Companies with Culture
The noise around Woodford’s humiliation last week was deafening. And it was a bad week for Hargreaves Lansdown (-14%). I don’t recall such a lot of noise around a fund manager since the demise of New Star in 2008 having paid a special dividend to shareholders and gearing up into a bear market. As one anonymous fund manager put it to me “It shows the perils of greed and believing one’s own press”. But with only one other director of Woodford Investment Management one can’t help but wonder if proper corporate governance had been in place the liquidity issues would have been addressed earlier.
Frequently in an industry that is very attractive it is easy to become complacent. Asset Management is a great industry. It has the accolade of being criticised in the FCA Asset Manager Review of 2017 for making consistently high margins where the average operating margin of firms surveyed was 34%. My colleague, Maynard Patton, posted an excellent review of Jupiter Asset Management last week as their high returns had caught his beady eye. But if the culture is wrong mistakes can be made.
Culture Matters
High return businesses frequently bring about complacency. Provident Financial springs to mind as an example. Businesses facing slowing growth can be tempted to take excess risk. I think that’s why fund managers are sometimes heard to say they aren’t keen on acquisitive businesses. Acquisitions are frequently a way of covering up reducing returns and involve higher risk than organic growth. Charles Taylor Consulting PLC is an example of this where growth has been manufactured by acquisitions resulting in growth at reducing ROE’s meaning the share price has gone from 290p 20 years ago to 224p today.
Source: Charlton Illingworth
The underlying business at Charles Taylor Consulting 20 years ago was a high return mutual management management business where the contract relied on using the clients balance sheet for working capital so was a wonderfully high ROE business that was low growth. And so, 20 years of acquisitions has manufactured growth at the expense of ROE. The share price tells us which matters more.
One notable example of excessive risk taking was Provident Financial. As a subprime lender the job of the company is to allocate capital efficiently and consequently ROE is a vital metric. And yet the incentivisation of the management was on EPS targets and total shareholder return, effectively incentivising management towards growth.
The result was growth from 2006 to 2016 while ROE started to decline in 2013:
Source: Sharepad
The drive for profit growth resulted in the poor culture requiring the FCA to intervene while shareholders took significant pain:
Source: Sharepad
Subsequent events
Non-Standard Finance recently proposed a nil premium all paper bid for Provident which was blocked by minority shareholders last week. A scan of their Non-Standard Finance’s remuneration report reveals that management receive 15% of any increase in the market capitalisation above 110p per share by December 2020. With the shares trading at 46p it becomes understandable that a significant “roll of the dice” may be required to get value from the LTIP.
Importance of Remuneration
One insight into the culture of a company can be seen from the remuneration reports.
Having surveyed 79 companies’ annual reports in my specialist sector only 5 disclose that they use ROE in their incentives which is surprising low, particularly in the financial services sector. Those five are Arrow Financial, Close Brothers, Investec, Rathbone, and TP ICAP. All of these are lenders, except for TP ICAP, where Terry Smith was once CEO and understands the importance of ROE.
Portfolio Construction
Culture is subjective, but remuneration reports are important. There does appear to be a correlation. Where management have a significant shareholding, the company tends to eschew LTIP’s. Only Interregnum have the confidence to publicly state that in their view they promote “dysfunctional behaviour”. Amongst the companies that eschew LTIPS are: Integrafin, Jarvis Securities, AJ Bell , and Manolete. These appear to be companies where the culture is healthy, but the ratings are generally high.
Source: Sharepad, Prospectus
Screen
Having met the management of all the above four companies it seems to me the culture is one of innovation combined with energy and conservatism which may be enabled by the management stake in the business. Searching for young companies with motivated management alongside low valuations with a strong ROE is restrictive. There aren’t many. A screen of AIM stocks for a forecast PE Ratio below 17X, Director holdings of 10% to 40% (higher may imply they are effectively a private company) and a ROE above 20% provides a list of just 7 companies out of the 1,148 companies listed on the market.
Source: Sharepad
Let us look at the first two of these.
Dart Group
Share Price 898p
Mkt Cap £1,327m
History
Formed in 1971 and bought out by the current CEO and Chairman, Philip Meeson in 1983 the company’s roots are in flying fresh produce and other freight around Europe. Fowler- Welch, a road transport business was acquired in 1994 and the passenger airline Jet2 was launched in 2003. Last year the Fowler Welch logistics business produced £4.4m PBT while the leisure travel business produced £130.2m PBT. While the logistics business derives from an acquisition many years ago the Jet2 business, which has been far more successful was launched organically. Philip Meeson currently holds 37% of the company. The company is based in Leeds.
Investment Case
The profits from entering the package holiday market have soared over recent years:
While logistics has been cash generative but lacks growth:
The result has been growth in revenues and importantly ROE
Source: Sharepad
Threats
Airlines are a competitive area with one of the longest lists of bankruptcies. Warren Buffett said in 2013 that investors “have poured money into airlines for 100 years with terrible results” – before buying into US airlines in 2016. Perhaps the world has changed. Perhaps with financial restraint, technology and big data to enhance efficiency, more efficient planes and the demise of trade unions the world has changed in Buffet’s view. But maybe also this company has a competitive advantage.
Competitive Advantage
With Jet 2 starting organically my own view is the reason for their success can be read in the chairman’s statement from 2012. “We devote great effort to knowing and understanding our customers better”. And “whilst a customer’s travel history is always a great indicator of what they may do next we have gone a step further by enriching our data”. By 2018 the language has become more corporate speak with “our customer focussed flying programme”. The Chairman’s statement is all about service. Somewhat different to Ryanair and easyJet. The culture of this company is plastered all over the narrative of the annual report with numerous repetitions of the strap line below:
Remuneration
There is a Senior Executive Incentive Plan “SEIP” which Philip Meeson doesn’t participate in. This can award senior executives up to 100% of their base salary. The targets are 60% on a profit target with 20% measure on customer metrics and 20% on individual metrics. Directors emoluments last year were:
Source: Annual report
It is unusual for customer metrics to be used in the incentivisation which underlines the customer focussed nature of this business. While Philip Meeson is a significant shareholder it is interesting that the other directors are paid more than him and he didn’t award himself a bonus last year despite 49% profit growth.
Estimates
Profits haven’t gone up in a straight line with a set-back in 2017 as the company invested in new bases at Stansted and Birmingham.
Source: Sharepad
There are reasons to worry about the short-term environment with volatile oil prices (the company hedges 90% of its fuel costs 12 months forward) and Brexit concerns. On 17 April the company updated that it expects results to March 2019 to be slightly ahead of expectations although Summer 2019 bookings were showing some signs of softening whilst still being positive. This had been previously highlighted at the interim results and consequently PBT is expected to fall this year from £175m to £153m.
Valuation
The shares look reasonably valued.
Source: Sharepad
More importantly is the cyclical range of PE ratios. In 2015 it traded at an average PER of 15.3X while in 2012 it traded at 6.3 X.
Source: Sharepad
Personal View
The culture in this business makes it a high-quality contender to be a medium term holding. In the short- term headwinds exist. I take the view that the Brexit uncertainty will pass. The weak pound will certainly make holidays more expensive so could well affect summer bookings. Full year results are due out on 11 July. A good downgrade then could well provide an opportunity for the contrarian investor. Rather like the reduction in profits in 2017 provided a cracking opportunity.
K3 Capital
Share Price 136p
Mkt Cap £46m
Source: Sharepad
History
This is another northern based company based in Bolton which is a business sales brokerage. The current management team took over in 2010 bringing an innovative business model of direct marketing to the business brokerage market. Since that time, they have become the number 1 firm in the UK for number of deals as they have taken market share. The business is forced into 3 division according to the size of the mandate. K3 Corporate Finance handles the larger transactions, K3 Corporate handles the medium size transactions and Knightsbridge commercial handles the smaller “pubs clubs and shops” transactions”. Ian Mattioli of Mattioli Woods is chairman and management own 37% of the business.
Investment Case
Like Dart Group the culture of this business is both innovative and conservative which is a difficult balance to maintain.
The strategy has been simply to achieve more and larger deals within an organisation that has rigid processes. Unlike most competitor business sales organisations who operate as boutiques sourcing deals through a network this company has field agents who are fed deals from a central direct marketing team. The field agent will sign up a business owner collecting a retainer before handing over to a production team to produce a flyer and an investment memorandum. This is then distributed to their known buyers as well as put into their buyer matching engine. Only when buyers have been identified to expensive corporate finance executives get involved.
The result of this innovative approach is the very exciting combination of high ROE (80%) and turnover growth. The company’s capital discipline aims for an 80% pay-out ratio as the business is highly cash generative ensuring a good dividend yield.
Source: Sharepad
Threats
Competition – The market of corporate advisory boutiques is fragmented but there are large banks involved in this space with plentiful access to capital. If K3Capital keeps to the smaller end mandates below say £100m of valuation this threat can be mitigated. Most of the fragmented boutiques at this end of the market use networks to source business rather than direct marketing. In order to prevent competitors from entering their space K3 Capital will have to maintain a cutting edge in their direct marketing which may involve substantial technology spending. It is a sign of conservatism that no costs are capitalised, and all technology and marketing spend is expensed through the income & expenditure account at K3 Capital.
Cyclicality – The M&A market is notoriously cyclical and in a recession few business owners are inclined to sell their business while prices of business sales also reduce. Because K3 Capital fees are typically a % of the sale price the fees reduce for each transaction as well as the number of transactions
Client Relationships – Importantly the traditional threat in this industry of a member of staff leaving and taking customers away is mitigated by the business model whereby each part of the sale process is carried out by different specialists. This ensures that clients are clients of the firm rather than an individual member of staff.
Competitive Advantage
No other company in the business sales space relies on direct marketing for its sales. This approach that has served the company well since 2010 enabling it to become the number 1 in the Reuters M&A tables for the last year. This innovation is combined with conservative accounting suggesting that admirable balance of innovation and conservatism in the culture of the company.
As well as having an innovative marketing approach the staff are generally paid modest salaries whilst being highly incentivised by annual bonuses.
Remuneration
There is no LTIP scheme. Instead the directors are material shareholders in the company:
Source: Annual report
Last year’s director’s remuneration is:
Source: Annual report
Here we can see the effective operation of the variable bonus structure where the strong performance in 2018 is reflected in bonuses.
Estimates
As the company has grown it has started doing larger mandates which has made the revenues lumpy. Having come to market in April 2017 the company on 5 April this year notified that a number of large transactions had failed to close ahead of their May year end resulting in a significant downgrade in the forecast EBITDA estimate from £7.1m to £4.6m for the year to May 2019. The May 2020 EBITDA number remained unchanged at £7.5m. Having come to market in April 2017 at 96p and risen to 355p concerns that the malaise may be more prolonged caused the share to come back to 109p. A trading update last week reassured that the pipeline is strong, and the board is confident for 2020.
Estimates are now as follows:
Source: Consensus estimates
There is the matter of an uncovered dividend in 2019 but going forward this is expected to be covered.
Valuation
On a PER of under 10X and yielding above 10% for the year just started to May 2020 the shares look cheap. Importantly the variability of the rating can be seen in the table below. In a growth market this company is a unique “category killer” and trades at 20X and in a slow market the company is a lumpy transactional business and trades at sub 10X.
Source: Sharepad
Personal View
This is looking like a good trading stock to buy when the lumpy revenues cause a downgrade. That window looks like now. On a medium term view the company with its innovative model should gain further market share. After all, if you are selling a business would you not go to the person with the largest pool of buyers. As it achieves scale the revenues become less lumpy and the model becomes that of a highly rated exchange. It is a bit early for that, but those sunny uplands are visible. Results are due on 17 September. It may be a bit late by then.
Summary
It is important for investors that stocks that held over the medium term have a strong culture of innovation and conservatism combined with energy. Remuneration reports, which are frequently overlooked by investors give some insight into a company’s culture when viewed in the context of management shareholdings. The two companies covered here appear to have a positive culture which will enable them to weather the bad times as well as enjoy the good times. Timing any purchases will be useful as both are in cyclical markets.
Upcoming Events
Weekly Commentary: 10/06/19
Companies with Culture
The noise around Woodford’s humiliation last week was deafening. And it was a bad week for Hargreaves Lansdown (-14%). I don’t recall such a lot of noise around a fund manager since the demise of New Star in 2008 having paid a special dividend to shareholders and gearing up into a bear market. As one anonymous fund manager put it to me “It shows the perils of greed and believing one’s own press”. But with only one other director of Woodford Investment Management one can’t help but wonder if proper corporate governance had been in place the liquidity issues would have been addressed earlier.
Frequently in an industry that is very attractive it is easy to become complacent. Asset Management is a great industry. It has the accolade of being criticised in the FCA Asset Manager Review of 2017 for making consistently high margins where the average operating margin of firms surveyed was 34%. My colleague, Maynard Patton, posted an excellent review of Jupiter Asset Management last week as their high returns had caught his beady eye. But if the culture is wrong mistakes can be made.
Culture Matters
High return businesses frequently bring about complacency. Provident Financial springs to mind as an example. Businesses facing slowing growth can be tempted to take excess risk. I think that’s why fund managers are sometimes heard to say they aren’t keen on acquisitive businesses. Acquisitions are frequently a way of covering up reducing returns and involve higher risk than organic growth. Charles Taylor Consulting PLC is an example of this where growth has been manufactured by acquisitions resulting in growth at reducing ROE’s meaning the share price has gone from 290p 20 years ago to 224p today.
Source: Charlton Illingworth
The underlying business at Charles Taylor Consulting 20 years ago was a high return mutual management management business where the contract relied on using the clients balance sheet for working capital so was a wonderfully high ROE business that was low growth. And so, 20 years of acquisitions has manufactured growth at the expense of ROE. The share price tells us which matters more.
One notable example of excessive risk taking was Provident Financial. As a subprime lender the job of the company is to allocate capital efficiently and consequently ROE is a vital metric. And yet the incentivisation of the management was on EPS targets and total shareholder return, effectively incentivising management towards growth.
The result was growth from 2006 to 2016 while ROE started to decline in 2013:
Source: Sharepad
The drive for profit growth resulted in the poor culture requiring the FCA to intervene while shareholders took significant pain:
Source: Sharepad
Subsequent events
Non-Standard Finance recently proposed a nil premium all paper bid for Provident which was blocked by minority shareholders last week. A scan of their Non-Standard Finance’s remuneration report reveals that management receive 15% of any increase in the market capitalisation above 110p per share by December 2020. With the shares trading at 46p it becomes understandable that a significant “roll of the dice” may be required to get value from the LTIP.
Importance of Remuneration
One insight into the culture of a company can be seen from the remuneration reports.
Having surveyed 79 companies’ annual reports in my specialist sector only 5 disclose that they use ROE in their incentives which is surprising low, particularly in the financial services sector. Those five are Arrow Financial, Close Brothers, Investec, Rathbone, and TP ICAP. All of these are lenders, except for TP ICAP, where Terry Smith was once CEO and understands the importance of ROE.
Portfolio Construction
Culture is subjective, but remuneration reports are important. There does appear to be a correlation. Where management have a significant shareholding, the company tends to eschew LTIP’s. Only Interregnum have the confidence to publicly state that in their view they promote “dysfunctional behaviour”. Amongst the companies that eschew LTIPS are: Integrafin, Jarvis Securities, AJ Bell , and Manolete. These appear to be companies where the culture is healthy, but the ratings are generally high.
Source: Sharepad, Prospectus
Screen
Having met the management of all the above four companies it seems to me the culture is one of innovation combined with energy and conservatism which may be enabled by the management stake in the business. Searching for young companies with motivated management alongside low valuations with a strong ROE is restrictive. There aren’t many. A screen of AIM stocks for a forecast PE Ratio below 17X, Director holdings of 10% to 40% (higher may imply they are effectively a private company) and a ROE above 20% provides a list of just 7 companies out of the 1,148 companies listed on the market.
Source: Sharepad
Let us look at the first two of these.
Dart Group
Share Price 898p
Mkt Cap £1,327m
History
Formed in 1971 and bought out by the current CEO and Chairman, Philip Meeson in 1983 the company’s roots are in flying fresh produce and other freight around Europe. Fowler- Welch, a road transport business was acquired in 1994 and the passenger airline Jet2 was launched in 2003. Last year the Fowler Welch logistics business produced £4.4m PBT while the leisure travel business produced £130.2m PBT. While the logistics business derives from an acquisition many years ago the Jet2 business, which has been far more successful was launched organically. Philip Meeson currently holds 37% of the company. The company is based in Leeds.
Investment Case
The profits from entering the package holiday market have soared over recent years:
While logistics has been cash generative but lacks growth:
The result has been growth in revenues and importantly ROE
Source: Sharepad
Threats
Airlines are a competitive area with one of the longest lists of bankruptcies. Warren Buffett said in 2013 that investors “have poured money into airlines for 100 years with terrible results” – before buying into US airlines in 2016. Perhaps the world has changed. Perhaps with financial restraint, technology and big data to enhance efficiency, more efficient planes and the demise of trade unions the world has changed in Buffet’s view. But maybe also this company has a competitive advantage.
Competitive Advantage
With Jet 2 starting organically my own view is the reason for their success can be read in the chairman’s statement from 2012. “We devote great effort to knowing and understanding our customers better”. And “whilst a customer’s travel history is always a great indicator of what they may do next we have gone a step further by enriching our data”. By 2018 the language has become more corporate speak with “our customer focussed flying programme”. The Chairman’s statement is all about service. Somewhat different to Ryanair and easyJet. The culture of this company is plastered all over the narrative of the annual report with numerous repetitions of the strap line below:
Remuneration
There is a Senior Executive Incentive Plan “SEIP” which Philip Meeson doesn’t participate in. This can award senior executives up to 100% of their base salary. The targets are 60% on a profit target with 20% measure on customer metrics and 20% on individual metrics. Directors emoluments last year were:
Source: Annual report
It is unusual for customer metrics to be used in the incentivisation which underlines the customer focussed nature of this business. While Philip Meeson is a significant shareholder it is interesting that the other directors are paid more than him and he didn’t award himself a bonus last year despite 49% profit growth.
Estimates
Profits haven’t gone up in a straight line with a set-back in 2017 as the company invested in new bases at Stansted and Birmingham.
Source: Sharepad
There are reasons to worry about the short-term environment with volatile oil prices (the company hedges 90% of its fuel costs 12 months forward) and Brexit concerns. On 17 April the company updated that it expects results to March 2019 to be slightly ahead of expectations although Summer 2019 bookings were showing some signs of softening whilst still being positive. This had been previously highlighted at the interim results and consequently PBT is expected to fall this year from £175m to £153m.
Valuation
The shares look reasonably valued.
Source: Sharepad
More importantly is the cyclical range of PE ratios. In 2015 it traded at an average PER of 15.3X while in 2012 it traded at 6.3 X.
Source: Sharepad
Personal View
The culture in this business makes it a high-quality contender to be a medium term holding. In the short- term headwinds exist. I take the view that the Brexit uncertainty will pass. The weak pound will certainly make holidays more expensive so could well affect summer bookings. Full year results are due out on 11 July. A good downgrade then could well provide an opportunity for the contrarian investor. Rather like the reduction in profits in 2017 provided a cracking opportunity.
K3 Capital
Share Price 136p
Mkt Cap £46m
Source: Sharepad
History
This is another northern based company based in Bolton which is a business sales brokerage. The current management team took over in 2010 bringing an innovative business model of direct marketing to the business brokerage market. Since that time, they have become the number 1 firm in the UK for number of deals as they have taken market share. The business is forced into 3 division according to the size of the mandate. K3 Corporate Finance handles the larger transactions, K3 Corporate handles the medium size transactions and Knightsbridge commercial handles the smaller “pubs clubs and shops” transactions”. Ian Mattioli of Mattioli Woods is chairman and management own 37% of the business.
Investment Case
Like Dart Group the culture of this business is both innovative and conservative which is a difficult balance to maintain.
The strategy has been simply to achieve more and larger deals within an organisation that has rigid processes. Unlike most competitor business sales organisations who operate as boutiques sourcing deals through a network this company has field agents who are fed deals from a central direct marketing team. The field agent will sign up a business owner collecting a retainer before handing over to a production team to produce a flyer and an investment memorandum. This is then distributed to their known buyers as well as put into their buyer matching engine. Only when buyers have been identified to expensive corporate finance executives get involved.
The result of this innovative approach is the very exciting combination of high ROE (80%) and turnover growth. The company’s capital discipline aims for an 80% pay-out ratio as the business is highly cash generative ensuring a good dividend yield.
Source: Sharepad
Threats
Competition – The market of corporate advisory boutiques is fragmented but there are large banks involved in this space with plentiful access to capital. If K3Capital keeps to the smaller end mandates below say £100m of valuation this threat can be mitigated. Most of the fragmented boutiques at this end of the market use networks to source business rather than direct marketing. In order to prevent competitors from entering their space K3 Capital will have to maintain a cutting edge in their direct marketing which may involve substantial technology spending. It is a sign of conservatism that no costs are capitalised, and all technology and marketing spend is expensed through the income & expenditure account at K3 Capital.
Cyclicality – The M&A market is notoriously cyclical and in a recession few business owners are inclined to sell their business while prices of business sales also reduce. Because K3 Capital fees are typically a % of the sale price the fees reduce for each transaction as well as the number of transactions
Client Relationships – Importantly the traditional threat in this industry of a member of staff leaving and taking customers away is mitigated by the business model whereby each part of the sale process is carried out by different specialists. This ensures that clients are clients of the firm rather than an individual member of staff.
Competitive Advantage
No other company in the business sales space relies on direct marketing for its sales. This approach that has served the company well since 2010 enabling it to become the number 1 in the Reuters M&A tables for the last year. This innovation is combined with conservative accounting suggesting that admirable balance of innovation and conservatism in the culture of the company.
As well as having an innovative marketing approach the staff are generally paid modest salaries whilst being highly incentivised by annual bonuses.
Remuneration
There is no LTIP scheme. Instead the directors are material shareholders in the company:
Source: Annual report
Last year’s director’s remuneration is:
Source: Annual report
Here we can see the effective operation of the variable bonus structure where the strong performance in 2018 is reflected in bonuses.
Estimates
As the company has grown it has started doing larger mandates which has made the revenues lumpy. Having come to market in April 2017 the company on 5 April this year notified that a number of large transactions had failed to close ahead of their May year end resulting in a significant downgrade in the forecast EBITDA estimate from £7.1m to £4.6m for the year to May 2019. The May 2020 EBITDA number remained unchanged at £7.5m. Having come to market in April 2017 at 96p and risen to 355p concerns that the malaise may be more prolonged caused the share to come back to 109p. A trading update last week reassured that the pipeline is strong, and the board is confident for 2020.
Estimates are now as follows:
Source: Consensus estimates
There is the matter of an uncovered dividend in 2019 but going forward this is expected to be covered.
Valuation
On a PER of under 10X and yielding above 10% for the year just started to May 2020 the shares look cheap. Importantly the variability of the rating can be seen in the table below. In a growth market this company is a unique “category killer” and trades at 20X and in a slow market the company is a lumpy transactional business and trades at sub 10X.
Source: Sharepad
Personal View
This is looking like a good trading stock to buy when the lumpy revenues cause a downgrade. That window looks like now. On a medium term view the company with its innovative model should gain further market share. After all, if you are selling a business would you not go to the person with the largest pool of buyers. As it achieves scale the revenues become less lumpy and the model becomes that of a highly rated exchange. It is a bit early for that, but those sunny uplands are visible. Results are due on 17 September. It may be a bit late by then.
Summary
It is important for investors that stocks that held over the medium term have a strong culture of innovation and conservatism combined with energy. Remuneration reports, which are frequently overlooked by investors give some insight into a company’s culture when viewed in the context of management shareholdings. The two companies covered here appear to have a positive culture which will enable them to weather the bad times as well as enjoy the good times. Timing any purchases will be useful as both are in cyclical markets.
Upcoming Events