Lighthouse Group — Well-established adviser with a specific angle

Lighthouse is a well-established financial adviser that provides holistic advice to both individuals and corporate customers. It is organised into three divisions with the national Lighthouse Financial Advice (LFA) advisers operating under the LFA brand. This area includes the 21 affinity partnerships under which Lighthouse acts as the preferred financial adviser for the union or corporate partner membership. Wealth Management serves a high net worth client base and incorporates employee benefit and other workplace benefit services. The Network division includes those advisers that operate under their own brands. Finally, there is the recently launched Luceo Asset Management business that offers a range of funds tailored to different risk profiles. The group’s strategy is to focus on development of the affinity business with Wealth Management and Luceo Asset Management expected to augment growth.

Historical and estimated numbers for revenue and EBITDA are summarised below showing an improving margin over recent years, which we expect to continue as earlier investment in providing resources to support the affinity business is leveraged.

At the end of 2017 the group had no debt and cash and cash equivalents of £8.7m. After regulatory and working capital requirements, there was excess cash of £4.7m providing both additional resilience and the means to take opportunities to add to the business through acquisition should an appropriate opening occur. We expect cash flow to strengthen as payments related to earlier provisions taper from 2019.

The business background for Lighthouse appears favourable given an ageing population, increasing longevity, the move from defined benefit to defined contribution pensions and complexity in rules relating to pensions and tax. Nevertheless, adverse surprises in market sentiment and the economic background in the UK would have a negative impact. Regulatory changes or individual lapses in the quality of advice (something which Lighthouse seeks to manage closely) could also have an adverse effect. Automated advice or robo advice could be disruptive for traditional financial advisers but recent comments from the FCA highlight the challenges in operating such platforms, and we see potential for technology to be an opportunity for incumbents to support face-to-face advice and broaden their market reach in due course. With its affinity relationships and target of serving Middle Britain, Lighthouse should be well placed if the market evolves in this way.

We have considered the valuation of Lighthouse shares in the context of a peer group comparison and the outputs of a DCF model. We see a value of c 44p as striking a reasonable balance with upside possible, particularly if development of the opportunity within the affinity area generates positive surprises.

Lighthouse is one of the largest financial advice firms in the UK with a combined history that extends back well before its formation and listing on AIM in 2000. Some key events in the group’s history are highlighted in Exhibit 2. Among these we would pick out the agreement with Liverpool Victoria (LV=) in 2007, which provided the basis of the advisory business serving affinity groups, an important and growing contributor to Lighthouse results. Also, while there have been acquisitions, including the merger with Sumus in 2008, Lighthouse has not been as active an acquirer of businesses as some of its peers in the industry, instead focusing on developing the business organically.

The business is organised in three divisions: Lighthouse Financial Advice, Wealth Management and and Lighthouse Advisory Services.

Lighthouse Financial Advice (LFA) is an advisory business with national coverage providing financial advice to what is described as Middle Britain. Advisers are self-employed but work under the LFA brand. LFA has contractual agreements with 21 affinity partners as a preferred provider of financial advice (see below for more detail). There are about 140 financial advisers including a number of dedicated mortgage advisers within this division.

Wealth Management provides advice to a high net worth client base through two businesses: LighthouseCarrwood and Lighthouse Wealth. LighthouseCarrwood has employed and Lighthouse Wealth self-employed advisers. LighthouseCarrwood has contractual relationships with c 45 accountancy firms to provide financial advice to their clients. The group’s employee benefits and workplace solutions business (part of LighthouseCarrwood) sit within this division.

Lighthouse Advisory Services is the group’s network of self-employed advisers who work under their own brands supported by the same software and researched solutions as used by other advisers within the group.

In addition to these activities is Luceo Asset Management. This was launched in September 2016 to offer an actively managed range of fund of funds (currently five) tailored to different risk profiles. The aim is to provide a wide range of clients with access to high-quality diversified investment portfolios. Octopus acts as investment adviser to the funds. At end 2017, assets under management at Luceo was £37m, compared with £4m at the prior year end.

Following the implementation of the Retail Distribution Review (RDR) from 2012 to 2013 (see appendix, page 13 for further discussion) most of the Lighthouse revenue from financial advice has been in the form of fees rather than commission. Reflecting client preferences and in line with the market as a whole, the majority of these are charged on the basis of a percentage of assets under advice (AUA) although in some instances charges may be based on an hourly tariff.

As an indication, the fee for initial advice including a holistic report on a client’s financial situation will tend to be in the range of 2-3% of AUA. The ongoing service fee for advice in subsequent years is likely to be between 0.5% and 1.0%. For FY17 recurring revenue was nearly 46% of the total, modestly above the prior two years but a step up from 40% for 2014.

Not all commission payments were precluded under the RDR so commission payments have continued for pre-RDR retail investment products held outside a platform, while Lighthouse also earns commission from other products including insurance protection products and mortgage advice. Approximately 12% of group revenue arises from commissions including pre-RDR trail commission that is set to continue generating commission until the products are liquidated.

Exhibit 3 shows how revenues have grown between 2013 and 2017. The key features here are that LFA (National) and Wealth Management revenues have grown strongly (9% compound annual growth in both cases) while Network revenue has contracted modestly. This reflects the group’s focus on the more profitable divisions where it provides greater input to advisers and exercises more oversight. We discuss group and divisional profitability in the financial section but note here that while the Network division was the largest revenue contributor over this period it only made a modest net contribution to EBITDA profit reflecting the lower productivity and profitability of some advisers in this area.

The affinity business, operated within LFA, was an important contributor to the growth in divisional and group revenues shown above and we discuss this area in more detail in the next section.

As mentioned, the agreement with LV= provided the basis for this activity, which forms an important part of the group and the Lighthouse Financial Advice division. In 2017 affinity-based enquiries generated revenue across the group equivalent to nearly 18% of the group total while the EBITDA contribution was over 50% of the total, excluding central costs and the loss arising in Wealth Management from investment in its auto-enrolment product. As noted earlier, the higher profitability reflects the lower amount paid to advisers where the group provides the client lead.

There are 21 affinity relationships, which are detailed in the next table, showing a range of union and corporate organisations, giving a mix of sector exposures and diversity of membership, which totals around six million individuals. The relationships position Lighthouse as a preferred supplier of financial advice. Lighthouse agrees service levels over the life of the agreement with the affinity partner and will provide a short free initial meeting with individuals, and runs group presentations and clinics in the workplace to discuss particular topics including, for example, mid-career financial advice, mortgage clinics, pre-retirement planning and, on occasion, advice arising from restructuring situations.

Having the affinity relationship does not guarantee any level of business and the environment is likely to remain competitive both in terms of winning an individual’s business and securing affinity partners. However, Lighthouse is well placed by dint of having already secured over 20 relationships, the investment it has made in IT systems, call centre support and event organisation staff and the experience it has built up in this part of the market. Arguably this creates something of a ‘defensive moat’.

Given the prominence of unions in this partnership list, we have provided some background data on UK union membership in Exhibits 5 and 6. The chart shows that although union membership has fallen sharply from its peak of over 13 million in 1979 to under seven million last year, there has been a flattening out in the decline and even a small increase in 2017. The table draws together some of the characteristics of union members compared with equivalent statistics for workers who are not union members. Features include a relatively older age profile, higher public-sector exposure (including education and healthcare), higher educational attainment and more professional occupations than for non-union employees. The high public-sector exposure may reduce the opportunities to offer pension-related advice, but this does not apply in all cases and many of the other characteristics can be regarded as favourable.

The demographic of Lighthouse’s affinity partners may differ from this union-wide summary but it is likely to be indicative. It should also be remembered that Lighthouse is in contact with c 15,000 new individuals a year drawn from the six million affinity partners so there should be substantial scope to increase penetration even if there are sections of the membership who are unlikely to be in the market for paid-for financial advice. Lighthouse notes that approximately one in three of the people they present to become fee-paying clients. As we will see in the next section, an important element of the group’s strategy is to continue to increase the level of engagement with affinity partner membership to drive client growth.

In Exhibit 7 we collate the financial disclosure that Lighthouse has provided for the affinity business. This shows compound annual revenue growth of 21% between 2014 and 2017 while new business revenues in 2017 were double the 2015 level. The EBITDA margin benefited from the revenue uplift increasing to nearly 20% in 2017.

Lighthouse identifies LFA and its affinity business as its key growth driver, reflecting the investments made, experience gained and market-leading position held in this area.

To increase penetration of the affinity partner membership, the main objective is to increase the number of engagements with new potential clients from this group. Currently around 100 events are arranged each month, putting the company in contact with c 15,000 individuals per year. The aim is to increase this to 20,000 then 30,000.

The group continues to focus on delivering a high-quality service to clients with the development of centrally researched but individually tailored solutions that should be instrumental in winning and retaining clients.

Wealth Management is seen as a stable and growing contributor with its mix of employed advisers serving clients from professional relationships (primarily with accountancy firms) across the UK and entrepreneurial self-employed advisers with a client base comprising high net worth individuals in the City of London and the South-East.

The Network business has been managed to a point where it has been profitable at the EBITDA level for the last two years with risks to clients, the group and network advisers minimised through use of the same IT infrastructure and financial solutions used in other parts of the group.

The Luceo Asset Management business has already increased its range of funds to cover a broader spectrum of risk appetites and is expected to add new fund management partners in due course in order to extend the options further. In the near term, accumulation of assets should progressively move the existing funds to a profitable size.

The group has a number of dedicated mortgage advisers and potential is seen here to increase lead generation, helped by the affinity business and add to the number of advisers to expand this area of activity.

Finally, although M&A has not recently been a feature in the group’s development, on the right terms management would not rule out a transaction that added capability to the service offering. The main potential stumbling block is a disciplined approach to pricing in a market where consolidators have been active for some time.

In the next section we summarise some of the broad industry drivers that appear positive and should support Lighthouse as it implements its strategy.

There is a range of demographic, legislative and economic factors that appear likely to create a favourable background for the financial advice industry and Lighthouse.

While the need for financial advice is related to the kind of structural factors highlighted above, the economic cycle and market sentiment is likely to affect appetite and ability to engage in financial planning activity. UK economic growth did slow in the first quarter and growth projections are more muted than previously, but Treasury-collected consensus expectations are still for GDP growth of 1.4% and 1.5% for this year and next.

Unemployment and redundancy rates (Exhibit 8) are running at historically low levels and indicators of retail investor sentiment are fluctuating but appear to be in neutral to positive territory (Exhibit 9).

On the supply side, the number of financial advisers fell by 16% following the implementation of the RDR in 2012 and has only recently returned closer to the levels seen previously (over 26,000). This can be seen as helpful for industry participants in that the market is not over-supplied but may make recruiting to support growth more challenging and potentially contributes to higher pricing in M&A transactions.

There is a potential advice gap for consumers dealing with the kind of decisions outlined above and one possible route for meeting this need is automated or robo advice. This has the support of the FCA, which sees innovation and competition as a potential contributor to good outcomes for consumers. A Deloitte report on automated advice sees potential for development of such services in the UK. The main positives are the potential to lower costs compared with face-to-face advice, increased convenience for the consumer, increased efficiency for the provider, consistency and a clear audit trail. Prominent barriers to development of such services are high customer acquisition costs, low fees and uncertainty over regulation. The last point hinges on the need to navigate between giving guidance and regulated advice with the latter carrying increased risks for the provider.

While the FCA is keen to see innovation, the challenge for the regulator and providers in this area have been very clearly highlighted in May this year by an FCA report, Automated investment services – our expectations. This reviewed seven firms providing online discretionary investment management and three automated retail investment advice companies. It reported a number of significant shortcomings; for the advice companies, these included inadequate fact finding and clients undertaking a different transaction from that which was recommended. There were also governance weaknesses at the firm level. This seems to point up the difficulty of finding the right balance between limiting potential harm to consumers and facilitating cost-effective services for a broader population.

From the perspective of an existing, purely face-to-face adviser such as Lighthouse, the development of automated advice can be seen as both a threat and an opportunity. The threat is that new suppliers with algorithms and lower fees pressure the conventional business model, while the opportunity is for incumbents to exploit technology to deliver cost-effective advice to a broader audience. Lighthouse has offered a pilot online advice service for one of its affinity partners but ended this experiment following very limited take up. It remains open to adopting an automated offering (perhaps in partnership) when the circumstances are right. Even if automated advice does gain greater traction, for more complex decisions such as those surrounding pension draw-down, face-to-face advice seems likely to remain important in ensuring the client’s requirements have been properly assessed and they have understood the options available to them.

In summary, the industry background does appear supportive and even the apparent disruptive threat of automated advice could provide an additional avenue for growth serving a wider customer base. Further discussion of the industry background can be found in the appendix on page 14. As outlined above, Lighthouse’s strategy is focused on realising the opportunity provided by its affinity relationships, delivering stable growth in wealth management and increasing the funds under management of the Luceo Asset Management business. In the next section we discuss our estimates for the business and its financial position.

We begin by summarising our divisional estimates for revenue and EBITDA in Exhibit 10. Our forecasts for the National business (LFA) assume revenue growth of 8.5% for 2018 and 2019, which appears low following the 26% growth seen in 2017. However, we have taken into account the incidence of fees last year associated with advice provided to affinity partner members affected by potential corporate changes in pension provision, and have assumed that these will not recur at the same level in the forecast periods. We expect further gentle erosion in the number of advisers in the Network division to be reflected in modestly lower revenue, but this should be ameliorated at the EBITDA level as those retained are likely to be more profitable, allowing the margin to increase slightly. Wealth Management is expected to see revenue growth of around 6.5%, which should progressively offset the costs invested in supporting the auto-enrolment offering. The small amount of revenue under the other segments heading reflects the Luceo Asset Management activity, where we have assumed that assets under management continue to build at a fast pace (from a small base).

Other points to mention in this table are that we have included a line for adjusted earnings. This deducts tax credits where these have arisen and applies a standard rate tax charge; for 2019 there is no adjustment. Second, we have shown two figures for revenue per adviser. The first is calculated from total revenue and inferred adviser numbers and the second (for historical periods) is the reported number. The reported number is lower because some income, including continuing trail income, is not allocated to advisers and this boosts our calculated number.

Looking at the balance sheet (see Exhibit 14) the group is in a strong position with remaining debt paid down in 2017 and cash and cash equivalents standing at £8.7m at the year end. Out of total assets of £24.4m there were £5.1m of intangibles which mainly comprised goodwill relating to the National and Wealth Management divisions. Software development costs and adviser contracts were the other small items. The only other feature we would highlight is the provisions balance, which stood at £3.9m at end 2017 but was as high as £10.5m in 2015. Within the £3.9m figure, £2.5m related to the expected cost of settling customer complaints and £1.3m to clawback of commissions by providers where products are cancelled. For both items Lighthouse makes a gross provision but can claim against the relevant advisers or insurers and recognises an asset within trade and other debtors to reflect this (£2.3m for complaints and £0.96m for commission in 2017). Prospectively we have assumed the level of provisions falls further as historical liabilities are settled.

This leads us to the simplified cash flow table for 2016-19e below. This shows that we expect cash outflows relating to provisions to tail off in 2018 and 2019. This contributes to an improvement in operating cash flows.

The regulatory capital requirement for Lighthouse is calculated as a percentage of turnover. Lighthouse reported that at the end of 2017 its cash position in excess of regulatory and working capital requirements would have been £4.7m, implying those requirements were about £4m. It also noted it had been released from undertakings to the FCA to maintain assets and seek prior approval for distributions by its regulatory subsidiaries. These undertakings were made in 2012 following historical issues in two subsidiaries that had ceased trading. The board has indicated its intention to hold the excess cash in short-dated deposits for the time being.

We have referenced a number of trends and expectations in the industry background and financials sections that are areas of sensitivity for the development of the group.

In this section we consider the valuation of Lighthouse shares in the light of a peer group comparison and the outputs of our DCF model. We conclude the shares are moderately valued and see a value of 44p as reasonable balance between near-term earnings multiples and the potential for positive surprises if the company can secure faster growth, most probably through increased penetration within its affinity group partners.

We have used quite a wide range of comparators for Lighthouse in the table below, including financial advice companies, discretionary fund managers and wealth managers (which we have grouped separately). Each has different characteristics and there is a wide range of market capitalisations. Nevertheless, investors interested in financial advice and retail investment might also consider these companies. Compared with what we have labelled the adviser/discretionary fund manager average, Lighthouse trades on a slightly above-average rating. The traditional wealth managers trade on lower prospective P/Es.

Our discounted cash flow valuation factors in the explicit estimates outlined in the finance section and assumes long-term growth of 3%. Factoring in a discount rate of 9% gives a valuation of c 44p. Exhibit 13 shows the sensitivity of this valuation to different discount rates and assumed long-term growth rates.

Taking into account both the peer comparison and the discounted cash flow outputs a valuation of around 44p seems reasonable, with the potential for this to rise as delivery of growth derived from the affinity partners is reported.

In this section we set out selected industry background information to provide additional context for the Lighthouse business. We have highlighted the ageing UK population profile as contributing to a favourable background for Lighthouse and others in the financial advice industry (see ONS estimates for the UK age profile in 2017 and 2027 in Exhibit 15). Combined with the shift from defined benefit to defined contribution pensions in the private sector (Exhibit 16), this has increased choice over how pension funds may be withdrawn, and tax complexity generally appears set to create a growing need for financial advice.

Even though a large part of the population may not be prepared to pay an economic price for financial advice, the scale of the potential UK market is still significant with Quilter, for example, citing a GlobalData study that indicates there are five million people with liquid assets of £0.1-£5m. With its Middle Britain focus and affinity partners, Lighthouse is likely to be addressing a broader group and it does not set a formal lower limit on assets under advice. GlobalData estimates there are a further 10 million people with assets of between £30,000 and £100,000.

Capacity in the industry, as measured by the number of advisers, was negatively influenced by the RDR (2012). RDR restricted the payment of commissions on retail investment products to remove the potential for bias, increased disclosure and introduced measures to raise standards of advice. This resulted in an initial drop in the number of advisers as some (typically those approaching the end of their careers) chose not continue under the new regime with its minimum qualification requirements (see Exhibit 17). The more recent trend, as shown in Exhibit 17, has been for a gentle recovery in the number of advisers but this is only just beginning to return the level close to the figures seen in 2009-2011.

The change in the mix of adviser income from commission to fees in the wake of the RDR is evident in Exhibit 18 with fee income now accounting for 76% of the total and commission 20%. Overall revenue as recorded by the FCA has grown at a compound rate of 11% between 2013 and 2017.

To give an indication of the distribution of financial advice groups within a relatively fragmented market, we have shown the top 26 companies ranked by CF30 advisers (based on the FT Adviser Top 100, 2017). There are two companies with over 2,000 CF30s (St James’s Place and Old Mutual Wealth: now Quilter which has recently been listed) and then a modest number in the 300-1000 range, including Lighthouse. Consolidation has been a feature in the industry reflecting the burden of increased regulatory requirements and overhead costs on smaller firms. Scale benefits are particularly relevant for platform or integrated businesses that can leverage their IT capabilities or capture vertical synergies.