Is Argentex (LON:AGFX) poised for a breakout?

The last three months have seen UK markets drift lower. The mood music has been downbeat, but I think there are still some good opportunities out there for investors.

For my first article in this new format, I decided to look for UK shares that have outperformed the market and delivered positive returns in recent months. One company that caught my eye is foreign exchange broker £AGFX.

AIM-listed Argentex provides foreign exchange services and advice for commercial clients. The company targets clients with annual FX turnover of between £1m and £500m and acts as a riskless principal FX broker. It only handles commercial transactions and does not engage in proprietary trading or currency speculation.

Argentex has been on my radar for a little while now, thanks to a trio of characteristics that I find very attractive.

1. Owner management

CEO Harry Adams and CFO Andrew Egan are co-founders and significant shareholders:

2. An excellent set of quality scores

Argentex boasts excellent profitability figures, along with a cash-rich balance sheet:

3. A potential bargain valuation

If the company can deliver on earnings growth forecasts, then the current valuation of eight times forecast earnings seems very modest to me for such a profitable business:

However, the foreign exchange market is an increasingly competitive space. A number of young businesses are trying to muscle in on a market that’s historically been dominated by the big banks.

Despite its apparent progress, Argentex seems to have disappointed the market over the last couple of years, when compared to sector peers Alpha FX (LON:AFX) and £EQLS.

Each of these companies have slightly different offerings, targeting different niches. But in all three cases the majority of their revenue comes from helping corporate clients manage foreign exchange transactions.

The market seems to have prized revenue growth ahead of profitability. While I think that Alpha FX probably deserves its premium valuation, it’s not clear to me why Argentex should be so much cheaper than hitherto loss-making Equals:

Argentex’s results for the 12 months to 31 March are due on 6 July. Ahead of these figures, I’ve been taking a closer look at the business to try and understand whether the stock’s weakness represents a buying opportunity or a potential risk.

Half-year results look encouraging

Argentex stock slumped when the company previewed its interim results with a trading update in October. But after looking at the half-year numbers, I couldn’t really see any obvious reason for this cool reception.

These results covered the period to 30 September 2021. They seem to show a resumption of growth after the pandemic-hit comparative period the previous year.

FX turnover: Foreign exchange turnover was 67% higher, split roughly equally between FX and FX swaps. Excluding swaps, FX turnover rose by 34% to £3.6bn.

Revenue: This FX turnover growth drove a smaller 33% increase in revenue, reflecting the minimal contribution made by FX swaps to the group’s performance.

If the proportion of FX swaps continues to rise, then I’d guess this could be a headwind to revenue growth. Argentex’s operating margin has fallen steadily over the last few years. I wonder if the minimal revenue generated from rising FX swap volumes is one reason for this:

Client activity: The increase in revenue was reflected in a higher number of clients trading during the period.

My sums suggest this equates to annualised revenue of £25k per client, up from £20k in FY21. I don’t know if there’s any seasonality to FX activity, but this seems an encouraging trend.

Profits: After-tax profit for the half-year climbed 22% to £3.3m. According to Stockopedia’s consensus forecasts, this puts Argentex on track for a return to pre-pandemic profit levels in FY22:

Broker forecasts suggest revenue and profit will hit record highs next year. Argentex is also now in the early stages of international expansion, with early-stage operations in the Netherlands and Australia.

A scalable strategy?

One criticism I have seen levelled at Argentex is that its strategy of offering a bespoke service to clients may not scale as well as that of some tech-focused rivals. The company says its ambition is to “operate like a private bank, giving our clients a bespoke service every time they deal with us”.

Cost structure: This service is delivered by “sales pods”. The company expects to have five sales pods by the end of September 2022:

The company says an optimal new business pod would contain 20 full-time staff and generate £12m of revenue per year. Of this, the sales team receives a commission of 10%-17.5% for the lifetime of the client. The dealing team receives a commission of 10%.

I don’t know how this compares to rival firms. But I’d imagine each client carries additional admin costs, in addition to variable remuneration for the fee-earning teams.

Overall, I wonder if this could be quite a high cost structure to scale up, given my estimate that Argentex’s average client may only generate around £25k of revenue per year.

Client concentration: The other thing that strikes me about this business is that it’s heavily focused on the financial sector.

During the first half of last year, 34% of revenue came from financial services or insurance clients. The next largest sector, food and beverage, generated just 6% of revenue.

In fairness, the situation is improving. Two years ago, the equivalent figures were 44% and 3%.

However, these numbers do suggest to me that Argentex is struggling to find sizeable clients anywhere outside the financial sector.

This is a notable contrast to rival Alpha FX, which only generates 18% of revenue from financial institutions. Alpha FX’s next-largest client sector is non-food manufacturing, which generates 17% of revenue.

In total, Alpha FX lists eight sectors that generate 6% or more of revenue. Argentex only has two such sectors.

Outlook: promising

Despite these concerns, my feeling is that Argentex’s strong quality metrics, continuing growth and modest valuation may indicate an opportunity.

Stockopedia’s algorithms seem to agree. While AlphaFX and Equals are branded as High Flyers, Argentex has Contrarian status, suggesting a potential value opportunity.

I’m also encouraged by the upwards progress of Argentex’s StockRank. This has been steadily trending higher since the company’s half-year results were issued in November:

I plan to take a close look at next week’s results from Argentex. If the numbers are in line with expectations – and if the company provides confident guidance for the year ahead, I think the outlook for the shares could be quite positive.

Please do let me know what you think about this somewhat unloved stock in the comments below. Is this a neglected stock that deserves a higher rating, or does Argentex deserve its discounted valuation?