Shore Capital Group — Update 9 May 2016

Shore Capital is an independent investment group with three main areas of business, each with its own drivers providing a measure of diversification and alternative opportunities for generating income: Capital Markets, Asset Management and Principal Finance. Over the last four years these activities have on average contributed respectively 67%, 21% and 12% to revenues (Exhibit 1). Pre-tax profits over the same period have mainly arisen from the Capital Markets activities, but the potential for Principal Finance to make a substantial contribution is evident in the latest results, for 2015, in this case reflecting profits from the sale of German radio frequency spectrum licences (Exhibit 2).

Management notes that since the company’s formation it has had an affinity with entrepreneurial businesses and individuals, aiming to provide them with a professional and personalised service to meet their needs, which might include funding a business, corporate development advice or providing an asset management product/service.

The group’s own entrepreneurial approach is illustrated by its involvement with and investment in a range of businesses including technology, hotel and property companies. This has included the establishment and subsequent acquisition of Puma Brandenburg to allow it to realise the potential of its investments. The acquisition of Puma Brandenburg led to a one-off profit of £63.1m arising from the fair valuation of the assets acquired. This made a substantial contribution to a compound growth in the group’s net assets per share plus dividends of 28% between 1 January 2000 and 31 December 2015 (this calculation includes the end September 2015 NAV of the holding in Puma Brandenburg, demerged in 2010). In 2011 an investment was made in Spectrum Investments, a company formed to acquire an interest (59.9%) in radio spectrum licences across Germany. Some of these licences were sold in 2015, generating net revenue of £9.2m.

Howard Shore (executive chairman), as founder, has overseen the development of the company and is responsible for the strategic direction of the business. Also on the board is Lynn Bruce, a chartered accountant with experience as CFO of wealth management and leasing companies; she chairs the audit committee and is company secretary. Details of board members, including the non-executive directors James Rosenwald III and Dr Zvi Marom, are given on page 13.

Other members of the senior management team are detailed in Exhibit 3, with a notable feature being the average time with the company of over 13 years.

This business has three components: market making, research-led broking and corporate finance. Management guide that they have tended to contribute broadly equally to revenues over time, although in any particular period the lumpy nature of transactions may bias the mix significantly.

Within corporate finance the team offer a full range of services including capital raising, initial public offerings, investor relations, advisory and corporate broking. They act as advisers to a wide range of companies from small to larger cap, aiming to provide services through the life of a company including flotation, mergers, disposals and secondary transactions. Fixed income capability was last year expanded from retail bonds by the addition of corporate bond specialists from Edmond de Rothschild; this is intended to provide mid-cap companies with additional funding options. The combination of the corporate finance team’s collective expertise and the in-house research and market-making teams mean that Shore Capital is able to present itself as a one-stop shop. It regards this and its entrepreneurial approach as differentiating characteristics.

Shore Capital is appointed as broker/joint broker to over 64 companies and, within this number, as Nomad (nominated adviser for AIM-listed companies) to 25 companies. Selected transactions and appointments since the beginning of 2015 are presented in Exhibit 4, giving a flavour of the variety of mandates that have been won and the breadth of the Capital Markets network.

Within the research and sales activity, the sales team was ranked among the top 10 teams for small and mid-cap distribution in Extel surveys for 2014 and 2015 and brings an average of 25 years of experience in financial markets to the task. An average tenure at Shore Capital of over 10 years also provides continuity in relationships with institutional investors.

Research is carried out by 19 analysts, providing IPO, secondary and thematic coverage of over 200 companies. Sector coverage includes consumer, real estate and construction, financials, support services, technology, natural resources and healthcare. The team rank sixth among UK small and mid-cap brokers, with seven sectors ranking within the top five in the 2015 Extel survey.

In market making Shore Capital is the third largest market maker on the London Stock Exchange by volume of trades and number of securities (over 1,500 stocks are covered by the team of 10 market makers). The market making platform is connected to a range of trading platforms including dark pools and crossing networks and has an electronic distribution network including links to institutional and retail brokers and major institutions. Management indicates that on an annual basis the market making activity has been profitable since it commenced 20 years ago and the risk framework helps the team of 10 traders ensure that loss days are a rare occurrence.

The Asset Management business comprises two elements, private client and institutional investments, with total AUM of approximately £770m.

Shore Capital’s range of private client tax-efficient investment products are grouped under the Puma Investments brand and started with the provision of a limited life venture capital trust (VCT) in 2005. The company has raised £30m for its 12th VCT (Puma VCT 12) and the previous fund also raised £30m; they were the largest single company VCT fund-raisings for the 2015/16 and 2014/15 tax years respectively. In total £200m has been raised for Puma VCT funds and £85m returned to investors. The first five funds have been repaid and have each returned the highest total return of their respective peer-groups. The investment approach is to seek asset-backed businesses providing relatively low risk in the context of smaller companies. The Puma EIS product has a similar approach applied to Enterprise Investment Scheme (EIS) qualifying companies and has so far invested in five contracting/asset-backed companies with AUM of £35m.

Two products are intended to provide a shelter from inheritance tax through business property relief: Puma Heritage plc and the Puma AIM Inheritance Tax Service. In both cases holding periods of only two years are required to secure tax relief. The particular appeal of these structures is that the investor retains control of their assets, avoiding the uncertainty that can arise if they are transferred earlier or put in trust. Puma Heritage concentrates on secured lending to SMEs and property finance with the aim of preserving capital and earning stable returns to offset inflation, while the Puma AIM Inheritance Tax Service invests in qualifying AIM stocks, again with a focus on capital preservation. Management sees these products as having particularly strong growth potential, reflecting investor demand and an ageing demographic profile.

Funds managed or advised on the institutional side of the business include Puma Brandenburg, Brandenburg Realty and St Peter Port Capital. As noted earlier, Puma Brandenburg was established by Shore Capital and then acquired, supported with additional capital and demerged. It invests in a mixed portfolio of properties in Germany including 3,000 apartments in Berlin, 32 Lidl stores (following sale of 13 in the first half of 2015) and hotels and commercial units. The Brandenburg Realty fund completed fund-raising in June 2015 (€150m, predominantly from the US) and focuses mainly on the acquisition of high-quality residential buildings in major German cities, particularly Berlin. Shore Capital has made a commitment of €12.5m to the fund, has a 20% interest in the Investment Adviser and Carry Vehicle and will provide local advisory services. The group has a team of 20 in Berlin, including asset managers, architects, finance, legal, sales and lettings staff.

St Peter Port Capital is a pre-IPO fund with significant exposure to natural resources. At the September 2015 half year end, total and net assets were just under £30m and the company reported that, since inception in April 2007, £65.9m has been realised generating a gain of 49% on the cost of those investments. Given the difficult environment in this area and investors’ interest in securing a return of cash, the emphasis is now on realising liquidity or value from its remaining portfolio holdings (currently 25) where possible.

Shore Capital invests its own capital on an opportunistic basis where it sees the potential for attractive returns. In the past investments have been made in property related companies, including Dawnay Shore Hotels and Puma Brandenburg, and a Black Economic Empowerment investment company in South Africa. Currently the main investment is in German radio spectrum licences via Spectrum Investments, as mentioned earlier. Following the sale of national and six regional licences in 2015 to Deutsche Telecom for €15.45m (and net revenue of €12.5m or £9.2m) there are 32 regional licences remaining. These give the right to use the 3.5 GHz range of frequencies (increasingly used for 4G services) in perpetuity. There can be no certainty regarding the potential value that can be realised from these licences, but the group highlights that the licences cover Germany’s largest metropolitan centres including Berlin, Leipzig, Dresden, Düsseldorf and Hanover. Discussions with the regulator are currently ongoing regarding the status of the licences and potential use of the frequencies. The investment was recorded on the year-end balance sheet as an intangible with a gross value, before minorities, of £1.8m.

In this section we describe the recent context in equity market issuance and trading volumes and and touch on the evolution of assets under management within the Asset Management division.

Our first two charts (Exhibits 5 and 6) show the trend in new and follow-on issuance on the AIM market, where Shore Capital is a leading player as a Nomad and market maker. The run up ahead of the financial crisis is evident in Exhibit 5, followed by a dramatic slowdown in the volume of IPOs subsequently. The subsequent recovery has still left the level of new equity issuance at relatively muted levels, with 2015 marking a sharp retreat from the prior year, largely mitigated by an increase in further issues by existing AIM-quoted companies.

For the Main Market, the pattern has been broadly similar, although the peak of the financial crisis was marked by substantial further issuance by banks to help support balance sheets. More recently, as for AIM, new issues fell last year, but further issues meant total equity raised was similar to the prior year (Exhibit 7).

Turning to equity trading activity, this hit a peak as the financial crisis approached and then collapsed with market confidence, subsequently fluctuating in a lower band more recently (Exhibit 8). A softening market in the second half of 2015 appears to have held back trading activity levels, although they ended 2015 only 10% below the average since 2011.

Looking at equity returns as represented by the FTSE All-Share, FTSE AIM All-Share and FTSE Small Cap indices (Exhibit 9), the impact of uncertainty and weakening expectations during 2015 are evident in each case. The chart also underlines the outperformance of small caps over the period and the significant relative weakness of the AIM Index explained in part by weakness in commodity stocks within the index.

Looking ahead, while market volatility has pulled back from the spike early in the year (see Exhibit 10, FTSE 100 Volatility Index), the economic and political background remains uncertain. Concerns include tapering global growth expectations, the outcome of the UK’s EU referendum and evolution of central bank monetary policy. Given this, further episodes of heightened volatility would be unsurprising with an accompanying dampening of the market’s animal spirits and the deferral of new issue plans, for example. On the other hand, global growth is being sustained and with most market participants reporting a good pipeline of transactions, a period of stability could see a strong rally in equity issuance.

The growth in Shore Capital’s private client AUM (Exhibit 11) has so far reflected growth in VCT assets, which in turn have been driven by strong demand (see recent industry issue in Exhibit 12) and the performance of the Puma VCTs. VCT demand looks set to remain robust, potentially helped by changing legislation on pensions. Changes in VCT rules narrowing the scope of possible investments is limiting sector capacity, creating a greater opportunity for the Puma offering, which so far has been less affected than perhaps some of its competitors. Prospectively, however, the bigger opportunity may be in the products providing an inheritance tax shelter, which are not size limited, are flexible and sold throughout the year (Puma Heritage, Puma AIM Inheritance Tax Service).

Institutional assets under management/advice are dominated by the two German property investment companies, where growth will reflect management of these portfolios and trends in the German markets (with an emphasis on Berlin residential). Puma Brandenburg’s NAV has increased threefold from its demerger in 2010 to end September 2015 and the Berlin residential market prospects (not the only factor) still appear favourable based on population growth and supply that continues to lag demand.

The group reported revenues up 3.4% to £42.0m, pre-tax profit of £11.7m, an increase of 40.8%, and earnings per share of 27.1p (+25.5%). No interim or final dividends were declared for 2015 (interim and final payments were 5p each for 2014). Following the sale of German radio spectrum licences, the group also returned cash of £10m to shareholders in November through a tender offer for up to 9.91% of outstanding shares.

The divisional performance highlights the diversification benefit of the group’s different revenue streams. The Capital Markets division was held back by more difficult market conditions. While Shore Capital was the leading Nomad on AIM in terms of IPO proceeds in 2015 and total capital raised for clients was £900m, this compared with a particularly strong figure of £2,400m in 2014. Secondary commissions and market making also faced headwinds and divisional revenue fell by 22%. Pre-tax profits fell by 52% with operational gearing moderated by the profit-related element of costs and the margin was still just above 20% (32%). Selected mandates and appointments in the year were shown earlier in Exhibit 4, including Shore Capital’s first role as a broker to a FTSE 100 company, Wm Morrison Supermarkets. Asset Management recorded a 12% increase in revenue and a similar, 11%, increase in pre-tax profit. Assets under management were £770m at the year-end compared with £680m in 2014, helped by the successful fund-raising for Brandenburg Realty. The implied revenue yield on average assets was 1.3%, an increase from the prior year figure of 1.1%, helped by strong progress in the private client business where management fees on AUM are augmented by administration charges levied on companies to which loans are made. Principal Finance saw a swing into pre-tax profit on the back of the radio spectrum licence sale. As noted earlier, this generated net revenue of £9.2m and, net of a write down of £1.1m relating to the group’s investment in St Peter Port Capital and other costs, pre-tax profit was £5.1m compared with a loss of £1.6m in 2014.

The balance sheet remains strong with available liquidity (cash, gilts and corporate bonds) of £28.7m including cash of £22.1m. Net cash stood at nearly £12.5m and at the year end the group’s £20m working capital borrowing facility was unused.

Shore Capital’s profitability has an obvious sensitivity to market confidence, which can have a positive or negative impact on commission, market making, new issuance and M&A related revenues. Asset management revenue may also be influenced at the margin by swings in investor confidence and hence AUM net flows, but the asset base is likely to be relatively sticky (tax-efficient wrappers and property funds), while specific product launches and product and fee margin mix are other potentially important variables. The group’s on-balance sheet investments may have a lumpy impact on profitability in an individual period as gains (or losses) are crystallised.

Thematically, prospective implementation of MiFID II (January 2018) and the existing downtrend in institutional commissions are likely to maintain pressure on this element of the group’s earnings (fortunately not a major determinant of revenue individually and mitigated by the strength of the Shore Capital offering). Key man risk is a consideration, particularly where a business relies on the entrepreneurial skills of key team members. Here the organisational structure with delegated responsibilities and diversification act to moderate the exposure. Regulatory change could affect a number of areas: within asset management, tax legislation could open or close opportunities for tax products and Shore Capital’s experience in structuring and identifying qualifying investments should stand it in good stead. Capital requirements could be increased for the business as a whole, although with capital resources over three times the requirement for 2015 this seems unlikely to be a constraint for the group.

In this section we consider some peer valuations, a historical comparison of Shore Capital’s own price to book value over time and the sensitivity of the output of a ROE/COE model to assumptions.

Our peer valuation table, Exhibit 13, shows the small number of listed UK brokers. While we suggest it should be treated with considerable caution, given the differences between the companies, it does serve as a reminder of the relatively small number of listed, independent survivors in the market and the significant differences in their size, the returns they earn and the valuation multiples they command. Shore Capital is among the companies that were profitable in the last reported financial year and, while the ROE is some way short of those recorded by Cenkos or Numis, its decision to return capital did help strengthen the return while leaving a generous capital cushion in place.

Exhibit 14 shows how Shore Capital’s price to book ratio has varied over time. The current price to book ratio stands close to its average level over the last 10 years, not suggesting a strong immediate valuation message in either direction, although maintenance of an ROE at or above last year’s level could warrant a higher valuation as outlined next.

We show the output from a simple ROE/COE model adjusted for different ROE and COE assumptions in Exhibit 15 (other assumptions include growth of 5% and a book value of 268.7p). As for any broking/investment banking business, the potential volatility of earnings makes it difficult to assign a sustainable ROE, but for our central assumption we take a return modestly above the central cost of equity of 8% (risk free rate 3.5%, equity risk premium 4.5% and beta 1.0). For comparison, Shore Capital was able to produce an average return of 6.3% between 2007 and 2015, a period that included the financial crisis and a small negative reported return in 2011. The balance sheet also carried excess capital providing resilience and the ability to invest when opportunities arose at the cost of suppressing the reported ROE over these years.

Finally, we include a share price performance comparison to show how the market is attempting to discount broader and stock specific changes in the outlook for the UK-listed brokers. Shore Capital has fared somewhat better than the average over a year, but has been weaker than others more recently. This could reflect a combination of tempering of expectations for earnings reflecting general market background and/or more cautious assumptions about possible realisation prospects. From this point, the scope for positive surprises could therefore be more favourable even though the near-term market background remains challenging. At this stage we think the central output of our ROE/COE model of c 360p represents a reasonable valuation assumption until there are clearer signals on market direction.

In our forecasts for 2016 we have assumed that conditions remain challenging for the remainder of the first half, with continuing macroeconomic and political uncertainty acting as a drag on activity levels in the market. Once the EU referendum has taken place one element of uncertainty may be removed (not in the event the vote is to leave), perhaps paving the way for a more robust end to the year. We have not allowed for any further radio spectrum sales given the ongoing discussions with the regulator. Our EPS estimate of 11.2p (diluted, 12.0p basic) is as a result between the levels seen in 2012 and 2013, prior to the stronger conditions seen in 2014 and the disposal-enhanced 2015 outcome. There would be scope for significant upside if our assumptions prove too conservative.

On the balance sheet, we have flagged earlier the position of strength with net cash of over £12m, available liquidity of more than £28m and a capital surplus of over £20m. In the context of the 1,500 stocks in which markets are made, the net bull positions recorded on the balance sheet are modest with an average level of £1.1m over the last five years (and £1.7m at end 2015). Turning to cash flows, growth in working capital in total has absorbed a net £10m over five years, leaving operating cash flow of approaching £14m, which was augmented by net flows from investing of £3m, supporting the payment of dividends totalling £8m and share repurchases of £11m.