southern cross report - $1.30 price target

We reiterate our Buy recommendation and have increased our price target to $1.30 (previously $1.20) on the back of higher expectations around performance fees and continued strong net-flows.

Weve revised our FY11 NPAT up by 17%, which follows a 20% upward revision in October this year. We believe KAM is the most leveraged wealth manager to improving market conditions.

Move to half-yearly distributions and performance fees
KAM has recently moved to half-yearly distributions (from annual) on the back of client demand and industry best practice. As a result, the funds have also moved to bi-annual performance fee payments which should help to smooth the earnings split in the year. Effectively the hurdle rates (for the Australian and International fund) still exist on a pro-rata basis (3% absolute performance per half, net of fees).

Performance fees to be the highlight of 1H11 result
KAM has a 20% outperformance fee in addition to a 1.5% management fee for the three main funds. The performance fee is absolute, with two funds subject to a hurdle rate and all funds to a high water-mark. In FY10 the overall performance fee was tempered as high water-marks needed to be recovered before such fees would accrue. However in 1H11 there is already enough performance to surpass both the hurdle rates and remaining high water marks. We estimate the three core funds (which represent 95% of FUM) are on track to deliver approximately $16.5m in performance fees

Positive net-flows for 17 months running
KAM has achieved positive net-flows for the last 17 months in a row (Figure 1), which we believe is a good sign considering much of the sector has been struggling for flows. The source of FUM is well diversified between platforms, direct, advisor relationships and institutional mandates. We believe the positive momentum is supported by double digit CAGR for the three main funds, coupled with a move to daily unit pricing and increased advertising over the last 12 months.

High dividend potential
We anticipate the majority of the earnings will be returned to shareholders via fully franked dividends. As such, we anticipate an 8% plus yield. We believe KAM is a great way to get leverage to improving market conditions, backed by strong performance, a high dividend yield and solid net-flows.

Company description
K2 Asset Management Holdings is an emerging absolute return, long / short fund manager. It currently has three flagship funds, including:

K2 Asian Fund;
K2 Australian Fund; and
K2 Select International Fund.

Founded in 1999, K2 has grown to over 26 employees. The company is based in Melbourne, Australia and has won numerous awards including: Best Long Short and Absolute Return Fund 2007 (Australian Hedge Fund Awards) and Fund Manager of the Year Award 2009 (Lonsec).

Investment strategy

We continue to maintain our positive view on the Wealth Management sector, believing that revenue drivers are heading in the right direction. We see KAM as providing significant leverage as 100% of its FUM attracts performance fees in addition to management fees and as the market continues to improve, the chances of KAM achieving performance fees increases.

Risks

Key risks for the stock include:

Key people risk Similar to other wealth management businesses, the loss of any key investment personal may result in the loss of investment mandates or retail fund flows. This is particularly relevant for KAM, with majority of shares concentrated with three staff members.

Performance risk Investors are wary of investment managers that charge active management fees and that have underperformed the index over a prolonged period of time. It is important for KAM to maintain reputable performance metrics across its product offering.

Liquidity risk As KAM is a small capitalised stock with approximately a quarter of total shares as free float, the liquidity available in the stock is limited. We view KAM as a long-term play, mitigating some of the risk associated with liquidity.