Cenkos Securities — A flexible model that rewards innovation

Cenkos is an independent, specialist institutional securities group with a focus on small- and mid-cap growth companies and investment companies. It was founded in 2004 and within the sector stands out for having been profitable in each year since (Exhibit 1).

Cenkos’s main business is institutional stockbroking, with services offered including corporate finance, corporate broking, research and execution. It is well diversified across sectors with a number of successful niches. It enjoys strong institutional relationships as evidenced by its fund-raising track record (£16bn raised since 2005, mainly acting as sole broker). It employs a total of approximately 120 staff across the London head office as well as offices in Edinburgh and Liverpool and a newly established subsidiary in Singapore, Cenkos Securities Asia.

Cenkos operates a business model that is characterised by flexible remuneration and other costs with relatively low basic remuneration and variable team rewards transparently linked to the net contribution made. The culture is client focused and entrepreneurial and the company aims to maintain experienced and stable teams who are aligned with the long-term growth objectives of the group.

In this section we briefly review the trends in UK equity issuance, stock market level and trading volumes that have an influence on Cenkos’s performance. Given that Corporate Finance & Placing revenues typically account for around three-quarters of total revenues for Cenkos (75% on average in the past three years and 69% in the quieter 2016 year), we would particularly emphasise the importance of equity issuance volumes and stock market performance.

Trends in new and follow on issuance on the AIM and LSE Main markets have been mixed over the last year. Cenkos has a strong position on AIM (it has averaged a 15% share of all AIM fund-raisings in the past three years and was 13% in 2016). Ahead of the financial crisis new issuance on AIM peaked at over £16bn in 2007, followed by a dramatic slowdown in the volume of IPOs. Subsequently there was a recovery, but levels remained comparatively muted. In 2016 (Exhibit 2) new issuance was held back in part by uncertainty surrounding the Brexit vote but further issuance was more robust, notably in the second half.

The Main Market (Exhibit 3) has shown a broadly similar pattern but with a stronger second half for initial fund-raisings as well as follow-on issues.

Turning to mergers and acquisitions (M&A) activity, the value of UK transactions collected by the Office for National Statistics saw a sharp increase in 2016 with the total value (Exhibit 4) more than three times the prior year, but this was primarily the result of a few very high value inward transactions. Looking at domestic and outward deals alone there was a strong rise of 25%, but the value was within the range seen in recent years.

While the market environment has an influence on the level of transactions of an individual firm, the incidence of activity among clients and the success of the Cenkos team in winning business are important. Exhibit 5 shows selected transaction highlights reported by the group. In 2016 Cenkos raised £1,325m, compared with £3,068m in 2015, which benefited from the £1,029m BCA Marketplace transaction.

Equity returns as represented by the FTSE All-Share, FTSE AIM All-Share and FTSE Small Cap indices are shown in Exhibit 6. The strength of the rebound post Brexit vote and support from the ‘Trump bounce’ are evident. The chart also shows outperformance by small caps over the period and significant relative weakness of the AIM Index, explained in part by weakness in commodity stocks within the index.

As Exhibit 7 shows, there has been a moderate increase in the average daily value of trade on the LSE order book, although the increase in 2016, at 3.6%, was lower than in previous years.

Looking ahead, newsflow on the terms of Brexit could cause fluctuations in market sentiment that would in turn have an impact on market level and corporate activity. However, while this will be a factor, the resilience shown by the UK economy and the fact that market levels are higher than might have been expected at the time of the vote creates a relatively positive backdrop for corporate activity including M&A, IPOs and follow-on issuance.

Cenkos management themselves note that there continues to be good institutional demand to fund high-quality companies and ideas and that Cenkos’s pipeline is encouraging.

2016 revenues of £43.7m were a little below our £46.0m assumption but staff costs were lower. PBT of £4.4m was ahead of our £4.1m estimate, but this was offset by the unusually high tax charge related to non-cash options related to the change in the value of the deferred tax asset, triggered by the share price decline.

Looking forward, although we are faced with the task of forecasting a specific financial outcome for Cenkos, it is in the nature of the industry in which it operates that over-reliance should not be placed on single point forecasts. For this same reason we restrict our estimates to the current year only. As noted above, revenue growth was stronger in H216 than in H1 and management describes the current pipeline of business as encouraging. Taking this into account, along with the market environment that we have described above, we have chosen to base our current year (2017) earnings forecast on estimated revenues of £52m but note that the timing of transactions, particularly large transactions, can make a material difference to the outturn in any given year, irrespective of the general market environment.

Our assumption of £52m for revenues, excluding any major transactions, is below the five-year average for reported revenue (a little over £60m) and a little ahead of the five-year average excluding the revenues earned on large AA and BCA Marketplace transactions in 2014 and 2015 (c £49m). Those transactions underline Cenkos’s ability to undertake larger transactions, and on a smaller scale but still significant is the November 2016 £350m Civitas Social Housing IPO. We note also that Cenkos is leading on the intention to float Eddie Stobart, with press speculation that the business could achieve a stock market valuation in excess of £550m (FT, 23 March 2017).

We have made no particular assumption about the make-up of revenues but stress the importance of deal flow and note that Corporate Finance & Placing fees have averaged 75% of all revenues in the past two years. Market Making activity represents an average 7.5% of revenues in the past two years and Corporate Broking, Research & Commission the remaining 17.5%. As noted above, the approach of MiFID II (1 January 2018 introduction) and the unbundling of research from dealing commissions in particular are maintaining pressure on secondary broking commissions. Although not separately identified, we believe that secondary brokerage is typically in the range of 5-10% of revenues (depending on the strength of other revenue streams in any one year) and on this basis Cenkos is less dependent on this sort of income than some competitors. In 2016, commission rate pressures were offset by new hiring and we believe that the Cenkos remuneration model, which transparently rewards analysts on their success in generating revenues, should continue to position it as an attractive employer to quality staff, in turn more likely to attract discretionary commission from clients.

We have assumed 2017 non-staff costs at £10.0m (2016: £9.2m), which allows for continuing investment. Staff costs (including bonus in lieu of dividend or BILD costs relating to the 8.8m Compensatory Award Plan 2009 options still outstanding) are forecast to decline as a share of revenues and the overall cost-income ratio to improve to 85.0% (2016: 90.1%). We assume a full payout of earnings or an 11p dividend for the year.

Our valuation assessment includes peer valuations, a historical comparison of Cenkos’s own price to book value over time and the sensitivity of the output of a ROE/COE model to assumptions.

The peer valuation comparison (Exhibit 8) highlights the relatively small number of listed independent brokers that have survived in the UK market. Given significant differences between the companies, including differences in their business models, the noticeable variation in their sizes, as well as the wide spread of returns they currently generate in relation to the valuation multiples they command, we recommend that this data be treated with caution. What is not shown in the exhibit but highlighted above is Cenkos’s unbroken track record of profitability since its formation in 2004. What can be seen is that it is among the few companies reporting profits in their most recent results, and while its ROE reduced in 2016, its strong capital position and full distribution of profits means that its yield is currently the highest in the group

Exhibit 9 illustrates how Cenkos’s price to book ratio has moved since the end of 2006. Over the past 12 months this ratio moved from being towards the top of the long-term range to near the bottom. Despite an increase in the share price over the past three months, the current price to book remains just below 2x and noticeably below the long-term average of 2.6x.

Exhibit 10 combines the ROEs and price to book ratios for our peer group in a scatter diagram. The results yield a mixed picture that reflects the current low profitability and strategic challenges facing some of the group together with an overlay of corporate action. Panmure Gordon recently agreed to a take-over approach by Atlas Merchant Capital (the private equity vehicle of Bob Diamond) and QInvest, the Qatari investment bank that already owned a 43% stake. In September 2016 WH Ireland confirmed that Kuwaiti European Holdings Group (KEH) had taken a 23% stake in the company. What is clear from the table is that the relatively high price to book ratio commanded by Cenkos is supported by an above-average ROE.

We show the output from a simple ROE/COE model adjusted for different ROE and growth assumptions in Exhibit 11 (other assumptions include a cost of equity of 10% and a book value of 49.8p, as at the end of 2016). As for any broking/investment banking business, the potential volatility of earnings makes it difficult to assign a sustainable ROE, but for our central assumption we take a return of 24%. This is the average between 2008 and 2016, a period that includes global financial crisis-affected years as well as very strong returns in 2014 and 2015. We had previously assumed a sustainable ROE of 25% compared with an average of 29% between the years 2008 and 2015. Taking our 24% ROE assumption with growth of 5% would point to a valuation of 189p (previously 212p). Using the same cost of equity, growth and book value assumptions, the ROE/COE suggests that the current share price implies an assumed return on equity of 14.5% for Cenkos: cautious in view of its recent performance and on a longer view, but perhaps understandable in view of elevated recent market volatility.

As noted earlier, Cenkos has been effectively distributing all its earnings in the form of dividends and share buybacks. This has contributed to the relatively high return on capital, which in turn supports further high dividend payments in periods of strong trading performance. Our estimates for 2017 assume substantially full payout of earnings in the current year or a dividend per share of 11p that would provide a yield of more than 10% at the current share price.

Exhibit 12 shows a price performance comparison for the UK-listed brokers. Cenkos has fared better than average over the past three months/the year to date, but has been a noticeable laggard over one year and from its 12-month high. 2016 revenues and profits were lower than we had hoped for a year ago and the FCA investigation and subsequent fine regarding Quindell/Watchstone may have had a negative impact on sentiment. The recent share price performances of Panmure Gordon and WH Ireland have been influenced by the corporate developments referred to above.