AFH Financial Group — Update 25 January 2016

During FY15 AFH completed 11 acquisitions at an average capped consideration of slightly above £1m. Deal activity in H215 was a little slower than H115, as management focused on integrating its H115 deals. We believe this integration process is now well advanced and that AFH is looking to complete a number of deals over the next six months. At this stage, we do not expect any to be transformational, although the successful integration of IFS may encourage management to consider deals somewhat larger it has in the past (historically, no deal was more than 10% of the market capitalisation of the group at the time). Management reports that pricing remains stable (maximum c 3x recurring revenue) in the deals that have recently been considered.

IFS (UK) was acquired by AFH Group on 30 April 2015. Not only was it the largest deal of the year but, by some margin, the largest ever undertaken by AFH. The scale and nature of IFS meant it was treated differently from the other deals. It was not immediately integrated into AFH's existing infrastructure and AFH incurred the full existing cost base of IFS for this period. The reason for this was that there was much more uncertainty than usual over the retention of advisers, given that the proportion of those who held equity was lower (giving them less of a deal benefit), and staff were accustomed to a different remuneration structure and working practices. IFS provided a different service proposition to its advisers and paid them accordingly (cost of sales mainly paid to advisers typically 70% against AFH average of c 48%). The existing arrangements were continued until 1 November 2015 to give both parties time to examine the fit. AFH had built into the deal structure with a much lower upfront consideration, with the right to review the maximum consideration after six months. AFH announced in the trading statement that the number of advisers who have been authorised under AFH, and hence the price to be paid for IFS UK, has reduced from the maximum level. The best estimation is that the total consideration will now be £2.9m.

The contingent consideration is payable in three tranches (16 November 2015, 31 December 2016 and 31 December 2017) and is subject to an earnout based on future turnover. On 1 December 2015 AFH announced that an earnout consideration comprising a cash payment of £357k and the issue of 218k shares (52k new shares, 166k from treasury, total value £357k) had been made. This implies that the current expectation is that the full £2.3m deferred consideration will be earned.

The post-acquisition revenue for the period ended 31 October 2015 was £1.7m and the post-acquisition profit for the period ended 31 October 2015 was £180k. If the acquisition had taken place on 1 November 2014, management estimates that the revenue would have been £3.4m and there would have been a profit of £250k, which implies a post-tax, pre-synergy multiple on the £2.9m total acquisition cost of 14.6x current. We would expect this to drop to well under 10x once cost savings are fully realised (the exceptional cost of integrating the business was £240k). These ratings compare with AFH’s own FY15 PE rating of 14.7x.

AFH structures its deal so that the deferred consideration, which is performance related, is paid from the cash by the business acquired. This has led to rapid growth in cash generation and in FY15 EBITDA (net cash generation from trading excluding non-cash, share-based payments) increased by 115% from £1.3m to £2.8m.

The upfront consideration for new acquisitions comes largely from equity issue carried out ahead of the deals (debt remains a very modest 28% of equity). To this end, AFH announced in December that it had raised gross proceeds of £6.37m (net £6.16m) through the issue of 3.8m shares at a price of 165p. With upfront consideration typically at around one-half of total consideration, and with some deals now involving equity consideration, we believe that the December raise should fund deals through 2016. The opportunity was taken to broaden the shareholder base (new shareholders included the River and Mercantile UK Micro Cap Investment Company and Octopus Investments), with the aim of enhancing liquidity down the line.

There is a range of sensitivities to market movements:

At this early stage of the year, we have not changed estimates for recent market falls.

We note that after many years of banks withdrawing from lower-end retail advice Santander may now be dipping its toe back in the market. We note that its typical customer had a lower portfolio than the average AFH customer. While some advisers may be tempted to switch back to a salaried employment, they are likely to be those who have been least successful in AFH’s fee structure.

The average of our valuation approaches for the existing business is 232p (previously 217p) per share, equivalent to 14x 2017e earnings, reflecting the long-term, double-digit growth story and the potential benefits of deploying further resources into acquisition opportunities. This multiple is below AFH’s broad peer group. Our value gives no benefit for deploying available equity in deals, which is likely to drive significant earnings upgrades. Over time, delivery of earnings and a continued effective execution of the acquisition strategy are the most likely catalysts for a higher share price.

We explicitly forecast operating cash generation until 2017, then apply a 5% growth rate for 10 years and a 10x multiple to the final year to establish the terminal value and add this to existing cash balances. We have also taken the balance sheet cash and added £6.2m for the equity raise. All cash flows are then discounted at the cost of capital (10% assumed), generating a fair value of 240p (down from our previous estimate of 272p). The December equity was issued at 165p (ie below our previous implied valuation). It is included in the calculation at par pending deployment, thus reducing the average valuation compared with our previous estimate. The cash generated from future deals should increase this valuation significantly.

We believe that a skills-based business, with suitable economies of scale, should be able to generate returns safely above its cost of capital. We assume AFH’s long-term return will be c 15%, against a cost of capital of 10% and long-term growth of 5%. The base case indicates that it should therefore trade at c 2x book. We then apply a premium for near-term performance as, despite recent equity raisings, the normalised 2016-17e ROE is below our long-term estimates, but the equity growth rate is well above. This indicates a fair value of 223p (up from our previous estimate of 161p). In this methodology we valued the equity issued in December at 2x book, hence this valuation has increased. The marginal equity generated from new deals is likely to see only a modest uplift to this valuation. The sensitivities are given below.

For the reasons identified above, we believe AFH’s business model is differentiated from peers. The companies above should only be taken as illustrative of AFH’s business, but it appears to be on a lower rating than peers.

On the upside, FY15 revenue was £477k ahead of expectations. Despite this, the cost of sales (fees to advisers) was a little higher than expected by £188k, driven by the mix of business. Administration costs were also higher (£449k), with the administration cost ratio of 39.8% against our forecast of 38.5%. Overall pre-tax profits were £195k ahead of our forecast. We have carried these trends forward into 2016e. The FY15 tax rate was also a little better than expected, but we have assumed standard taxes going forward. The EPS estimates have fallen because we have included the equity raised in December 2015, but no benefit for its deployment in due course. On a one-half upfront consideration, this equity could finance acquisitions of nearly £10m, around a quarter the current market capitalisation providing significant scope for estimate upgrades. Our new organic 2017e show modest growth with tight cost control.