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While it looks like a disappointing year ahead for the Investment Services sector, derivatives brokers and inter-dealer brokers still offer the potential for good gains, and now is the time to jump aboard, as valuations stand at attractive levels.

by Simon Keane

It is the ‘non-directional’ plays investors need to look out for in the Investment Services sub-sector. That means the derivatives brokers IG Group (IGG), London Capital (LCG:AIM) and Worldspreads (WSPR:AIM) and inter dealer brokers ICAP (IAP) and Tullett Prebon (TLPR). Here volatility is what counts rather than whether the markets are going up or down.

Unfortunately the rump of this segment, including the broker/advisory companies such as Evolution Group (EVG) and Numis Corporation (NUM), will continue its downward trajectory so long as sinking stock markets continue to depress both primary activity (new floats) and secondary business (trading volumes). Evolution’s chief executive Alex Snow recently described today’s experience as like operating ‘over a canyon on a high wire’. This is a telling comment, since it comes from the firm with the second highest cash balances in the sector (see table).

Stockbroking operations suffer as rising client losses hit both retail and institutional trading volumes. Meanwhile, the advisory arms of these businesses are in the doldrums as the Aim float gravy train has ground to a halt.

Where opportunity knocks

Bid activity has created a few bright spots as valuations are now so depressed there is scope for private equity-backed management buyouts (MBOs) or mergers & acquisitions. Back in March, media reports suggested staff at Panmure Gordon (PMR:AIM) had been thinking of taking the business private, which is hardly surprising, since the firm’s £31.4 million net cashpile compares with a £30 million market cap. Arden Partners (ARDN:AIM) is in the sights of Indian bidders and last week the news Collins Stewart (CLST) had received an approach sent the shares up 30% on the day (7 August).

Excessive fear of a bear market has also generated juicy trading opportunities. The shares of the London Stock Exchange (LSE) have run up by 37% since Shares (10 July) flagged their attractions bang on the year’s 671p low. The fact the stock has been heavily shorted may explain why the LSE turned sharply as overwrought fears about competition and trading receded, converting short sellers into panic buyers at the flip of a switch.

Spread betting provider London Capital, down 32% since the start of the year versus a 12% fall from rival IG Group, looks like the next opportunity to turn a quick profit as it rerates towards a similar earnings multiple as its peer. In this case, the bears had been worrying about mounting client losses in the sector as investors struggle to keep up with volatile markets. Such fears were firmly put to bed by last week’s interim results.

However, the reason to buy London Capital is far more than just technical. The £114 million cap’s business is in the rare position of offering growth where growth is hard to find. There is much debate about the impact of the past bear market on rival IG – revenues were flat in 2002 – and we do not really know how clients, who at least in terms of equities tend to be net long, will react to the losses incurred since last summer. The market is clearly nervous about client losses dampening activity, since IG’s shares plunged 13% after last month’s full-year results revealed a marked rise in bad debts, betting duties (an indicator of client losses) and decline in year-on-year customer cash balances.

London Capital, however, delivered a clean bill of health with its figures. Bad debts rose by a meagre £1,000 to £8,000. In addition, client cash balances for its spread betting operation at the period end rose 59% year-on-year to £22.3 million, which suggests losses at IG were concentrated among a few clients. Once the market has come to terms with the non-directional nature of London Capital and IG, and the fact clients can prosper so long as there is volatility, both stocks should resume their upward trajectory. Those with long memories will remember IG, or Investors’ Gold, was born out of volatility in gold prices when founder Stuart Wheeler launched the business in the turbulent year of 1974, and Wheeler’s initial offering was a spread betting product on gold.

Analysts have started off the new financial year predicting IG’s revenues to grow at around 20% in the 12 months to 31 May 2009, but investors may expect to see this gradually tick up, given an average annual compound growth rate in revenues of 40% in the past ten years. IG is set to benefit from expanding its contracts for difference (CFD) business into Europe, while overseas expansion is also on the cards for London Capital. The group’s key retail spread betting operation Capital Spreads recently launched a new platform targeting Germany and announced last week it is developing a CFD platform to target international markets – continental Europeans have long used warrants and so can quickly be educated in the other margin products such as CFDs.

Gaining from forex turbulence

ICAP and Tullett have to be the top picks in the sub-sector as they look set to continue to benefit from high volatility in foreign exchange, commodity, credit and equity markets. The Chicago Board Options Exchange (CBOE) Volatility index, or VIX, is a reliable lead indicator of volatility of America’s S&P 500 index and remains at elevated levels (see graph). Last week, the LSE delivered its latest monthly update on volumes and values flowing through its SETS electronic order book. Average daily trades hit an all-time high in January of 913,117, the month America’s Federal Reserve pushed through an emergency 75-basis point cut in interest rates. On the day of that dramatic action (22 January) to prop up the country’s monoline insurers, daily trades on the LSE hit an all-time high of 1.4 million. Nor have trading volumes collapsed subsequently, despite a near-17% drop in the FTSE All-Share index. July saw an average daily trade figure of 794,820, a year-on-year increase of 43%. Granted, average daily values for July, at £8.8 billion, are a fifth down on January’s £11.2 billion, but are constant year-on-year. Volatility, it seems, remains very much alive and kicking (see LSE average daily trading volumes/values chart).

Historically, organic revenue growth at ICAP, the largest inter-dealer broker in the world and so a good proxy for the market as a whole, has been 7%, according to analysts at Kaupthing Singer & Friedlander. Heightened volatility is predicted to drive organic growth up to 10%-12% over the next two to three years says Kaupthing, which suggests there are upgrades to come, given the current single-digit consensus expectations for sales growth in 2009 and 2010 for both ICAP and Tullett.

Earlier in the year ICAP was trading on a 20-plus multiple but, after a 30% fall since January, the shares are now realistically priced on a prospective price/earnings ratio (PE) for 2009 of 13.8. Tullett rightly trades on a lower multiple of 10.2 times’ next years’ consensus earnings forecasts, as electronic broking is much higher-margin than telephone broking, and Tullett derives an estimated 2% to 3% of sales from electronic trades against ICAP’s 21%.

Corporate advisory drought

With Aim IPO volumes having fallen off a cliff since markets took a nose-dive last summer (see table) the backcloth for the corporate advisory businesses has deteriorated significantly. Their fate has not been helped by tougher Aim rules, introduced by the LSE to tackle concerns about the quality of companies joining the junior market. Nominated advisers – the gatekeepers of quality on Aim – are now expected to dedicate more resources to monitoring companies they wish to bring to market. The fate of Nabarro Wells, its reputation shredded following a £250,000 LSE fine, illustrates the dangers of skimping on regulation. Nabarro was eventually sold to Ambrian Capital (AMBR:AIM) for the pittance of £821,000. On top of these pressures the retail and institutional brokerage parts of these businesses have suffered falling volumes. The shares of Blue Oar (BLUE:AIM), Panmure Gordon and Daniel Stewart Securities (DAN:AIM) have all plunged by than 50% this year. This has at least stoked up takeover talk but, to date, this chatter has largely been inaccurate.

Manchester-based broker W.H. Ireland (WHI:AIM) rejected two bids in 2007 and, in April this year, knocked back a third – rumoured to be from Blue Oar. Management, led by chief executive Laurie Beevers, has always fought fiercely for the company’s independence and looks to have secured it after attracting new investors. Spearheaded by Carphone Warehouse (CPW) co-founder David Ross, Conservative party treasurer Jonathan Marland and JJB Sports (JJB) founder David Whelan, this consortium injected about £2.3 million of cash into the business, bolstering an £8.7 million net cash position at the 30 November year end.

Of all the smaller corporate advisory/brokerage businesses the £20 million cap W.H. Ireland looks the most secure, with good asset-backing in its recently refurbished headquarters: as of 30 November last year, W.H. Ireland’s net asset value per share came to 114.3p, against a share price of 101.5p.

Bar the distressed sale of Nabarro, the only takeover deal to complete this year has been the purchase of Hichens, Harrison & Co by Religare Capital Markets, the investment banking arm of Indian financial services group Religare Enterprises. Religare is also reported to have made an approach to Arden Partners. Arden revealed it had received ‘approaches’ back in May, at the same time as it rejected a tilt from Cenkos Securities (CNKS:AIM). Cenkos in turn had previously launched a failed bid for Close Brothers (CBG) jointly with Landsbanki. As of last month’s interims, Arden’s discussions with its suitor were still under way, with two other bidders fingered in press reports, namely Mumbai-based financial services group JM Financial and an Indian investment bank.

Headhunting rules

Those holding out for market consolidation, in the form of larger cashed-up London-quoted brokers picking off the smaller players, are likely to be disappointed. The strategy of Numis’s chief executive Oliver Hemsley is to pick off staff from rival firms, as recently demonstrated by a successful bit of poaching over at Panmure Gordon. Last week’s approach for Collins Stewart again appears to have come from abroad with reports putting an unnamed Asian bank and Australia’s Macquarie in the frame.

For most companies in the sector, investors should expect another disappointing year ahead. There, is, however, a silver lining to this cloud in the shape of the non-directional plays. The derivatives brokers and inter-dealer brokers still offer the potential for good gains, and now is the time to jump aboard, as valuations stand at attractive levels.

CONCLUSIONS: Investment Services

Risk to earnings forecasts: 2 (5=upside risk, 1=downside risk)

Earnings predictability: 1 (5=very high, 1=very low)

Valuation: 3 (5=cheap, 1=expensive)

Balance sheet strength: 3 (5=cash rich, 1=heavily indebted)

Cashflow: 2 (5=very strong, 1=very weak)

Over-owned? 2 (5=all brokers negative, 1=all positive)

TOTAL 13 / 30

Stocks to buy: Tullett Prebon, ICAP, London Capital

Stocks to avoid: Blue Oar, Cenkos, Daniel Stewart

Total Broker Buy Ratings on Stocks: 30

Total Broker Hold Ratings on Stocks: 2

Total Broker Sell Ratings on Stocks: 10

SECTOR RATING: UNDERWEIGHT

SPOTLIGHT

IG set for FTSE 100

With many markets still to conquer IG Group’s profitable expansion looks assured

A leap into the FTSE 100 index awaits IG Group (IGG) at some stage in the future as it taps into a growing European-wide appetite for derivatives trading

via spread bets and contracts for difference (CFDs).

Since re-floating in 2005 revenues have increased four fold to £184 million and the rate of quarterly account openings has also quadrupled to more than 10,000 – and that is just by tapping the UK market. Just imagine what could happen over the next few years following recent expansion into mainland Europe.

Brokers Landsbanki predict revenues will quadruple again to £700 million by 2015. With a market cap of £1 billion the company is valued at around 5.5 times sales so, given the above prediction, it is not too hard to imagine £4 billion capitalisation by then, a figure which would in all likelihood be an entry ticket into the UK’s headline stock index.

IG still faces its challenges, not least the difficult equity market environment of 2008. Given current trading conditions it is no surprise some analysts have started to question whether IG can maintain the 40% annual compound growth it has achieved over the past decade.

That 40% figure does mask some slower periods along the way, since revenues were flat in the bear market year of 2002, and analysts are perhaps wise to have started the new reporting period cautiously with estimates of 20% growth. But IG has a track record of beating expectations so investors should be inclined to believe chief executive Tim Howkins’ assurances IG is less vulnerable to a bear market than the market fears.

The long way round

IG, which stands for Investors’ Gold, has come a long way from its inception in 1974 when founder Stuart Wheeler spotted an opportunity for spread betting on the price of gold. At the time, a period of huge economic turmoil against a backcloth of spiralling oil prices and soar away inflation, the gold price was highly volatile but exchange controls prevented investors buying the metal directly.

Eight years later, IG became the first company to offer spread bets on the FT30, which was the major index of the day before the FTSE 100’s creation in 1984, and in 1995 it became the first to offer bets on individual shares. After floating the business in 2000, Wheeler subsequently sold out to a private equity-backed management in 2003, in a deal which laid the foundations for the business as it is today.

Entrepreneurial flair

With equity ownership spread widely across top management IG has transformed itself into a fully fledged corporate without losing any of the entrepreneurial flair which made it what it is today. In theory IG clients should be able to profit from volatile markets. In practice most of its customers tend to be net long of equities so will have incurred losses during the past year’s market decline.

That said, individual equities are just a small part of overall client activity. IG also offers exposure to currencies, commodities, options and equity indices. It is in these alternative asset classes that customers tend to be more free thinking and go short as well as long. Investors should therefore not become too preoccupied with the direction of markets.

Last month’s full-year results noted client activity and new recruitment had remained healthy in the early stages of the new financial year. But rising bad debt figures saw investors take flight and the stock is down 12% since the start of the year. Analysts remain uncertain about what a bear market means for IG and this, coupled with delays in the launch of a new internet platform, explains their reluctance to predict anything more adventurous than growth 20%.

Margins are likely to take a short-term dip from last year’s 53.5% as IG expands its CFD business into mainland Europe and Spain, Italy, France and Germany in particular. A rapid bounce back to the historic level of 60% still seems a sensible assumption. Meanwhile the rewards of overseas expansion, largely made possible by the European Union’s new Markets in Financial Instruments Directive (MiFID) in November, should quickly reveal themselves in the top line.

CONCLUSION: IG GROUP (IGG) 364p

Risk to earnings forecasts: 5 (5=upside risk, 1=downside risk)

Earnings predictability: 3 (5=very high, 1=very low)

Valuation: 3 (5=cheap, 1=expensive)

Balance sheet strength: 4 (5=cash rich, 1=heavily indebted)

Cashflow: 4 (5=very strong, 1=very weak)

Over-owned? 2 (5=all brokers negative, 1=all positive)

TOTAL 21 / 30

RATING: BUY

TRADES TO MAKE THIS WEEK - BUYS

Sets the standard

ICAP (IAP) 510.5p BUY

The inter-dealer broker will continue to benefit from ongoing volatility in the credit, interest rate and foreign exchange markets. Analysts at Kaupthing Singer & Friedlander Capital Markets calculate the compound annual rate of organic revenue growth at ICAP has been 7% over the past five years. Kaupthing uses this figure as a proxy for industry-wide revenue growth since ICAP is the largest company in the segment. In anticipation of continued and prolonged volatility the same analysts are expecting revenue growth to ratchet up to 10% to 12% over the next two to three years.

This potential for an acceleration in organic growth, when combined with further acquisitive expansion, make ICAP consensus revenue growth forecasts of 9.2% in 2009 and 9.8% in 2010 look conservative, and investors may expect to see earnings upgrades. Citigroup analyst Daniel Garrod is currently at the top end of the forecast range for 2009 with an earnings per share (EPS) estimate of 43.5p compared with a consensus of 39.3p implying potential for upward revisions of more than 10%. A 30% fall in ICAP’s shares from their December 728p peak means the stock has been heavily de-rated along with the rest of the financials this year. A prospective PE of 13.8 for 2009 is attractive, especially as earnings forecast upgrades would make the stock look cheaper still.

Healthy rivalry

Tullett Prebon (TLPR) 455.8p BUY

ICAP rival Tullet Prebon will also benefit from any prolonged volatility in financial markets, and this too has yet to be factored into analyst expectations. ICAP has the more profitable business model given its lead in electronic broking where margins are higher than voice broking. Last year ICAP generated 21% of its revenues from its electronic platforms while analysts at Kaupthing Singer & Friedlander Capital Markets estimate the figure was 2% to 3% for Tullett. This explains Tullett’s lower rating of 10.2 times prospective earnings. Such a discount could disappear if talk of a possible tie-up with New York rival GFI bears fruit, as the two firms combined would be a more formidable competitor to ICAP. Cost synergies would also boost earnings by between 5% and 10% according to Kaupthing but it is the potential for organic growth which makes this company a buy regardless of what happens with GFI. Upgrades seem likely given consensus revenue growth forecasts of 8.1% in 2009 and 6.2% in 2010 versus expected industry organic revenue growth of 10% to 12%. Kaupthing’s Sarah Ing is at the top of analyst forecasts predicting EPS of 45.8p in 2009 which implies potential earnings upgrades of 5% versus consensus EPS of 43.7p.

Ready to perform

London Capital (LCG) 300p BUY

As predicted last week by Shares (7 August) the interims were good, and stock has ticked up by 8%. There should be further returns to come.

The market was reassured last week by news bad debts were stable and client cash balances up. Now the market’s attention is likely to turn to the valuation anomaly between London Capital and rival IG Group (IGG) and investors may expect to see the stock re-rated on to a comparable PE multiple of 16 for 2008 and 13.8 for 2009.

Such a PE, given EPS forecasts for this year of 21.9p from Justin Bates at Daniel Stewart, explains the analyst’s 350p price target and that is before upgrades Bates is planning following last week’s better-than-expected numbers.

Last week London Capital announced plans for a new CFD platform to target international clients. International expansion is a trend well in motion over at IG and the fact London is now looking overseas is another reason why it merits a similar rating to its larger peer. Smaller derivatives brokers run a large ‘principal risk’ where the potential for unhedged client losses to impact earnings is far greater. But it would seem the £110 million cap London Capital is now past this difficult phase so earnings should prove more predictable than implied by the current earnings multiple.

TRADES TO MAKE THIS WEEK - SELLS

Business blues

Blue Oar (BLUE:AIM) 10.3p

Since all of the company’s £17.5 million market cap is covered by a £23.1 million net cash position there is clearly an argument to say Blue Oar’s shares cannot fall much further. That cash level equates to 14p a share versus the 10.5p share price. Unfortunately there is unlikely to be any catalyst to crystallise that value for the next 12 to 18 months, meaning your money is best parked elsewhere.

Blue Oar has been making acquisitions to build a presence in asset management and stockbroking but the company is still very much dependent on corporate advisory work – predominately in the small cap sphere. A cursory glance at new floats and secondary fundraisings on Aim in the past year makes it clear times are tough. April’s bid for WH Ireland (WHI:AIM) was a brave move. Ireland’s broking business would have been a fairly predictable earnings stream, as would its growing wealth-management business.

Further to fall

Cenkos Securities (CNKS:AIM) 115p

The argument for selling Cenkos is much the same as it is for selling Blue Oar. Like its smaller rival, Cenkos is heavily dependant on corporate advisory work which, as conceded in the latest AGM statement, is suffering.

Cenkos is much more highly valued than Blue Oar, with a market cap of £62 million versus a net cash position of £16.2 million, but all this serves to underline is the potential for further share price falls on top of the 49% decline recorded this year.

Cenkos does have a bit of a cushion in that it is reasonably diversified and at the AGM chairman John Hodson said the company would continue to trade profitably.

Last year, however, some £42.1 million of a total £53.8 million in revenue was derived from corporate finance – the bulk of which came from primary work (floats). The company has a reasonably sized institutional brokerage (£7.7 million of sales last year) but other areas of the business, including a market-making business and asset manager, are still in their early stages of development. Failed bids for Close Brothers (CBS) and more recently Arden Partners (ARDN:AIM), leaves the credibility of chief executive Andy Stewart dented.

Hit hardest

Daniel Stewart Securities (DAN:AIM) 3.1p

This is another corporate advisory business which is set to suffer from the downturn in floats and secondary fundraisings. The shares are off 64% so far this year but if the valuation becomes as depressed as Blue Oar there may be further falls yet given the current market capitalisation of £6.7 million remains double the £2.8 million net cash position – although that was the position as reported at October’s interims.

There has been no news on current trading since there has not been an update following the 31 March year end. The last update came at the time of the interims on 24 October when chief executive Peter Shea reported a ‘solid start to the second half’. Last year’s finals were published on 13 August, so the lack of a date for this year’s finals numbers (as at the time of going to press) is not encouraging.

Like Blue Oar, Daniel Stewart plies its trade in the lower market reaches where activity is hit the hardest. At the interims the company noted that the average size of clients had risen in excess of £30 million up from £24 million the previous year, but that is still a small cap client base by any standards.

June’s trading update – ahead of the half-year results on 3 September – flagged a pre-tax loss of £1.1 million in the period and unless the company can expand new income streams quickly there is a danger the cash position will suffer serious erosion.

TREDNSPOTTING

Market recovery required

Deeper weakness could undermine the recent rally

by Simon Griffin

This sector’s latest rally looks like a possible spike low, which might suggest climactic capitulation by the bears leaving the way for the establishing of a new bull trend. Yet the sector must now face a test of the bear channel upper resistance line, which may prompt short-term weakness. It seems the sector must stay above its critical June low (some 21% below current levels) and is a sector to consider further if the whole market is seen to have finally based.

On a capitalisation weighted basis in the recent bull market, the sector outperformed the FTSE 100 by some 70%. Last summer's financial market downturn then began to bite and the sector peaked late last year.

It has since declined by an equivalent of the 61.8% Fibonacci retracement of the preceding 2003-07 bull market. The sector may have based off this level, at least for now, bolstering the idea the sector could be oversold. This is supported by the fact the sector decline has met the target derived from the bear pennant pattern formed in April and May this year.

That said, it would be brave to suggest the blood-letting in the markets is over. Since many of the woes that have resounded around the markets had their origin in some cases with companies operating in this sector, investment services stocks could yet see further weakness. Just as they outperformed on the way up, they will underperform on the way down.

The overall sector has lagged the wider market by a net 20% so far in 2008 and lost some 43% of its value in the first six months of this year.

Shore Capital Group (SGR)

BUY - 39p

TARGET - 64p

STOP LOSS - 35p

A dynamic breakout is encouraging. A minor double bottom pattern may be in place, offering an eventual 46p target. Success in a likely test of the long-term bear trendline would point to 64p and coincidence of the 50% retracement of the recent fall from 96p and previous congestive resistance and support.

In the bull market Shore Capital rose 11-fold to February 2007, in a multi-year move dominated by a bull channel on the log scale chart. As the broader market turned, the shares fell. After a 30% drop to test 66p this time last year, the channel baseline failed and selling continued to a low so far of 29p, seen a month ago. In this fall the 50-day average has capped any upside movement, and the moving average pair I favour has given good signals on a crossover basis - it would have been wise to note July 2007’s ‘sell’ signal. More recently the shares seem to have found support near 30p, helped by the proximity of the minor low seen in June 2004, and appear to have built a bit of a saucer-shaped base pattern. This is usually encouraging but this time it may have been concluded by an upside breakout that has boosted the shares to test resistance from the descending 200-day average. Short term this may have led to some overbuying and there is a risk of a downside correction taking them possibly back to test support at 36p before they kick on again.

Investec (INVP)

BUY - 372p

TARGET - 495p

STOP LOSS - 340p

If a double bottom pattern is confirmed and expected resistance from the coincidence of the 23.6% Fibonacci retracement level and the falling 200-day average currently near 390p can be dispatched, a rise toward a retest of 495p looks possible. The chart shows strong downside support from here in 2006 and 2007 and it can be expected to give similar resistance on the upside.

The share price fall since May 2007’s 765p high has seen a loss of some 63% in market value, but Investec is still the third largest company in the sub-sector. The stock has lagged the FTSE 100 by 50% since its peak and slipped by some 45% relative to the broader general financials sector. The resultant bear trendline can be developed into a bear channel. March's weakness took the share price below 300p and produced a break below the channel return line, then tested the channel top line and tested the return line again in early July. Now the shares have broken above the channel topline and seem to have completed a slanting double bottom formation. The chart could see a move producing symmetry to the March downside break, and could be about to see a new bull trend.