A Close Encounter With a Merchant Bank

This British merchant bank is an incredibly steady performer

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Jun 07, 2022
Summary
  • Close Brothers is a merchant bank operating in the U.K.
  • It is notable because of high predictability, solid dividends and significant undervaluation.
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Close Brothers Group PLC (

LSE:CBG, Financial) (OTCPK:CBGPF ) is a U.K. merchant banking group providing lending, deposit taking, wealth management services and securities trading with a history going back 144 years. A FTSE 250 company, the group employs over 3,700 people, principally in the U.K., and is listed on the London Stock Exchange.

Below is a chart of selected metrics for the stock (currency in British pound (£) unless indicated otherwise; at the exchange rates as of this writing, 1 British pound equals $1.26).

Ticker

Company

Current Price
£

Market Cap (£million)

Enterprise Value (£million)

Revenue (£million)

PE Ratio

PB Ratio

PS Ratio

Tangible Book per Share

Price-to-Ta ngible-Book

LSE:CBG

Close Brothers Group PLC

10.78

1,630

3,240

1,022

8.06

1.01

1.60

9.11

1.18

This company is notable because of high predictability, solid dividends and significant undervaluation, all of which make it an excellent under-the-radar value opportunity, in my opinion.

Business analysis

Close Brothers operates through five segments: Commercial, which lends to small and medium-sized enterprises, both through its direct sales force and via broker distribution channels; Retail, which provides loans to individuals and small businesses, through a network of intermediaries; Property, which focuses on short-term residential development finance; Asset Management, which provides financial advice and investment management services; and Securities, which comprises Winterflood, a market maker for retail stockbrokers and institutions.

Below is a chart detailing the operating income for the different segments for full fiscal 2020 (ended in July 2019) and full fiscal 2021 (ended in July 2020).

Operating Income

Report Date

07/31/2020

07/31/2019

Currency

£

£

Scale

Thousands

Thousands

Commercial

246,600

249,900

Retail

218,400

223,200

Property

121,000

129,500

Asset Management

128,200

120,400

Securities

151,900

93,400

Total

866,100

816,400

In more recent news, the banking group released its earnings results for the first half of fiscal 2022, which extended from August 2021 to January 2022.

Close Brothers delivered decent performance in the first half of fiscal 2022, with adjusted operating profit up 1% to £129.8 million compared to £128.5 million in the first half of 2021, corresponding to a return on opening equity of 12.2% vs. 13.2% in the prior half-year. The group's performance benefited from income growth in its lending business and positive momentum in asset management, offset by reduced trading opportunities in Winterflood following the exceptional highs experienced during the Covid-19 period. The group’s net income was broadly stable at £471.6 million vs. the year-ago number of £474.0 million.

The group's business has significant headroom above the applicable minimum regulatory requirements, with a CET1 capital ratio of 15.1% on Jan. 31. The following is a diagram of the group's balance sheet, featuring an equity-to-asset ratio of 0.13.

1533828228819525632.png

The pofitability figures are solid; the group has been profitable for the last 15 years:

Profitability Rank

6/10

Net Margin %

19.83

ROE %

13.03

ROA %

1.65

The company has consistently paid dividends, currently offering a trailing 12-month yield of 5.94% at a payout ratio of 0.45.

The following chart shows key per-share metrics for Close Brothers over the last 15 years. The company has posted 4% to 6% annualized growth in revenues, earnings, book value and dividends. Overall, in my opinion, this is a very steady performance through recent business cycles, which included two recessions.

1533590246313238528.png

Valuation

I utilized the GuruFocus discounted cash flow (DCF) calculator to estimate the fair value of Close Brothers. For growth over the next 10 years, I used the earnings per share trendline of 4.6% from the previous 10 years. I used a discount rate of 7%, which is the weighted average cost of capital. The business has a high predictability score of five stars, so the DCF model can be considered relatively reliable thanks to historical consistency. The DCF calculator shows that Close Brothers has a large margin of safety when using these assumptions.

1533828229968764928.png

Close Brotherss' Graham Number as of the latest earnings results is £16.56. The Graham Value is a conservative valuation approach that measures a stock's fundamental value by considering the company's earnings per share and tangible book value per share. It is calculated as follows:

Graham Number = Square Root of (22.5) x (TTM EPS) x (Book Value per Share)

The 22.5 is included in the formula as a rule of thumb to account for Graham's assumption that the price-earnings ratio should not be over fifteen and the price-book ratio should not be over 1.5 for an undervalued stock. The Graham Number is the upper bound of the price range that a defensive investor should pay for the stock. According to this valuation theory, any stock price below the Graham number is considered undervalued. Currently there is a 29% margin of safety below the Graham Number.

Conclusion

Close Brothers is a conservatively capitalized and highly predictable merchant bank with a low price-earnings ratio of 8.5, trading close to book value and growing in the low single digits. It pays an exceptionally good dividend of almost 6% and looks undervalued on a DCF and Graham Number basis. I believe this under-the-radar stock is a worthy opportunity.

Disclosures

I/we have no positions in any stocks mentioned, and may buy the stocks mentioned or may initiate a short position in any of the stocks mentioned over the next 72 hours. Click for the complete disclosure
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