Cenkos Securities — Uncertain background but resilient model

Exhibit 1 sets out an analysis of the FY21 profit and loss account allowing comparison with the prior two years and shows the two halves of FY21.

Within the overall y-o-y revenue gain of 18% or £5.6m for FY21, the largest absolute contributor was corporate finance where revenue was up 22% or £4.9m on the back of the increased number of transactions and funds raised during the year. Nomad, broking and research revenues were stable, with an increase in the number of clients and hence retainer fees offset by lower commission income on reduced secondary trading volumes. Execution net trading gains increased by 20% even though the level of capital committed was limited to control risk exposure in volatile markets. As the half-yearly figures show, net trading gains were lower in the second half than the first at £1.5m versus £2.4m.

Other operating income/expense. This line item has been broken out separately for 2020 and 2021 and relates to movements in the fair value of options and warrants received in lieu of fees. Previously this was included within execution revenue. This figure swung during 2020 as the market first declined sharply and then recovered following the onset of the pandemic. That year ended with a positive movement while for 2021 there was a small negative change in both halves.

Staff costs, before restructuring and incentive plan costs, increased by 13% mainly reflecting higher pre-bonus profitability and hence variable compensation. The average number of employees was flat at 91 but the year-end number was 95 versus 90 at end December 2020. During the year there were 18 new hires across the firm including recruits from large investment banks and professional firms. Cenkos remains committed to maintaining a high staff to corporate client ratio to support the level of client service it aims for. As a percentage of revenue, staff costs were 65%, slightly below the FY20 percentage (67%).

Administrative costs (also before restructuring and incentive plan costs) were 9% higher than FY20. The main reason for the change was increased transaction costs as a result of higher corporate finance activity.

The combination of the revenue increase of £5.6m and an increase in costs/other expenses of £3.7m resulted in a 47%, or £1.9m, increase in underlying operating profit to £5.9m.

Restructuring costs were lower at £0.4m versus £0.7m with a final charge related to the FY19 restructuring plan being taken in H121. Incentive plan costs increased from £0.9m to £1.4m and included charges relating to the short-term incentive plan (launched in April 2020, due to end H122), long-term incentive plan (launched in April 2021 and focused on senior management) and company share option plan (launched March 2021 for all employees).

After these costs and net finance costs, pre-tax profit was 75% higher at £4.0m while a lower tax charge (14% versus 20%) left diluted earnings per share up 88% at 6.0p.

A final dividend of 3.0p is proposed versus 2.5p for FY20 giving a total of 4.25p (+21%). The board aims to return significant shareholder value by establishing a level of consistency of dividend payments through periods of market fluctuation. It will explore other potential returns of excess capital subject to capital and liquidity requirements. The intention is to purchase shares over time to match unvested share awards and manage the issued share capital.

In Exhibit 2 we show key performance indicators used by Cenkos. Over the six-year period shown, the variation in revenue per head was influenced by the fluctuation in funds raised for clients, which in turn affected the level of underlying profit and dividend payment. The corporate client count was lower in 2020 but, positively, saw a net increase of seven in 2021 including 17 new companies. While the level of non-corporate finance revenue to fixed costs was slightly lower at 54% in 2021 (versus 57% in 2020) this is still an indicator of resilience as is the level of cash on the balance sheet (£33.5m) and the regulatory capital surplus of £15.8m.

Last year’s transactions included two IPOs (Lords Trading and GEN inCode) while early 2022 included two IPOs and an introduction to AIM: Facilities by ADF, Clean Power Hydrogen and Neometals. Cenkos carried out 10% of all AIM fund-raisings in 2021 (8% 2020) and reports that in terms of AIM clients it was ranked second by number and sixth by aggregate market capitalisation according to Corporate Advisers Rankings Guide.

In this section we discuss the background and outlook 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 period of recovery following the initial impact of COVID-19 in 2020 and then a more stable period before macro-economic concerns began to have greater influence followed by the initial reaction to the war in Ukraine. The relative strength in small-cap equities from the end of 2020 to September 2021 reflected a rotation towards higher risk/more economically sensitive stocks. The weakening in the market year to date has been more pronounced for the small cap index but even so, the small-cap index as outperformed by 30% over the period shown. In Exhibit 4 we can see the brief spike in trading activity on the London Stock Exchange Main market order book in early 2020 at start of the pandemic. This was comparable with the levels seen during the global financial crisis but shorter lived. Subsequent activity subsided before rising again with the invasion of Ukraine. AIM activity rose later than the Main market, which reflects the rotation highlighted previously.

The next two charts show levels of equity issuance on the London Stock Exchange Main and AIM markets 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 2021 Main market money raised fell back by 30% to £26.1bn, but on AIM there was a further year of substantial growth with £8.7bn raised (+52%). AIM also saw a small increase in the number companies on the market (up 4% to 852). With 74% of its clients on AIM, Cenkos was more aligned in 2021 with the pattern at AIM, with its £1.2bn of total funds raised for clients representing an increase of 28% from 2021, while funds raised for clients on AIM doubled from £0.4m to £0.8bn.

What next? The potentially far-reaching impact of the war in Ukraine on the global geopolitical climate, and the pre-existing uncertainty over the impact of prospective rises in policy rates and continuing supply-chain disruption, create challenging conditions for market participants. Acknowledging this, Cenkos does not assume earlier favourable market conditions will persist, but it does remain confident in its business model. In addition to cost discipline, which helps contain fixed costs, its focus on providing a responsive client service through fostering a collaborative and entrepreneurial approach in its teams and maintaining a strong balance sheet is designed to allow it to navigate market fluctuations.

Exhibit 7 provides some perspective here, showing the rate of transactions per client since 2016. This highlights the probability that a certain number of clients are likely to want to carry out equity-supported deals over time. As would be expected, the number of transactions fluctuates from year to year (the percentage varied between 25% and 35% in the period shown) but activity does sometimes show surprising resilience and has tended to bounce back following a phase of market uncertainty and muted activity. The number of clients increased last year following a decline from 2018 and the average deal fee (broadly reflecting the deal size and complexity of transactions) also increased for a second year, although was still below the level seen in 2017 and 2018.

Sensitivities for the business include changes in equity market conditions, the loss of key staff, reputational risk and regulatory change. While risks remain significant, considering mitigating measures, Cenkos reports no change in the residual risks in its annual report.

Given the uncertainty over prospective revenues, we do not include estimates in this note. However, it is useful to highlight the impact of the company’s disciplined approach to fixed costs mentioned earlier.

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 FY21 these increased by 13% to £18.6m compared with £16.5m for FY20, but were still 24% below the level in 2018, prior to the restructuring programme initiated in FY19. Ignoring the accrual of incentive plan costs and any restructuring costs (£1.4m and £0.4m respectively in FY21), this would mean annual revenue would have to fall toward £20m before an underlying loss was incurred. Alternatively, on an underlying basis, Cenkos generated an operating profit of £5.9m in FY21, which could fall to £1.8m if revenue fell to the 2019 level of £25.9m or increase to about £6.2m if revenue reached the historical five-year average of £40m (making an assumption about the level of variable compensation, allowing for fixed costs to rise to £20m and factoring in a 19% tax rate versus 14% for FY21).

Looking at cash flow, FY21 operating cash flow before working capital movements and tax was £5.9 versus £5.5m for FY20. Working capital movements are typically volatile between individual periods for stockbroking firms, reflecting the timing of fees, bonus payments and market-making positions. In FY19 there was an outflow of £9.0m, for FY20 there was a positive move of £11.6m while in FY21 there was an inflow of £1.5m. This left net cash flow from operations at £6.6m. After outflows of £1.9m for dividends and £3.1m for share buybacks and with other smaller movements, there was an overall cash inflow of £0.7m, leaving net cash at £33.5m (£32.7m at end FY20).

On capital, as shown in Exhibit 2, the FY21 year-end regulatory surplus over Pillar 1 capital requirements stood at £15.8m versus £14.5m at end FY20.

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 share price is unchanged over three months and year-to-date (compared with average falls of 17%-19% for other quoted UK brokers and 6-7% for US and European investment bank and advisory firms) and is trading at a book multiple of around 1.4x, which compares with a 10-year average of 2.1x (see Exhibit 8). This relatively depressed level can be set in context by looking at the ROE that Cenkos has earned over a number of periods. Taking reported earnings, the FY21 return was 13%, compared with the five- and 10-year averages of 11% and 23% respectively. Historically, Cenkos results benefited from the execution of a number of large transactions, which may not be repeated, while regulatory costs and MiFID II impacts have been 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, and if growth in client numbers and more positive development in the AIM market persist, then this should underpin higher longer-term returns. Using a ROE/COE model and assuming long-term growth of 2% and a COE of 10%, the share price suggests the market assumes an ROE of 13%, matching the FY21 level.