Monday, 27 March 2017

IG Group (LON:IGG); What is the case for the Value investor?

Want to be the next Paul Tudor Jones?
IGG is a CFD and spread betting platform offering trading across the UK, Europe, Australia and other international markets. 

The company offers a wide range of markets to trade including indices, forex, shares and options. This is a spread business and the primary revenue is from acting as a broker and trading platform.

The company has grown strongly in recent years but in November the industry faced several regulatory enquiries which have substantially dented the share price. So does IGG have a price below intrinsic value for the value investor?

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The regulatory actions seem to be off the back of sterling flash-crash in October - the issue being people stopped out of positions with negative balances due to meteoric midnight drop in GBP. Positions were liquidated and bad debts left outstanding. Many clients will feel aggrieved at losing more than their posted margin in such an extreme event - and also being stopped out of positions which then recovered somewhat. Action has been the pipeline for longer than this though and the situation is both complex and interesting.

When Japan implemented a similar regulatory inquiry and major limits on leveraged products in the 2010-2012 period the impact on revenue meant it fell from May 2009 year end of £28m to  £16m by May year end 2013. (There was a slight strengthening of the Yen in that period.) So revenues fell ~50% on that basis from leverage limits. At the time IGG wrote off >£100m in goodwill related to the acquisition of the Japanese business only a few years before.

Amiable Minotaur Model: Base case model
 (Note the exceptional 2011 result includes impairment of Japanese goodwill)

This Japanese revenue drop of 50% sets a base case bearish scenario for the CFD/Spread bet market going forward. Note this is not a parliamentary legal issue but rather a regulatory enquiry so regulatory capture is probable. The FCA are so good at being captured they had to change their rebrand from the FSA a few year back after they went 'light touch' and let all the banks run riot in the run up to 2008. The regulators have an interest in retaining some form of onshore industry if they want it to exist at all for UK clients - as more unscrupulous operations like to locate in places like Cyprus. IG and CMC seem to be the most engaging with regulators probably because they have the most to lose as the bigger and generally more responsible incumbents.

This is now a low growth business -only so many people have the capital and mindset for this kind of trading. Or at least only so many people should. I.e professional traders and market participants. The business makes small amounts of revenue on every trade through the spread - this accounts for the vast majority of revenue. Unfortunately the company do not break does a stratified analysis of their client book by revenues only an average revenue per client across the whole business so it is difficult to assess the impact of curbs around retail/small accounts on the overall revenue picture. 

The new Limited Risk Accounts should provide some security for new clients as these prevent a client losing more than their posted margin through extreme movements. To be fair to retail clients how can one learn to trade and gain experience other than by actually trading. Still I would imagine growth in customers will slow dramatically in future in part due to regulation and likely some curbs on advertising (I see a lot of advertising everyday for financial betting which is targeted at the general public.) 

Amiable Minotaur Model: Base case revenue and growth

IGG are already diversifying into lower risk areas such as share-dealing - IG now offer very competitive share commission rates of £8 which is below most other brokers who offer around £10-£12 commissions (this is making me reconsider my broker choice). This is another way to leverage the power of your existing platform and diversify away from the regulatory risks associated with leveraged trading. CMC markets have been doing a similar thing recently announcing a share dealing tie up in Australia. Note though that currently share dealing is 0.25% of revenue and CFDs are 40%. There is a long way to go.

IG has scale - this means more people and tighter liquidity in your closed spread bets market. Also this allows for market leading SG&A ratios due to the dilution of centralized costs. The model is also capital light (Capex inc intangibles  is 2% of sales!) and easy to scale globally as it is internet based. So this is definitely a business which lends itself to scaling. That is always an interesting kind of business. It also means if revenues drop costs scale down as the company can cut headcount and marketing costs quite easily in proportion to a fall in client numbers and order sizes. 

Barriers to entry are relatively low hence why small specialist operations keep cropping up. Such high returns with such low risk to capital invite competition so it pays to market aggressively, tie up referring partners and buy out small operations. All things IGG do to protect their market share. IG also have the barrier of a large and well researched platform. More size means more trading options and better research and PR. This also means they can more easily extend their platform into areas like share dealing or even data analytics in future. I have an IG Index account myself for periodic shorting of bad value propositions - and I find it a useful tool for general market data and analysis.

The equity value screens super well on DCF/DDM due to low volatility and super low beta (0.2! I adjust to 0.8 in my model) - depends on your view of cost of capital. I think CAPM is fairly useless in reality but handy as a concept. CAPM gives a 6.3% cost of equity so at 2.7x P/B a 6.3% Ke implies a 17% sustainable ROE. If Ke is 6.3% and the sustainable ROE is above 20% investors should pay 3.2x book for this business or a ~18% premium over the price today. Presently one is paying 2.7x price to book for an ROE of 24.7% trailing - which is pretty cheap.

Amiable Minotaur Model: Base case ROE vs P/B

This assumes of course underlying absolute profit doesn't shrink hugely after regulatory action. In the event of a major drop in trading activity the company would likely still get a > 20% ROE they would just pay out a special dividend in the interim (probably around 50p-60p per share to gain a 20% ROE) to realign the required capital position with the size of their trading book (excluding any impairments - which do not effect regulatory capital as goodwill is inadmissible). But future earnings in aggregate would be smaller going forward despite  maintained ROE which would substantially reduce the value of the shares.

Valuation wise I set up three models with a Bad, Base and Positive regulatory outcome from recent events in the UK and Europe:

Bear Case; Revenue drops 50% in Europe and in the UK. The company scales down costs in proportion. I make a valuation range of £5.40 - £3.50 - the upper being a DCF and DDM model where the low cost of equity flatters the share and the latter being a target 15x P/E. Let us say floor value is £3.50.

[Why 15x? I think 15x is as much as I would want to pay for a company with stable cashflow, an acyclical market leader in its sector and excellent returns on capital - assuming it will fail to grow much beyond the current time]

Base Case; Revenue drops 25% in Europe and 20% in the UK. The company scales down costs in proportion. I make a valuation range of £7.00 - £4.75 - the upper being a DCF and DDM model where the low cost of equity flatters the share and the latter being a target 15x P/E. Let us say floor value is £4.75 or just below the current share price.

Bull Case; Revenue drops 12% in Europe and 10% in the UK. The company scales down costs in proportion. I make a valuation range of £9.00 - £5.75 - the upper being a DCF and DDM model where the low cost of equity flatters the share and the latter being a target 15x P/E.

IGG is a supreme cash machine. A classic story of owning the casino. The issue of course is anything offering such high returns on capital attracts (a) competitors and (b) regulators and this issue is linked because smaller and more unscrupulous competitors entering the market make the regulators much more interested in the industry. So the outcome of the various regulatory proposals will ultimately determine the future value of the company. 

I see a risk reward scenario skewed to the upside. The stock is down around 50% from its peak last year and the company has no secular or cyclical issues to contend with (except a recent period of low volatility which can weigh on revenues.) Therefore should regulatory action be particularly bad we could see a value around £3.50 a share or 30% downside. 

However my base case suggests a more modest proposal with a value around £5 per share. No real upside but it acts like on option on the best case scenario of > £5.75-£9.00 a share. In the meantime one can expect cash dividends of 5% or so which is not a bad return at all. 

Disclosure: I have modest long positions in LON:IGG and LON:CMC. This analysis does not constitute investment advice. I also hold a trading account with IG Index. Read my disclaimer.

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