London Capital Group - Worth A (spread) Bet

25th Jan '13 by CantEatValue

16 comments 11202 reads

OK, so the title isn't winning any awards for the terrible pun but hopefully the rest of the post will compensate. I'm a fan of London Capital Hldg (LON:LCG) as I believe it's a business that is fundamentally very attractive and is suffering from a number of headaches in the short term which don't really impair the long term value anywhere near as significantly as the market is pricing it to.

So, what's the story? LCG are a spread betting firm, a mix of their own brands and white label to other big names such as TD Waterhouse, Betfair, Bwin.Party and Saxo bank. They offer a number of products but by far the most significant is their UK Financial spread betting service (£26.6m revenues in 2011) followed by their Institutional FX business (£8m revenues in 2011). Whilst you might think this business is something similar to a stock exchange in characteristics I see it far differently; the economics share far more similarities to the gambling sector, an area I used to work in and know fairly well. The vast, vast majority of clients do not use spread betting like true 'investors' but instead they speculate heavily on margin - and they don't speculate very well. Nearly all the clients end up as net losers. A few people have asked me how such a model is sustainable, how does the business survive if the customers keep going bust? It's simple really - the same way William Hill & co survive, through a combination of recruiting new accounts and having old accounts redeposit. You'd be amazed at the gamblers who deposit year in, year out and somehow convince themselves that they are actually 'winners' and 'the sharp money'. Spread betting is, as the name suggests, gambling. The average revenue per user is much higher than traditional gambling too, at ~£1.4k per annum compared to more like £300 for a bookie.

At the end of 2008 LCG were riding high with their share price touching 400p. Now they are hanging just over 33p. What happened? The classic case of high profit multiple (20x in 2007) meets profit collapse in the 2009 recession. Since then the company has lurched from disaster to disaster; first the FSA forced them to pay a significant fine on grounds that seem very harsh, then the company had to write…

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shipoffrogs

26th Jan '13

An interesting find, and a great write up. Do you have any take on whether they take on the investment risk when white labelling?

Thanks

CantEatValue

What do you mean by investment risk? Start up costs for new white labels should be relatively low as they just leverage existing facilities. As for the risk from the bets themselves I believe they manage the white labels the same as their own brands - their partners typically just get a revenue share from the clients they provide

Hi - I meant the second one, that's what I guessed, too. Thanks

Paul Scott

31st Jan '13

Good article, thanks.

I've also looked at this company recently, and am intrigued.

My main worry is that spread betting companies are intrinsically very high risk - it would only take one major IT malfunction to potentially bankrupt them, if their systems go haywire and fail to lay off risk correctly.

Also, as has been proven by some collapses in this sector, the people who run SB companies can sometimes be big gamblers themselves. So who knows what they are doing with their own funds, and look what happened with MF Global - supposedly the biggest & safest of the lot, yet their management were doing insane, multi-billion punts with company funds, which took them under.

I might have a punt on London Capital Hldg (LON:LCG), but am going to keep it a very small part of my portfolio, just in case!

Very competitive sector too, with profit margins being squeezed.

Jonniegul

3rd Feb '13

Hi,
It's a nice write up, particularly interesting as London Capital Hldg (LON:LCG) was a share I held until Nov last year. I like the company, but I don't see a short term recoevery, particularly in the current (bull?) market. They need some volatility in my view.
This is what I wrote back then (over on TMF):
I’ve used my time usefully to review my LCG investment (oh dear!)
Bottom line, I’ve decided to sell.

These are the numbers:
Year to December 31 2007 2008 2009 2010 2011 2012
Turnover (£000) 18,890 28,878 27,645 34,491 38,963 25,000e
Operating profit (£000) 8,440 10,449 5,699 -140 5,890 -25 (to Jun)
Exceptional/other items (£000) - - - 6,394 743 1900e
Net interest (£000) 134 401 149 85 248 350e
Pre-tax profit (£000) 8,574 10,850 5,848 -56 6,141 0,6 (to Sept)
Shares in Issue (m) 39 39 39 39 48.8 48.8
Earnings per share (p) 15.7 19.9 10 -0.09 8.64 Not much!
Dividend per share (p) 6.5 11 2.5 1 3.9 1.3e (1.3 Paid)

I should emphasize 2012 is my estimate based on nothing more than a finger in the air! Well OK, I did have a look at the numbers from H1 but guessed the rest from the last trading statement.
The first half was flat (compared to 2011) and I was hopeful of a similar full year to 2011, but the last trading statement suggests to me that will not be the case. Unless activity (i.e. market volatility) picks up, I don’t see any recovery in the short term.

Longer term, I do like the company. Yes management have made mistakes, but I’m still inclined to give some benefit of doubt here given the holdings they still have and indeed the strike price of options held. And surely they are learning by now!
Happily, LCG was a mere 1.5% of my portfolio. Less happily, it’s only 1% today! The only question remaining is where to put that 1% to work? I think I’ll put it with the other 99% of the portfolio invested in dodgy O&G shares!! :-)
I received in region of 8% of my purchase cost in divi’s along the way, so my loss on this is approx. 21%. Ah, it’s not a disaster.

I could have sold out at something like 30% profit and that was an acceptable outcome

I’m going to keep my eye this one and may buy back in, but for now it is to be sold.
The thought does occur that they may become a takeover target, though at what price that might be, I wouldn’t want to guess.

Anyway, thanks for putting it back on the radar and starting a discussion. Always interesting.

Regards,
Jonniegul

Asagi

I would have expected that a bull market would be very good for London Capital Hldg (LON:LCG)

We know that spread betters (bettors?) are nearly always long.

LCG needs them to be long and wrong.

Retail investors are notorious for having appalling timing. Strong equity markets will attract punters to the company's leveraged products. They will then bail out on any pullback (providing a win for LCG) or get greedy and place more bets.

Now you might think that there is a flaw to this logic but gamblers are overwhelmingly too short of discipline to walk away with their winnings. In the meantime of course, LCG will be winning on any shorts. Don't underestimate the size of the herd vs. the smarts. LCG identifies the smarts and hedges them.

Nice (!) febrile markets and the time honoured tradition of greedy, dumb punters should serve LCG very well.

Let's keep discussing this. In my opinion LCG is one of the very best 'hold for recovery' plays on the market today.

Asagi (no position)

Hi Asagi,
"Retail investors are notorious for having appalling timing."
Yeah, that'd me...
I haven't looked at the numbers again since I wrote that post originally back in October and I'm not sure if/when the 2012 results are out - perhaps I better go check.

Cheers,
JG

Paul,

Indeed one big IT cock up would cause major problems but I see this as being highly unlikely, it's the kind of obvious risk that needs checks and balances in place to prevent as well as detect should they occur. Given they've gone this far without problems I'll give management the benefit of the doubt here and trust them to have anticipated this risk and prepared. Arguably almost all companies have some kind of "black swan" type risk in them - a few very low probability events that could happen to seriously impair the business - but that's what diversification is for.

As for the MF Global type risk I don't think you'd have seen Jon Corzine making such crazy bets if he'd had a significant percentage of his net worth invested in the company's stock. Three of the founders still own a large share of LCG and two of them are still on the board. Their incentives are very much aligned with my own - if they want to go crazy it will only wind up hurting themselves in the end.

As for your profit margin comments, I discussed what I think is causing the current low margins in my post but even over the last few years of what I'd call "poor" performance margins were still in the high teens to twenties - I'd call that decent. IG Groups are even more impressive, being up in the forties! I still believe LCG have scope to improve margin for the reasons I outlined.

Jonniegul,

Sad to hear the investment didn't work out for you but I'm positive on the share from the current price. I'm always interested in the long term and I think the company has a lot of potential to improve from this relatively low base. I'm happy to wait for the years it'll probably take for LCG to reveal the true earnings power of the business here.

Asagi,

Indeed I hope that the bull market starts to draw more interest in shares in general and hence allows LCG to grow their business even further. If you look at their historical revenues in the graph I put in the post you can see there's volatility but it's around a trend of general growth. I see the volatility as offering a very attractive entry price at the moment as the market prices in no allowance for regression to the mean.

I agree with your general sentiments around the gamblers - the human tendency for a gamble isn't going away any time soon and speculation in stocks has been around as long as stocks themselves, in that sense I see it as being a business that will last and isn't just a fad. Eventually volatility will swing the other way again and earnings will return, especially as management now will be looking to take an axe to the cost base.

12th Feb '13

Anyone know if there's any news that's causing the current rise? I can't find anything of significance

....and I spoke too soon! This came out just now.

http://www.investegate.co.uk/london-capital-group/lcg/statement-re-share-price-movement/201302121514317296X/

As I said in my thesis (and Simon mentioned in the Mello presentation) there's likely to be a number of bidders around for the company given it's so undervalued right now. I reckon that management will bat away any bids that are too opportunistic so it'll be interesting to see what happens now.

Mark Simpson

3 bidders clearly helps maximise value and management have a big enough stake to refuse low-ball offers, IIRC there was a big trade a week or so ago so I wonder if any of the bidders has been doing a little bit stake building while the SP was low. I guess we'll find out when the 1% announcements start coming in.

Thanks CEV,
intrigued by your article I did some more research and seeing the price rise again this morning bought in and was mighty tickled when the takeover announcement came a couple of hours later. Fascinated to see three parties in the race from the off - looks like management are keen to unload it.

Here's a cross post I did from TMF on what a potential acquirer might pay:

Well this is interesting! Not one but three bidders for the company. Given the access to cheap capital companies have and the M&A 'animal spirits' that appear to be stirring it's not surprising opportunistic bids have arisen.

Now, what might a bidder pay? I must admit I hold a very different view to the market here and think the company is significantly undervalued - but how much? Let's consider a few valuation scenarios and see what they come out with.

First, the bear scenario valuation: Let's assume that the £28m revenue is the 'new base' going forward and growth will be off this. I think this is wrong, but we're being bearish. If we assume that margins here will forever be weak relative to history let's say they can only make an average of a 10% margin. This gives PBT of £2.8m. Put on a low multiple of 8 (which I think is very harsh given the high ROE qualities of this business, but we're being bearish) and we get 43p per share.

Now, the middle case scenario valuation: Let's take the average revenue of the last 5 years and call that the base - £31.7m. Assume an average margin of 20% (still not ridiculous, the business has averaged 28.8% excluding exceptionals over the last five years and did 40%+ before 2009) for a PBT of £6.35m. For a multiple of 8 still, we arrive at a valuation of 97p.

Now for the optimistic scenario valuation: Let's take assume the revenue base is the average of the last 3 years: £33.8m. Now, let's assume the business can bring margins back to an average of 30% through cost cutting and efficiency (remember margins were consistently above 40% pre 2008, so this isn't ridiculous) for a PBT of £10.15m. Giving a more generous multiple of 10 (remember a well run IGG is on a P/E closer to 15 so we're still on a decent discount here) we'd get a valuation of £1.94

So we arrive at a range of 43p-97p-194p. Now, I know that even my middle case scenario looks optimistic compared to the current market price but this is just how I see the business and why I liked the investment so much - I felt that even under poor operating conditions the business was worth far more than the current market price and if they managed even a relatively mild turnaround there's significant multi-bagging potential with the downside heavily protected. Now, the fact that not one but three competitors have come out the woodwork implies to me they see the value too.

The other major thing to consider here is this: LCG are the 2nd biggest CFD provider in the market and any acquirer here not only has the potential for major synergies (which they should pay a premium for) but the increased scale from combining two smaller players should allow them to dominate the number 2 position in the market and hence be valued on a higher multiple as well as achieve higher margins from the efficiency of scale. The 30% margins I used in my optimistic case don't look so hard when you consider the synergies possible and the fact 40%+ was achieved pre-2008 and IGG consistently do 40%+. Given you also have three competitors that know this I could see a bidding war erupting and LCG getting taken out for a good price given the arguments I've set out here. Assuming these strategic and synergistic effects are worth a 30% premium to the acquirers then we get a range of 55.9p-126p-252p

Am I being optimistic? Possibly, the market loves to focus on near term problems rather than long term earnings power but any realistic valuation should be focusing on the long term earnings ability and I've tried to be conservative in my assumptions for calculating this and I still come out with big valuations. This is why I'm bullish on what the business is worth (and even more bullish on what a strategic acquirer in a bidding war could pay for it). I'd actually kind of prefer for this bid to fail now and the price to drop back down to ~33p as I'd be more interested in holding until true earnings power was revealed and the share re-rated significantly but I don't blame the three firms for trying to snag a bargain. I'm now annoyed this offer has come before I had a chance to increase my stake as I'm very keen on this share - as you can see by my valuation range!! Ah well, we can't win 'em all.

Thinking about it more I find it highly unlikely that not one of the three bidders will be willing to stump up a price that is more reasonable for the business (and above the level at which the three founders will accept) that isn't above the current market price even after the rise so for those who like to speculate on bidding wars I'd definitely be tempted to top up even now - I think the risk/reward ratio is pretty good.

Final thoughts: Bull markets are awesome fun.

13th Feb '13

CEV - your valuation process seems to ignore the cash on the balance sheet. I would have thought that merits adding to your valuations based on future cash flows.

14th Feb '13

SOF,

I actually deliberately excluded it and here's why. I only include cash in my valuations if it's excess cash - cash above and beyond the working capital needs of the company and could be paid out. Because basically all that cash needs to be retained by the company for regulatory needs it cannot be paid out or used for acquisitions or whatever - it's essentially working capital. Of course, one could always shut down the business and return this cash to shareholders but so long as the business earns a decent return on the capital employed then it's worth carrying on keeping it as regulatory capital. An alternative analysis based on liquidation value would of course consider the value of this cash but I think the business has far more value as a going concern and so liquidation analysis is inappropriate.

24th Apr '13

I did a write up on the AGM yesterday here: http://boards.fool.co.uk/yesterday-i-attended-the-lcg-agm-together-with-12794610.aspx

London Capital Group - Worth a (spread) bet

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CantEatValue

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