Cenkos Securities — Gained market share in tough conditions

Exhibit 1 sets out an analysis of the FY22 profit and loss account with the previous two years shown for comparison and also the first and second halves of FY22.

Total revenue fell by £17m or 46% to £20.3m for FY22. Corporate finance, down 52%, accounted for £14m of the reduction. Reflecting the market background, funds raised for clients in FY22 were less than half the FY21 level at £524m (see Exhibit 2). Positively, nomad, broking and research proved resilient, supported by recurring retainer fees and a net increase in the client list; revenues for the division increased by 7%. Even though there was substantial market volatility, execution net trading gains for the year remained positive. Nevertheless, net gains decreased by 87% to £0.5m and there was a small loss in the second half.

Staff costs, excluding restructuring costs and incentive plans, were 48% lower given the reduction in pre-bonus profitability and hence variable compensation. Underlying staff costs as a percentage of revenue dropped slightly to 62% compared with 65% in FY21. The average number of employees increased to 97 (FY21: 91). Cenkos continues to make selective hires to strengthen its capabilities. Appointments have been made in sponsor services, M&A and group management.

Administrative expenses, excluding restructuring costs and incentive plans, decreased by 4% mainly due to the decrease in transaction costs associated with corporate finance deals.

A £12.8m reduction in total underlying costs enabled Cenkos to remain in underlying profit albeit £4.1m or 95% lower than in FY21.

In order to reconcile underlying with reported operating profit we need to add back the day one value of options and warrants and adjust for changes in their fair value. Charges relating to restructuring and incentive plans are also deducted. In FY22 the main items were a £2.2m reduction of fair value of options and warrants (shown under other operating income/expense) and a £1.3m charge, almost all relating to incentive plans.

After a small net interest item, the result was a pre-tax loss of £2.7m compared with a profit of £4.0m in FY21.

Keen to maintain its unbroken dividend distribution record but acknowledging the tough market and reduced revenue level, Cenkos proposed a final dividend of 0.5p, bringing the total for FY22 to 1.5p per share, down from 4.25p in the previous year.

Exhibit 2 shows the key performance indicators used by Cenkos. Variations in revenue per head over the six years broadly reflect changes in funds raised for clients and hence revenues, which then feed through to the underlying profit. The corporate client count fell between 2017 and 2020, but growth subsequently resumed, with 17 new clients added in FY22 resulting in a net addition of six companies to the list after churn/M&A activity. Unsurprisingly, given the reduction in execution revenue, non-corporate finance revenue as a percentage of fixed costs fell by 16 percentage points to 38% over the year. As noted earlier, this implies that fixed costs were effectively held at the prior year level. Cash flow is discussed in the financials section, but in broad terms the reduction in cash from £33.5m to £14.2m mainly reflected lower profitability combined with the payment of prior year bonus awards, share buybacks and dividend payments.

The group is not showing the regulatory surplus metric following the introduction of the Investment Firms Prudential Regime (IFPR) at the beginning of 2022, which means comparable figures will not be published. The group notes that under the transitional arrangements, its overall regulatory capital requirement is similar to prior periods and at the year end it held regulatory capital of £20.4m, which was in excess of the requirement. Maintenance of a strong balance sheet and capital position enabling the group to grow opportunistically remains one of the board’s strategic objectives.

Against a background with low levels of activity, Cenkos indicates that it gained market share, advising on transactions accounting for 15% of total funds raised on AIM. This included the three largest initial public offerings (IPOs) by money raised (Facilities by ADF, Clean Power Hydrogen and Sondrel, which accounted for 55% of funds raised on AIM in relation to new issues). The latest AIM adviser directory shows that, for those companies with an identified adviser, Cenkos ranked second by number of roles with a share of 8% (finnCap ranked first with 9%) and fourth by market cap, again with a share of 8% (Numis first with 17%). The average market capitalisation for Cenkos clients was just above the overall average at £122m and this compared with £72m for finnCap and £636m for Numis, for example.

In execution services, Cenkos maintained a top three market share in 68% of client stocks (74% in FY21) and has expanded the number of AIM and Main Market stocks in which it makes markets from 231 to 315, extending its sectoral coverage within areas where it already has representation. Its risk criteria are maintained.

In this section we discuss the trading background for Cenkos, including charts showing the recent performance of the UK equity market and levels of trading volume on the Main and AIM markets.

Looking at the UK equity market, Exhibit 3 shows the initial impact of COVID-19 in 2020 and then a period of recovery before macroeconomic concerns began to have greater influence, followed in 2022 by the initial reaction to the war in Ukraine and then the September mini budget. More recently markets strengthened as inflation/interest rate expectations moderated, although the recovery has stalled as opinions on the rate outlook continue to fluctuate. Periods of relative strength in small-cap equities, such as that from the end of 2020 to September 2021, reflected a rotation towards higher-risk/more economically sensitive stocks. Exhibit 4 shows trading activity levels on the Main Market and AIM, with each seeing spikes at different points following the pandemic, but both trending down more recently. For AIM, the average daily value traded in 2022 was down 32% compared with 2021, while for the Main Market the average was 4% higher.

The next two charts show levels of equity issuance on the London Stock Exchange Main Market and AIM since 2010. For both markets, activity strengthened in 2020, driven mainly by further issuance, with IPO numbers restricted by the market background. Fund-raising to support balance sheets played a prominent role for the Main Market in 2020 after the onset of the pandemic, but the subsequent bounce back in new issuance and fund-raising was directed more towards financing M&A and growth. In 2022, Main Market money raised fell by 68% and on AIM the reduction was 73% following three years of growth. Unsurprisingly given the fragile state of market confidence, the contraction in new issuance on AIM was particularly marked at 93% and total money raised in 2022 was down 73% compared with 2021, at the lowest level since 2003.

In the first two months of the current year, the level of activity on the Main Market and AIM has been lower than the same period last year but above the H222 run rate by 34% and 30%, respectively, bearing out Cenkos’s indication that the tough conditions seen last year have eased slightly.

Exhibit 7 provides further perspective by showing the annual rate of transactions for Cenkos’s clients since 2016. This highlights that a certain number of clients are likely to want to undertake equity supported transactions over a period of time. The number of transactions can be seen as a function of the nature of the client base, the number of clients, market conditions and the ability of the Cenkos team to execute. As would be expected, the number of transactions fluctuates between years, but between 2016 and 2021 the number of transactions as a percentage of the client base was between 25% and 35%, underlining how marked the reduction in activity to 15% in 2022 was.

A further variable as far as revenue is concerned is the size of transaction and nature of the mandate and this is evidenced in the table by the average deal fee. Here the range in the period shown was from just below £0.7m to just over £1.0m, with the latest value only slightly below average at £0.8m. To support improvements in the rate of transactions and average deal fee, Cenkos aims to be a long-term partner to ambitious companies potentially seeking equity capital to help support growth.

Given the uncertainty over prospective revenues, we do not include estimates in this note. It is nevertheless useful to consider the potential impact of the group’s model, which incorporates a disciplined approach to controlling fixed costs and alignment of remuneration with the long-term success of the business.

Each year Cenkos reports the percentage of fixed costs covered by non-corporate finance revenues (see Exhibit 2), allowing us to track an indicated level of underlying fixed costs. In FY22 these increased only marginally to £18.7m. Allowing for some impact of inflation in costs, we assume this could rise to nearly £20m. Ignoring the accrual of incentive plan costs, any restructuring costs or movements in the value of options and warrants, this would mean annual revenue would have to be £20m or below before an underlying loss was incurred. A recovery in revenue to £32m (in line with the five-year average) or £40m would generate pre-tax underlying profits of £3.4m or £5.8m respectively (making assumptions about the level of variable compensation); applying a tax rate of 25%, return on equity in these scenarios would be 10.5% and 17.9%.

Turning to cash flow, FY22 operating cash flow before working capital movements was modestly negative at £0.8m compared with an inflow of £5.9m in FY21. Working capital movements tend to be volatile between periods for stock broking firms and in FY22 there was a working capital outflow of £11.4m (a £1.5m inflow in FY21) with lower bonus accruals a factor here. After tax the net operating cash outflow was £12.8m. Share buybacks and dividends absorbed £5.4m (FY21: £5.0m). There were other net negative movements of nearly £1.0m, leaving an overall outflow of £19.2m and cash of £14.2m.

As we do not currently publish forecasts for Cenkos and last reported earnings were negative, our valuation discussion is focused on the historical price to book ratio and the current implied sustainable return on equity based on an ROE/COE model.

Reflecting its capital markets exposure and bias towards small and mid-cap corporate clients, the Cenkos share price is down 24% over 12 months. This is similar to the average for other UK quoted brokers but weaker than the average for the larger US and European investment bank and advisory businesses (down 12% over the same period).

At a price of 42p the shares trade at a book multiple of 1.1x compared with the 10-year average of 2.1x (see Exhibit 8). Based on an ROE/COE model, assuming growth of 2% and a discount rate of 10%, the shares discount a sustainable ROE of 10.8%. This is in line with the average for FY17 to FY21 based on reported earnings and including the depressed result for FY19. It is also similar to the level that would be earned on an underlying basis if revenue returned to its five-year average level (FY18–FY22); see the Financials section above.