Numis Corporation — Update 4 January 2017

Founder of Numis and former CEO Oliver Hemsley formed Hemsley & Co Securities in 1989, which became the basis of Numis Corporation. The company developed its corporate finance business, initially focusing on Lloyd’s of London corporate vehicles. It listed on AIM in 1996 and broadened its expertise, expanded its institutional broking and market making activities and established a US office in 2004 (North America accounts for more than 25% of secondary commission). There are now just under 200 corporate clients (Exhibit 1) and the average market capital has increased to c £560m, whilst the company has not forsaken its traditional strength in small-cap broking with the median market cap being £240m. Profitability was maintained through the financial crisis on a normalised basis, which excludes fair value losses incurred on investments in FY09. Revenue and profitability have subsequently expanded with the client base (Exhibit 2).

Revenue per head has more than doubled since FY12 (Exhibit 3) and Numis has collated data showing that, on this measure, it leads quoted and unquoted UK brokers and is only second to Goldman Sachs among investment banks. From FY13 the cost income ratio has been held at or below 74%, enabling increased revenues to flow through to profits and cash flow (see page 7). Analysing revenues for the last five years (Exhibit 4) corporate broking and advisory accounted for 59% of the total, including 37% for placing commissions, while institutional income contributed 41%, with most of this coming from commissions (33% of total revenue).

FY16 saw management succession, with Alex Ham and Ross Mitchinson taking on joint CEO roles, while Oliver Hemsley remains on the board as an executive director.

Numis reported strong results for the year to end September, with revenues up 15% and pre-tax profits ahead 25% in a period when the market background was mixed and characterised by periods of heightened uncertainty. The corporate client list continued to grow and a smooth management succession appears to have been achieved. Key points were as follows:

Exhibit 5 sets out the segmental analysis of revenues over recent years. In FY16 trading income showed a sharp increase after a relatively depressed performance in 2015. However, this was only 10% above the result for the previous four years and in our estimates we assume a contribution only modestly below the FY16 outcome. Institutional commissions have faced headwinds from long-term downward pressure on rates, but were up 9% last year and Numis reports that it has not yet seen a significant change in behaviour of institutional clients ahead of MiFID II (see page 6 for discussion). The contribution to secondary commissions from trading in the shares of corporate clients has become increasingly important and now accounts for 60% of the total compared with 44% in FY13: an encouraging feature given the continued growth in the client base.

On the corporate broking and advisory side of the business, the salient feature was the strength in placing commissions, up 27% in the year (and over four times since 2012). Here there was a particularly good year for block trades where 13 placings had an aggregate value of £1.1bn. As noted above, a total of £1.8bn was raised in IPOs and secondary issues. FY16 was not a particulary strong year for IPOs (see Exhibit 7) but Numis highlights that this high profile and relatively volatile source of income only accounted for 15% of total revenue, underlining the greater stability of large elements of revenue given normal market fluctuations. Otherwise, deal fees were 9% lower following a strong year in FY15 and corporate retainers increased by 8% reflecting the addition of new clients and increases in fee levels, both factors that will continue to flow through to revenues in FY17.

Other operating income swung from a loss of nearly £2m to a positive contribution of £3.8m, largely reflecting fair value movements on investments, including the FP Numis Mid Cap Fund.

In this section we review recent activity levels in the UK equity market and the level of corporate activity. This provides a context for considering the outlook for Numis, but its prospects will also depend very much on the work of the various teams in the firm and activity levels in its specific corporate and institutional client base.

Exhibits 6 and 7 show the value of equity issuance on the AIM and LSE Main markets over the last three financial years to end September. The first chart, which looks at issuance by market, highlights that the level of issuance on the Main market has been noticeably more volatile than for AIM, particularly in FY16. AIM issuance was consistent between the two halves, while for the Main market the chilling effect of political uncertainty surrounding the EU referendum was much more evident in the second half. The second chart makes clear the greater fluctuation in the level of new issuance compared with further issues. Again the second half of FY16 was a particularly soft period for new issues, tying in with multiple reports of postponed or cancelled IPO plans attributed to restrained market appetite/uncertainty.

Turning to mergers and acquisitions activity, Exhibit 8 shows figures for UK transactions collected by Bloomberg (in this case deals up to £7bn as these are more relevant to Numis). For the year to September there was a 44% y-o-y decline in the value of transactions, but the number of transactions was only slightly lower (1,522 compared with 1,577). Removing the limit on transaction size makes the value of transactions more volatile over time, but the broad pattern of a post-crisis recovery in activity levels that has recently flattened out (by number) or fallen back (by value) remains in place.

Recent equity market trends as captured by the FTSE All-Share, FTSE AIM All-Share and FTSE Small Cap indices are shown in Exhibit 9. Performance in 2015 and early 2016 was held back by weakening economic expectations, while the EU referendum contributed to subsequent volatility. Nevertheless, market levels can be seen as resilient despite the uncertain background, which restrained equity issuance, as noted above. The performance of the indices over the period shown is differentiated, with AIM showing relative weakness (partly reflecting negative trends for commodity shares in the earlier years) and a period of outperformance for the small-cap index.

Turning to trading activity, we can see from Exhibit 10 that the value of equity trading on the London Stock Exchange order book has been largely range bound in the post-crisis period, although there has been a modest uptrend since 2012. The level of trading during Numis’s FY16 compared with FY15 was modestly lower by value (-5%).

Looking ahead, the negotiation of Brexit seems likely to generate swings in sentiment and adds to normal economic uncertainties. Nevertheless, the economy has proven resilient to the initial surprise of the outcome and remains reasonably robust. Although Brexit negotiating positions appear tough, the reality may prove less challenging economically, meaning a more amenable background for corporate activity and helping to maintain equity market levels. On this scenario, at some point corporate developments that have been deferred may return, providing a more active environment for Numis and other market participants.

The implications of research unbundling mandated in MiFID II and due to be implemented in national legislation in January 2018 remains a potential sensitivity for Numis, as for other brokers. The need for asset managers to pay for or arrange research payment accounts for research and establish quality criteria together with other pressures on active asset managers’ profit margins (see FCA market study) could all have negative implications for a segment of institutional commission income (see Edison white paper for a discussion of the future of research).

On the other hand, it should be noted that Numis’s institutional commissions in FY16 showed further resilience even though some asset managers are reported to be adjusting their approach already. Numis indicates that it has not seen a significant change in its clients’ behaviour to date and, in its own discussions with clients, it has not so far identified a negative trend beyond the general pressure on commissions that has been a feature of the industry for some time.

Even if the prospective changes do indeed result in a contraction in research budgets across the industry, as many commentaries have assumed, then mitigating features for Numis should be the research reputation it has established (evidenced by strong survey rankings, including four years as number one broker in the Extel small- and mid-cap survey), the contribution from US-generated commissions (25% of secondary commission) and the potential to gain share from peers with weaker franchises.

In its full year results commentary, Numis highlighted the development of its ability to conduct private placements. This arises from the Numis Venture Broking team, which focuses on advising fast-growing private companies, and works with seed, venture capital and growth, listed and private equity investors. The team typically meet over 200 companies a year and identify promising companies that it can advise and help introduce to potential investors. As noted earlier, in FY16 Numis took part in a £128m private placement for Skyscanner and since the year end has raised money privately for Oxford Science & Innovation and Accelerated Digital Ventures. This is seen as an exciting growth area, addressing a large existing market that is set to expand as companies choose to stay private longer before considering a listing. From the perspective of investors such as family offices and sovereign wealth funds, there is greater interest in direct private investments in order to avoid the fee drag that would otherwise be incurred on investments through private equity funds. Given Numis’s traditional strength in the small- and mid-cap segment and its ability to call on a broad sectoral research expertise, this appears to be an area with considerable promise in its own right that should also feed into IPO and corporate deal flow in due course.

Drawing these strands together, there are political and economic uncertainties to consider but the starting point is substantially more positive than might have been feared earlier in the year. Regulatory change (MiFID II, research unbundling) could be a negative as implementation approaches but there are mitigating factors for Numis. More generally there is also the positive momentum Numis has demonstrated in developing its franchise with corporate clients and institutions. While relatively small currently, the venture broking piece could become a significant. contributor for the group. Meanwhile, returning to the very near-term outlook, Numis has reported a solid start to the current financial year. In the next section we discuss changes in our estimates and include a sensitivity analysis around our central estimate for the current year.

Changes in our estimates are summarised in Exhibit 11, now including an estimate for FY18 for the first time. Our revenue estimate for FY17 is slightly lower than previously, reflecting a combination of increased retainer income, increased placing fees (although below the high level recorded in FY16) but a more cautious assumption for deal fees. We have allowed for a contribution to other income of £0.7m from the c £10m seed investment in the FP Numis Mid Cap Fund and other investments. There are minor reductions of 2-3% in our pre-tax profits and earnings per share estimates which we now show on an as-reported IFRS basis to avoid confusion when comparing estimates and because previously excluded share-based payments have been satisfied by cash purchases of shares whilst other income is likely to see continuing positive and negative contributions from investments.

Sensitivity to equity market developments and corporate confidence make forecasts for brokers’ earnings more than usually tentative. So in Exhibit 12 we show an updated version of a scenario analysis we included in a note published in May 2016.

This shows alternative scenarios with revenues 15% higher or lower than our central case. The low case would take revenues just below the FY15 figure but still well above the levels seen before this. However, it should be remembered that the number of corporate clients has increased significantly (Exhibit 1). While the cost/income ratio flexes higher on lower revenues and lower on higher revenue, variable compensation does moderate operational gearing.

The group’s balance sheet has strengthened further, with the net asset value increasing by 11% from FY15 to £129m. The cash balance increased by £29m to £89m, helped by a £9m reduction in current trading assets, including lower net trading book positions (we assume this will partly reverse this year).

Taking a longer view, since the end of FY12, Numis’s cash balance has increased by more than £50m after paying dividends totalling nearly £45m and buying back shares to the value of almost £48m. Net cash flow from operating activities has fluctuated but has averaged £25m per annum.

Numis reports its Pillar I capital requirement at £30m so it has a significant surplus above this and will consider further capital returns, which are likely to be by way of an enlarged share buyback programme (for FY16, buybacks for treasury and the employee benefit trust totalled £6.7m). At this stage we have not factored this into our cash flow or earnings estimates, but in our valuation discussion we use £25m as an indicative figure for surplus capital/cash. This allows for the group’s likely desire to maintain liquidity as well as capital buffers to cater for market fluctuations and swings in collateral requirements for clearing purposes.

We have updated our comparative table showing Numis alongside other quoted UK brokers. Given the smaller size and different profile of each of these peers, we have also cast the comparative net wider and added metrics for US/European investment banks together with UK quoted auctioneers, interdealer brokers and estate agents on the argument that these all provide intermediary and or advisory services (Exhibit 13). While the comparability of some of these businesses is arguable, the cross-sectoral list does provide a broader background against which to consider the valuation.

Among the UK brokers, Numis is one of four reporting profits, earns the highest return on equity (despite its cash balances) and trades on an above-average price to book, ranking second on this measure. Looking outside the UK brokers, Numis trades on a P/E ratio discount to US and European investment banks, auctioneers and interdealer brokers. Estate agents, de-rated since the Brexit vote, trade on similar prospective earnings multiples.

To give a historical perspective, Exhibit 14 shows that Numis is trading modestly above its 10-year average price to book ratio (2.3x versus 1.8x), but at the lower end of its more recent range, probably reflecting elevated market uncertainty during 2016.

Next we show a comparison of returns on equity and price to book, including both the UK peers and the sectors included in the comparison above. Here the inclusion of the two companies recording losses makes for a wider than normal dispersion, but among the companies and sectors with a positive return on equity Numis appears in line or towards the attractive segment of the grouping, given its relatively high return.

We have also updated our ROE/COE model; we have used unchanged assumptions for cost of equity (10%), a sustainable return on equity of 20% and growth of 5%. Applying this to the year-end NAV of 113p per share gives an indicative central value of 340p per share, similar to the central value indicated in our last note in October (339p). If we allow for a one-off return of excess capital of £25m, this results in a return on remaining equity of nearly 25% and after adding back the capital return would take the central value to 384p. A sensitivity table (Exhibit 16) shows the values that result when using different growth rates and returns on equity (in this case excluding a return of capital).

Lastly, we include a table showing the share price movements for the peer group shown earlier. Numis has outperformed the UK broker average but underperformed the investment bank average over one month, three months and a year. The ‘local’ outperformance is understandable by virtue of the returns Numis is earning and the growth in its franchise, but having lagged the US/European investment banking average on a year’s view there may be scope to make good this difference prospectively.