Tullett Prebon is the world’s second largest inter-dealer broker. It acts as an intermediary in the wholesale financial markets, facilitating the trading activities of its clients — in particular commercial and investment banks — and collecting commissions and spreads for their involvement. The shares look attractively valued as a stand-alone business. Furthermore, I see a number of potential positive catalysts.
The IDB market is dominated by a few oligopolistic operators, with Tullett being either number one or number two in all of its major product groups. Dealers voted the company “inter-dealer broker of the year” and it won first place in 31 products. Its main competitors are ICAP and BGC.
Results were out today on August 2 — they were broadly in line with expectations and the stock was up more than 5%, showing how depressed sentiment has been.
Attractive Valuation Metrics and Cash Flow
The stock currently sits at 355p and is expected to earn 45p in 2011 down from 46p in 2010. This places it on a current P/E of 7.8x earnings. The dividend this year is 16p, equating to a yield of 4.5%. They have grown the dividend from 6p to 16p in the last five years — a compound growth rate of 21.6%. Dividend Cover is 2.6x. TLPR trades at a large discount to main rival, ICAP on 12x this year’s earnings and a 4.2% yield.
Speculatively one might assume that a fair valuation of the business would seem to be a P/E of 10x and 1.25x revenue (i.e., circa 500p), while during a period of uncertainty a P/E of 8 and 1.0x revenue would be more sensible (i.e., 400p).
Due to the nature of the business it is incredibly cash generative and requires very little in the way of capex. Remarkably, the capex run rate is as low as £10m per year, and the vast majority of expense is staff remuneration. Like other well run “professional service” businesses this affords a very attractive ROE in excess of 20%.
Historically the company has an excellent track record of turning almost all of it’s operating profits into cash with a range of between 119% and 86% over the last five to six years. The free cash flow yield is currently between 12–13%.
Strong Financial Position
The company stated in 2010 that they had over £150 million in surplus capital, which would continue to build. As this is over and above any regulatory capital requirements and given the company’s low capital expenditure (normally around £10m per year), there is a strong chance that this could be returned to shareholders either via a special dividend or a share buyback. The former is more likely as the company has chosen that option historically — a £150m distribution would be worth c75p per share. This idea has been mooted by brokers before and may just be wishful thinking. It would, however, help to optimize the balance sheet.
While in the past the company has paid out c30% of earnings as dividends, there is an argument that this should be increased, providing scope for a material increase in the dividend payout.
On June 8, 2011, management announced that the FSA had renewed its “waiver from consolidated capital resources requirements” until June 2016. Tullett Prebon’s disclosures under Pillar 3 reveal that at end 2010 the group’s capital resources were £461.1 million above its total capital requirement (Dec 2009: £358.1 million). If the group had £150 million of excess capital in 2009, it arguably has over £250m of excess capital now.
The balance sheet currently has £330 million of cash sitting on it which is 42% of the market cap. Simplistically you could pay off the long-term debt of £238 million and the non-current liabilities of £33 million and still be left with a cash pile of 7.5% of the market cap. Demonstrably, this is a well-capitalized business! If and when this is returned to shareholders, there is scope for the market to substantially re-rate the stock.
Asian Potential
The company has been building a business in Asia and while operating margins are currently small as the costs of setting up are absorbed, there is clearly significant potential here as capital markets become more developed, liquid and westernized. Clearly the trend of IPOs in Hong Kong, like Prada for example, show that involvement on the Far Eastern Bourses is essential for the long term business model.
Viable M&A Target?
The company itself believes further consolidation is inevitable — but rather than IDBs bidding for other IDBs, it will be exchanges bidding for IDBs (there are 7 to 8 exchanges and 4 to 5 IDBs). This is an active area right now (TSX & LSE and the Deustche/Euronext deal) as the exchanges are getting acquisitive around each other and deals are being made to achieve operational scale.
The London Stock Exchange held talks with Icap in 2007 and their CEO has repeatedly spoken of his quest to turn it into a £10 billion business (currently £2 billion). Tullett itself was approached early in 2010, with the most likely predator thought to be an overseas exchange.
It seems likely that a takeout valuation would exceed 518p per share (i.e., a sensible valuation during a period of uncertainty plus a premium of greater than 100p per share for the Asian potential) to take control of the business from its strategic shareholders who appreciate the long-term oligopolistic advantages of the industry.
Skin in the Game
The CEO, Terry Smith, holds a 4.5% stake in the company and has been a buyer of the shares around current levels. He is a very vocal character and it could be argued that a less controversial CEO would do the share price some favours however his fans argue that it takes a strong hand to run an army of bolshy brokers.
http://www.terrysmithblog.com/straight-talking/
It should also be mentioned that due to his new project FundSmith (a fund management company) he will hopefully be toning down the rhetoric! Needless to say, however, with a stake worth £56 million, his interests and ours are aligned.
Why Is It Cheap? What Is Worrying the Market?
Capital Markets
Tullett has clearly been tarred with the “capital markets brush.” Nobody wants anything to do with an opaque financial services firm where people do not instantly recognize the value add and the source of profits. I think the first reaction is to want to look elsewhere.
Regulatory Change
It is as much an opportunity as a threat and it is clear that the impact will be far less than first feared. As discussed above, on the June 8, 2011, management announced that the FSA had renewed its “waiver from consolidated capital resources requirements” until June 2016.
Concerns over restrictions being placed on proprietary trading look to be overdone — Icap suggest that only 3% to 7% of trading revenues for the banks came from proprietary trading and that banks will need to continue to manage their structural positions (reconciling FX positions, hedging interest rate risk, etc.).
Technology is addressing many of the regulatory concerns with Tullett themselves increasing the use of electronic broking following a tie-up with Millennium IT and through their hybrid model (combination of voice and electronic broking on one platform).
High Court Ruling
High court judgement, following BGC’s “raids” on Tullett in 2009, sets a legal precedent and could be a major positive for those IDBs in particular that already have teams covering the main markets (e.g., Icap and Tullett). Longer term, it should be reflected in higher valuations as it makes the businesses lower risk and potentially higher margin.
This presents a good opportunity to tackle another one of the problems Tullet encounters. It is, to some extent, hostage to its employees — it is a people business and when the people leave, as they did with the BGC raids, then potentially the clients/customers go with them. This new legal precedent reduces this concern somewhat but I imagine it will still linger as it does in traditional stockbroking.
At previous results, management have commented that there is an unfortunate trend in the broker comp/revenue ratio trending higher towards 60% over the last few years — this was put down towards fear of staff retention.
A Buying Opportunity... At the Right Price?
With an attractive yield, buying the shares around 350p would offer the potential for a 16% total return to the base case valuation — and materially higher should one of a number of potential scenarios play out.
It is not beyond the realm of possibility that the market decides this is a stock deserving of a 12x multiple due to its balance sheet strength, oligopolistic market positioning and cash generation. If we see earnings of 45p in 2012, then it would be a 540p stock with 2 x 16p dividends, meaning we are looking at 572p over the holding period. A compelling 61% return on investment or 27% CAGR.
The IDB market is dominated by a few oligopolistic operators, with Tullett being either number one or number two in all of its major product groups. Dealers voted the company “inter-dealer broker of the year” and it won first place in 31 products. Its main competitors are ICAP and BGC.
Results were out today on August 2 — they were broadly in line with expectations and the stock was up more than 5%, showing how depressed sentiment has been.
Attractive Valuation Metrics and Cash Flow
The stock currently sits at 355p and is expected to earn 45p in 2011 down from 46p in 2010. This places it on a current P/E of 7.8x earnings. The dividend this year is 16p, equating to a yield of 4.5%. They have grown the dividend from 6p to 16p in the last five years — a compound growth rate of 21.6%. Dividend Cover is 2.6x. TLPR trades at a large discount to main rival, ICAP on 12x this year’s earnings and a 4.2% yield.
Speculatively one might assume that a fair valuation of the business would seem to be a P/E of 10x and 1.25x revenue (i.e., circa 500p), while during a period of uncertainty a P/E of 8 and 1.0x revenue would be more sensible (i.e., 400p).
Due to the nature of the business it is incredibly cash generative and requires very little in the way of capex. Remarkably, the capex run rate is as low as £10m per year, and the vast majority of expense is staff remuneration. Like other well run “professional service” businesses this affords a very attractive ROE in excess of 20%.
Historically the company has an excellent track record of turning almost all of it’s operating profits into cash with a range of between 119% and 86% over the last five to six years. The free cash flow yield is currently between 12–13%.
Strong Financial Position
The company stated in 2010 that they had over £150 million in surplus capital, which would continue to build. As this is over and above any regulatory capital requirements and given the company’s low capital expenditure (normally around £10m per year), there is a strong chance that this could be returned to shareholders either via a special dividend or a share buyback. The former is more likely as the company has chosen that option historically — a £150m distribution would be worth c75p per share. This idea has been mooted by brokers before and may just be wishful thinking. It would, however, help to optimize the balance sheet.
While in the past the company has paid out c30% of earnings as dividends, there is an argument that this should be increased, providing scope for a material increase in the dividend payout.
On June 8, 2011, management announced that the FSA had renewed its “waiver from consolidated capital resources requirements” until June 2016. Tullett Prebon’s disclosures under Pillar 3 reveal that at end 2010 the group’s capital resources were £461.1 million above its total capital requirement (Dec 2009: £358.1 million). If the group had £150 million of excess capital in 2009, it arguably has over £250m of excess capital now.
The balance sheet currently has £330 million of cash sitting on it which is 42% of the market cap. Simplistically you could pay off the long-term debt of £238 million and the non-current liabilities of £33 million and still be left with a cash pile of 7.5% of the market cap. Demonstrably, this is a well-capitalized business! If and when this is returned to shareholders, there is scope for the market to substantially re-rate the stock.
Asian Potential
The company has been building a business in Asia and while operating margins are currently small as the costs of setting up are absorbed, there is clearly significant potential here as capital markets become more developed, liquid and westernized. Clearly the trend of IPOs in Hong Kong, like Prada for example, show that involvement on the Far Eastern Bourses is essential for the long term business model.
Viable M&A Target?
The company itself believes further consolidation is inevitable — but rather than IDBs bidding for other IDBs, it will be exchanges bidding for IDBs (there are 7 to 8 exchanges and 4 to 5 IDBs). This is an active area right now (TSX & LSE and the Deustche/Euronext deal) as the exchanges are getting acquisitive around each other and deals are being made to achieve operational scale.
The London Stock Exchange held talks with Icap in 2007 and their CEO has repeatedly spoken of his quest to turn it into a £10 billion business (currently £2 billion). Tullett itself was approached early in 2010, with the most likely predator thought to be an overseas exchange.
It seems likely that a takeout valuation would exceed 518p per share (i.e., a sensible valuation during a period of uncertainty plus a premium of greater than 100p per share for the Asian potential) to take control of the business from its strategic shareholders who appreciate the long-term oligopolistic advantages of the industry.
Skin in the Game
The CEO, Terry Smith, holds a 4.5% stake in the company and has been a buyer of the shares around current levels. He is a very vocal character and it could be argued that a less controversial CEO would do the share price some favours however his fans argue that it takes a strong hand to run an army of bolshy brokers.
http://www.terrysmithblog.com/straight-talking/
It should also be mentioned that due to his new project FundSmith (a fund management company) he will hopefully be toning down the rhetoric! Needless to say, however, with a stake worth £56 million, his interests and ours are aligned.
Why Is It Cheap? What Is Worrying the Market?
Capital Markets
Tullett has clearly been tarred with the “capital markets brush.” Nobody wants anything to do with an opaque financial services firm where people do not instantly recognize the value add and the source of profits. I think the first reaction is to want to look elsewhere.
Regulatory Change
It is as much an opportunity as a threat and it is clear that the impact will be far less than first feared. As discussed above, on the June 8, 2011, management announced that the FSA had renewed its “waiver from consolidated capital resources requirements” until June 2016.
Concerns over restrictions being placed on proprietary trading look to be overdone — Icap suggest that only 3% to 7% of trading revenues for the banks came from proprietary trading and that banks will need to continue to manage their structural positions (reconciling FX positions, hedging interest rate risk, etc.).
Technology is addressing many of the regulatory concerns with Tullett themselves increasing the use of electronic broking following a tie-up with Millennium IT and through their hybrid model (combination of voice and electronic broking on one platform).
High Court Ruling
High court judgement, following BGC’s “raids” on Tullett in 2009, sets a legal precedent and could be a major positive for those IDBs in particular that already have teams covering the main markets (e.g., Icap and Tullett). Longer term, it should be reflected in higher valuations as it makes the businesses lower risk and potentially higher margin.
This presents a good opportunity to tackle another one of the problems Tullet encounters. It is, to some extent, hostage to its employees — it is a people business and when the people leave, as they did with the BGC raids, then potentially the clients/customers go with them. This new legal precedent reduces this concern somewhat but I imagine it will still linger as it does in traditional stockbroking.
At previous results, management have commented that there is an unfortunate trend in the broker comp/revenue ratio trending higher towards 60% over the last few years — this was put down towards fear of staff retention.
A Buying Opportunity... At the Right Price?
With an attractive yield, buying the shares around 350p would offer the potential for a 16% total return to the base case valuation — and materially higher should one of a number of potential scenarios play out.
It is not beyond the realm of possibility that the market decides this is a stock deserving of a 12x multiple due to its balance sheet strength, oligopolistic market positioning and cash generation. If we see earnings of 45p in 2012, then it would be a 540p stock with 2 x 16p dividends, meaning we are looking at 572p over the holding period. A compelling 61% return on investment or 27% CAGR.
