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. 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 investors in the Hennessy Funds, taxes, general economic and business conditions, interest rate movements, inflation, the personal savings rate, 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 fund assets we currently manage and the generation of inflows into the 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. 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 12 of the 16 Hennessy Funds internally. For the remaining four 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 onsite visits to sub-advisors, as feasible. Our secondary business activity is providing shareholder services to investors in the Hennessy Funds. Prior to January 31, 2022, the day-to-day management of two Hennessy Funds, the Hennessy Energy Transition Fund and the Hennessy Midstream Fund, was performed by a sub-advisor, BP Capital Fund Services, LLC. Effective as of that date, we mutually agreed with BP Capital Fund Services, LLC to terminate the sub-advisory agreement for those 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 of 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. 30 Table of Contents U.S. equities had negative performance for the one-year period ended September 30, 2022, with the S&P 500 ® Index returning -15.47% and the Dow Jones Industrial Average returning -13.40% for the period (on a total return basis). Equity prices dropped sharply during the period as investors have turned their attention to rising interest rates amid continuing inflationary concerns. Recent interest rate hikes by the Federal Reserve and the expectation of further rate hikes have contributed to weakness in equities. Despite weakness in economic growth, the Federal Reserve has indicated that it will likely raise rates at upcoming meetings in an attempt to tame inflation. According to Bloomberg, the Consumer Price Index is expected to increase 8.0% in 2022, while real GDP is expected to advance 1.6%. While lower economic growth expectations would typically lead to talk of an easing interest rate environment, a strong labor market and volatile energy prices have contributed to stubbornly high and above average inflation levels. The Federal Reserve has indicated a resolve to do what it takes to bring inflation down, regardless of economic growth conditions. Long-term U.S. bonds declined meaningfully during the one-year period ended September 30, 2022, as the Federal Reserve tapered its bond-buying activity and continued to raise the Federal Funds rate. With a yield curve that is currently inverted, investor attention has focused on economic growth projections that continue to be revised downward. While the unemployment rate in the United States stood at an incredibly low 3.5% as of September 2022, economic growth expectations continue to trend lower. According to Bloomberg, consensus estimates for real GDP growth for 2022 are 1.6% and for 2023 are 0.7%. The sharp decline in equities, coupled with recent weakness in the residential real estate market, likely portends some softening in consumer spending in the months to come. For the one-year period ended September 30, 2022, 10-year U.S. Government Bond yields rose from 1.49% to 3.83%. The Japanese equity market declined 28.41% (in U.S. dollar terms) for the one-year period ended September 30, 2022, as measured by the Tokyo Stock Price Index. Like many other markets, Japan has experienced elevated levels of inflation coupled with restrained trade with key trading partners. China’s zero-COVID strategy has hampered growth in the country and adversely affected Japanese economic growth. Japanese Yen weakness versus the U.S. Dollar contributed to weak absolute dollar returns as the Tokyo Stock Price Index was only down 7.29% in local currency terms. Against this negative equity performance backdrop, only three of the 16 Hennessy Funds posted positive returns for the one-year period ended September 30, 2022. The longer-term performance numbers remain strong, with 13 of the Hennessy Funds posting positive returns for the five-year period ended September 30, 2022, and all 14 Hennessy Funds with at least 10 years of operating history posting positive returns for the 10-year period ended September 30, 2022. 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 market insights, sector highlights, and other resources to help them manage their fund investments with confidence. 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 help retain assets and 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 over 145,000 fund accounts nationwide, including accounts held by investors who employ financial advisors to assist them with investing as well as accounts held by retail investors who invest directly with us. We serve approximately 12,600 financial advisors who utilize the Hennessy Funds on behalf of their clients, including nearly 800 who purchased one of our Funds for the first time during fiscal year 2022. Approximately 17% of such advisors own two or more Hennessy Funds, and nearly 400 advisors hold a position of over $500,000. While numbers have declined in recent years, we continue to focus significant efforts on financial advisors who own two or more Hennessy Funds or hold a position of over $500,000 in an effort to build and maintain brand loyalty among our top tier of advisors. 31 Table of Contents Total assets under management as of the end of fiscal year 2022 was $2.9 billion, a decrease of $1.2 billion, or 28.8%, compared to the end of fiscal year 2021. The decrease was attributable to net outflows of the Hennessy Funds and market depreciation. The following table illustrates the changes in our assets under management over the past three fiscal years: Fiscal Years Ended September 30, 2022 2021 2020 (In thousands) Beginning assets under management $ 4,065,922 $ 3,564,597 $ 4,873,839 Acquisition inflows — — — Organic inflows 656,491 818,358 571,195 Redemptions (1,147,888 ) (1,345,371 ) (1,771,127 ) Market (depreciation) appreciation (678,808 ) 1,028,338 (109,310 ) Ending assets under management $ 2,895,717 $ 4,065,922 $ 3,564,597 As stated above, the fees we receive for providing investment advisory and shareholder services are based on average assets under management. The following table shows average assets under management by share class over the past three fiscal years: Fiscal Years Ended September 30, 2022 2021 2020 (In thousands) Average assets under management - Investor Class $ 2,199,250 $ 2,394,194 $ 2,556,875 Average assets under management - Institutional Class 1,445,112 1,595,106 1,541,529 Total $ 3,644,362 $ 3,989,300 $ 4,098,404 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 investment funds. As of the end of fiscal year 2022, this asset had a net balance of $80.9 million, an increase of $0.3 since the end of fiscal year 2021. The increase is related to costs associated with the definitive agreement signed with Stance Capital in August 2022. (See Note 16 in Item 8, “Financial Statements and Supplementary Data.”) On October 20, 2021, we completed a public offering of the 2026 Notes in the aggregate principal amount of $40.25 million, which included the full exercise of the underwriters’ overallotment option. 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 4.875% per annum, payable on the last day of each calendar quarter and at maturity, beginning December 31, 2021. 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. The 2026 Notes are the principal liability on our balance sheet at $38.9 million, net of issuance costs. 32 Table of Contents RESULTS OF OPERATIONS The following table sets forth items in the statements of income as dollar amounts and as percentages of total revenue: Fiscal Years Ended September 30, 2022 2021 Amounts Percent of Total Revenue Amounts Percent of Total Revenue (In thousands, except percentages) Revenue Investment advisory fees $ 27,468 92.6 % $ 30,367 92.7 % Shareholder service fees 2,199 7.4 2,393 7.3 Total revenue 29,667 100.0 32,760 100.0 Operating expenses Compensation and benefits 8,322 28.0 9,078 27.7 General and administrative 5,036 17.0 4,754 14.5 Mutual fund distribution 536 1.8 485 1.5 Sub-advisory fees 5,727 19.3 7,332 22.4 Depreciation 207 0.7 232 0.7 Total operating expenses 19,828 66.8 21,881 66.8 Operating income 9,839 33.2 10,879 33.2 Interest expense 2,122 7.2 — — Other income (229 ) (0.8 ) (2 ) (0.0 ) Income before income tax expense 7,946 26.8 10,881 33.2 Income tax expense 1,756 5.9 2,979 9.1 Net income $ 6,190 20.9 % $ 7,902 24.1 % Revenue – Investment Advisory Fees and Shareholder Service Fees Total revenue comprises investment advisory fees and shareholder service fees. Comparing fiscal year 2022 to fiscal year 2021, total revenue decreased by 9.4%, from $32.8 million to $29.7 million, investment advisory fees decreased by 9.5%, from $30.4 million to $27.5 million, and shareholder service fees decreased by 8.1%, from $2.4 million to $2.2 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 shareholder 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 2022 was $3.6 billion, which represents a decrease of $0.3 billion, or 8.6%, compared to fiscal year 2021. The Hennessy Fund with the largest average daily net assets for fiscal year 2022 was the Hennessy Focus Fund, with $1.0 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 2022 was the Hennessy Japan Fund, with $583 million. We collect an investment advisory fee from the Hennessy Japan Fund at an annual rate of 0.80% of average daily net assets. However, we pay a sub-advisory fee at an annual rate in the range of 0.35% to 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. 33 Table of Contents Total assets under management as of the end of fiscal year 2022 was $2.9 billion, a decrease of $1.2 billion, or 28.8%, compared to the end of fiscal year 2021. The decrease was attributable to net outflows of the Hennessy Funds and market depreciation. The Hennessy Funds with the three largest amounts of net inflows were as follows: Fiscal Year Ended September 30, 2022 Fund Name Amount Hennessy Cornerstone Value Fund $ 12 million Hennessy Japan Small Cap Fund $ 2 million Hennessy Cornerstone Growth Fund $ 2 million The Hennessy Funds with the three largest amounts of net outflows were as follows: Fiscal Year Ended September 30, 2022 Fund Name Amount Hennessy Japan Fund $ (222) million Hennessy Focus Fund $ (181) million Hennessy Cornerstone Mid Cap 30 Fund $ (31) million Redemptions as a percentage of assets under management decreased from an average of 2.8% per month during fiscal year 2021 to an average of 2.6% per month during fiscal year 2022. Operating Expenses Comparing fiscal year 2021 to fiscal year 2022, total operating expenses decreased by 9.4%, from $21.9 million to $19.8 million. The decrease in operating expenses was primarily due to decreases in sub-advisory fee and compensation and benefits expenses, partially offset by increases in general and administrative expense and mutual fund distribution expense. As a percentage of total revenue, total operating expenses remained flat at 66.8%. Compensation and Benefits Expense : Comparing fiscal year 2021 to fiscal year 2022, compensation and benefits expense decreased by 8.3%, from $9.1 million to $8.3 million. As a percentage of total revenue, compensation and benefits expense increased 0.3 percentage points to 28.0%. The decrease in dollar value of compensation and benefits expense was due primarily to a decrease in head count and incentive-based compensation during fiscal year 2022. General and Administrative Expense : Comparing fiscal year 2021 to fiscal year 2022, general and administrative expense increased by 5.9%, from $4.8 million to $5.0 million. As a percentage of total revenue, general and administrative expense increased 2.5 percentage points to 17.0%. The increase in general and administrative expense was due to an increase in overall business travel, including conference and other industry event attendance, as we trend towards pre-pandemic travel levels. Mutual Fund Distribution Expense : Mutual fund distribution expense consists of fees paid to various third-party financial intermediaries that offer the Hennessy Funds as potential investments to their clients. When the Hennessy Funds are purchased through one of these financial intermediaries, the intermediary 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 intermediaries, which are affected by inflows, outflows, and fund performance. In addition, some financial intermediaries charge a minimum fee if the average daily net assets of a Hennessy Fund held by such an intermediary are less than a threshold amount. In such cases, we pay the minimum fee. Comparing fiscal year 2021 to fiscal year 2022, mutual fund distribution expense increased by 10.5%, from $0.49 million to $0.54 million. As a percentage of total revenue, mutual fund distribution expense increased 0.3 percentage points to 1.8%. 34 Table of Contents Mutual fund distribution expenses are affected by many factors, including the following: • average daily net assets held by financial intermediaries; • the split of average daily net assets held by financial intermediaries in Institutional Class shares of the Hennessy Funds versus Investor Class shares of the Hennessy Funds; and • fee minimums at various financial intermediaries. Sub-Advisory Fees Expense : Comparing fiscal year 2021 to fiscal year 2022, sub-advisory fees expense decreased by 21.9%, from $7.3 million to $5.7 million. As a percentage of total revenue, sub-advisory fees expense decreased 3.1 percentage point to 19.3%. The decrease in sub-advisory fees was due to a decrease in average daily net assets of the sub-advised Hennessy Funds, with an additional decrease as a result of us no longer paying sub-advisory fees with respect to the Hennessy Energy Transition Fund and the Hennessy Midstream Fund after January 31, 2022. Depreciation Expense : Comparing fiscal year 2021 to fiscal year 2022, depreciation expense decreased by 10.8% from $0.23 million to $0.21 million due to fewer fixed asset purchases. As a percentage of total revenue, depreciation expense remained flat at 0.7%. Interest Expense Comparing fiscal year 2021 to fiscal year 2022, interest expense increased from $0 to $2.1 million. The increase in interest expense was due to our issuance of the 2026 Notes on October 20, 2021, for which we make interest payments quarterly, with the first interest payment made on December 31, 2021. Income Tax Expense Comparing fiscal year 2021 to fiscal year 2022, income tax expense decreased by 41.1%, from $3.0 million to $1.8 million. The decrease in income tax expense was due primarily to lower net operating income in the current period and secondarily to a lower effective income tax rate as discussed in Item 8, “Financial Statements and Supplementary Data.” Net Income Comparing fiscal year 2021 to fiscal year 2022, net income decreased by 21.7%, from $7.9 million to $6.2 million. The decrease in net income was primarily due to the interest expense related to the 2026 Notes 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 2022 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. On October 20, 2021, we completed a public offering of our 2026 Notes in the aggregate principal amount of $40.25 million, which included the full exercise of the underwriters’ overallotment option. 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 4.875% per annum, payable on the last day of each calendar quarter and at maturity, beginning December 31, 2021. 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. 35 Table of Contents Our total assets under management as of the end of fiscal year 2022 was $2.9 billion, a decrease of $1.2 billion, or 28.8%, compared to the end of fiscal year 2021. 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 2022 was $3.6 billion. As of the end of fiscal year 2022, we had cash and cash equivalents of $58.5 million. The following table summarizes key financial data relating to our liquidity and use of cash: Fiscal Years Ended September 30, 2022 2021 (In thousands) Net cash provided by operating activities $ 8,665 $ 10,386 Net cash used in investing activities (231 ) (249 ) Net cash provided by (used) in financing activities 34,217 (4,256 ) Net increase in cash and cash equivalents $ 42,651 $ 5,881 The decrease in cash provided by operating activities of $1.7 million was mainly due to the interest expense related to the 2026 Notes in the current period. The cash used in investing activities of $0.2 million remained the same in both periods. The increase in cash provided by financing activities of $38.5 million was due to the issuance of the 2026 Notes on October 20, 2021. Dividend Payments . We have consistently paid dividends each year since 2005. Our quarterly dividend rate remained constant during fiscal years 2022 and 2021, and our dividend payments totaled $4.1 and $4.0 million in each such fiscal year, respectively. 2026 Notes . On October 20, 2021, we completed a public offering of our 2026 Notes in the aggregate principal amount of $40.25 million, 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. 36 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 2022 as the more-likely-than-not threshold was not met as of the end of fiscal year 2022. The costs related to our purchase of the assets related to the management of investment 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 $80.9 million as of the end of fiscal year 2022. RECENTLY ISSUED AND ADOPTED ACCOUNTING STANDARDS We reviewed accounting pronouncements issued between November 24, 2021, the filing date of our most recent previously filed Annual Report on Form 10-K, and December 7, 2022, 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 2022. 37 Table of Contents