I owe compliments to Wexboy for bringing this business to my attention in a recent blog post. After having a discussion with the management team and fleshing out the investment thesis further, I believe Record Plc (LSE:REC) presents an attractive risk/reward bet. It’s exactly the type of stock I look for – hidden value
Record is a growth stock in disguise. It offers three key products engaged in the outsourced currency trading business. The two “active style” strategies have been materially declining since 2008 & 2011 – with the Dynamic hedging business falling 56% from its peak and the Currency for Return product declining by >95%.
While these two product segments have been struggling, the Passive Hedging product has quietly been growing at ~30% p.a. for 10+ years! 2017 was a key inflexion point for the business where the fast-growing Passive hedging business became the majority of group revenues (~53%) and the decline in the other two products began to slow. I believe the business should now be able to post “group level growth” as the passive hedging product forms an increasingly larger slice of the overall pie.
Another important point in the FY17 report was the change in capital management policy. Historically, the company had maintained a cash buffer of 2 years’ worth of expected overheads. Given the return to group growth and highly cash generative nature of the business, the management team decided to reduce this to 1 year of expected overheads, resulting in the generation of £10m in surplus capital becoming available for distribution.
I believe that the market is failing to correctly value the business given the lack of broker coverage, low liquidity and because the growth business has been hidden behind the decline of the other two segments. As the business returns to growth, pays out excess cash and introduces a new progressive dividend policy I believe the stock is likely to re-rate to a more growth style multiple.
Record is a provider of Investment Management services, specifically related to the asset class of currency. They charge a management fee based on the nominal value of outstanding forward contracts held for clients. This provides a clear and transparent fee structure that differs from many players in the FX market who charge an opaque spread.
Founded in 1983 by current Chairman (and 32.60% shareholder) Neil Record, the company experienced explosive growth leading up to the GFC – driven by their Currency for Return product. The business grew from ~£5.5m in management fees in 2005 to over £66m in 2008. In the aftermath of the GFC, the currency for return product has seen its management/performance fees fall to under £3m. Throughout this transition, Record managed to stay incredibly profitable with operating margins never falling below 30%
Record operates a fairly lean structure, with two account managers looking after the client relations for each product and the dealing for all products being centralized across one team to generate economies of scale. This should allow the business to generate positive operational leverage an increase margins over time as a new client does not require a 1:1 increase in headcount.
On face-value, Record does not look like a growth story, with revenues and operating profit in 2017 still lagging their results from 2011. However, under the surface, their passive hedging product has been growing >25% p.a. for 10+ years:
2017 also marked an inflexion point for the business, where this high growth product started contributing over half of the groups revenues:
Source of competitive advantage:
- Intangible assets – their long track record and history with clients forms a barrier to entry. Given the size of the transactions and autonomy given to Record in execution, it would take some time to build this credibility
- Record have been working as a currency specialist for over 30 years
- Cost advantages – there are some benefits to scale. It allows them to reinvest in systems and people to remain compliant in an increasingly complex environment
On current (LTM) earnings, I think Record is fair to slightly undervalued. Post the tender offer to buyback ~22.3m shares, REC is trading on ~13.5x LTM PER:
|Old share count:||216.95m|
|Post tender EPS:||0.032p|
However, given the positive operational leverage in Record’s business model, where the headcount does not need to increase 1 for 1 in line with new mandate wins, I believe the current level of profitability could be understated by up to 600bps. Assuming the top-line and OPEX growth trends of the past few years continue, Record could be earnings ~40% operating margins within 3 years and the current multiple would fall to <12x
To get a long-range valuation, I think it is pertinent to look at three potential scenarios involving different growth/decline rates for the product range and different cost growth.
|Scenario||Assumptions||2020 EPS||Implied valuation|
|Base:||Dynamic declines at 10% p.a. + Passive grows at 20% + Return declines at 10% & costs grow at 5% p.a.||0.044p||66 – 88p|
|Worst:||Dynamic declines at 15% p.a. + Passive grows at 15% + Return declines at 20% & costs grow at 6% p.a.||0.026p||26 – 38p|
|Best:||Dynamic remains flat + Passive grows at 25% + Return remains flat & costs grow at 5% p.a.||0.066p||100 – 133p|
Upside to base = 20p
Downside to worst = 8p
Risk/reward = 2.5: 1
I see the downside case as unlikely and given the long history of consistent profitability combined with the stated target of a growing progressive dividend, I believe the stock price is likely to be supported by the consistent yield.
The major risk would be the loss of a large mandate.
- In FY17, the top 10 clients accounted for £7m in management fees (74% of total fees)
- If we assume they’re all equal in size, the loss of one client would reduce sales by ~7%
- However, given the somewhat fixed cost base, if they couldn’t remove any costs, profit would fall ~25%
Disclaimer – the above is for informational purposes only and does not constitute financial advice. I or my employer may hold shares in the positions discussed and may trade in and out of them without further updates.