Record — Update 25 July 2016

Established in 1983 by Chairman Neil Record, the company’s original and current main activity is the provision of currency hedging services to clients including public and private defined benefit pension schemes and other institutional investors. In the last financial year to end March, hedging services accounted for 85% of fee income. Passive hedging mandates require expertise in execution and operational efficiency and Record uses its experience to help tailor the systematic approach to meet each client’s needs. The company’s status as a well-capitalised independent operator is a positive factor when it tenders for such mandates. Dynamic hedging also targets a systematic reduction of currency risk but has a secondary aim of generating value by modifying the level of hedging dynamically to allow clients to benefit from weakness in their base currency.

The remaining 15% of fee income is generated by Record’s currency for return strategies. The company employs its experience in and understanding of currency markets to identify stable inefficiencies that it can seek to exploit for clients to generate diversifying returns. While foreign exchange markets are highly liquid, they are also characterised by a majority of non-profit seeking participants, providing the opportunities Record targets with its strategies. The strategies include:

Record has noted that a challenging market environment requires a flexible approach and openness to innovation. Illustrating this has been the licensing agreement concluded with WisdomTree Investments Inc (sponsor of exchange traded products and asset manager). Record is to provide signals that will be used to hedge currency exposures dynamically for WisdomTree’s rules-based indices. Given that Record provides signals rather than managing currency exposures for the related exchange-traded funds, these assets will not be included in the assets under management equivalents (AUME), which the company uses as a measure of the size of its mandates. Income will be included in the ‘other’ category.

In Exhibit 1 we have gathered the analysis of AUME, fees and clients that Record provides. Within this we would highlight a number of features.

The analysis by strategy makes clear the substantially lower level of fees that are applied to passive hedging mandates (3 basis points), which have accounted for a rising proportion of total AUME (now over 82%). Positively, these mandates have tended to be more sticky and are not subject to the same performance risk that applies to dynamic hedging and currency for return (as for any active fund manager). Passive hedging mandates also now account for the largest individual portion of fee income.

The client analysis highlights that, even against a background that has been more or less challenging, Record has succeeded in making net additions to clients in recent years. This has contributed to the rise in AUME from $30.9bn to $53.7bn between FY12 and FY16 (CAGR 15%), allowing fee income to make modest progress despite a significant mix change away from the higher fee margin categories over the period. As shown, corporate and public pension funds each make up over 40% of AUME, while concentration is quite high, with the top 10 clients accounting for approaching 80% of fee income.

Geographically, by client location, Switzerland accounts for two-thirds of AUME, with the Swiss franc a similar proportion of the underlying base currency of the funds for which currency is managed. The UK and sterling come second at just above 20%.

The last section of the table shows the underlying asset class exposures within the hedging segments of AUME. If we assume that fee margins are broadly consistent within each hedging category then equity exposure would account for c 40% of total fees, but the more stable fixed income element is still significant at 23% and this falls within the passive hedging area, which, as noted, has tended to be more sticky.

The board comprises 10 directors, with two of the non-executive directors, Cees Schrauwers and Andrew Sykes, set to retire in November this year, at which point they would have no longer been deemed independent, having joined just prior to the IPO in 2007. In anticipation of this, two appointments as independent non-executive directors have already been made. Jane Tufnell joined in September 2015, bringing experience in investment management (she was a co-founder of Ruffer, serving on its board until 2014), and Rosemary Hilary in June this year; she is a qualified accountant and has held senior positions in audit, risk and financial services regulation. The other members of the board are: Neil Record (chairman), James Wood-Collins (CEO), Leslie Hill (head of client team), Bob Noyen (chief investment officer), Steve Cullen (CFO) and David Morrison (non-executive).

Results for FY16, announced in June, showed AUME modestly down in US dollar terms, client numbers up and pre-tax profit down 10% compared with the prior year. In the Q1 update to end June, AUME in dollar terms was reported as down 1.3% but up 6.1% in sterling terms. Key figures were as follows.

As a reminder, the definition of AUME, used as a measure of mandate size and shown in the chart below, includes the following: (1) for dynamic hedging, the total amount of clients’ investment portfolios denominated in liquid foreign currencies that may be hedged under the mandate; (2) for passive hedging, the actual nominal amount of hedges outstanding; (3) for currency for return, the maximum nominal amount of outstanding forward contracts; and (4) for cash, the total set aside by clients and managed or employed in futures contracts.

Reporting on FY16 performance in the currency for return strategies with the full year results, Record reported a difficult environment with an absence of persistent themes of individual currency strength or weakness and a narrowing of expectations of differentials in interest rates. Forward rate bias and emerging market strategies both suffered from a generally ‘risk-off’ market environment producing negative returns in the financial year, while the lack of trends led to the momentum strategy underperforming. By contrast, the value strategy performed strongly on the back of yen and euro strength. In the first quarter, forward rate bias performance remained negative, reflecting exposure to some of the more volatile currencies. Emerging markets turned positive contributing with momentum and value strategies to a positive outcome for multi-strategy. Over the period of the UK’s EU referendum, with agreement from clients, Record took measures that succeeded in reducing the impact of heightened volatility on portfolios and contained cash trading costs.

On the dividend, the company has indicated that, subject to business conditions, it expects to maintain the dividend at 1.65p in the current year to end March 2017. The board will continue to set a level that is at least covered by earnings and allows for sustainable growth in line with profitability. Additionally, however, the board now regards the balance sheet and capital buffer as being sufficiently strong to support the return of at least part of any surplus of earnings over ordinary dividends, potentially through special dividends. The policy would be that the total payout would still have to be covered by earnings. Based on our current year estimated earnings per share there could be an additional payout of 0.45p. Adding this to the indicated ordinary dividend would give a yield of 8.3%, versus 6.5% excluding.

As far as capital is concerned, the group had year-end operating capital (net current assets of the parent company and the main trading subsidiaries) of £31.7m, of which £8.5m was allocated as regulatory capital, with the £23.2m balance being significantly greater than required for day to day operations in the view of the directors.

Exhibit 3 summarises the modest changes in our estimates compared with our last published forecasts. The 3% forecast increase for FY17 reflects the changes in AUME and exchange rates noted above, partly offset by an increased lease cost for the Windsor HQ. New forecasts for FY18 are also introduced. The numbers are shown on an underlying or normalised basis, excluding the contribution of seed investments in funds that are consolidated.

The macro background is one of accentuated uncertainty in the wake of the UK referendum result with the risks of slower global growth highlighted by a range of forecasters. This could continue to suppress the divergence of monetary policy that had been expected last year. However, expectations could change again and, together with other events such as the presidential election in the US, could give rise to further exchange rate volatility. Record has reported a divergence of responses among its clients in the policies they wish to adopt and with its range of strategies it appears well placed to offer appropriately tailored services.

As previously, when preparing our estimates we have not allowed for any net new money inflows or outflows, with only small assumed performance-based increments in the AUME that forms the basis for our revenue estimates; by inference there is therefore no significant expected change in the fee mix within our estimates, another important driver/sensitivity. (See Exhibit 5, Financial summary, for additional P&L, balance sheet and cash flow information.)

As a specialist foreign exchange manager with a current emphasis on hedging strategies, Record is differentiated from other quoted asset managers. However, while the drivers of AUM and AUME are markedly different, there is some commonality in the business model with asset managers, so, for reference, we show a comparison of valuation measures with UK-quoted asset managers. Within this list (Exhibit 4), Record features among the lowest rated on both prospective P/E ratio and EV/EBITDA and is significantly below average, particularly in terms of EV/EBITDA.

The presence of nearly £28m of cash and money market instruments (excluding cash consolidated from seed funds) on the balance sheet is a positive feature when considering the valuation of Record. Having said this, it is difficult to judge what portion of this could be regarded as truly surplus to requirements. As noted earlier, when considering the capital position, approximately £23m of capital is classified as other operating capital. The business could presumably operate with lower levels of capital/cash but, without experimenting, it is not possible to say where the tipping point from a client perspective would lie. For the moment we would follow the line adopted by the board that aims to retain the current capital/liquidity buffer rather than build it further or reduce it. Conceivably if there were ever to be a change of ownership then this buffer could be a source of additional value that is, arguably, not fully reflected in the share price.

In any case the strong balance sheet, below average prospective P/E and EBITDA multiples, a yield based on the ordinary dividend of over 6% and the potential for a usefully higher total payout all suggest the current valuation is cautious. Positive signals in terms of mandate wins or improved performance in the currency for return strategies could be particularly well received.