Two days ago City of London Group (CLIG) presented its half year results for 2013/2014. Profit before tax for the first half is GBP 3.3 m and in line with my base case full year estimation. They also reported that the expected investment performance of the emerging markets closed end fund team should place them in the top of the second quartile for 2013. You can find my initial investment case here.
For the first time the company provides a detailed quarterly guidance until June 2015. You can find the yearly summary below. Please note that in 2013/2014 management will change the financial year from end May to end June. The numbers below are adjusted for this non-recurring event:
|in GBP million||2013/2014||2014/2015|
Based on this projection, the company is currently valued with a 5.7x pre-tax multiple after adjusting for excess cash for the financial year 2014/2015 (8.0x for 2013/2014). The current dividend yield is 9.8%.
The management also presented the basic assumptions of their forecast:
“Starting point current FuM (Dec 2013)
– Pipeline of potential mandates (additional USD 500 m) straight-lined to Dec 2014 and target new money for 2015 (additional USD 500 m) straight-lined Jan-Dec 2015
– Operating margin adjusted monthly for change in client mix and commission run-off
– Market growth: +5% (six months end June 2014) + an additional 10% (twelve months June 2015)
– Increase in overhead: +1% (2014/15)
– Assumes total number and mix of staff overhead between the four offices remains constant
– Corporation tax baased on an estimated average rate of 28% for Y/E 2014 and 27% for Y/E 2015
– Exchange rate assumed to be GBP/USD 1.63 for entire period
– Number of CLIG shares in issue (27.0 m) less those held by the ESOP Trust (1.8 m) as at 31st Dec 2013
– Includes extra month of income in Q4 2014
– Includes in Q3 2013/14 profit of USD 250,000 from sale of CLIM International CEF Fund”
Using management’s quarterly guidance and the assumptions above, I came up with the following table. As the reporting currency is GBP, I am also showing AUM in GBP instead of USD (All numbers in GBP million):
|Adj Profit / AUM||0.054%||0.059%||0.045%||0.051%||0.057%||0.059%||0.063%||0.066%|
“Adj Profit” is net profit adjusted for non-recurring items (sale of CEF Fund and change in financial year). Management expects AUM to increase by 38% to GBP 3.0 bn (USD 4.8 bn) over the next six quarters. However, this increase also includes GBP 0.4 bn (USD 0.6 bn) coming from market growth. Obviously, market movements are hard to predict. From my perspective, it makes more sense to assume a flat market going forward.
Management makes some statements about potential increases of AUM:
“In light of the above it was with considerable pleasure that we witnessed towards the end of the 6 month period both confirmation of the turnaround in our investment performance together with renewed interest in taking advantage of a “cheap” Emerging Markets CEF sector by contrarian and opportunistic investors. New funds under management (“FuM”) have subsequently been subscribed both by existing and new clients in our core Emerging Markets CEF products”
“As we have suggested in previous statements we are gradually gaining traction in a number of areas of our business. The Absolute Return group has won a mandate for USD 20 m and the Frontier, Developed and Natural Resource teams are all expected to win additional mandates prior to the end of calendar year 2014.”
Until the end of 2014 management targets GBP 2.5 bn (USD 4.0 bn) ignoring market growth. This expectation is quite similar to my best case scenario in my original write up, which assumes an increase in AUM to the same level:
“1) Upside scenario:
If CLIG can revert to its 2012/2013 profit level, the upside potential for the share price will be approx. 70%. This implies an increase in AUM of approx. USD 0.5 bn or 13% (based on the assumptions made to compute the pre-tax normalized profit).
Management stated in their latest annual report that they aim to achieve that goal until January 2014. From today’s perspective this time frame seems quite ambitious. However, given the marketing efforts they are currently undertaking it seems to be a realistic goal over the next twelve months.”
From the table above, we can see that CLIG’s profit estimation for an AUM level of roughly GBP 2.5 bn (USD 4.0 bn) is GBP 1.42 m (Q1 2014/2015) leading to an annualized net income estimation of GBP 5.7 m or GBP 8.0 m pre-tax profit. This is approx. 10% below the company’s 2012/2013 profit level. Based on this more conservative projection, the company is currently valued with a 6.4x pre-tax multiple after adjusting for excess cash for the financial year of 2014/2015.
Obviously, performance of CLIG’s funds and sentiment for emerging markets remains most important for the company’s development. Apart from that, I see the following risks:
1. Pressure on fees
Currently, most asset managers find it hard to keep their fee level constant as many of their clients get more and more educated and are eager to negotiate lower fee levels. This trend can be witnessed across the industry. CLIG’s management is aware of this and has already made progress in reducing overhead costs. Management does not outline whether a lower fee level is included in their forecast. So this is certainly a risk to my profit estimation which is mitigated by the share’s low multiple compared to its peer group.
2. Decline in dividend
With the current share price providing a 10% dividend yield, I assume that many income oriented investors are involved. A decrease in the dividend could therefore lead to another drop in the share price. Management seems to be aware of that:
“In the light of both our substantial liquid resources, together with the improved trading outlook, it is our intention, notwithstanding the weaker trading over the first half year, to pay a maintained dividend of 8p on 28th February 2014 to shareholders on the register on 7th February 2014. Our dividend payment policy has normally been based on a split of one/two thirds between the interim and the final, and currently there are no plans for this to change however this assumes a continuation of the recovery that we have been benefiting from in recent months. In the light of the limited amount of working capital that a business of this nature both needs and, in addition, is required by the regulators to maintain, the board is reviewing the logic of our historic policy of a target cover as high as 1.5 times.”
For this financial year 23% of the dividend payment will be financed out of reserves. Based on my profit estimation above, 5% of the dividend for the 2014/2015 will not be covered by net income. This is currently not an issue as the company has enough excess cash on its balance sheet. However, this is not sustainable over the long run. Hence, an improvement in operating performance is crucial to secure the high dividend payments.
3. Remuneration of employees
In my original assessment of the company, I made the following statement:
“Under its ESOP programme the company provides share options to its employees. All share options granted are equity settled. So the shares issued under the ESOP programme are non-dilutive for existing shareholders as they are purchased in the market. Shares held by the ESOP programme are not entitled to dividend payments. In their annual report management describes the process as follows:
“Half way through the year, the Group took the opportunity to use some of its surplus cash to fund the purchase of 404,086 Company shares at a price of £2.55. Half the shares were cancelled and the £0.5 million cost set against retained earnings. The other half were taken up by the Company ESOP thereby increasing its loan from the Company by £0.5 million. As the ESOP has waived its right to dividends, both transactions effectively enhance earnings per share for the remaining shareholders, albeit only the cancellation does so on a permanent basis. During the year Directors and employees exercised 261,300 dilutive options and 70,627 ESOP held options, raising £0.2 million.”
At the end of May 2013 total ESOP holding comprised 6.8% of total shares outstanding.
With regard to the dilutive share option programme total rewards represented 1.0% of outstanding shares.
The average number of outstanding shares has decreased from 27.4 m to 25.4 m from fiscal year 2007/2008 to 2012/2013. Overall, there has not been any dilution for shareholders in the past. To the contrary, management has actively reduced the share account.”
Here my reasoning was too simplistic. The problem is that the company is constantly repurchasing shares for their employee share option trust. However, buybacks are only good for shareholders when company stock is purchased at such a discount to intrinsic value that it offers a return on capital greater than any other use of cash. Given the low share price, this might be the case at the moment. Nevertheless, this was not the case in 2010/2011 when the company repurchased stock for their trust in an amount of GBP 1.5 m, while the share price traded 80% higher than today. As a consequence, these repurchases are not opportunistic, but do only keep the share count down due to increasing share count from options. They do not represent greater value for shareholders.
Although I have changed my opinion regarding CLIG’s remuneration policy, I really like management’s willingness to constantly improve the reporting to their shareholders. I think the projection for the next six quarters is very useful. Overall profit estimation seems to be ambitious. However, even a slower reversion to former profit levels implies a lot of upside for the share price given the low valuation.
I will increase the holding to a 4% position for the portfolio with a share price limit of 260 pence. Liquidity increased over the last couple of days so it might take approx. 2 trading days to build the position assuming Wertart Capital trades one third of daily volume. Please click here for more information on WertArt Capital and the virtual portfolio.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!