Cenkos Securities — Strong FY20 and positive outlook

The year 2020 was one substantial fluctuation in the equity market background for Cenkos. Following the December 2019 general election, the year started with stronger corporate activity that was halted by the initial impact of COVID-19. A period of increased fund raising to support balance sheets then followed and strength in equity markets sustained capital markets activities through the balance of the year and into 2021. Exhibit 1 provides a summary of FY20 results compared with FY19 and shows the first half/second half split. We highlight the main features below, with comparisons against FY19 unless stated.

Revenue increased by 23%, mainly driven by corporate finance where revenue was 28% ahead. While some of the fundraisings were to support companies’ balance sheets during the pandemic, more were to raise funds to take opportunities for acquisition and expansion. Although the number of stocks in which Cenkos made markets decreased from 237 to 197 reflecting risk appetite, net trading gains from Execution jumped by 77% to £3.5m. To put these figures in a longer-term context, the five-year average for corporate finance is £29.2m and for execution £4.1m. Nomad, broking and research revenue fell 6%, reflecting a lower client count.

Staff costs, before restructuring and short-term incentive plan (STIP) costs, increased 35% reflecting higher variable costs on increased pre-bonus profit, partly offset by a lower fixed cost following headcount reductions. Staff numbers fell from 114 at the beginning of FY19 to 95 at the end of the year and 87 by the end of FY20, giving an FY20 average of 91 versus 111 (-18%).

Administrative costs, again before restructuring and STIP costs, fell by 24%, reflecting the review of fixed costs undertaken in 2019.

As a result, underlying profit reached just over £4m compared with £1.4m in FY19.

The review of overheads initiated in 2019 and further measures taken in H120 resulted in restructuring costs of £1.3m and £0.7m in FY19 and FY20, respectively. The measures were expected to reduce costs by £3.8m per year in total and, based on the group’s measure of fixed costs to non-corporate finance revenue, fixed costs in FY20 were £3.9m lower than in the prior year.

Another element of one-off cost in FY20 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, the cost is accrued from the beginning of 2020 to April 2022, with a charge of £0.9m for FY20. Based on this charge and the accrual periods we estimate the total fair value of the scheme is circa £1.7m with about £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, pre-tax profit was £2.25m compared with £0.15m.

Following the interim dividend of 1p, the board declared a final payment of 2.5p giving a total dividend of 3.5p versus 3.0p for FY19, reflecting confidence in the group’s strong capital position and strategic direction.

In Exhibit 2 we summarise performance indicators for Cenkos between 2015 and 2020. This shows significant recoveries in 2020 versus 2019 in the level of funds raised for clients, revenue per head, underlying profit, cash at bank and non-corporate finance revenue to fixed costs. The latter measure reflects a combination in increased non-corporate finance revenue and lower fixed costs (at £17.0m versus £20.9m) following the restructuring measures mentioned above.

The corporate client base saw a further but smaller decline than seen in 2019 with a net reduction of six to 94 reflecting a combination of client rotation, delistings and acquisitions in large part offset by 18 new client additions. Approximately half of clients have been with Cenkos for over five years.

The regulatory surplus over Pillar 1 capital requirements increased by £1m to £14.5m. The company notes that, while the exact details of the calculation of the new Investment Firm Prudential Regime (which will apply from January 2022) have yet to be settled, it is confident its significant financial resources and transitional arrangements will mean it remains comfortably capitally adequate.

Exhibit 3 sets out a list of selected transactions carried out during 2020 and 2021 to date. This includes four IPOs for FRP Advisory raising £70m, Calnex Solutions (£22.5m), Round Hill Music Royalty Fund ($282m) and HeiQ Materials (£60m). Placings included those for Saltlake Potash ($98.5m), Diversified Gas & Oil (£69.4m) and Venture Life (£45m).

In December 2020 chief executive and founder shareholder Jim Durkin announced his retirement. Julian Morse has been appointed as his successor, subject to FCA approval. Julian was appointed as a board member in May 2020, has 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 to senior management included the appointment of Jeremy Osler, co-head of Corporate Finance and Sponsor Services & General Counsel, as an executive board director, subject to approval by the FCA.

The board approved a strategic plan put forward by the incoming management team. The plan provides continuity and evolution, building on existing dual strengths in corporate finance and broking while ensuring increased collaboration between sector teams. Two taskforces addressing capital markets and business development will seek to increase synergies across the business. A reformed executive committee is engaged with firm-wide development, governance and deployment of enhanced systems and processes to deliver increased performance and service levels. The group sets out four strategic objectives:

Exhibit 4 sets out the recent equity market trends highlighting the initial impact of COVID-19 last year and the significant recovery that has followed. Since the end of 2020, the bounce back in small-cap equities has been most pronounced as market sentiment rotated towards higher risk/more economically sensitive stocks. In total, 74% of Cenkos corporate clients were listed on AIM at end 2020. Exhibit 5 illustrates the trading activity level on the London Stock Exchange order book, showing there was a sharp but short spike in activity after the start of the pandemic. This was comparable with the levels seen during the global financial crisis but shorter lived. Subsequent activity subsided to earlier levels but has increased to some extent more recently.

The next two charts look at trends in equity issuance on the London Stock Exchange Main and AIM markets. 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 after the onset of the pandemic but, starting in September, there was a bounce back in new issuance and fund raising was directed more towards financing M&A and growth. Total funds raised on the Main Market in 2020 increased by 122% and on AIM by 50%.

Looking ahead, the strength in the equity market after the early impact of the pandemic, particularly for smaller-cap and AIM stocks, provides a helpful background for continued equity issuance. In its annual report Cenkos commented that its 2021 business pipeline is healthy.

Sensitivities for the business include changes in equity market conditions, the loss of key staff, reputational risk and regulatory change. Changes in risk mentioned by the company in its assessment include an increase in residual risk given the reduction in number of retained clients, increased threats to IT security following the pandemic, and global economic stress induced by COVID-19. Mitigating measures and the further strengthening of the financial position of the group in 2020 are positive factors.

Given the continuing uncertainty over prospective revenues, we do not include estimates in this note. However, it is useful to highlight the impact of the measures to contain fixed costs mentioned earlier (total underlying fixed costs in FY20 of £17m compared with £20.9m for FY19). Ignoring the accrual of STIP costs (we estimate £0.9m in 2020 and c £0.6m and £0.2m in FY21 and FY22, respectively) and any restructuring costs (£0.7m FY20), this would mean annual revenue would have to fall toward £17m before an underlying loss was incurred. Alternatively, on an underlying basis, Cenkos generated an operating profit of £4.0m and an ROE of 14% in FY20, which could rise to about £6.5m and 19% respectively if revenue reached the historical five-year average of £41.2m (making an assumption about the level of variable compensation and factoring in a 19% tax rate versus 12% for FY20).

Turning to cash flow, operating cash flow before working capital movements and tax in FY20 was £5.5m. Working capital movements are typically volatile between individual periods for stockbroking firms, reflecting the timing of fees, bonus payments and market-making positions. In FY20 there was a positive move of £11.5m compared with an outflow of £9.4m in the prior year. There were outflows of £1m for dividends and £2m for share buybacks and, with other small movements, there was an overall cash inflow of £14.4m, leaving net cash at £32.7m.

On capital, as shown in Exhibit 2, the FY21 year-end regulatory surplus over Pillar 1 capital requirements stood at £14.5m compared with £13.5m at end FY19.

As we are not publishing forecasts for Cenkos, we focus on where the valuation stands in terms of the historical price to book multiple and look at the implied ROE based on an ROE/COE model.

The shares are trading at a book multiple of around 1.4x, which compares with a 10-year average level of 2.2x (see Exhibit 8). This relatively depressed level can be set in context by looking at the returns on equity that Cenkos has earned over a number of periods. Taking reported earnings, the FY20 return was 7%, significantly below the five- and 10-year averages of 10% and 23% 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 control over fixed costs should help protect profitability as set out in the Financials section. Using a ROE/COE model and assuming long-term growth of 2% and a COE of 10%, the share price suggests the market assumes a ROE of 13.5%, still below the 14% underlying FY20 ROE we calculated in our illustration in the Financials section.