IFG Group — Investing for growth

IFG is a financial services group with a primary listing on the Irish Stock Exchange (ISEQ) and a secondary listing on the LSE, which accounts for an increasing proportion of shares traded. Recent years have seen a refocusing, now complete, on two main, UK-based, businesses: James Hay and Saunderson House. Proceeds from the disposal of non-core businesses have left the group debt free with an end FY16 cash balance of £28.2m to support investment in further growth, both organic and potential consolidation opportunities among SIPP providers.

IFG is already a leading provider of SIPPs through James Hay Partnership (JHP). It continues to invest in IT and broadened its capabilities so that it can describe itself as the sixth largest platform in the UK specialising in retirement wealth planning, with assets under administration of £22.1bn at the end of FY16. It has secured partnership agreements with companies such as Capita and Towry (2014 and 2015, respectively) and is in the process of focusing its efforts on the higher end of the adviser market to achieve more profitable growth. Key indicators for JHP include the number of clients, client usage of different services and, to a limited but growing extent, the level of trading.

Saunderson House (SH) is a financial advisor based in the City of London that has traditionally provided financial and investment planning, charging fees on an hourly rate. The SH clients are typically drawn from the professions including partners in legal and accounting firms. This is reflected in a high level of average assets under advice (AUA) per client, increasing to more than £2.3m at the end of FY16 with total AUA increasing to £4.6bn. In 2015 SH launched its discretionary asset management service, which it believes will provide access to a broader range of clients at an early stage; clients with a currently lower level of assets but strong future earnings prospects and the potential to become full advisory clients over time. SH’s key indicators comprise chargeable time, capacity utilisation, number of clients, investment performance, staff retention and assets under advice.

2016 saw growth in revenues, client numbers, and assets under administration and advice, all positive indicators for future performance. However, accelerated investment at JHP, designed to further enhance IFG’s ability to serve clients and deliver ongoing sustainable growth was a drag on earnings in addition to the previously flagged negative impact from lower interest rates following the August cut in the UK base rate. A repricing initiative within JHP, to be introduced in stages in H217, will increase fee revenues per average SIPP client and ameliorate the loss of interest earnings.

During 2016 IFG’s assets under advice and administration increased by 14% to £26.7bn. At JHP a 13% increase in client assets was driven by higher average assets per client, with the number of SIPPs increasing only marginally. SH grew clients by 8% and client assets by 15%.

Revenues grew by 10% for the year, a slowdown from 16% at H116, which significantly reflects the £1.6m negative impact of lower interest rates towards year end as well as the positive H116 impact from SH clients seeking additional advice around the time of the EU referendum.

Underlying costs increased by 15%, including increased investment spend, particularly within JHP. Although evident throughout the year, investment spending was accelerated after John Cotter became CEO in September 2016. Exceptional costs of £1.7m included several items: £2.7m related to the closure of the old Dublin HQ following relocation to London and the closure of a regional office at Swavesey; external advice costs of £0.5m related to corporate governance changes; an exceptional gain of £1.0m triggered by completion of the 2014 sale of IFG UKFS; and an exceptional gain on a payment received from the associate Rayband that was impaired in 2013. Excluding exceptional items as well as amortisation of acquired intangible assets, adjusted operating income declined 14%. Supported by a lower tax rate and a £242k non-recurring contribution from previously sold associates, the decline in adjusted EPS was lower at 7%. The dividend was increased by 11%.

Revenues increased by 8% over the year (12% before the impact of the interest rate cut), substantially driven by growth in the book of SIPPs during FY15. Management notes that the uncertainty created by the EU referendum decision and aftermath has had a negative impact on the industry and JHP. Reflecting this, but also the focus of JHP marketing efforts on to a smaller number of higher-value/volume adviser partners, the number of SIPPs at the end of FY16 was little changed (+1%) compared with the prior year, but with assets under administration increasing by 13% to £22.1bn. Strategic distribution relationships have been established with several well-established partners, and the average case size for the flagship Modular iPlan product increased by 35% during the year.

Organic additions of SIPP accounts increased slightly from 4,042 in FY15 to 4,396, but there was no repetition of the 8,042 accounts acquired in FY15. The number of outgoing accounts ticked up slightly, reflecting in part a deliberate rationalisation of legacy products and consolidation of client holdings into one account where possible. The company intends to continue to migrate legacy products to the Modular iPlan product (MiPlan) where this is in the interest of clients.

Improvements to technology and service quality have remained a focus for JHP as it moves towards a digital platform that will improve client service, enhance scalability and facilitate new service developments. In developing this platform, IFG highlights the advantages of control and flexibility conferred by its proprietary in house technology. Investment Centre (fund platform) assets increased by 41% to £4.8bn in the year, providing a growing asset base from which to generate revenues.

Cost growth (+19%) substantially outstripped revenue growth as a result of the planned investment in change and IT development. The new group CEO has accelerated the pace of planned investment since his appointment in Q316. Having substantially invested in previous periods in upgrading the customer-facing platform technology, attention has shifted to back office service quality and efficiency with a focus on retraining and hiring. Management expects that the accelerated measures taken in Q416 will begin to generate efficiencies in H217.

Partly in response to the pressures on revenue as a result of the cut in interest rates, a new pricing structure has recently been announced and is being rolled out in stages. Annual SIPP administration charges will reduce from £195 to £175, while investment centre platform charges increase and will be applied to all assets including cash. The platform charge increases are structured to strategically favour larger investors, increasing from 0.18% to 0.25% on the first £300,000 and increasing in stages; assets between £300,000 and £600,000 will be charged at 0.20%, between £600,000 and £1,000,000 at 0.15%, between £1,000,000 and £1,500,000 at 0.05%, and 0.01% on assets above £1,500,000. Based on James Hay’s average Modular iPlan portfolio size, the cumulative change will result in an average annual increase of around 0.036%.

SH added 147 net new clients in FY16, an increase of 8% on the opening number. Although this marked a slowdown from FY15 (net 201 increase), there was a good (13%) growth in revenues as activity was diverted by the EU referendum away from acquisition activity to meet a marked increase in client demand for advice, with decisions on hiring a financial adviser being deferred. Management indicates a good start to FY17, with client numbers now above 2,000. Also contributing towards FY16 revenue performance was a 6% increase in the fee rate at the beginning of the year, the first for some years. Within the net client addition total there was an unusual increase in attrition (68 versus an average of 45 in the previous three years). Management indicates that less than a third of the client losses (c 1% attrition) were the result of clients switching adviser, with death or other reasons accounting for the majority. As a proportion of the average number of clients during the period, the annual rate of attrition (for all reasons) remains low at c 4%, albeit an area to which management pays close attention.

Operating margin improved slightly during the year and SH remains focused on refining its operational processes to deliver productivity gains.

Updated investment performance data for the SH balanced model portfolio continues to show performance ahead of its private client benchmark, the FTSE All-Share Index, and inflation over most periods, as illustrated in Exhibit 4. We note that strongly positive returns over 12 months are below the FTSE All-Share Index but are ahead of the private client benchmark. Over all periods shown, the SH portfolio was ahead of its comparator benchmark with volatility that was somewhat higher. It also outperformed the FTSE All-Share Index for one, three and 10 years with significantly lower volatility.

The domestic market and economic background will for some time yet retain an overlay of uncertainty associated with the Brexit negotiations. It is also relatively early for the market to assess the extent and implications of changes in economic and trade policy that will emerge form the new US administration. The near-term reaction to both has so far been relatively positive, more so than some expectations.

While renewed periods of market volatility seem quite likely, these should pass, and for both JHP and SH the longer-term background of an ageing population and increase in pension flexibility seems likely to support demand for their investment platform and advice services.

For JHP the August 2016 25bp reduction in the Bank of England’s base rate that followed the EU referendum will continue to represent a drag on revenues. The impact on H216 was a negative £1.6m and management has guided to a negative £3.5m in H117 (a full six-month effect). The recently announced repricing initiative is designed to counter this impact while at the same time improving JHP’s relative appeal to clients with a larger pool of assets to invest. The new charges will be introduced in phases and will ameliorate the interest rate impact in H217 before making a full contribution in FY18. Investors will pay close attention to H117 SIPP numbers for any impact on the current customer base.

Although JHP has accelerated its investment in the business in FY16, continued investment will be necessary to maintain competitive positioning. We expect JHP costs to fall in FY17 but not by as much as previously forecast and not enough to offset the reduction in our forecast revenues. For FY18 we look for JHP to benefit from investments made and a full year of repricing, and for operating margin to significantly increase (18.5% for the year and 19.2% in H2) with the potential for continued revenue growth and operational gearing to again lift margin above 20% in FY19.

Strategically, JHP will continue to monitor developments in its industry where it continues to expect to see further consolidation, particularly as recently introduced higher capital requirements pressure smaller players. It will continue to focus on the higher end of the adviser market as a source of business. Partnerships such as those with Towry and Capita are attractive as they provide a good flow of new accounts and impose a lower proportionate administrative burden than would be the case for smaller, less active advisers.

SH expects to return to a more normal balance of client advice and client acquisition in the current year, a process that is likely to benefit from continued confidence in markets. We therefore look for a reacceleration of the growth in clients for 2017 and 2018, but with only modest growth in the average revenue per client. The latter reflects the potential for the number of younger clients with smaller portfolios and less complex requirements for advice to increase, attracted by the discretionary asset management offering. As well as being lower revenue, these clients should also be less complicated to service and lower cost, with earnings potential that suggests potential to migrate over time to SH’s full advice offering.

FY16 revenues were in line with our forecasts, but costs within JHP significantly exceeded our expectations as a result of the accelerated investment spending highlighted above. Our group estimates for the current year and next are reduced as a result of the revised near-term outlook for JHP profitability. For FY17 we have reduced our forecast for JHP revenues and increased our cost estimates, expecting the underlying operating margin to be broadly stable at c 15%. For FY18 we look for further growth in client numbers and AUA JHP as well as full-year impact of the repricing initiative with a recovery in operating margin, towards 20% by year end (18.5% for the year).

The reduction in JHP divisional forecasts is partly offset by an increase in our SH expectations, resulting from a slightly higher base than we has expected in FY16, combined with a slightly higher revenue per client assumption than previously.

During FY16 IFG repaid all remaining bank debt (£7.0m), which resulted in a decline in the period end cash balance to £28.2m from £34.1m. Deferred consideration of c £4.0m, expected before year end, was received in Q117. Before debt repayment cash flow remained positive (£1.0m) despite lower operating cash flow, higher dividends and increased capex.

The capital position of the group remains strong. Management indicates that the Pillar 1 capital requirement is covered c 7x (similar to FY15 when the Pillar 3 disclosure showed capital resources of £40.5m compared with a requirement of £5.7m) despite new capital requirements for SIPP operators that came into force in September 2016 that increased the capital requirements in respect of non-standard investments held in SIPPs.

Our updated DCF valuation is 165p, compared with 181p previously, as a result of the estimate changes described above. The main assumptions remain unchanged, including a 10% discount rate, 10x terminal multiple and a 4% longer-term growth rate beyond 2020. We have allowed for two years of 10% growth in 2019-20 when JHP may expect to benefit from the investment programme underway. Any change to this assumption would have a significant impact on the indicated DCF value in addition to the sensitivities shown in the table below. Adjusting both the intermediate and long-term growth rate to match the current share price would require both to be set at little more than 1%, which suggests that market is continuing to take a relatively risk-averse approach, perhaps to the market outlook or more specifically to JHP’s ability to generate growth and efficiency gains, when assessing the valuation.

Our updated our sum-of-the-parts valuation is set in line with our DCF valuation. We have shifted the focus onto the prospective FY17 year, keeping the SH multiple and that applied to central costs unchanged. On this basis, the multiple for JHP has fallen again, to 19.7x (previously 20.5x), slightly lower than the implied multiple for the group as a whole (20.5x).

By way of a “sense check” on our JHP valuation we show a simple comparison with various other platforms (Hargreaves Lansdown, Alliance Trust Savings, Share plc) and the SIPP administrator Curtis Banks in Exhibit 8. Even among the platforms, differences in scale, particularly for Hargreaves Lansdown, and business mix mean that this comparison should be treated with some caution. We show the respective revenues and AUA, together with corresponding multiples. For JHP we have taken the valuation assumed in our sum-of-the-parts and for Alliance Trust Savings (ATS) we have taken the fair value disclosed by Alliance Trust. Although IFG Group would appear to carry excess capital, we have allocated none of this to JHP as we are unable to identify the correct amount and in any case we expect the group to make use of its capital position for future investment.

There is a wide variation in valuation multiples shown in Exhibit 8. Perhaps unsurprisingly, Hargreaves Lansdown, as market leader by a large margin with an established record of strong growth and profitability, is the most highly valued across each of the measures. JHP shares similar multiples to ATS despite its larger scale. Curtis Banks focuses on SIPP administration and is not a platform or provider of investment advice. Its profitability (before tax, amortisation, and non-recurring costs) reduced to 24% in FY16 from 35% in FY15 as it invested in its infrastructure after significant organic and acquisition-led growth, but is above JHP, which would support its higher multiples of AUA and revenues.