Cenkos Securities — Update 26 May 2016

Founded in 2004, Cenkos is an independent, specialist institutional securities group with a focus on small and mid-cap growth companies and investment companies. It has been profitable in each year since its formation (Exhibit 1).

Cenkos’s main business is institutional stockbroking with services offered including corporate finance, corporate broking, research and execution. A total of approximately 120 staff are allocated between corporate finance (22), corporate broking (31), research (18), execution services (13) and support staff (37). In addition to the London head office, there are offices in Edinburgh, Liverpool and a newly established subsidiary in Singapore, Cenkos Securities Asia.

Cenkos is characterised by flexible remuneration and other costs with 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.

Trends in stock market level, equity issuance and, to a lesser extent, trading volumes are important for Cenkos. In 2015, corporate finance revenues accounted for 79% of total revenues (2014 was similar at 78%), with corporate broking, market making and commission revenues accounting for the balance. In this section we describe the recent trends and touch on prospects in these areas.

Cenkos ended 2015 with a corporate client base (nomad, sponsor, broker, financial adviser appointments) of 124. This was slightly lower than in 2014 (130), reflecting takeovers as well as the departure of some smaller clients that were potentially better suited to other nomads.

Exhibits 2 and 3 show the trend in new and follow on issuance on the AIM and LSE Main markets. Cenkos has a strong position on AIM, reporting a 17% share of all fund-raisings in 2015 (2014: 15%). The run up ahead of the financial crisis saw new issuance on AIM peak at more than £16bn in 2007, followed by a dramatic slowdown in the volume of IPOs. A subsequent recovery from a trough of £3,161m in 2012 has still left the level of new equity issuance at relatively muted levels. The 2015 total of funds raised by all companies on AIM at £5,463m was not far short of the previous year total of £5,868m, which itself represented growth of 50% y-o-y. A feature of 2015 was the growth in further issuance and a noticeably lower level of new issuance.

For the Main Market (Exhibit 3), the pattern has been broadly similar, although the peak of the financial crisis was marked by substantial further issuance by banks to help support balance sheets. As for AIM, new issues fell last year, but further issues meant total equity raised was similar to the prior year (£22.0bn versus £22.6bn).

Turning to mergers and acquisitions (M&A) activity, the value of UK transactions (as tracked by Bloomberg) increased from £100.1bn in 2014 to £114.9bn in 2015, with a broadly similar number of transactions (1,572 versus 1,532). The activity level in the first quarter of 2016, although lower than the recent quarterly average and the same period in 2015, was ahead of Q114.

While the market environment has a considerable 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 also important. Exhibit 5 shows selected transaction highlights reported by the group. Of the £3,068m of funds raised for clients by Cenkos in 2015, the largest was the £1,029m BCA Marketplace transaction. In 2014 the £2,816m raised included a £1,385m contribution from the IPO of the AA Plc. So far there has not been a transaction of comparable size in 2016, but the list demonstrates that the diversity of clients helps provide a continuing flow of deals, even in more difficult market circumstances.

Over the last five years the value of equity trading on the London Stock Exchange order book fluctuated within a range that appears relatively narrow in the context of the pre-crisis peak. In 2015 the value traded was 6% above 2014 and 10% below the average since 2011. For 2016 to end April, the value traded was 6% below the same period in 2015.

Equity returns as represented by the FTSE All-Share, FTSE AIM All-Share and FTSE Small Cap indices are shown in Exhibit 6. The impact of uncertainty and weakening expectations during 2015 are evident in each case, although the sharp market dip seen in the first quarter of 2016 has been recovered. The chart also underlines the outperformance of small caps over the period shown and the significant relative weakness of the AIM Index, explained in part by weakness in commodity stocks within the index.

Looking ahead, market volatility has pulled back from a spike in February this year, but the economic and political background remains uncertain. Concerns include tapering global growth expectations, the outcome of the UK’s EU referendum and evolution of central bank monetary policy. Given this, further episodes of heightened volatility would be unsurprising, with an accompanying dampening of market confidence and the deferral of new issue plans, for example. On the other hand, global growth is being sustained and with most market participants reporting a good pipeline of transactions, a period of stability could see a strong rally in equity 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 satisfactory given the market environment.

The nature of Cenkos’s business means that overreliance should not be placed on forecasts and accordingly we restrict our estimates to the current year only. Taking into account the market environment described above, we have framed our base case earnings forecast for 2016 on estimated revenues of £58m. This is the average of revenues recorded over the period 2010-15, is materially lower than the revenues recorded in both 2014 and 2015, but crucially assumes no large transactions during the year (like the AA and BCA Marketplace transactions in 2014 and 2015, respectively). The timing of deals, particularly large deals, can make a material difference to the outturn in any given year, irrespective of the general market environment.

To avoid an unrealistic reliance on any single forecast, alongside our base case forecast we provide a range of upside and downside scenarios, driven by the change in revenue assumption, which we believe cover a range of realistic outcomes.

In building our scenarios, we estimate 2016 non-staff costs at £9.0m are lower than the £11.2m incurred in 2015, which included investment costs as noted above. We have made our own assumptions about fixed staff costs based on 125 staff at a notional average £100k per head. Bonus in lieu of dividends (or BILD, relating to the Compensatory Award Plan 2009 of which 8.8m options remain, with last expiry dates in July and October 2019) is a function of dividends paid. We have assumed that distributions are all in the form of dividends (rather than buy-backs) such that BILD increases as assumed dividends increase. In our downside scenario we assume that there is no interim dividend declared for 2016, such that the estimated BILD costs reflect payment of the final 2015 dividend only. Based on historical observation, we would expect variable staff costs to rise and fall with changes in profits after fixed costs and BILD, but not in a completely linear fashion; variable pay substantially compensates for a revenue decline but not fully, while not sharing fully in revenue upside. Given the underlying complexity of such arrangements, we stress that our assumptions are made in order to facilitate the scenario illustrations above.

The group ended 2015 with cash of £33.1m (2014: £32.9m) and an undrawn borrowing facility of £5m. This was after combined dividend payments and share buybacks totalling £28.5m. The group’s capital position at the year-end remained strong with surplus capital resources of £11m, only modestly below the £12.4m at the end of 2014, despite these dividend and buyback payments.

In this section, we present some 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.

Our peer valuation table, Exhibit 9, highlights the relatively small number of listed independent brokers that have survived in the UK market. We suggest it should be treated with considerable caution, given the differences between the companies and the noticeable variation in their size, the returns they earn and the valuation multiples they command. As noted earlier, Cenkos has recorded profits in each of the 11 years since its formation in 2004 and is among the companies reporting profits in their most recent results. It also stands out as earning comfortably the highest return on equity in the group.

Exhibit 10 illustrates how Cenkos’s price to book ratio has moved since the end of 2006. The current price to book stands just above its average level over the last 10 years; in isolation, this does not seem to indicate a strong valuation message in either direction.

When we combine the ROEs and price to book ratios for our peer group in a scatter diagram (Exhibit 11), the relatively high price to book ratio commanded by Cenkos appears to be fully deserved. Long-term growth and maintenance of even a significantly lower return on equity could warrant a higher valuation, as we discuss next.

We show the output from a simple ROE/COE model adjusted for different ROE and growth assumptions in Exhibit 12 (other assumptions include a cost of equity of 10% and a book value of 53p, as at the end of 2015). 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 25%. This compares with an average return of 29% between 2008 and 2015, a period that includes crisis-affected years as well as very strong returns in 2014 and 2015. Taking our 25% ROE assumption with growth of 5% would point to a valuation of 212p. This compares with our last published value of 229p, which included a separate add-on for potential capital returns, which we no longer explicitly assume although these could help underpin prospective ROEs, potentially justifying a higher sustainable ROE target. 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 18.5% 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 estimate for 2016 assumes a pay-out of 94% and a dividend of 13p that would provide a yield of over 9% at the current share price.

Finally, we include a share price performance comparison to show how the market is attempting to discount broader and stock-specific changes in the outlook for the UK-listed brokers. Cenkos has fared better than average over one year and from its 12-month high. While a stronger absolute performance might be expected in view of the results delivered and current valuation, the marked weakness from 12-month highs across Cenkos and its peers can be explained by an increase in risk aversion that could reverse if the market were to enter a quieter phase.