Cenkos Securities — Reinvigorated and looking to the long term

Cenkos is a specialist securities firm that focuses on both corporate and institutional clients. Its main activity is as a stockbroker to UK small and mid-cap companies and investment funds. At end H121 it had 100 retained corporate clients. It has a disciplined approach to controlling fixed costs, which enables attractive rewards for staff when activity is high while containing costs in quiet periods. The reward structure has been modified more recently to provide better alignment with the longer-term development goals of the business and to help support a culture of teamwork and compliance with regulatory requirements.

This year a new leadership team is in place, including CEO Julian Morse who joined the firm in 2006 and led the Cenkos growth companies team from 2016. This has brought new energy and focus to the company in pursuing its goals: to become the number one broker in its core areas; to generate more consistent and sustainable revenue; and to increase total shareholder returns.

In the near term, Cenkos has continued to be active in the second half to date and has a good pipeline of transactions. The AIM market is seeing an increase in the number of quoted companies after a period of decline. While this favourable environment may change, recent history suggests Cenkos is likely to see a certain level of activity among its clients over a number of years (see Exhibit 13). Also, if it can build its client base further (a net six corporate clients added in H121) then the level of sustainable revenue will increase. In H121 non-corporate finance revenue accounted for 61% of fixed costs.

The group has a strong position in terms of both regulatory capital (surplus over Pillar 1 requirement £17m) and liquidity (cash at the half-year end was £24m).

The shares are valued at 1.6x book a level that would be consistent with an ROE of nearly 15%; as noted, this is above the five-year historical average (10%) but on a scenario assuming current fixed cost levels, potential variable costs and historical average transaction volumes and the H121 average fee level we model an underlying return of 15%.

With offices in London and Edinburgh and 92 employees at end H121, Cenkos provides an integrated service as a nominated adviser, sponsor, financial and strategic adviser and market maker to 100 retained corporate clients with a focus on growth companies and investment funds listed or planning to list on the London Stock Exchange Main and AIM markets. The group seeks to maintain long-term relationships with its corporate clients through understanding their businesses and being able to provide both financial and strategic advice as part of delivering good outcomes for them. An indicator of the success of this approach is that nearly half of its corporate clients have been with the firm for more than five years.

Cenkos sees its relationship with institutional clients as based on the quality of its corporate client list and of its sales, research, execution and investor relations services. Cenkos’s research reaches c 1,000 institutional investors. Its trading and market making activity seeks to provide investment clients with liquidity and competitive prices and in H121 maintained a top five market share in 90% of client stocks while making a market in a total of 219 equities and investment trusts.

At its inception in 2005, Cenkos brought together several teams of experienced market professionals who provided the company with a strong network of institutional and corporate relationships, a characteristic that has been retained through more recent management and staff succession. Cenkos itself was listed on the AIM market in 2006. It established a strong track record for fundraising, including a number of larger transactions in addition to a flow of deals for smaller and midcap clients (larger transactions boosted funds raised in some years as shown in Exhibit 1).

Looking at Cenkos’s market position, 73 of its clients are on the AIM market, accounting for 8.7% of the total quoted on AIM at end August. After a period of decline (from a peak of 1,550 in 2008) the number of companies quoted on AIM has increased in 2021 to 836 (August), following a pick-up in IPOs in 2020 and 2021 year-to-date (see Exhibit 12). Cenkos has a good presence in growth areas such as healthcare and technology within a diverse sector exposure (Exhibit 3). The largest single area of exposure is to investment trusts, which account for 22% of Cenkos’s corporate clients and c 58% of the total market capitalisation of its corporate client base. The 22 investment trust clients account for 5.6% of the total number of investment trusts. Cenkos has clients in the fast-growing alternatives area of investment trusts (including Round Hill Music). Two other clients are on the Main market and three on other markets giving the total of 100 clients.

A feature of the business since its formation has been a flexible business model (due in part to the variable components of staff compensation) that has rewarded and helped retain teams while containing costs in periods of weaker corporate activity. This has protected the profitability of the business through market fluctuations, as shown in the chart of revenue and pre-tax profit below. Management succession and evolution in the regulatory environment has meant adjustments in approach and the aim now is to align discretionary variable remuneration with the long-term success of Cenkos rather than simply tracking yearly performance.

Reflecting this approach, the company has demonstrated substantial flexibility of overall costs in response to revenue generation and acted in 2019 and H120 to review and reduce ongoing fixed costs by £3m and £0.8m, enhancing its ability to trade through fluctuating market conditions.

Our next table shows Cenkos’s revenue by segment over the last five and a half years. Corporate finance has accounted for over 70% of the total on average, peaking at 74% in 2017. This income is subject to the timing and size of corporate transactions and variations in the level of these transactions largely explains the substantial moves in overall revenues shown in Exhibit 4, above. Nomad and broking fees are relatively stable given their recurring nature, subject to changes in the number and mix of clients, but research income, already under pressure, was affected by MiFID II implementation, reducing the overall contribution from nomad, broking and research over the period. Finally, execution income is affected by the impact of market moves on the value of shares held as a market maker and, before a change in presentation from 2020, shares received in lieu of fees; between 2016 and 2020 it generated average income of £4.1m.

Exhibit 6 summarises the recent evolution of key performance indicators that Cenkos’s management monitors. The variation in funds raised for clients influences revenue per head, underlying profit and dividend figures. The corporate client count declined in 2019 and 2020 but has increased this year: a positive indicator for the future. Important indicators for resilience of the business are liquidity (cash balance: £24m), regulatory capital surplus (£17m) and non-corporate finance revenue as a percentage of fixed costs (61%).

There was a change in management this year after the announcement in December 2020 that CEO Jim Durkin would retire. Julian Morse was appointed as his successor, taking up his role in May 2021. Julian was appointed as a board member in May 2020, led the Cenkos growth companies team since 2016 and joined the firm in 2006. He has over 25 years’ experience in the City, including previous directorships at Beeson Gregory and Evolution Securities. Other changes included the appointment of Jeremy Osler, co-head of corporate finance and sponsor services and general counsel, as an executive board director. Succession has also taken place within teams across the business, which has given the company a new energy in pursuing its strategy.

Management has set three goals for Cenkos: to become the number one broker in its core business areas by reputation and market share, to generate more consistent and sustainable revenue and to deliver increased total shareholder returns.

To achieve this Cenkos will invest selectively in people, business development and technology. A focus on its core credentials and increasing the client base should contribute to a more sustainable revenue base while increasing the potential upside when market conditions are favourable for equity issuance. Finally, Cenkos will consider adding synergistic activities to augment revenue but this would only be in low-risk areas.

Management regard a focus on maintaining a healthy culture at the firm as essential and to this end is encouraging teamwork, mutual respect and integrity. All staff have an opportunity to contribute ideas and work is being undertaken to increase synergies across the business.

As can be seen in Exhibit 7, Cenkos’s revenue fluctuated in the six-month periods between H119 and H121 but has increased substantially over that time. Following a subdued H119, revenue recovered and 2020 was a strong year despite a hiatus in activity following the onset of the pandemic with full-year revenue increasing by 23%. For H121 revenue almost matched the level earned in H220 and was 37% ahead of H120. The other salient feature to note over this period is the completion of the group’s review of fixed costs initiated in 2019. Although the variable element of staff costs increased with higher revenues, a reduction in fixed costs contributed to the move from a small underlying loss in H119 to a profit of £2.8m in H121.

Within the overall revenue gain of 37% y-o-y in H121, the largest absolute contributor was corporate finance where revenue was up by 38%, while execution revenue trebled against a relatively weak period in which the equity market fell sharply as the COVID-19 pandemic took hold. Nomad, broking and research revenues were 5% lower y-o-y, reflecting a lag before the full benefit of a net addition of six clients in the period (12 new clients added) is seen in revenues.

Other operating income/expense. This line item has now been broken out separately for H121 and 2020 and relates to movements in the fair value of options and warrants received in lieu of fees. Previously this was included within execution revenue. As shown, there was a £0.4m negative item in H120, a period of market weakness, with swing to a positive £0.6m in H220 as markets recovered. H121 saw a small negative item.

Staff costs, before restructuring and incentive plan costs, increased by 59% mainly because of higher variable compensation, but there was also a small net increase in the number of employees (92 at the end of the period versus 89 at end June 2020 and 90 at end December 2020). As a percentage of revenue, staff costs were 65%, above the level of 56% for H120 but similar to the FY20 percentage.

Administrative costs (again before restructuring and incentive plan costs) were virtually unchanged compared with H120 but up £0.5m versus H220, reflecting control over the cost base balanced by selective investment.

The combination of revenue and staff cost growth with stable administrative costs resulted in a 44% increase in underlying operating profit to £2.8m.

Restructuring and incentive plan costs taken together (£1.1m) fell by 8% versus H120 and comprised approximately £0.5m in restructuring costs and £0.6m relating to the short-term incentive plan (STIP, launched April 2020), long-term incentive plan (LTIP, launched May 2021 and focused on senior management) and company share option plan (CSOP, also launched May 2021 for all employees).

After these costs and net finance costs pre-tax profits were 124% higher at £1.7m while a lower tax charge (11%) left diluted earnings per share up 146% at 2.7p.

An interim dividend of 1.25p is to be paid compared with 1.0p for H120. The board aims to continue to return significant value to shareholders through dividends and share buybacks, while managing a level of consistency of dividend payments through periods of market fluctuation. Since admission to AIM in 2006, Cenkos has returned the equivalent of 180.8p per share in cash to shareholders.

In Exhibit 8 we have collated a list of selected transactions carried out in 2021 to date, illustrating the range of client mandates in the period and highlighting the activity following the half-year end including two IPOs (Lords Trading and GEN inCode).

Exhibit 9 shows recent equity market trends underlining the initial impact of COVID-19 last year and the significant recovery that has followed. Since the end of 2020, the relative strength in small-cap equities has been pronounced with a rotation towards higher risk/more economically sensitive stocks. Cenkos’s corporate clients are mainly small and mid-cap companies, with 73 of its 100 corporate clients listed on AIM at end H121. The level of trading activity on the London Stock Exchange Main market order book (Exhibit 10), showed a sharp but short spike after the start of the pandemic, while AIM activity surged more recently in tandem with its period of relative strength. Activity for both markets has returned to more normal levels recently.

The next two charts look at trends in equity issuance on the London Stock Exchange Main and AIM markets. Both markets saw stronger activity in 2020, although this was more marked for the Main market, driven primarily by further issuance with IPO numbers restricted by the market background. Fundraising to support balance sheets played a prominent role after the onset of the pandemic but, starting in September 2020, there was a bounce back in new issuance and fund raising was directed more towards financing M&A and growth. For the eight months to end-August this year, the value of Main market total issuance was 23% lower than the same period in 2020, driven by lower further issuance compared with the very strong prior year period; in contrast, new issuance was up 89% from the subdued 2020 level. In the same period AIM recorded a 42% increase in total money raised including a near-sixfold increase in new issuance and a 19% rise in further issuance. The total raised in the first eight months of this year on AIM (£5.4bn) nearly matched the full-year total of £5.8bn for 2020.

Since the half-year end, Cenkos report it has already carried out two IPOs and a further eight fundraisings, which it sees as demonstrating the strength of the business and its pipeline. While there can be no certainty over how long the current favourable market conditions will continue, the recent strength in small-cap and AIM stocks has created a positive environment for growth-focused corporate clients to raise capital.

To put the variability of corporate finance revenue into perspective it is useful to consider the recent history in terms of number of deals and the percentage of corporate clients carrying out transactions in a year. This is shown in Exhibit 13, where the number of transactions as a percentage of client numbers has averaged 30% over the period, ranging between 25% and 35%. The deal fee has averaged £0.86m over the period, with a high of £1.07m and low of £0.77m. The combined variation in transaction numbers and fee size produced a significant variation in corporate finance revenue between periods (a high of £44m in 2017 and a low of £17.4m in 2019). However, the table gives an indication that transactions continue through market cycles and that, providing Cenkos can maintain or increase its client count, it is likely to be able to achieve a certain level of transactions and revenue over a number of years.

On a longer view, Cenkos’s focus on its goals and culture, attention to control of fixed costs, commitment to maintenance of a strong capital position and investment in staff and technology should help the business to grow through market cycles.

Sensitivities for the business include changes in equity market conditions, the lumpy nature of corporate finance mandates, the loss of key staff, reputational risk, regulatory, conduct and financial risks. We comment briefly on four of these areas below.

Given uncertainty over the incidence of corporate transaction fees, we are not publishing forecasts for Cenkos at this point. However, it is useful to highlight the potential impact of the reduction of fixed costs since 2019 and to bear in mind the average corporate finance activity levels we discussed in relation to Exhibit 13. First, looking at fixed costs, Cenkos indicates that non-corporate finance revenue accounted for 61% of fixed costs in H121, indicating a run rate for fixed costs of c £18m per year currently. If we ignore non-cash incentive plan payments (£0.6m H121, which we assume to continue at a similar or lower rate for the rest of this year and 2022) and restructuring costs (£0.5m H121 and unlikely to be recurring, given the company reports that its restructuring is complete) then revenue would have to fall towards £18m before a loss would be incurred. Alternatively, if we assumed a scenario in which Cenkos achieved its historical five-year average transaction rate of 30 deals at the H121 average fee rate of £0.796m, then total revenue might reach £34.4m and a return on equity of 15% could be earned (making assumptions about variable compensation and allowing for a 19% tax rate). Allowing for an assumed incentive plan charge of £1.2m would reduce the ROE to 12% in this scenario.

Looking at H121 cash flow, the operating cash flow before working capital movements was £3m compared with £2m in H120. Working capital movements were a negative £8.1m versus a £3m inflow (such movements between individual periods are not unusual for stockbroking firms reflecting timing of fees, bonus payments and movements in market-making positions). Tax and lease payments absorbed £0.9m while dividends and share buybacks accounted for a further £2.8m, giving a total cash outflow for the period of £8.8m and closing cash of £24m compared with £32.7m at the end of 2020 and £22.4m at end H120.

H121 net assets at £25.4m were maintained at very close to the year-end level with profits earned broadly balanced by share buybacks and dividends paid in the period.

As noted earlier, the regulatory capital resources surplus above the Pillar 1 requirement has increased from £14.5m at the end of 2020 to £17m underpinning the sustainability of the business and providing some headroom for selective investment.

As we do not currently publish forecasts for Cenkos, we continue to focus our valuation discussion on where the valuation stands in terms of price to book ratio and the implied return on equity based on a ROE/COE model.

After a strong performance year-to-date (up by more than 50%), the shares trade on a price to book ratio of c 1.6x but this is still below the10-year average level of 2.1x (see Exhibit 14). To put this in context, Cenkos earned an ROE of 12% in H121 compared with five- and 10-year averages of 10% and 23% respectively. The 10-year average was augmented by a number of large transactions, which may not be repeated while regulatory costs and MiFID II effects have come into play subsequently. Positively, Cenkos has acted to control costs and is investing to support growth in the future, which should help support returns. Using a ROE/COE model with assumed long-term growth of 2% and discount rate of 10%, the share price at time of writing suggests the market is assuming a return on equity of nearly 15%. This is just below the underlying ROE of 15% calculated in the scenario discussed in the financials section (although above the 12% if we allow for a potential non-cash incentive plan charge).