The primary sources of our revenues, liquidity, and cash flow are our investment advisory fees and shareholder service fees, which are based on, and generated by, our average assets under management. Our average assets under management for fiscal year 2021 was $4.0 billion. As of the end of fiscal year 2021, we had cash and cash equivalents of $15.8 million. 36 Table of Contents The following table summarizes key financial data relating to our liquidity and use of cash: Fiscal Years Ended September 30, 2021 2020 (In thousands) Net cash provided by operating activities $ 10,386 $ 10,623 Net cash used in investing activities (249 ) (882 ) Net cash used in financing activities (4,256 ) (24,473 ) Net increase (decrease) in cash and cash equivalents $ 5,881 $ (14,732) The decrease in cash provided by operating activities of $0.2 million was due mainly to decreased operating income. The decrease in cash used in investing activities of $0.6 million was due to a payment for the purchase of assets related to the management of the BP Funds made in the prior period. The decrease in cash used for financing activities of $20.2 million was due primarily to the prepayment of the remaining outstanding balance payable under our term loan agreement with U.S. Bank National Association in the prior period. Dividend Payments . We have consistently paid dividends each year since 2005. Our quarterly dividend rate remained constant during fiscal years 2020 and 2021, and our dividend payments totaled $4.0 million in each such fiscal year. Our Bank Loan . On March 26, 2020, we prepaid in full all principal, accrued interest, and costs and expenses outstanding under our term loan agreement with U.S. Bank National Association. The aggregate prepayment amount of $15.4 million was funded by cash on hand, and we did not incur any prepayment penalties. 2026 Notes . On October 20, 2021, we completed a public offering of 4.875% notes due 2026 in the aggregate principal amount of $40,250,000, which included the full exercise of the underwriters’ overallotment option. The 2026 Notes bear interest at 4.875% per annum, payable on the last day of each calendar quarter and at maturity, beginning December 31, 2021. The 2026 Notes mature on December 31, 2026. CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States, which require the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. These accounting policies, methods, and estimates are an integral part of the financial statements prepared by management and are based upon management’s current judgments. Those judgments are normally based on knowledge and experience with regard to past and current events and assumptions about future events. Certain accounting policies, methods, and estimates are particularly sensitive because of their significance to the financial statements and because future events affecting them may differ markedly from management’s current judgment. Described below are the accounting policies that we believe are most critical to understanding our results of operations and financial position. Our operating revenues consist of contractual investment advisory and shareholder service fees. We earn our investment advisory fees through portfolio management of the Hennessy Funds, and we earn our shareholder service fees by assisting investors in purchases, sales, distribution, and customer service. These fee revenues are earned and calculated daily by the Hennessy Funds’ accountants. In accordance with Financial Accounting Standards Board (“FASB”) guidance on revenue recognition, we recognize fee revenues monthly. Our contractual agreements provide persuasive evidence that an arrangement exists with fixed and determinable fees, and the services are rendered daily. The collectability is probable as the fees are received from the Hennessy Funds in the month subsequent to the month in which the services are provided. 37 Table of Contents The management contracts we have purchased are considered intangible assets with an indefinite life and we account for them in accordance with Accounting Standards Codification 350: Intangibles – Goodwill and Other (“ASC 350”). Pursuant to ASC 350, an entity first assesses qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform a quantitative impairment test. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. If an entity determines that it is more likely than not that an indefinite-lived intangible asset is impaired, then it must conduct an impairment analysis. We were able to forego the annual impairment analysis for fiscal year 2021 as the more-likely-than-not threshold was not met as of the end of fiscal year 2021. The costs related to our purchase of the assets related to the management of mutual funds are capitalized as incurred. The costs are defined as an intangible asset per the FASB standard “Intangibles – Goodwill and Other.” The acquisition costs include legal fees, fees for soliciting shareholder approval, and a percent of asset costs to purchase the management contracts. The amounts are included in the management contracts asset, totaling $80.6 million as of the end of fiscal year 2021. RECENTLY ISSUED AND ADOPTED ACCOUNTING STANDARDS We reviewed accounting pronouncements issued between December 1, 2020, the filing date of our most recent previously filed Annual Report on Form 10-K, and November 24, 2021, the filing date of this Annual Report on Form 10-K, and have determined that no accounting pronouncement issued would have a material impact on our financial position, results of operations, or disclosures. There have been no other significant changes to our critical accounting policies and estimates during fiscal year 2021. 38 Table of Contents