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IDB at a Huge Discount: Tullett Prebon – I Trust Terry

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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%


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.



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 a takeout valuation would exceed 500p per share (i.e. a sensible valuation during a period of uncertainty plus a premium of >100p per share for the Asian potential) to take control of the business from it’s strategic shareholders who appreciate the long term oligopolistic advantages of the industry.

A Private Equity backed MBO was mooted by analysts at Numis. This has attractions because the cash generative nature of TLPR can support the debt burden of a leveraged buyout and also tying the management and key staff into the deal means there is less risk of them leaving to competitors during any shake up.


Attractive Valuation Metrics and Cash Flow

The stock currently sits at 365p and is expected to earn 45p in 2011 down from 46p in 2010. This places it on a current P/E of 8.1x earnings. The dividend this year is 16p, equating to a yield of 4.4%. They have grown the dividend from 6p to 16.3p in the last 5 years – a compound growth rate of 21.6%. Dividend Cover is 2.6x. TLPR trades at a large discount to main rival, ICAP on 12x this year’s earnings and a 4.2% yield.

Speculatively one might assume that a fair valuation of the business would seem to be a PE of 10x and 1.25x revenue (i.e. circa 500p) , while during a period of uncertainty a PE of 8 and 1.0x revenue would be more sensible (i.e. 400p). This doesn’t seem unreasonable for an entrenched market leader in an oligopolistic, cash generative industry. Even at 500p it would still be a 3.2% yield on this year’s dividend.

Due to the nature of the business it is incredibly cash generative and requires very little in the way of Capex. Remarkably, the capex run rate is as low as £10m per year, the vast majority of expense is staff remuneration. Like other well run “professional service” businesses this affords a very attractive ROE in excess of 20%.  This lack of capital intensivity means that most of incremental revenue increases can flow straight into earnings and shareholder distributions.

Historically the company has an excellent track record of turning almost all of it’s operating profits into cash with a range of between 119% and 86% over the last 5-6 years. The Free Cash Flow yield is currently between 12-13%.


Strong Financial Position

The company stated in 2010 that they had over £150m surplus capital which would continue to build.  As this is over and above any regulatory capital requirements and given the company’s low capital expenditure (normally around £10m per year), there is a strong chance that this could be returned to shareholders either via a special dividend or a share buyback. The former is more likely as the company has chosen that option historically – a £150m distribution would be worth c75p per share. This would echo a 2007 distribution of £300m. This idea has been mooted by brokers before and may just be wishful thinking. It would however help to optimise the balance sheet.

While in the past the company has paid out c30% of earnings as dividends, there is an argument that this should be increased, providing scope for a material increase in the dividend payout.

On the 8 June 2011 management announced that the FSA had renewed its “waiver from consolidated capital resources requirements” until June 2016. Tullett Prebon’s disclosures under Pillar 3 reveal that at end 2010 the group’s capital resources were £461.1m above its total capital requirement (Dec 2009: £358.1m). If the group had £150m of excess capital in 2009, arguably it currently has over £250m of excess capital.

The Balance Sheet currently has circa £300m of cash sitting on it which is almost 40% of the market cap. Simplistically you could pay off the long term debt of £238m and the non-current liabilities of £33m and still be left with a cash pile of circa 5% of the market cap. Demonstrably, this is a well capitalized business! If and when this is returned to shareholders, there is scope for the market to substantially re-rate the stock.

For a business that spends so little on Capex (around £10m or 1% of sales) it is bizarre to me that TLPR has a payout ratio of only 33%. Tullett is in a position to structurally review/rebase it’s dividend to a much higher level. There is the possibility that Capex will need to increase over the next few years should they decide to launch new initiatives or programmes to improve their electronic offering.

Skin In The Game

The CEO, Terry Smith, holds a 4.5% stake in the company and has been a buyer of the shares around current levels. He is a very vocal character and it could be argued that a less controversial CEO would do the share price some favours however his fans argue that it takes a strong hand to run an army of bolshy brokers. To his credit, Terry has managed the TLPR pension fund to a surplus due to his shrewd investing.


It should also be mentioned that due to his new project FundSmith (a fund management company) he will hopefully be toning down the rhetoric! Needless to say however, with a stake worth well over £50m at 4.5% of shares outstanding, his interests and ours are aligned.
I love investing in Owner Operators, it’s a consistent theme in my holdings – one day I’ll do a post on the attractiveness of them specifically.


Why is it Cheap? What is Worrying the Market?

Capital Markets

Tullett has clearly been tarred with the “Capital Markets Brush”. Nobody wants anything to do with an opaque financial firm where people do not instantly recognise the value add and the source of profits. I think the first reaction is to want to look elsewhere.


Concerns that Tullett Prebon is behind the curve technologically seem overblown. There has been no sign to date that the company has struggled relative to more electronically-inclined peers, neither in terms of revenues or market share. Moreover inconsistent performance from existing electronic swaps platforms suggest that it is probably too early to talk about any first-mover advantage being lost to peers like ICAP that have already rolled out electronic dealing systems.

Regulatory Change

On the capital requirements front it seems to me to be as much of an opportunity as a threat and it is clear that the impact will be far less than first feared. As discussed above, On the 8 June 2011 management announced that the FSA had renewed its “waiver from consolidated capital resources requirements” until June 2016.

Concerns over restrictions being placed on proprietary trading look to be overdone – ICAP suggest that only 3 to 7% of trading revenues for the banks came from proprietary trading and that banks will need to continue to manage their structural positions (reconciling FX positions, hedging interest rate risk, etc.).
Technology itself is addressing many of the regulatory concerns with Tullett increasing the use of electronic broking following a tie-up with Millennium IT and through their hybrid model (combination of voice and electronic broking on one platform).

High Court Ruling

A High court judgement, following BGC’s “raids” on Tullett in 2009 – BGC took 77 brokers from TLPR which decimated their US business and required several years of restructuring. TLPR closed satellite US offices and installed new management – they are now back to the same number of operating brokers. The High Court Ruling sets a legal precedent and could be a major positive for those IDB’s in particular that already have teams covering the main markets (e.g. Icap and Tullett).  Longer-term, it should be reflected in higher valuations as it makes the businesses lower risk and potentially higher margin.

This presents a good opportunity to tackle another one of the problems Tullet encounters. It is, to some extent, hostage to it’s employees – it is a people business and when the people leave, as they did with the BGC raids, then potentially the clients/customers go with them. This new legal precedent reduces this concern somewhat but I imagine it will still linger as it does in traditional stockbroking.

At previous results management have commented that there is an unfortunate trend in the broker comp/revenue ratio trending higher towards 60% over the last few years – this was put down towards fear of staff retention.

A Buying Opportunity…At The Right Price?

With an attractive yield, buying the shares around 350p would offer the potential for a 16% total return to the base case valuation – and materially higher should one of a number of potential scenarios play out.

It is not beyond the realms of possibility the market decides this is a stock deserving of a 12x multiple due to balance sheet strength, oligopolistic market positioning and cash generation. If we see earnings of 45p in 2012 then it would be a 540p stock plus 2 x 16p dividends and we are looking at 572p over the holding period. A compelling 61% return on investment or 27% CAGR.

I don’t currently own the stock but I would certainly consider a position if the shares traded back towards 330-350p – at that kind of level I believe there is an attractive Margin of Safety for embracing regulatory risk.

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