AFH Financial Investment Thesis Nov-17
Market cap: £94m (post raise)
Enterprise value: £73m (excluding net cash adjusted for regulatory capital)
AFH raised £17.5m via an institutional placement to accelerate their growth trajectory. Based on the increasing deal size, combined with managements ambitious growth aspirations, we believe they will be able to deploy a material portion of this incremental capital over the next 12 months. If we assume 75% of the new capital is deployed in-line with historical multiples (4x EBITDA post integration) the accretion looks very attractive:
|Net cash:||£4m||Net cash:||£7.5m|
|FY1 EBIT:||£7m||FY1 EBIT:||£10.8m|
AFH Financial is an Independent Financial Advice provider pursuing a consolidation strategy on the highly fragmented UK market. There are structural tailwinds driving this consolidation and we believe AFH provides an attractive home for the clients of retiring advisors due to their decentralised operating model and in-house investment management and custody services which provide as good a service, at a lower cost to the client.
We believe there is 50-85% upside over a 2-3 year holding period as the management team deploys excess capital on further acquisitions at an attractive 3-4x post-integration EBITDA multiple. Downside is somewhat limited by sticky, recurring style revenues, and the current valuation is supported by the earning power of the existing business, on an annualised basis. We believe the market is failing to value the business on a run-rate basis and is instead waiting to see the profits appear in the accounts. By framing the investment case in this manner, we can determine what the business would be earning on an annualised basis if they deployed the current resources on acquisitions in-line with historical returns.
- Financial services firms are highly regulated and this leaves the business exposed to unfavourable changes
- The FCA/HMRC etc. could decide to impose limits on market aggregation due to perceived anti-competitive pressures from consolidation
- Unlikely anytime soon given the highly fragmented industry and AFH’s size
- Could be pressure on the advice fee they charge (i.e. percentage of assets)
- We view it as unlikely given the fees they charge (<1%) seem reasonable for the all-encompassing service they provide
- Given they’re a highly acquisitive firm, there is a risk of integration going poorly and leading to an increase in client churn
- To date, AFH have been very successful at acquiring in-line with their stated goal and keeping churn to less than 5%
- Consistently pay out 90%+ of deferred consideration
- Increase in transaction multiples
- Potential, but limited by the business being undervalued on the current book of business & an aligned owner-operator focussed on generating attractive returns on capital
- Material decline in equity markets
- AUM beta to markets approximately 0.40 based on average portfolio exposures
- Relatively high fixed cost base means that a small movement in assets, would lead to a higher profit impact
- Failure to deploy the incremental capital quick enough
Business model overview
AFH are pursuing a consolidation strategy for the UK IFA (independent financial advice) market. The strategy involves buying books of business from advisors looking to retire and then transitioning the clients over to existing advisors within the network. The structure is highly decentralised with all advisors operating from home, with centralised admin, compliance, and acquisition teams, allowing for easy integration and lower risk. The acquisition risk is further reduced via a deferred payment schedule where they pay 50% of the total cost upfront, 25% in year 1 and 25% in year 2 – pending EBITDA performance. Given they aim to acquire on 3-4x post integration EBITDA, the upfront capital at risk, equates to only 1.5-2x EBITDA.
While always difficult to discern how well the businesses are being integrated in a highly acquisitive model, we note that to date, they have paid out in excess of 90% of deferred payments. They also model for 5% client attrition post-closing a deal, but have historically performed better than this. Further, as discussed below, the numbers they’re reporting mirror exactly what the company states they target. Therefore, we believe there are sufficient signs that the management team have historically been successful at integrating the acquired firms.
Are they really better together?
Most roll-up strategies use a public-private multiple arbitrage to generate the majority of their returns and the businesses make little sense in being “together.” However, in the IFA space, we believe there are benefits to scale and the market is being pushed to consolidate by the increasing burden of compliance costs.
We believe there are benefits to aggregation from:
- Spreading a fixed compliance cost across a larger client base
- Reduced key man risk through a deeper bench of support staff (average advisor age approaching retirement)
- The ability to manage investments in house, which reduces overall costs & reduces VAT risk
The benefits can be seen through analysing pre and post integration EBITDA margins. On average, the acquired firms go from earning margins <20% to in excess of 30%. From a group level, AFH should see continued margin expansion due to the higher cut of fees they take for an “AFH generated client.” If the advisor generates a client then they keep 60% of the advice fee, however, if AFH generates the client (i.e. through an acquisition in which the client is transferred to an existing advisor within the network) the PLC keeps 60%.
We believe AFH is an attractive home from the advisor’s perspective because:
- Long term home for their clients, as opposed to a PE firm which would look to re-sell within a few years
- Most advisors continue to work from home
- AFH provides compliance support as well as scaled marketing which should drive new business
- AFH provides in-house investment management
From a client’s perspective, AFH is attractive due to:
- If the advisor is retiring, the transition is very smooth as the client “stays within the system”
- The greatest inertia in winning new clients is the hassle associated with transition
- Will be served by an existing advisor within the AFH network who is normally younger/more eager than the prior advisor and is highly incentivised to ensure client satisfaction
- Will not see any increased fees, in some cases, fees actually decrease because AFH gets institutional rates on the funds they use and do custody in house (removing the 30bps platforms charge)
Finally, we believe one of the key factors driving current consolidation is the treatment of financial services and VAT (Value Added Tax) exclusion. Currently, many smaller IFA’s are outsourcing the investment management services to a separate, specialist entity. If this is performed by a completely separate, 3rd party, operator, the advisor fee is subject to VAT and should be ~20% higher than what most are charging. Currently, most small IFA’s are not charging VAT because “nobody’s doing it” and there is a strength in numbers. However, under the AFH banner, where they manage investments in-house, this risk is eliminated. We believe this risk is in the back of most IFA’s and may be contributing to the acceleration in consolidation we have seen in recent years.
Attractive returns on incremental capital
From 2014 to the end of 2016, AFH spent ~£14.5m on acquisitions. In 2017, the firm achieved EBITDA of ~£5.6m, of which, ~£1m related to acquisition made within the 2017 fiscal year. Therefore, organic operations and acquisitions made up until the end of fiscal year 2016, generated EBITDA of ~£4.6m.
In 2014, the year they began the new acquisitive strategy, the firm generated EBITDA of £1.3m. Therefore, through a combination of organic growth and acquisitions (majority), the company has added £3.6m of incremental EBITDA. Or, said another way, the company has achieved a return on incremental capital of 25% (£3.6m / £14.5m acquisition spend).
Therefore, the numbers they’re achieving are in-line with management’s statement of targeting a 4x post integration multiple. This is an extremely attractive return given the sticky and recurring nature of the revenues they’re acquiring.
To determine whether the acquisitions are performing in-line with stated targets, we calculate a theoretical EBITDA that uses the prior year’s acquisition spend, to determine what the current year’s profit should be:
Therefore, while year-to-year there are some small differences, when the theoretical EBITDA overshoots, the actual tends to overshoot in the following year. Given the timing differences in when acquisitions are made and slight variations in integration timeframes, this seems reasonable. In general, the expected returns tend to be lining up with the actual results the company is posting.
A recent survey by Minerva revealed that only one in five UK investors would trust software to make their investments decisions, one in ten would trust a robo advisor, but 72% trust a traditional financial advisor. Therefore, at this stage, we do not believe robo-advisors provide an immediate threat to the industry. If anything, it may provide an operational cost opportunity.
Our edge in AFH comes predominantly from time arbitrage and valuing the business from a “run-rate” point of view. What we mean by this is as follows:
- For the year to 31-Oct-17, AFH will likely earn ~£5.6m EBITDA
- Therefore, post-raise, it looks somewhat expensive, on an EV/EBITDA multiple of ~13x
- However, once you include a full year contribution from the acquisitions made in FY17, the multiple falls to around 8x
- Therefore, by analysing what the current business could earn on an annualised basis, we can determine a more accurate estimate of the earning power and thus, current implied valuation
This way of framing the earning power of the business can be extended into outer years. For example, post the raising, AFH will have around £20m in excess capital available to be deployed on acquisitions. If we assume the management team can continue to acquire businesses on 4x post-integration EBITDA, this will add £5m of incremental profits.
AFH deployed >£17m on acquisitions in FY17, therefore, they should be able to deploy £20m over the next two years. Taking our current estimate of their “run-rate” and adding the incremental EBITDA they should be able to acquire using current resources, we get to a future earning power of close to £15m in EBITDA. Currently, the only analyst that covers the stock has them achieving ~£10m EBITDA for the FY19 fiscal year. This is only marginally higher than what we believe the current book of business should be able to generate on a full 12 months, hence, there should be room for material earnings revisions in time.
Shareholder value drivers
We believe AFH is currently going through the “discovery phase” where brokers and institutions begin to become aware of the firm. This should lead to the market valuing the company on a higher multiple, in time. When combined with the strong acquisition pipeline, and likelihood of continued organic growth, we have several levers available to drive shareholder returns:
- The company is about to reach a key market cap threshold (£100m) which introduces a broader set of investors
- The stock is only covered by one analyst and all stakeholders are pursuing further research breadth
- The retail following is extremely low, evident through the low level of bulletin board discussion
- ADVFN currently has ~75 messages discussing the company, vs. our stock Universe average of >750
- The house broker is currently looking at introducing the company to one of the retail newsletter writers (key stock price driver for UK micro-caps)
Finally, the company just posted a very positive update, but the stock hasn’t moved because all of the institutional holders have been wall crossed due to the placement. Therefore, once the large investors return, we could see the positive results get priced in.
All ideas, opinions, views, forecasts, comments, suggestions, or stock picks included in this blog are for informational, entertainment or educational purposes only and should not be considered investment advice. I do my best to ensure all information provided is accurate, but do not guarantee it and I will make mistakes from time to time. Please do your own research and do not rely on any facts, figures or opinions in this blog.
Funds I manage hold positions in AFHP.L and may trade in or out without further notice.