Close Brothers Group $CBG

50% margin of safety, low risk of permanent loss

[Written February 2022]

Summary

CBG is a portfolio of three excellent businesses that is worth £24.50 per share vs a current share price of £10.70, now trading at 1.1x NTAV vs a historic average of 2.1x.  Its main lending business (80-85% of profits) has averaged 19.5% return on tangible equity in the last 20 years whilst growing its loan book at a 10.5% CAGR.  Its other two businesses are in wealth management and market-making, earn 30%+ ROE each, and are non-core (a view not shared by CBG). 

The focus of this write-up is two-fold: firstly, to expose the low downside risk in the core lending business, which makes the upside/downside asymmetry very attractive as far as position-sizing is concerned; and secondly, to explain the increased potential for value creation from corporate activity.   

With regards to corporate activity, there are a number of factors at play.  CBG is more likely to attract the attention of a growing number of activists in the moribund UK equity markets, because it is statistically cheaper than ever and because it has a mixed record on capital allocation.  Although CBG has been extremely effective at reinvesting capital, it is myopic beyond that.  Its dividend yield is now 6%, it is better capitalised than ever, it is trading at its highest ever discount to intrinsic value, and all the major UK banks have announced share repurchases - yet CBG has never done a single share buyback. Furthermore, its three businesses could be separated as they share no synergy and both the wealth management and market-making businesses would be more valuable to other owners.  CBG is not a retail bank and its wealth management business is now an attractive mid-sized player in a rapidly consolidating sector where big retail banks and asset managers have been actively acquiring.    

A valuation of £24.50 per share, or £3.7 billion, values CBG as follows:

·      Winterflood (10% of earnings) - £340m or 11x EBIT, in line with comparables.  Winterflood is the largest wholesale equities broker by volume in the UK with a strong market position in UK small caps especially and an excellent track record of returns.  It has averaged a 35% return on equity over the last 15 years.

·      Close Brothers Asset Management (10% of earnings) - valued at £430m or 2.5% AuM, in line with recent transactions.  CBG has built an attractive, vertically-integrated business - coveted by acquirers - with £17.2bn AUM at 90bps revenue margins, 10% net inflows per annum since 2014 and a 30% return on equity.

·      CBG Banking (80% of earnings) - valued at £3.1bn or 2.7x NTAV. CBG’s core banking business is a collection of excellent speciality finance businesses that over the last 20 years have generated an average 19.5% return on tangible equity while maintaining a conservative balance sheet.  Even more impressive, it has generated those returns while growing loan book at a 10.5% CAGR, and paying out half its earnings in dividends.  It achieves 9% average NIMs over the cycle with very little volatility in its bad debt ratio, the latter having remained at an average of 1.3% of receivables with a high of 2.6% in 2009.  It has consistently kept its expense ratio at around 50% over that period, which is good for a service-oriented, multi-line lender. 

·      Corporate expenses capitalised at £175m.

Even without corporate activity, an investment at the current share price will do well as the price to book ratio eventually reverts to mean, 75% above the current level.  In the meantime, investors get the 6% dividend yield and 8% projected growth in the banking and wealth management businesses, which account for 90% of CBG's profits.

Let's return later to valuation and the potential for corporate activity.  But now, let's look at why CBG's banking business has such low downside risk.

CBG's banking business generates high returns from conservative lending

Typically, what puts investors off banks is the low, commodity-like returns vs the uncertainty of equity being wiped out by asset write-offs, exacerbated by funding crises.

CBG's banking business is exactly the opposite.  It is a collection of simple lending businesses that generates consistently high returns from a mix of excellent underwriting and good market positions, with a very conservative balance sheet.

Simple business with conservative underwriting

CBG Banking's only assets are cash and loans, and its loan book is secure and historically well underwritten.

It divides its operations into five lending divisions:  asset finance (33% of book), property (20%), invoice finance (12%), motor (22%) and insurance premium funding (13%).  Its loans are small and short duration, on average 17 months.  With a total loan book of £8.6bn, average loans sizes are: Asset finance £58k, Invoice £458k, Motor £7k, premium finance £500, and property £1.2m.

90% of CBG's loan book is either secured at conservative loan to value ratios, or structurally protected.  LTVs are:  asset finance 80-90%, motor 75-85%, property 50-60%, invoice 80% and premium 91%.  In areas where LTVs are slightly higher, CBG also has other structural protections.  In premium finance, in addition to recourse to the insured, CBG often has recourse to the broker if the insured defaults; and if the insured cancels a policy, the premium is refunded directly to CBG by the insurer.  Motor finance is prime lending and 90% of the loans are hire-purchase loans where the entire value of the car is paid off over the loan life, eliminating residual value risk at maturity.  Finally, in invoice finance, CBG's system is connected directly to the customer's sales ledger via an API and takes daily updates. 

CBG's historic underwriting has been excellent.  It has never posted a loss, with loan impairments showing low historic volatility, ranging from 0.6% to 2.6% over the cycle with an average of 1.3%.  CBG's lending is very relationship-driven with manual underwriting and high levels of repeat business, which reduces underwriting risk and improves recoveries.  Having a diversified portfolio of lending niches also means CBG is not as reliant on one sector as many other specialist lenders, tweaking the mix of its lending according to where it sees the best returns. 

CBG's capital position is strong

CBG's capital position is strong enough to absorb multiples of its highest ever loan impairment charge.  Its current leverage ratio is 11.1%, representing £1.4bn of tangible equity.  It also generates an average yield on loan book of 3.2%[1], or £275m on the current book, for a total of £1.7bn of loss-absorbing capital.  To put that in perspective, its highest every impairment ratio was 2.6% (2009) which on today's loan book would equal a £225m charge. 

This strong capital position means CBG also has significant regulatory capital buffer above its current minimum common equity tier 1 (CET1) requirement of £800m.  This threshold is the level below which dividends and bonuses lock up, with an equity raise being required only below a threshold of £475m[2]. Furthermore, CBG's true CET1 buffer is likely to be even better.  This is because CBG's risk-weighted assets are calculated using standardised risk-weightings mandated by the prudential regulator, which need to be conservative enough to cover all manner of banks.  CBG has applied to the regulator for permission to calculate tailored risk-weightings that reflect the actual risk of its loan book - called the internal-ratings based approach ("IRB") - initially for its property, motor and energy books, which account for around half its lending.  It is particularly disadvantaged in its property book and moving it alone onto IRB could conceivably lower its CET1 requirement by £150m[3].

The key point to take away in all this is that CBG is very well capitalised relative to its long term impairment track record.  This means the likelihood of insolvency is remote.  It also means CBG is well positioned for a tighter credit environment, when historically it has grown its book at 20%+ p.a.  Given the discount to intrinsic value, there is also the potential for buybacks - more on that later.

It is not surprising that CBG is unique in having CET1 as a significant bonus target for its CEO and CFO (currently 20% weighting) and that CBG's bank has a higher credit rating than the major UK clearing banks

CBG has very little liquidity risk

CBG has exceptionally low exposure to another major risk with banks, liquidity risk, ie in extremis a run on the bank forcing the sale of assets to meet liabilities and precipitating eventual insolvency.  CBG 'borrows long and lends short' - its average loan tenor is 17 months and funding maturity 24 months and its loans to available funding is 85%.  It also does not have any current accounts and its funding is very diversified, with a blend of corporate and retail savings deposits accounting for 2/3rds of funding, and a diverse mix of wholesale funding comprising securitisation, unsecured debt, revolvers and central bank funding. 

To further contextualise CBG's liquidity as compared to major UK banks, CBG's liquidity coverage ratio (LCR) is 1,000% vs 150% for the major UK banks[4].  

CBG has strong market positions in its niches

CBG explicitly underwrites for return and not market share, with market share an output and not an objective.  Nonetheless CBG has strong market positions which give it scale in its individual niches:

·      Asset finance (33% of book): 10% share of £16bn UK market with 30+ years operating history and NPS of 72.  Asset finance in particular is comprised of various niches where CBG will typically hire industry specialists to branch into new areas, eg photovoltaic systems and most recently agricultural equipment

·      Motor finance (22% of book):  CBG's market share by volume of cars varies between 6-12% through the cycle depending on its underwriting appetite.  It lends directly to around 6,000 small independent dealers out of a total UK population of 8,000, focusing primarily on smaller independent dealers who are underserved by the big banks' auto lending businesses (eg Lloyds' Blackhorse, the market leader).  It will move in and out of mid-sized dealerships depending on the lending environment.  For 3/4 of its dealer base, it is the first-choice provider.  NPS of 70.

·      Property (20% of book): CBG only does residential development lending, not investment lending.  It targets the sub £10m sector where it is the largest non-clearing bank lender with a 10-20% market share, operating for over 40 years in this segment and with 76% repeat business and an NPS of 87. 

·      Premium (13% of book):  CBG has a 45% share of the 3rd-party funded insurance premium market, operating in a quasi-duopoly with Premium Credit, together holding app. 90%.  Only around 1/3 of premiums in the UK are financed and of that around 75% are funded internally by brokers or insurance companies.  CBG serves 3 million customers through 1,600 direct insurance broker relationships, with 98% broker retention.

·      Invoice (12% book):  CBG is the 6th largest player with a 3% share in a £21 billion market, but focused on SMEs (5k customers).  70% of the market is served by the big 4 clearing banks and there are around 15 smaller players behind CBG. 

CBG operates in niches where the big banks do not compete, whilst having scale advantages vis-a-vis smaller monoline specialist lenders.  For example, it has been steadily increasing deposit-taking as a proportion of funding, launching a retail deposit platform in 2018 that has grown customers 27% p.a. since and has an NPS of 72.  This has helped lower CBG's cost of funds, as deposits currently yield a 60bps advantage over CBG's blended cost for wholesale funding. 

CBG Banking has high loan book growth and will do even better if there is a recession

CBG has averaged 10-year rolling loan book growth of 13% p.a. over the last 20 years and a loan book CAGR of 10.5% p.a. over the same period, whilst paying out half its earnings in dividends.  However, these averages understate the countercyclical or 'antifragile' nature of CBG's business, especially relevant this far into an economic cycle with rate rises looming.  In the two years following the dotcom bubble, CBG grew its loan book 30% p.a.  And in the three years following the financial crisis, it grew it 20% p.a., from a larger base. 

The reasons for this countercyclical strength are as follows.  CBG's loan book will suffer less than most banks if there is a recession.  Its retail lending areas - insurance premiums and used cars - are not cyclical.  In its commercial lending, any market cyclicality is more than compensated by market share gains.  During the financial crisis, it remained profitable and indeed grew its loan book from £2 billion in 2007 to £2.4 billion in 2009, making several opportunistic acquisitions of lending businesses and loan books.  It then emerged from the financial crisis with a robust capital position, able to take advantage of the main deposit-taking banks retrenching from its core SME markets and smaller, less-experienced competitors either having insufficient capital or liquidity to continue lending.  From 2010 to 2016, its loan book grew 15% p.a. from £2.4 billion to £6.4 billion, while posting average return on equity of 23%.  As we now emerge from Coronavirus, CBG is anticipating loan book growth of 8% but modelling 20% growth in an economic downturn scenario. 

CBG Banking - summary

This section has underscored the quality of CBG's banking business, which accounts for 80-85% of CBG's profits.  It generates consistently high returns and loan book growth, but it does so with a very conservative business model that results in little downside risk to equity. 

Now let's look at CBG's non-core businesses, which account for around 15-20% of profits.

CBAM: vertically-integrated wealth manager growing AuM

Close Brothers Asset Management (CBAM) has £17.2bn AUM with close to 10% net inflows per annum since 2014 with a revenue margin of 90bps and return on equity of 30%.  It operates a vertically integrated business model, offering financial advice/wealth management and investment management, and it operates its own funds.

The wealth management market is growing because the population is aging, there are less people in defined benefit pensions, and the number of financial advisers in the UK has been declining.  From £1.6 trillion of AuM in 2020, the market is forecast to reach £2.1 trillion in 2024[5] for a CAGR of 7%.  Given its mid-tier size and the large and fragmented nature of the market, CBAM has scope to continue outperforming market growth.  Its vertically integrated business model, which it has operated for many years now and before its competitors, is likely to thrive going forward given the demand for advice in particular. 

To position itself for growth, CBAM has been investing above normal since 2017 in new investment manager hires, who are initially loss-making, and also in upgrading its customer-facing and operations-related technology to improve efficiency and user experience.  It has also made 7 tuck-in acquisitions of smaller financial advisers.  All this has held back operating margin - for eg depreciation accounts for 4.4% of revenue now vs 1.9% pre-investment.  It anticipates its technology upgrade programme to be completed in 2022 and to achieve greater operational leverage as it continues to scale AuM.  Brewin Dolphin, a larger peer with £54m AuM, indicates the potential.  Despite equivalent compensation ratios of 55% (ie staff costs % of revenue), Brewin Dolphin's operating margin is 23% vs 17% for CBAM.  And other larger UK wealth managers, for example Quilter with £54bn of managed assets, have similar margins to Brewin Dolphin's.    

CBAM Valuation

CBAM is valued at £430m using a DCF, supported by recent transactions.

DCF:

Assume CBAM continued to grow through 2030 at historic rates of roughly 8% p.a. and 90bps revenue margin, while increasing its margin 50bps per annum from its current 17%, then by 2030 it would reach £34 billion of AuM and £63m of operating profit at an operating margin of 22%[6], in line with larger peers.  Using a terminal value of 2% AuM, tax rate of 19% rising to 25% from 2023, and a 10% discount rate gives a valuation of £465m or 2.7% current AuM. 

As a downside, if there were a market downturn causing a decline of 40% of in AuM in 2023 that it took 3 years for CBAM's AuM to recover from, that would lower valuation to £430m.

Let's use the £430m valuation as a market downturn seems a realistic scenario.

Comps:

There has also been a spate of transactions in the UK in the sector as the market consolidates, with the most relevant recent comps being:

·      June 2021. Charles Taylor with £25bn AuM was acquired by Raymond James for £279m or 1.1% of AuM.  74bps revenue margin.

·      October 2021.  Adam & Co with £1.7bn AuM was acquired by Canaccord Genuity for £54m or 3.2% of AuM.  80bps revenue margin.

·      December 2021.  Punter Southall with £5bn AuM was acquired by Canaccord Genuity for £164m or 3.3% of AuM.  100bps revenue margin.

·      March 2022. Brewin Dolphin with £56bn AuM, was acquired by RBC for 22x earnings or 2.7% AuM.  78bps revenue margin.

·      March 2022 - bid rumour.  Natwest rumoured to be exploring £2.5 - £3 billion bid for Tilney, Smith & Williamson, owned by Permira and Pincus Warburg which has £58bn AuM, therefore valuing it at 4.7% of AuM. 

The DCF base case of £465m is broadly in line with Brewin Dolphin's valuation, a good comparator as its vertically integrated business model is similar to CBAM's.  Both have above 90% of discretionary AuM, which are more profitable, and have similar revenue and operating margins.  Charles Stanley sold at a lower multiple, but had only 60% of AuM as discretionary under management and a lower operating margin at 10%.

Winterflood:  stable market leader generating high returns

Winterflood is the largest UK market maker by volume, with a leading position in particular in small caps and AIM market stocks, which generate 60% of revenue and where there is less competition by high frequency trading firms.  Similar to the rest of CBG, it provides a high-touch service, to over 400 counterparties in 15,000 instruments with 90 traders, but with 97% of all orders received and executed electronically via its proprietary platform.  It acts in a principal capacity only but manages risk well, averaging 2 loss days p.a. in the last five years with 7 loss days only during 2020, despite high volatility.

There would be no shortage of buyers for Winterflood.  Its main competitors in its core market-making business are investment banks with their own market-making operations. In addition, Winterflood is growing adjacent businesses where investment banks have greater scale, such as corporate broking, and dealing and custody services for institutional clients.

There are no public comps for Winterflood in the UK.  In the US, there is Virtu Financial, which has more volatile earnings than Winterflood given its focus is options and futures.  Nonetheless, Virtu trades at an EV/EBIT of 11.2x using its average earnings for the last 10 years.  Winterflood's average EBIT over that period is £31m, which would value the business at around £340m.

Valuation and returns

Intrinsic value - sum of the parts

The most appropriate approach for determining intrinsic value of CBG Group is a sum-of the parts, as the 3 businesses are operated separately and have no material synergies.  For example, CBAM has very little cross-selling with CBG, given it does not operate a full-service retail bank. 

As explained above, Winterflood and CBAM are worth £340m and £430m respectively. 

For Banking, given the high historic (10%+ p.a.) and projected loan book growth rates, it would be appropriate to do a discounted cash flow.  Let's assume:

·      Management's forecast base case loan book growth of 8% per annum through to 2026, which seems reasonable given CBG's track record and the fact that it is still a relatively small player;

·      Net interest margin (NIM), cost to NIM ratio, and impairment ratios of 9%, 50%, and 1.3% respectively, in line with historic averages;

·      Corporation tax of 19% rising to 25% in 2023.  Banking surcharge tax of 8% on profits over £25m in 2022, and 3% on profits over £100m thereafter (per government announcement 27 October 2021);

·      Terminal value of 2.5x NTAV, reasonable given 19.5% historic return on NTAV and that growth will very likely continue beyond 2026.  Assuming 2% growth beyond 2026, for example, 2.5x NTAV implies a cost of equity of 9.8%, which is reasonable given the quality of this business;

·      Discount rate of 10%

This yields a value of £3.1 billion for the banking business, or 2.7x current NTAV.  Of course, banking could continue to grow at higher rates beyond 2026 given CBG's relatively small size, which would be upside to this.

There are then corporate expenses of £28m p.a.  Let's assume half of this amount would need to be replicated by the 3 individual businesses if separated, 2% growth and a 10% discount rate, which equals £28m *0.5 = £14m/(10%-2%) = £175m

Taking all this together then yields an intrinsic value of approximately £3.7bn or £24.5 per share.

Valuation at historic CBG multiples

Of course, a sum-of-the-parts valuation often proves elusive without a catalyst or the market recognising it.  This has indeed been the case with CBG. As banking represents 80-85% of its profits, CBG is classified as a bank and the analyst community treat it as such, valuing it on a price-to-consolidated book basis. 

So it is right to ask, what happens if nothing is done by way of corporate activity to crystallise intrinsic value?  To answer this, let's look at CBG's historic multiples to see what its valuation might revert to with time and given that its business is fundamentally stronger now and likely to continue growing.

CBG's average price to NTAV since 2011 is 2.1, with a high of 3.0x over the same period (2015).  Let's assume it took four years for a rerating from the current valuation of 1.2x to the historic average of 2.1x.  It's unlikely to take that long as it has traded above 2x at some point in every year since 2013.  But even if it did, that is a 15% CAGR.  Add to that the current dividend yield of 6% and you have a 21% return.  But you also have the growth in banking and CBAM (90% of profits combined) over that period, which means a total return of around 28% assuming 8% growth in each as per above. 

Furthermore, under a scenario where CBG's multiple remained at such a discount to intrinsic value, these returns would be enhanced even further by share repurchases.  Just commuting the dividend to buybacks over the next four years would increase returns by 200bps (at prices that assume a linear recovery of the P/B multiple over the 4 years).   This is to say nothing of any distributions beyond that given CBG's current capital position, especially once it is approved for IRB. 

Margin of safety vs downside risk

They key takeaway in all of this, for position sizing, is that we are getting a margin of safety of 50% but with very little downside risk given the quality of CBG's businesses and the operational track record. 

Potential for corporate activity

There is no impending catalyst nor none needed given the steep discount to intrinsic value and the likelihood of a rerating, given historic multiples.

That said, two factors could make a catalyst more likely now:

M&A in wealth management market

Firstly, there is the active M&A market for wealth management businesses.  CBAM has the critical mass to be a platform for a strategic buyer or a financial buyer looking to consolidate, or a meaningful tuck-in to one of the larger existing players, and it will have increasing scarcity value as potential targets disappear.  The Board would have to give serious consideration to any offer at the full prices that are currently being offered.  A sale of CBAM could also highlight Winterflood as a potential target and accelerate a rerating of the banking business.

Activism

Secondly, there is more activism in the UK equity market generally as it remains cheap. 

As noted earlier, this is especially relevant to CBG given its Boards mixed record on capital allocation. Although it does not do silly things and also scores an A for generating high returns from reinvestment into the business, the Board is myopic beyond this, adhering religiously to a dividend policy demanded of them by dividend-hungry UK retail income funds and institutions.  This is the world of UK equity markets.  This situation could well invite an activist into the fray, who with even a small stake could pressure the Board on two fronts (and at a minimum expose CBG's mispricing):

1.     Share repurchases.  CBG has never done share buybacks, despite the share price often trading at a steep discount to intrinsic value.  It is currently trading at the steepest discount ever and many of the main clearing banks have announced share repurchase programmes this year.  CBG deserves ample credit for holding capital optionality so it is able to come out swinging in case a downturn forces competitors to retreat.  However, its capital position is now stronger than ever and the dividend should not be sacrosanct when the return from buybacks is 100%.

2.     Breakup.  The Board has not explored breaking the company up to crystallise the fair value of the three separate and different businesses.  Winterflood, for example, is valued by Management for its countercyclical earnings, but this is to support the cherished dividend track record.  Neither of these businesses are a headache for CBG, in terms of consuming capital or management time, but breaking the company up cannot simply be batted away when the share price has been trading below intrinsic value for so long.   

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[1] NIM less loan impairment and operating costs

[2] CBG has a CET1 equity requirement of 5.1% of risk-weighted assets below which it would need to raise equity.  In addition to this, it is required to hold 2.5% of risk-weighted assets as a capital conservation buffer, which if breached would result in bonuses and shareholder distributions being blocked. Furthermore, the Bank of England has recently re-imposed a countercyclical capital buffer of 1%, which if breached also restricts shareholder distributions.  This gives a total requirement of 8.6% CET1 for CBG on risk-weighted assets of £9.3 billion, against a current CET1 ratio of 15.1%.

[3] The standardised risk-weighting applied to CBG's £2.5bn property loan book (£1.5bn loans outstanding plus £1bn undrawn commitments) is 150%, which means CBG is required to hold £300m of capital against its property book, as minimum capital requirements are 8% of risk-weighted assets.  CBG's overall risk-weighting is 70% across its entire book, which means the property book requires more than twice as much capital even though it has by far the lowest impairment ratio of CBG's lending segments (0.3% in the last five years vs 1.2% for the remainder of the loan book). CBG's lending is risk-weighted as if it were commercial property development even though it does residential only with LTVs of 50-60% of developed value.  A comparison with mortgage books also provides some indication of the difference between standardised and IRB ratings:  10-13% for IRB vs 35% standardised, or a 3-fold difference (source: https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/consultation-paper/2020/cp1420.pdf.  See paragraphs 1.7-1.8).

[4] The LCR is the ratio of a bank's high-quality liquid assets to 30 days of cash outflows, with the regulatory minimum being 100%.

[5] Source: Oliver Wyman

[6] This is consistent with a metric management gave during an investor seminar for CBAM in 2019, where they estimated operating profit changed £600k for every 1% change in AuM.  8% growth p.a. x £600k = £4.8m x 9 years = £43.2m incremental profit over 2021 operating profit of £23.3  = £66.5m