By Kelpie Capital

Price – 365p      Market Cap – £784m    2011 EPS – 45p

2011 P/E Ratio – 8.1x    Div Yield – 4.4%    FCF Yield – 12%

2011 Rev – £906m     2011 EBIT – £145m   

Net Cash on B/S – £51m (6.5% of market cap or 24p per share)

EBIT Margin – 16%

Business

Tullett Prebon is the world’s second largest inter-dealer broker (IDB) and acts as an intermediary in the wholesale financial markets, facilitating the trading activities of its clients, in particular commercial and investment banks. The shares look attractively valued as a stand-alone business, furthermore I see a number of potential positive catalysts. The industry faces some serious headwinds/uncertainty in the meantime which we must address.

Industry Analysis

The IDB market is dominated by a few oligopolistic operators, with Tullett being either number one or number two in all of its major product groups.  Dealers voted the company “interdealer broker of the year” and it won 1st place in 31 products. The single most important product area is the interest-rate derivatives market at just less than one-quarter of industry revenues, the majority of which is from broking interest-rate swaps to industry and financials.

Amongst competitors, ICAP has the largest number of voice brokers, at ~2,300, while Tullett Prebon, Tradition and BGC all have around ~1,600. It seems that revenue per broker is broadly flat across the industry with ICAP and TLPR slightly ahead, which probably reflects the power of their franchises.

The need for large fixed cost back office, infrastructure and technology has meant that the industry continues to see consolidation under the major players which should help reduce competition.

 

Macro

IDB’s provide a valuable service in the facilitation of global trade. Derivatives, as you may know were invented long ago in Ancient Egypt as a way for farmers to hedge or sell forward their grain/wheat production and provide price certainty. At that point Agriculture was likely a very large contributer to GDP. Tullett deal in similar derivatives today although like their share of GDP, agricultural derivatives are now a small part of the total notional market. Today it is the multinational industrials, mining companies and techonology giants that require interest rate and currency hedging – they are the drivers of global trade and GDP and it is their success that is the rising tide that will increase TLPR’s top line.

Although I personally believe that the “financialisation” of the developed world has likely peaked or plateaued, it is key to recognise that “financial innovation” has probably not stopped (I am reminded of the quote from Paul Volcker about the only worthwhile financial innovation since the 1970’s being the ATM!). Only a decade ago the market for CDS barely existed, now it’s a key revenue source for IDB’s. New products will likely be designed and forge new revenue streams and there are several key events in the future which may open up huge opportunities – a free floating (and therefore hedge-able) Yuan, for example?!

In essence, developing economies require less in the way of financial sophistry than developed economies do – as the BRICS and Frontier Economies emerge they will increasingly participate in global commerce and increasingly require FX and hedging services.

 

The OTC derivatives market which constitutes about 45% of IDB revenue is seeing unprecedented reform (Dodd-Frank, EMIR / MiFID II) and therefore unprecedented uncertainty. The precise implications for participants are uncertain as rules have not been finalised. However, it seems likely that greater regulation and greater capital requirements for derivatives trading will weigh on volumes AND size (a recent survey of derivatives dealers suggests that 90% expect volumes to fall as a result of new regulation). Interestingly, Berensberg Bank think that the regulation could be broadly favourable to the IDBs by enhancing their status as intermediaries in OTC derivatives trading – I’m not entirely sure I understand WHY this is the case and they don’t explain it!

For all IDBs by far their biggest cost is broker remuneration which often extends in excess of 50% of revenues. This is a positive in a way because it allows a very large part of the cost base to be flexible due to the discretionary bonus system.

 

Electronic trading to the rescue?

In the long term, IDBs should see a continued adoption of hybrid/electronic trading with corresponding margin benefits. A near-term ‘step change’ in operating margins seems unlikely as the IDBs try to migrate the more liquid parts of the OTC derivatives trading to electronic order-book trading. There are too many uncertainties, including: (i) the impact of trading and clearing reform on overall OTC derivatives activity; (ii) the extent that OTC derivatives can move to a purely electronic model. I can’t see how voice brokers don’t remain an important part of the trade process (a ‘hybrid’ trading model), which will limit the margin expansion opportunity for the sector BUT benefits the more voice orientated players like TLPR.

 

A Variant Perception on European Exposure

It’s core European division (~75% of group profits) has returned around 23% operating margins in the last two years in spite of the tough trading environment. This resiliency in the face of what has been a fairly horrid macro and market environment is encouraging. Perhaps the market is marking TLPR down on the back of this high European and UK exposure in contrast to attractive Asian growth. One thing I learned when I worked in Singapore was the value of GMT time. No matter how weak the macro environment the fact is that there are many advantages to doing business on GMT – you can speak to Asia in the morning and the US in the afternoon. That will NOT change therefore I think its very hard to challenge the ascendancy of London and to a lesser extent Edinburgh, Geneva and Frankfurt as financial capitals.

Asian Potential

The company has been building a business in Asia and while operating margins are currently small as the costs of setting up are absorbed, there is clearly significant potential here as capital markets become more developed, liquid and westernised. Clearly the trend of IPOs in Hong Kong, like Prada for example, show that involvement on the Far Eastern Bourses is essential for the long term business model.

As alluded to in the “Macro” segment – Asia offers massive growth potential in financial products, despite having a total GDP of 1.5x that of Europe – Tullet manages to derive only one fifth as much revenue from Asia as Europe. As Asian businesses become more global and financially sophisticated and their capital markets deepen this balance is likely to shift dramatically.

 

 

Viable M&A Target?

The company itself believes further consolidation is inevitable – but rather than IDB’s bidding for other IDB’s, it will be exchanges bidding for IDB’s (there are 7/8 exchanges and 4/5 IDB’s).  This is an active area for M&A bankers right now (TSX & LSE and the Deustche/Euronext deal) as the Exchanges are getting acquisitive around each other and deals are being made to achieve operational scale. So there are guys in sharp suits with sharpened pencils churning out pitchbooks which will have Tullett as a potential acquisition target or an acquirer.

London Stock Exchange held talks with Icap in 2007 and their CEO has repeatedly spoken of his quest to turn it into a £10bn business (currently £2bn).  Tullett itself was approached early in 2010, with the most likely predator thought to be an overseas exchange.

It seems likely that

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