We recommend a long position in UK investment advisory company, AFH Financial Group. Company trading at GBP 3.30 (10x P/E) but probably worth more like GBP 5-6 (15-18x P/E). We expect the company to grow sales and earnings mid to high single digit over next 5+ years. Mgmt does have a goal of doubling earnings by 2023-2025. 

Description:

-        -  Wealth mgmt advice and services to mass afluent clients. AFH prides itself of being advice- and customer led (as opposed to asset gatherers). Company manages on avg. GBP200k per client (virtually all of clients’ assets). Majority of assets is pension or ISA, i.e. tax advantaged accounts. Company doesn’t try to beat benchmark – all about adequate return + tax planning and inheritage planning + stable relationship with trusted financial advisor

-        -  Pricing model: Initial planning fees + 0.5% of assets on ongoing basis (assets put in 1 of 5 model portfolios) or 1% for discretionary accounts (takes 85bps on avg. in recurring fees). The clients also pay fees to third party investment managers (but no platform fees, as for other IFAs)

-        -  Has network of 230+ IFAs (Independent Financial Advisors) – 2/3 of advisors are self-employed (get cut of business they make) and 1/3 employed by company

-        -  Company also owns an insurance broker business where they sell life, income protection, home, critical illness and private medical insurance on behalf of insurance companies. They bought this business on a opportunistic basis and for a very cheap price - and made a lot of money on it. However, it is not related to the core business.

Thesis

1.     -  Mid single digit organic growth + accretive bolt-on acquisitions, but company only trades at 10x EPS (vs. competitors at 20x)

o   Cash generative given capital light business model

o   Very sticky customers given relationship to advisor

o   Stock is at a 50% discount to peers because

§  1) historical CF conversion has been weak due to WC investment in the insurance broker business; strategy was changed in fall 2019 to ensure CF close to earnings

§  2) Company has been raising a lot of equity several times to fund acquisitions which has probably subdued price in last couple of years

§  3) Investors might be worried about the multiple acquisitions over past 5 years – company is now focusing on proving that they are an a solid, growing company with increasing earnings and high cash flow conversion. Only smaller highly accretive, low risk bolt-on acquisitions

2.       - Competitive advantages

o   Cheaper than competitors, mainly other smaller independent advisors, made possible due to scale. Scale benefits are passed on to clients – benefit normally approx. 30-40bps:

§  Other IFAs usually place orders to a platform that charges the client 0.3%. Since 2018, AFH is not charging clients for platform fees – AFH owns their own platform powered by BNY Mellon/Pershing

§  Scale also beneficial for IT, tax calculations etc. – the IFAs are “GPs” with specialists available at corporate

o   Better service given dedicated investment specialists available

3.       - Roll-up potential at cheap prices

o   Principal at many independent advisor firms will be retiring over coming 5 years

o   Multiple arbitrage – buy at 3-4x EBITDA after synergies and they expect to be valued at 10x+ over time

4.       - Market has significantly expanded for IFAs, given pensioners don’t have to buy annuity but can continue to invest assets as they see fit (change in regulation in 2015)

5.       - CEO very incentivised given ownership stake. He strikes us as being very driven by the challenge of growing the business and value of the company

The company does a decent job of highlighting the opportunity in front of them in presentations for H1 2020 and FY 2019: https://www.afhwm.co.uk/investor-relations/publications/ 

Risks

1.      - Regulation/compliance – risk of fines if advisors give inappropriate advice. Big banks, local banks and building societies have exited face to face advice, among other things given significant fines

o   Mitigants: AFH has never received a fine, advice led (not AuM led) and most advice is vetted by corporate specialists

2.      - Competition and fee pressure – from 1) banks threatening to reenter this business now and then (however, actually the trend is for big bank and local banks to exit this space because of compliance burden), 2) robot advice (probably still 15-20yrs out before people starts trusting robo advice), 3) people withdrawing and using indices (target clients don’t mind paying GBP 1000 a year to have a trusted advisor that can help them with investing, tax advice, inheritance plannning etc.)

3.      - AuM decline – either through 1) Equity market decline, 2) withdrawals

o   Mitigant: significant portion invested in debt and for a 20% decline in equity market, clients’ portfolio down only 10%

o   Mitigant: Withdrawals in H1 2020 very low in spite of significant volatility

4.      - CEO leaving because of a health issue or something else