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IG Group (IGG) had delivered 600% growth for those shareholders who got in at the IPO in 2005, this compared to 40% for the FTSE100 over the same period. Disaster struck though earlier this month with the shares down almost 45% to 441p in the month of December so far, this being some way off their record high of 967p, set earlier this year. In this article I consider whether the the sell off is overdone or whether investors should start to think about catching a falling knife?
What Prompted the Major Fall in the share price?
FCA has concerns that more retail customers are opening and trading CFD products that they do not adequately understand. The FCA’s analysis of a representative sample of client accounts for CFD firms found that 82% of clients lost money on these products…
It is fairly shocking at first that almost 84% of punters lose money, but once you reflect further consider whether this is any different than a casino or a bookies? No, in fact the win ratio is slightly better for punters at the likes of IG than the rest of the gambling industry, in fact data compiled by the WSJ suggests that 90% of non financial gamblers lose over a 2 year period. The real beef the FCA has is around the marketing of the spead betters products, is it really clear to people they are gambling as opposed to investing? The other beef is the leveraged nature of the products, which is another difference versus the average bookie, they don’t lend you money to bet and there would be massive public outcry if they did! The measures proposed as follows by the FCA therefore seem to be in the public interest:
- Introducing standardised risk warnings and mandatory disclosure of profit-loss ratios on client accounts by all providers to better illustrate the risks and historical performance of these products.
- Setting lower leverage limits for inexperienced retail clients who do not have 12 months or more experience of active trading in CFDs, with a maximum of 25:1.
- Capping leverage at a maximum level of 50:1 for all retail clients and introducing lower leverage caps across different assets according to their risks. Some levels of leverage currently offered to retail customers exceed 200:1.
- Preventing providers from using any form of trading or account opening bonuses or benefits to promote CFD products.
How do CFD/Spread Betting companies make their money?
The clue is in the name. The principle revenue stream for companies such as IG is the spread between the buy(long) and sell(short), this is effectively the profit margin on a trade for companies such as IG. Bear in mind lots of punters will be betting in varying directions at different prices. The net exposure therefore may be neutral and the companies will often buy shares in the market to hedge the total net position where not. Offering leverage magnifies these gains because margin calls are required if the price moves against you, miss these calls and the position can be closed resulting in a potential new trade and consequently margin for IG. Leverage of course also allows for the total position to be larger than otherwise, which means more profit from the spread. On top of the margin from the spread, companies like IG also charge interest on the leverage as punters are effectively borrowing money, for IG this is 2.5% + Interbank rate.
So how will these measures affect IG?
The FCA states:
We expect that these measures will reduce the overall number of clients, the total volume and value of trades and total firm revenues. These measures could consequently affect the profitability of firms across the sector…
The FCA believes the total saving for consumers, consequently losses for the industry will be around £150m to £295m (see figure 3). Pretty big figures but when you consider 45% was wiped from IG Group’s valuation, i.e more than £1bn does the sell off begin to look extreme then? Maybe, let’s look into the exposure further:
Per Figure 1 below almost all of IG Groups revenue comes from the products that are under the spotlight:
The FCA though only has jurisdiction over the products sold to UK customers. Figure 2 indicates this makes up around 50% of the total group revenue.
It is pretty clear from the above that a question mark has been placed over a large chunk of IG’s business, but the extent of the sell off is due to uncertainty discount factor. There is a need to estimate how the regulation will really flow to the bottom line.
So what is the likely effect on earnings and dividends?
IG Group has not yet revised market guidance to take account of the new regulations, the above measures are currently under consultation, a process which is not expected to conclude until summer 2017 and realistically become law before 2018. The current share price gives a Price/Earnings ratio of 10 for 2017 and 2018 based on prior guidance, but let’s look at how we might expect the P/E ratio of future years to be if the regulations are implemented.
The FCA further states in its paper:
We calculate investor benefits on the expectation that investor losses will be between 20% and 40% lower after introducing leverage limits.
Taking the mid point 30% here and multiplying it by the 50% revenue from UK customers gives an expected reduction of revenue by 15% for 2018, which is the first full financial year likely to be affected by the new regulations. Current guidance for revenue in 2018 is £510m, so this would fall to £434m. Applying the operating margin of 42% earnings would fall £32m to £150m, or £117m using an effective tax rate of 25%. This gives a P/E of 17, pricey. However IG has stacks of cash so perhaps better to look at EV/E given the circumstances, this gives little over 12 against a current enterprise value of £1.43bn. This starts to look like a potential value stock.
On the dividend yield front, this is currently 6.95% and with a cash pile of £329m, zero debt and a dividend cover of 1.4x (before revised guidance), this distrubution looks more than sustainable in the near term to me.
Is there a risk to other geographic markets IG operate in?
Potentially and if so we could expect further mark downs on earnings. It would not be surprising that regulators in other countries follow the lead of the FCA. Germany earlier in December introduced measures ‘propos[ing] that the marketing, distribution and sale of CFDs to retail clients in Germany can only be undertaken if the client is not at risk of losing more than the value of their account.’ This is a lighter touch than the FCA and IG have recently created limited risk accounts, i.e. where the maximum punters can lose is the value of their account. Ultimately the regulatory risk remains but I see this as a mid term threat, given how slow regulators are to act.
What else has IG Group got in its locker?
IG group recently launched ISA and Share dealing accounts. I think management probably knew leveraged CFDs were on borrowed time so they made this decision to broaden their offerings last year, it pleases me that they have vision here. I admit these products currently are a tiny proportion of revenue but I see a lot of potential. The leader in this area is Hargreaves Lansdown and I think to compete with HL is obviously a huge ask. However I believe IG can focus on a different segment entirely, they are offering share trading with Direct Market Access and Level 2 prices. This enables their customers to place orders directly at the market, so being a ‘price setter’ rather than a ‘price taker’. Level 2 prices also give visibility over the order book to better time position taking. The requirements for these services are just a trading balance of £1,000 and a small fee of £10 for the LSE, refundable if 1 trade a month is placed. This service attracts serious private traders and some smaller institutions, a completely different sector to HL, whom are more focused on the moderate/limited knowledge investors with a particular focus on Open Ended Fund markets.
It is not inconceivable either that that IG Group could move into this lucrative fund area too. One big advantage IG has is it’s focus on technology. This can lower the costs of trading/holding and carve some market share. Hargreaves Lansdown based on it’s 2016 results I calculated earns on average profit £300 a person on it’s popular ISA Vantage platform and has 0.86m accounts. The operating margin is 67% too, this suggests to me a market ripe for further competition.
IG has a long way to go granted, counting just 3,000 active clients to May 2016 but has grown this product by 600% on an annualised basis. The company is also rolling out this stock broking service to Australia. To temper the excitement there may well be an uptick in costs in the near term to market and manage this new sector, so some short term transitional pain is likely.
IG also continues to move into new markets for it’s leveraged products including Dubai and Singapore, potentially in doing so diversifying some of its exposure further from the more regulated European markets.
The final positive for IG is the ‘only the strongest survive’ mantra. IG has a solid balance sheet, it could be that these regulations put some of the weaker competition out of business, so could IG pick up more customers from this in the mid term, which could smooth or even offset the negative earning impact?
BUY – Target 600P.
Based on the current business model a PE ratio of 17 makes the IG valuation fairly full but when you include the cash position the EV/Earnings ratio is just 12 after adjusting for likely impact of the new regulations. Given the new areas of growth for IG and the potential picking at the carcass of any troubled competition I think the sell off is well over done. On top of this the current dividend yield is around 7% and well covered. I would therefore be fairly comfortable with the EV/E sitting around 15, a 25% uplift giving a target of 600p. Do monitor carefully the regulatory enivroment in all the key markets IG operate in, also the fate of competitors and perhaps most critcally pay close attention to IG’s stock broking take up. Good luck punters!
Disclaimer – I have a long positions in this stock equal to 2% of my NAV bought at 465p. To my knowledge no close family, friends nor associates have any further position.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.