Note: the authors fund holds a material position in the company and may trade in or out of its position. This is not financial advice, please do your own research. This report was created in mid June-2017 at a stock price of 45p and all return calculations are based on such. I provide no gurantee for the validity of any data point in this report.
In March of this year, Her Majesty’s Revenue, and Customs (HMRC or the British Tax Office) announced changes to the taxation of Qualified Recognized Overseas Pension Scheme’s (QROPS). QROPS management fees contributed around 50% of STM’s FY16 revenues and ~80% of operating profit. As such, the market sent the shares down >20% on the day of the announcement. The taxation change will not be retrospective but will impact the number of potential new clients materially. Therefore, the ability for STM to grow organically has been substantially impeded. However, the existing book of QROPS forms an annuity revenue stream with very low annual attrition (<3%).
After making an adjustment for regulatory capital which should be released this year and become available to the company, we estimate the stock is trading for an enterprise value of ~£20m & assuming a full year contribution from the recent LCH acquisition should generate sustainable free cash flow of £2.8m. Therefore, at a current price of 45p we view STM as a quasi-bond yielding 15% with the potential to grow via consolidation of sub-scale players in the now “runoff” QROPS market.
The vast majority of STM’s business stems from the administration of QROPS. A QROPS is essentially a structure that is used when someone who has previously worked in the UK, and built up a pension asset there, decides they wish to retire outside of the UK. At this point they transfer their UK pension into a QROPS, which will then deliver them an income stream in the region they choose to retire. For the administration and management of these schemes, STM charge a fee of ~£750 per annum.
The economics of this business are very attractive once scale is achieved. It costs around £30,000 in salary for a person to administer a QROPS and each employee can handle ~500 schemes:
|Schemes per employee:||500|
|Revenue per scheme:||£750|
|Cost per employee:||£30,000|
|Gross profit per employee:||£345,000|
|Implied gross profit margin:||92%|
Spring Budget 2017 Tax Changes
On the 8th of March this year, HMRC announced they were introducing a 25% tax charge to any pension transfer in a QROPS, unless, both the individual and the scheme are in countries within the European Economic Area; both the individual and the scheme are domiciled in the same country; or the QROPS is an occupational pension scheme.
The company believe this will impact the growth of all non-EU potential clients. Historically, non-EU clients have made up ~80% of new client adds. Historically, organic growth from new QROPS clients has been 10-20%. Post change, we estimate this to now be 2-4%
Why does the opportunity exist?
We believe the opportunity exists for several reasons:
- The market is failing to account for the release of £2m in regulatory capital post the consolidation of LCH. This dramatically reduces the enterprise value of the business
- The market is incorrectly classing STM as a book of QROPS in runoff and not considering the consolidation opportunity
- Given the lack of organic growth opportunities and the fragmented nature of QROPS administrators (mostly Mom & Pop shops) we believe that STM is in a prime position to roll up the sector
- As shown in the overview, the economics of this business flourish when a business is at scale i.e. a few thousand schemes
- Our research suggests that STM could acquire these books for 1-1.5x trailing revenue
- Assuming they acquire 8,000 schemes, we estimate this would add over £8m of incremental EBITDA and generate >20% returns on incremental capital
3. The stock has a messy balance sheet due to regulatory capital associated with the Life Assurance business and the underlying profitability of the QROPS business is masked by lower margin segments
- Given the consolidation opportunity, we believe the management team is looking to sell most of these other segments to free up capital to employ in acquisitions
- This will clean up the balance sheet and allow the true profitability to shine through
What is our edge?
- Predominantly, it stems from a fundamental disagreement with the market. In our opinion, the outlook for STM actually improved post the tax changes because:
- It made existing customers stickier because less people are bidding for their business
- It reduced the likelihood of new entrants (runoff style business)
- It lowered acquisition multiples & opened up the consolidation opportunity
- The current sell-side numbers are also extremely conservative
- Assume none of the cost-out that management has spoken to
- Assume no growth going forward
What will cause the market to correct this mistake?
I think the market will begin to re-rate the business once they make their first acquisition. This will allow the market to see that a growth story remains intact, albeit a slightly different one to what most had planned on investing in.
If the mispricing lasted for too long I could see a small Private Equity firm getting interested (we estimate that 30% IRR’s are on offer assuming a 25% take out premium) or one of the SIPPS providers may look to acquire the cash cow QROPS book and plug it into their existing infrastructure, generating higher margins through cost synergies.
At current prices (~45p) I think STM is selling for the present value of its existing QROPS book + the excess cash that should be released to the company post the consolidation of the recent LCH acquisition. Valuing the existing QROPS book is fairly simple given the low churn and fixed annual fee:
This means that we are getting the SIPPS book, Trust business and Life Assurance firm for free! These other segments are expected to generate ~£1.5m EBITDA in FY17. Valuing this stub on a conservative 6x puts the group value at ~60p (33% above current levels)
We believe that post the change in taxation legislation, the QROPS market has become ripe for consolidation given the benefits associated with having scale. We also believe that the market multiple for these existing books is falling and will continue to do so given they are now essentially in wind-down. The management team of STM is acutely aware of this phenomenon and is actively looking to “roll up” the industry.
We believe it is likely that STM will divest some of their non-core business units for multiples of 1-1.5x sales. When this cash inflow is combined with the existing cash to be released from the reserves of the Life Assurance business, they should have over £8m in funds available to acquire QROPS books. If we assume they can purchase these books for 1.5x sales, this would add over £1.5m of incremental EBITDA. A stable, recurring stream of QROPS fee income could trade for 15x – implying a valuation of ~100p (over 100% upside)
- The major risk would be any negative regulatory impact from STM failing to perform due diligence on the underlying investments held in their clients’ accounts
- The major “risk” to the business has already been aired – i.e. the change to the tax treatment for new schemes. Therefore, I see any further negative regulation as low probability
- Poor capital allocation
- The management team could squander the cash flows produced by the QROPS/SIPPS books
- See this as somewhat limited given the high insider ownership & short, but promising track record regarding use of capital (i.e. potentially spinning off non-core segments)
- Small & illiquid stock
- The lack of liquidity may limit the ability for it to re-rate
- If the consolidation story struggles to get moving, there won’t be a growth story to attract incremental buyers & we will have a difficult time exiting the positon
- This is limited through having a lower weight
Base case valuation = 73p
Base case return = 28p
Worst case return = (5)p
Risk/reward = >5:1
Catalysts & Tripwires
- Acquiring a decent sized QROPS book & explaining the consolidation story to the market
- Consolidating LCH and allowing additional cash to be released
- Any sign of organic growth in new QROPS
- Divestment of non-core segments allowing the underlying profitability to shine through
- Increase in dividend or capital returns
Tripwires / reasons to sell:
- A material and continued increase in client churn
- A material increase in “reinvestment for growth”
- Inability to deploy capital into new QROPS books acquisitions
- Acquiring something outside of the pensions business (QROPS & SIPPS)