Cenkos Securities — Strong activity and lean cost base

Cenkos is an independent specialist institutional stockbroking company with offices in London and Edinburgh, with 89 employees at end H120. It provides an integrated service as a nominated adviser, sponsor and financial advisor to c 97 client companies with a focus on growth companies and investment funds listed or planning to list on the London Stock Exchange Main and AIM markets. At its inception in 2005, it brought together a number of teams of experienced market professionals who provided the company with a strong network of institutional and corporate relationships, a characteristic that has been developed since then. This has enabled Cenkos to establish a strong track record for fund-raising, including a number of larger transactions in addition to a flow of deals for smaller and midcap clients (see Exhibit 1). Cenkos itself was listed on the AIM market in 2006.

The group seeks to maintain long-term relationships with its clients through a focus on understanding their financing needs, maintaining continuity of key staff and delivering good outcomes for them. An indicator of the success of this approach is that, as at the end of 2019, 45% of its corporate clients had been with the firm for more than five years.

A feature of the business since its formation has been a flexible business model 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 above. The regulatory environment has evolved and the group’s remuneration policy reflects this, with the aim being to align discretionary variable remuneration with the long-term success of Cenkos rather than simply tracking yearly performance. The company has still 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 four 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 2, 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 shares received in lieu of fees; between 2016 and 2019 it generated average income of £4.3m.

The group has straightforward strategic objectives, reflecting its role and the existing and prospective client base:

Details of group board members are given on page 10. The group board currently comprises three non-executive directors and two executive directors: Jim Durkin (CEO) and Julian Morse (head of Growth Companies). The non-executive chairman, Lisa Gordon, took up her position in June 2020 and brings more than 25 years of experience in executive and non-executive board roles in quoted and private companies. Julian Morse also formally joined the board in May 2020; he is head of the Growth Companies team and is one of the founding members of the team, having joined Cenkos in 2006.

The majority of the management team joined the company at or around the time of its formation and have substantial experience in the securities industry, providing the business with continuity and a range of well-established business relationships.

In a period characterised by initially stronger corporate activity post-general election and then the impact of COVID-19, Cenkos generated a strong increase in revenue compared with a weak H119. It also moved from loss to profit year-on-year and delivered a sequential increase in profits despite a reduction in revenue versus H219. Exhibit 3 provides a summary of the H120 results compared with H119 and H219 and we comment on the main features below, with comparisons against H119 unless stated.

Revenue increased by 22%, driven by Corporate finance where the gain was 48%. The level of funds raised for clients (£340m) was similar to the prior year and the number of transactions (11) was the same, indicating a richer mix of mandates in terms of fee generation in the current year.

While some of the fund-raisings were to support companies’ balance sheets during the pandemic, more were to raise funds to take opportunities for acquisition and expansion. Reflecting this, the average price discount achieved for placings in the period was 5.4% (compared with the previous day’s share price).

Nomad, broking and research revenue fell 6%, reflecting a lower client count. There was a net loss of three clients since the year end, comprising eight new clients and 11 departures, five of which were delisted or taken over. Execution revenue fell 52%. This reflected the sharp fall in equity market levels as the pandemic took hold. Even so the execution business still generated gains, making markets in 185 stocks, and maintained a top three market share in 80% of client stocks.

Staff costs, before restructuring and short-term incentive plan (STIP) costs, increased 16% yo-y reflecting higher variable costs on increased pre-bonus profit, partly offset by a lower fixed cost following headcount reductions (staff numbered 95 at end 2019 versus 114 at the beginning, falling to 89 by the end of H120).

Administrative costs, again before restructuring and STIP costs, fell by 18% y-o-y and 19% sequentially, reflecting the review of fixed costs undertaken in 2019.

These moves resulted in an underlying profit of nearly £2m in H120 compared with a small operating loss in H119. Importantly this was also ahead of the profit of £1.5m recorded in H219 despite lower revenues sequentially, a result that reflected the benefit of the cost reduction measures undertaken.

The review of overheads initiated in 2019 resulted in restructuring costs totalling £1.3m, of which £1.1m fell into the second half. As noted above, there was a headcount reduction of 19 during the year and staff and other costs were expected to be £3m lower in 2020 as a result. Further cost reduction measures were taken in H120 with the headcount falling by six to 89. Restructuring costs were nearly £0.7m in the period and the ongoing cost benefits are put at £0.8m in a full year.

Another element of one-off cost in H120 was the STIP, which was put in place in April to retain and incentivise staff. This was funded by shares already held in the employee benefit trust (the net asset value of the company had already been reduced by the purchase of these shares with the cost taken straight to equity). The shares vest on the first and second anniversaries of the scheme (April 2021 and 2022). While the grant of the shares is one-off by nature the cost is accrued over the period from the beginning of 2020 to April 2022 with a charge of £0.5m for H120. Based on this charge and the accrual periods we estimate the total fair value of the scheme is circa £1.7m with £1m of this charged to the P&L in 2020, approaching £0.6m in 2021 and the balance in H122.

After the restructuring and STIP costs and the relatively small investment income and finance cost items, H120 pre-tax profit was £0.75m compared with a loss of £0.20m in H119 and a profit of £0.34m in H219.

The interim dividend was 1p compared with 2p in H119. It is in line with the 1p final dividend for 2019, which was announced in April at a time when the group faced similar circumstances, with an encouraging pipeline but an outlook that is clouded by COVID-19. In the next section we provide further detail on the market background and outlook.

Exhibit 5 sets out the recent equity market trends showing the initial impact of COVID-19 in March followed by a recovery. The CBOE UK Alternative 100 (AIM issuers) index has staged the most marked recovery and is marginally up year to date, while the all-companies and small companies indices are down 21% and 22% respectively; 78% of Cenkos corporate clients were listed on AIM at end 2019.

Exhibit 6 shows trading activity levels (here for the Main Market) showing that the volatility-induced spike in transactions was both sharp and short, when compared with the global financial crisis.

The next two charts look at trends in equity issuance on the London Stock Exchange Main and AIM markets. For both markets, activity year to date has been dominated by further issuance with IPO numbers restricted by the market background. Looking at the Main Market first, total issuance in the first nine months of the year increased by 72% y-o-y reflecting in particular fund-raising undertaken to support balance sheets as the pandemic and countermeasures made an impact. In September there was a bounce back in new issuance and for the third quarter as a whole total issuance increased by over three times compared with Q319. For AIM the equivalent figures are positive but the swings in activity have been less dramatic. Total issuance for the first nine months was 44% ahead, while Q320 versus Q319 has seen a 68% increase.

The next table shows selected transactions undertaken by Cenkos year to date, as shown on its website. In addition to these transactions we note that the completion of the acquisition of Share plc, a Cenkos corporate client, took place just after the half-year end. The table shows the continuation of activity following the half-year end and in its outlook comments the group refers to an encouraging current pipeline and indicates that it is continuing to win new clients.

In terms of the prospective market background, the progression of the pandemic and related restrictions is a prominent source of uncertainty, while the outcome of the US presidential election and progress on Brexit negotiations are other potentially important influences on market sentiment.

For Cenkos itself, continued benefits from the cost reduction measures undertaken last year and in H120 will be positive factors irrespective of the level of revenues achieved.

We have already mentioned a number of sensitivities for Cenkos’s business and here provide a brief summary of some key factors to monitor.

Given the continuing uncertainty over prospective revenues, we do not include estimates in this note. However, it is useful to highlight the potential impact of the measures to contain fixed costs set out earlier. The underlying administrative costs excluding staff costs reported for H120 of c £3.5m (Exhibit 4) point towards an annual run rate of c £7m. Following the further headcount reduction in the first half, we would estimate an annual run rate of fixed staff-related costs of nearly £10m, giving a total run-rate underlying fixed cost figure of c £17m per annum. Ignoring the accrual of STIP costs (£1m in 2020 and approaching £0.6m in 2021, we estimate) and restructuring costs (£0.7m H120), this would mean that annual revenue would have to fall toward £17m before an underlying loss was incurred. Alternatively, if we assume the same level of revenue as reported for 2019 (£25.9m), use £17m of fixed costs and make assumptions about the level of variable compensation then this would give an underlying profit of over £3.0m and a return on equity (ROE) of approximately 11% (all pre-STIP/restructuring).

Looking briefly at H120 cash flow, operating cash flow before working capital movements and tax was £2m. Working capital movements are typically volatile between individual periods for stockbroking firms, reflecting the timing of fees, bonus payments and market-making positions (although the net exposure here is closely controlled). In the first half there was a positive movement of £3m, while in the four years to 2019 movements averaged out and there was a marginal net negative movement on average. There was little movement in investing activities and under financing activities there was an outflow of £0.5m for dividends, largely offset by a lease incentive received and £0.9m was spent on share buybacks. This left cash at £22.4m versus £18.3m at end 2019.

On capital, as shown in Exhibit 4, regulatory surplus over Pillar 1 capital requirements stood at £15.8m compared with £15.9m at end H119 and £13.5m at end 2019.

Given that we are not currently publishing forecasts for Cenkos, we focus here on where the valuation stands in terms of the historical price to book multiple and look at the implied ROE based on an ROE/cost of equity (COE) model.

The shares currently trade at a book multiple of around 1x, which compares with a 10-year average level of 2.2x (see Exhibit 10). This relatively depressed level needs to be viewed in the light of the returns on equity that Cenkos has earned over a number of periods. Taking reported earnings, the annualised H120 return was only 5%, well below the five- and 10-year averages of 17% and 24% respectively. Historically, Cenkos benefited from an ability to execute a number of large transactions, which may recur but are unpredictable, while regulatory costs and MiFID II impacts are permanent negative changes. Against this, Cenkos’s flexible operating model and cost discipline should help protect profitability as we demonstrated in our discussion in the Financials section. Using an ROE/COE model and assuming long-term growth of 2% and a cost of equity of 10%, the current share price suggests the market assumes a return on equity of 10.3%, similar to the 11% return on equity we calculated in our illustration in the Financials section.