Lighthouse Group — Affinity and recurring revenue continue growth

Lighthouse has a long track record of providing holistic financial advice to both individuals and corporate customers. It reports its activities in four segments: National, Wealth Advisory, Communities and Other. The National segment includes Lighthouse Financial Advice advisers operating under the LFA brand and Lighthouse Mortgage and Protection advisers. This segment is responsible for the 23 affinity partnerships under which Lighthouse acts as the preferred financial adviser for the union or corporate partner membership. Wealth Advisory serves a high net worth client base, and also incorporates employee benefit and other workplace benefit services. The Communities segment is a legacy activity providing a network and support for advisers that operate under their own brands within local communities. Finally, under the Other segment there is the Luceo Asset Management business launched in 2016 that offers a range of funds tailored to different risk profiles. Lighthouse has recently established a strategic partnership with Tavistock Investments that will provide access, subject to due diligence, to additional investment products to meet client needs. The group’s strategy is to focus on development of the affinity business with Wealth Advisory and Luceo Asset Management expected to augment growth. A strategy review which is underway may lead to additional investment in personnel to accelerate growth.

As noted earlier, we have tempered our estimates following the FY18 results, but we still look for a continuation of the growth in revenues, EBITDA and cash flow as shown in the table below. The 41% increase in adviser productivity between 2014 and 2018 is notable and has contributed to the strengthening of EBITDA margin and cash flow.

The business background for Lighthouse seems positive given an ageing population, increasing longevity, the move from defined benefit to defined contribution pensions and complexity in rules relating to pensions and tax. Nevertheless, as Q418 illustrated, market volatility and uncertainty over the macro outlook can dampen near-term activity levels. Regulatory changes or individual lapses in the quality of advice (something which Lighthouse seeks to manage closely) could also have an adverse effect. While technology could be a disruptive factor, it also provides an opportunity for incumbents such as Lighthouse to support face-to-face advice and broaden their market reach in due course. With its affinity relationships and target of serving Middle Britain, Lighthouse should be well placed if the market evolves in this way.

Lighthouse trades at a significant discount to peers and, on an average peer rating, would be valued at c 29p. A DCF calculation suggests a much higher valuation could be supported through delivery of longer-term growth potential (41p on our assumptions: see page 10).

Lighthouse is one of the larger financial advice companies in the UK with its precursor businesses established well before the group’s formation and listing on AIM in 2000. It targets the mass affluent or Middle Britain with a particular focus on developing its affinity partner relationships, predominantly with trade unions. Important corporate developments have included: the 2007 agreement with Liverpool Victoria (LV=), which provided exclusive access to offer financial advice to a number of affinity groups; the merger with Sumus in 2008, which increased the scale of the business; and, more recently, the launch of Luceo Asset Management (2016) and the strategic agreement with Tavistock Investments in 2018 to augment the in-house product offering. While Lighthouse has made and remains willing to make acquisitions, it does not seek to build its client and advisor base through an active acquisition programme.

The group’s activities are arranged in four segments.

Exhibits 2 and 3 show revenue and contribution analyses by segment.

These show that while the National and Communities both contributed c 40% of group revenue, the National segment accounts for the largest share of profits (shown here before indirect costs) reflecting the lower level of pay-away to advisers, which in turn reflects the greater level of input, including client introductions provided by the group; the contribution margin for National is 26% compared with 14% for Communities. The Wealth Advisory contribution margin was again lower (9.5%), partly reflecting the level of pay-away to self-employed advisors and also the costs associated with the auto-enrolment proposition. Absent the latter cost, we estimate the contribution margin would have been close to 12%.

Following a strategic review of the auto-enrolment business, the group decided that it lacked the necessary scale to justify further investment and has identified the AutoEnrolment Master Trust (operated by Smart Pension) as the most appropriate candidate to take over responsibility for the assets and members involved. The proposed transfer is expected to be cost neutral in 2019 and to generate a small net income stream thereafter.

In November 2018, Lighthouse announced a strategic agreement with Tavistock Investments that will provide it with access to Tavistock’s investment solutions. These include two recently launched capital protection funds. The funds are mainly invested in BlackRock iShares; the capital underpin is provided by Morgan Stanley and scales with the value of the fund. Tavistock also has a risk-graded fund range, a model portfolio service and plans to launch an app allowing consumers to buy a guaranteed fund provided by a large investment bank. The agreement is set to help deliver the broader offering Lighthouse seeks for Luceo. In conjunction with this agreement, Lighthouse subscribed £1m to Tavistock’s £1.25m equity fund-raising, giving it a 5.3% stake.

Exhibit 4 sets out the additional revenue disclosure provided by the group in the 2018 results release. This highlights the relatively small but rapidly growing contribution from the LMPS mortgage/protection activity. The small reduction in LFA revenue in 2018 is attributed to the increase in market uncertainty in Q418 and a levelling out of pension transfer advice. Affinity-related revenue, mostly within LFA, accounted for 18% of group revenue.

Most of the Lighthouse revenue from financial advice is in the form of fees rather than commission. Reflecting customer preference and general practice in the market, most fees are charged on the basis of a percentage of assets under advice. The fee for initial advice, including a holistic report on the client’s financial position, will tend to be in the range of 2–3%, while the ongoing fee for advice in subsequent years is likely to be between 0.5% and 1.0%. Not all commission payments were precluded by the Retail Distribution Review (RDR: implementation 2012–13), so commissions have continued for pre-RDR retail investment products held outside a platform and are also earned from other products including insurance protection products and mortgage advice. Commission accounts for c 12% of total revenue.

Exhibit 5 shows the progression of group revenue, EBITDA and EBITDA margin over the last five years. Group revenue has grown at a compound rate of 3% during this period but this has been depressed by the gradual contraction of the legacy network Communities segment, while the softer market background and levelling off in pension transfer business influenced the 2018 result, as noted above. The development of the more profitable LFA business, including the affinity relationships, contributed to a more rapid growth in revenue per adviser (9% CAGR) and, as shown in the chart, the more than doubling of the EBITDA margin, generating compound growth of 26% in EBITDA.

There are 23 affinity relationships (up from 14 in 2013 and 21 in 2017), including a range of union and corporate organisations, giving a mix of sector exposures and diversity of membership, which totals over six million individuals. The relationships position Lighthouse as a preferred supplier of financial advice. Lighthouse agrees service levels over the life of the agreement with the affinity partner and will provide a short free initial meeting with individuals, and runs group presentations and clinics in the workplace to discuss particular topics including, for example, mid-career financial advice, mortgage clinics, pre-retirement planning and, on occasion, advice arising from restructuring situations.

Having the affinity relationship does not guarantee any level of business and the environment is likely to remain competitive, both in terms of winning an individual’s business and securing affinity partners. However, Lighthouse is well placed by dint of having already secured over 20 relationships, the investment it has made in IT systems, call centre support and event organisation staff, and the experience it has built up in this part of the market. Arguably, this creates something of a ‘defensive moat’, a point supported by its record of so far retaining all relationships on contract renewal.

The development of revenues and recent profit after direct costs are shown in Exhibit 6. Affinity revenue across the group has grown at a compound rate of 14%, recurring revenue accounted for 50% of total revenue in 2018 and the contribution margin was 29%.

The next table shows the partnerships and approximate membership numbers. Points to note from this are the significant relationships in the public sector education and healthcare sectors, while the scale of the Unison and Unite unions within the multi-sector area bolsters the overall affinity membership base substantially. The high public sector exposure may reduce the opportunities for provision of pension-related advice, but this would not apply in all cases and the scale of the potential audience for Lighthouse to address provides substantial scope for increased penetration and hence growth.

Lighthouse is in the process of reviewing its strategy for the next five years and is likely to be in a position to provide further information on this by the time of its H119 results (September). The review will seek to identify areas that are most likely to generate further earnings growth, with affinity and professional connections cited as examples. We assume that the affinity business will continue to be seen as the main growth driver, while Wealth Advisory will provide a stable and growing contribution and the Communities network will be supported but represent a smaller part of the business over time.

Lighthouse notes that investment may be needed in adviser recruitment, lead generation and marketing to support growth. As an example, in the affinity business, the group would need to add to its marketing spend, regional partnership relationship personnel and advisers in a co-ordinated way in order to accelerate lead generation and maintain a high level of service to new customers. With recruitment and initial uncovered costs for a new adviser amounting to as much as £50,000, this could have a material near-term impact on results before the benefit of increased growth flows through in year two and beyond. Lighthouse notes that it has already started to recruit employed advisers to LFA, which previously had an entirely self-employed team. Given the group is able to generate a flow of leads for new advisers, it is able to focus on hiring advisers without an existing client base mitigating the competitive pressure and costs involved to some extent.

To increase penetration of the affinity partner membership, the main approach is to increase the number of engagements with new potential clients from this group. Around 100 events are arranged each month, putting the company in contact with c 15,000 individuals per year. The aim is to increase this to 20,000 then 30,000.

The Communities (network) business has been managed to a point where it has increased its profitability over three years with risks to clients, the group and network advisers minimised through use of the IT infrastructure and financial solutions also employed in other parts of the group. The intention is to continue supporting these businesses but not to recruit new advisers to the network.

Luceo Asset Management has a range of funds to cover a broad spectrum of risk appetites and the partnership with Tavistock Investments (see earlier) is set to extend the range of in-house products available for clients (subject to due diligence on the funds). Accumulation of assets should progressively move the existing Luceo funds to a profitable size.

The increasing involvement of mortgage and protection advisers in the affinity business should aid lead generation and may justify adding to the number of advisers in LMPS.

M&A has not recently been a prominent feature in the group’s development but, subject to strict pricing discipline, management would not rule out a transaction that added capability to the service offering.

Details of the P&L result are given in Exhibit 8. Group revenues were down slightly reflecting a softening in financial markets at the end of the year (affecting customer confidence) and a levelling out of pension transfer advice in the second half. Segmentally, National, which includes the affinity business, was marginally ahead despite this and, as shown earlier, affinity-related business across the group was up 3.3%. Wealth Advisory showed healthy growth of 9% and revenue from the other segment multiplied as Luceo Asset Management began to scale up (AUM increased from £37m to £58m). The only segment to see a revenue decline was the Communities network, partly influenced by a lower number of advisers (-3% to 168) and partly because of the market weakness mentioned above).

Not shown in the table below, the level of recurring income increased by 10% and now accounts for 53% of total customer revenue vs 48% in 2017, while the average revenue production per adviser was maintained at £122,000.

Direct costs including cost of goods sold and other directly attributable costs were 2.4% lower reflecting general cost control, allowing the overall contribution margin to increase from 16.2% to 17.1%. Looking at the segmental profits at this level the largest move (+50%) was in Wealth Advisory where the main driver was a reduction in the level of costs associated with the auto-enrolment activity that is included here; excluding this, there was a 5% increase to £1.25m. Otherwise changes were much more limited. After a 3% increase in indirect costs underlying EBITDA increased by 7% to £3.4m.

Pre-tax profit was up 5% and while a reduced availability of tax losses and a tax charge gave rise to a reduction in basic earnings per share of 7%, diluted underlying EPS, calculating using a normalised tax charge, were 1.54p vs 1.49p (+3.4%).

The full-year dividend of 0.70p represented an increase of 67%, reflecting the group’s progressive policy. Cover on diluted underlying EPS remains over two times.

While market weakness and related macro uncertainties may have dampened near-term activity levels for Lighthouse, there are a range of longer-term factors that seem likely to prove favourable for the financial advice industry and Lighthouse.

The demographic trend towards an ageing UK population with an increasing proportion aged over 60 and increased longevity is set to mean a growth in the numbers approaching retirement and a longer decumulation period for those in retirement. This should generate increased demand for advice on pension saving and management of assets during the drawdown phase.

The demographic driver meshes with the shift from defined benefit to defined contribution pensions placing responsibility on individuals, while the pension freedoms introduced in 2015 lifted the requirement to purchase an annuity on retirement but increased the complexity of choices people have to make in managing their finances. The tax regime has been subject to continued change and the interaction of choices on drawdown with inheritance tax are examples of tax complexity that encourage people to seek financial advice.

On a cautionary note, surveys have suggested that many people may not be willing to pay for financial advice, but the population of affluent and mass affluent categories is substantial at an estimated five million and 10 million respectively, pointing to a still attractive market to address.

As noted earlier, Lighthouse has a particular focus on developing the penetration of its affinity partnerships and to this end is likely to invest in additional staff. It is well placed to do this given year-end cash of £9.55m of which roughly half could be regarded as available for deployment after allowing for regulatory requirements. Another use of cash could be to develop (or acquire) in-house specialist services or products to meet client needs.

In the next section we highlight the adjustments we have made to our forecasts.

Changes in headline numbers from our estimates are shown in Exhibit 9. Our group revenue assumptions are 4% lower (similar to the shortfall versus estimate for 2018), but containment of assumed cost growth feeds through to more modest reductions in EPS. Our estimates do not allow for a market acceleration in staff recruitment, which may follow the strategy review discussed earlier. Such an investment would be likely to affect earnings initially but have a neutral then beneficial impact in subsequent years as revenue growth responded. Reflecting the higher than expected dividend payout for 2018, we have increased our estimates for 2019 and 2020 significantly. Further detail from our estimates is included in the financial summary.

As noted in the previous section, the group remains in a strong position financially with no debt and cash of £9.55m; this was after investing £1m in Tavistock Investments shares. Lighthouse has substantial headroom above its regulatory capital requirement.

Our simplified cash flow table for 2016–20e below shows that we expect net cash generation to accelerate now that outstanding provisions have fallen to below £1m compared with £3.9m at end 2017. As a reminder, provisions include those made for the expected cost of settling customer complaints and the potential clawback of commissions paid by providers where products are cancelled: in both cases the group can claim against relevant advisers and an asset within trade and other creditors is recognised to reflect this. On our estimates, the payment of corporation tax as tax losses wind down and increased dividend payments only partly offset the beneficial impact of increased operating profits and a neutral position on provision movements.

In this section we consider the valuation of Lighthouse shares in the light of a peer group comparison and the outputs of our DCF model.

Our updated peer group table (Exhibit 11) includes a range of financial advice companies, discretionary fund managers and wealth managers (which we have grouped separately). Each has different characteristics and there is a wide range of market capitalisations, but investors interested in the financial advice and retail investment markets might also consider these companies. Following significant share price weakness in the last month (down c 14% at time of writing) Lighthouse now trades below the average P/Es for both groups and offers an above average yield.

Our discounted cash flow valuation takes into account our explicit estimates set out in the financial summary table and assumes long-term growth of 3%. Factoring in a discount rate of 9% gives a valuation of c 41p (44p previously). Exhibit 12 shows the sensitivity of this valuation to different discount rates and assumed long-term growth rates.

Referencing the peer group comparison suggests this valuation would be too demanding in the near term, given the implied Lighthouse P/E multiples of 27x and 23x for FY18 and FY19 respectively. Putting Lighthouse on multiples in line with the averages for advisory peers shown above would give a value of c 30p (still 20% above the price at time of writing). In due course, successful implementation of an investment plan to accelerate growth and further evidence of increasing penetration of the affinity partners’ membership base should warrant a progressively higher valuation.