I sent the following letter to the Board on 4-2-09:

I am writing to you to express my strong disappointment in the fourth quarter operating results of the company. Operating margins, which have been trending lower over the last two years, in spite of increasing revenues, fell to under 19% in the fourth quarter of 2008. This figure is well below Mr. Dillon’s 33% target expressed at the 2007 annual meeting, even though AUM is higher now than then. The 19% operating margin is also well below the 30% operating margin that Mr. Dillon asserted in his 2007 Shareholder Letter was the norm for asset managers that achieve scale, which Diamond Hill has. Both figures are below the 40% plus operating margins that the company should be achieving if it properly compared its reported numbers to others in the industry and adjusted for operating in a lower cost environment (see my previous letters written in 2006 regarding the operating margin issue).

There is no valid reason why the company did not achieve at least the 30% margins that Mr. Dillon previously felt was a reasonable split of the economics of the business. The mentality appears to be heads management wins, tails management wins. No matter what happens, management is apparently going to get large bonuses, and shareholders should be happy with whatever is left. I am all for proper compensation and retaining talent, but to see the board swing so far in favor of management is disappointing.

I am aware that Diamond Hill’s 10-K notes the start-up costs of Beacon Hill and accelerated stock vesting as the reasons for the lower margins but no corresponding decline in incentive compensation. The filing also notes that the Compensation Committee used adjusted operating margin as the factor in the determination of incentive compensation. The Plan allows for more categories which would have better reflected the operating results of the company (EPS, Net Income, Investment Performance, Operating Income, Intrinsic Value, ROE, Return on Sales, and Revenue). Nearly all of the other categories would have shown weaker results in 2008 versus 2007, yet inexplicably none appear to have been used.

The fact that Diamond Hill’s Board approved a higher level of incentive compensation in 2008 versus 2007 is evidence of a failure to incorporate the proper metrics to judge company-wide and individual performance. Diamond Hill should have industry leading margins due to its lower-cost location. The benefits of a low cost operating environment should not be allocated to the employees of the firm.

Diamond Hill has the second highest compensation cost as a percentage of revenue of any small to mid-size publicly traded investment management firms. The only firm higher, Epoch Holding, is predominately a sub-advisory firm, which by nature would have a similar cost structure in order to manage a given level of assets, but a lower revenue base due to sub-advisors typically receiving a smaller management fee.

(chart deleted due to difficulty showing up on message board)

The above chart used firms that are slightly smaller, near the same size, and somewhat larger than Diamond Hill. It is surprising that a firm based in Columbus, Ohio, is near the top of the list.

It has become apparent to me, and many fellow shareholders, that change in the composition of the Board is needed. The existing Board is not standing up for the company’s shareholders. As a shareholder, I am informing the Board that I nominating two people, myself and one other, for the Board. Our goal is to represent shareholders and to push for a fair split between owners and employees of the economics of the business.

Sincerely,
Tim Eriksen
Eriksen Capital Management