Description

I will not count this write-up for my annual contribution requirement as I published it also on my blog. But given that nobody reads it, it seemed a waste not to share this one. Also, I'm hoping for some pushback to see if I've missed something substantial.    

FlatexDeGiro (FTK, ~€ 680m market cap) is one of the largest pan-European online discount brokers focussed on retail trading. The company in its current form is the result of after a merger between Dutch online broker DeGiro and Germany’s Flatex (completed in July 2020). As can be expected from an online broker, FTK’s share price performance over 2020 and 2021 was amazing, as people confined at home picked up trading (a.o. things). In addition, the meme-stock frenzy (e.g. Gamestop, BBBY) attracted many retail investors into speculating with stocks. All this led to great results.

2022 is looking different however, and the share price is down ~70% for the year. After a few years with surging numbers of new users and user transactions, KPIs slowed down and even turned negative in the case of the number of transactions. Combining negative comps with a rise in interest rates, Europe’s energy related woes, pressure on consumers wallets from inflation, a looming recession and a listing on a German stock exchange, and we have a perfect cocktail for a lower valuation. 

In addition, earlier this week FTK released a profit warning, cutting its FY outlook to € 380m revenues and ~37% ebitda margin as the expected improvements in 4Q did not materialise, resulting in c. -15% ebitda estimated for 2022 vs consensus. On top of this, German regulator Bafin slapped FTK on the wrist, citing improvements needed on governance and (temporarily) increasing regulatory requirements. FTK is not ‘small and non-complex’ anymore and requires some structural and organisational changes. The company acted swiftly, reorganising some managerial positions and increasing capital buffers with € 50m + fully retaining 2022 net profit. All in all, the market got scared, sell-side analysts downgraded the stock and shares dropped >40%. The profit warning itself wasn’t the biggest driver of the decline. Sure, a worse than expected 4Q is not good news, but it was the combination of a warning from Bafin and comments on capital allocation that scared markets the most; the first gave German investors a nice Wirecard déjà vu, while the latter was a 180 degree turn from recent management commentary. FTK is projecting very strong cash flow generation and prepared markets for some form of sustainable capital return policy; this is now pushed to next year.

Why my interest in FTK, given that high(er) interest rates, pressure on consumer spending, etc. are probably not going away anytime soon? A few reasons. One is that, notwithstanding the slowdown in transactions this year, the company’s profitability has continued to grow strongly, and I expect it to continue to grow given increased penetration, scale effects and monetisation initiatives. FTK’s ebitda margin is now in the high 30s % and I see no reason why it could not catch up to more mature peers (>60%). Another reason is that FTK is now trading at a single-digit forward p/e, compared to ~18x historically (5y) and ~20x currently for peers. And even if multiples would stay the same, with earnings growing >25% p.a., FTK’s share price should perform quite nicely over the next years. Let’s look at the story in more detail.

Background

FTK operates in ca 20 countries in Europe. Activities are split between Core Markets (Austria, Germany, the Netherlands), which account for ~2/3 of revenues, and Growth Markets (mainly France, Spain, Portugal, Italy, Switzerland, UK, Ireland), which take the rest. The company has ~2.4m clients (98% retention rate) and ~€ 38bn assets under custody, of which € 3.5bn cash. FTK has a banking licence, which is a competitive advantage as most peers outsource their banking activities. Roughly 1/3 of the shares are owned by insiders (management and/or co-founders of FTK and DeGiro).

Revenues are generated from three different sources: 

• Brokerage commissions are by far the largest source, at ~80% of revenues. The commissions are simply a function of # of users, total transactions and an average commission per transaction. Commissions are generated mostly with transactions of shares (~70%) and ETPs (~25%). Over the past years, the focus has been on growing users as rapidly as possible. Although growth has been slower due to high comps, FTK has still been able to grow users more rapidly than peers; for 2022, the company estimates ~300k net new users, ca. 40% more than net new users from peers Avanza, Nordnet and Fineco combined. Furthermore, now that the total user base is significant, FTK has increased its focus on monetisation. New initiatives include increases in the handling fee (to € 1.00 from € 0.50), expansion of margin loan offering, the use of early and late trading by customers in international market and new ETP product offerings. As a consequence, average revenue per transaction (careful, not commissions per transaction) was ~€ 5.30 in the first nine months of 2022, +19.3% yoy.
• Interest income accounts for ~15% of revenues. This is income from margin lending (90% in 2021) or alternative investments (10%). For 2021, FTK earned on average 242bps of interest on roughly ~€ 1.3bn of assets under management. This average rate is the result of c. 300bps-500bps interest on loan margins and c. 200-300bps for alternative investments. Additional income is expected over the coming years given rising interest rates; more on this later on.
• The remaining ~5% of revenues are generated from IT services, i.e. third-party projects, software, etc. This revenue is non-core and I’ll assume it to remain constant as % of total revenues.

Strategy

FTK’s focus and main strategy has always been to be the cheapest online retail broker, have a large offering, provide user-friendly interfaces (desktop and smartphone app) and consequently attract a large user base. This has worked well over the last years, as users flocked to the broker. And as the user count increased, so did FTK’s earnings: group ebitda increased from ~€ 30m in 2017 to ~€ 110m in 2021. 

FTK’s race to the bottom continues today. For that purpose, about a year ago FTK introduced its new ‘DeGiro goes zero’ model. As the name implies, this offering is based on a commission-free model. In short, this new offering consists of: 1. no trading commissions for a variety of exchanges (NYSE and NASDAQ, Euronext Paris and Lisbon, Bolsa de Madrid, Borsa Italiana, NASDAQ Stockholm and Copenhagen). Important to note that for the previously mentioned Core Markets, transaction charges remain for transaction on the local exchanges; combined with 2. higher handling fees and FX charges (now € 1.00, from € 0.50, ~60% of transactions are subject to handling fees; charges for FX transactions have risen to 0.25%, from 0.10%).

The idea behind the changes was partly window dressing, as marketing a ‘zero commissions’ model is clearly beneficial, but it also increased transparency, which is something European markets lacked given the many different brokers. Customers have now a much clearer overview of overall costs given the ability to trade in many different markets on the same platform. Overall, average revenue per user increased after the introduction of the new model, from € 4.59 on average in 2021, to € 5.30 on average for the first 9 months of 2022. 

As mentioned, FTK’s strategy has always been based on being the first in the ‘race to zero’ on commissions, i.e. to have a very broad offering, the lowest commissions and consequently the highest growth rate. With the new model, FTK takes another step down the cost curve and remains on average one of the cheapest online broker. This will continue to be beneficial for FTK’s growth and maturation.

Competition and competitive advantage

One possible threat is the growth in Europe of zero-commission models, similar to Robinhood in the US. These models dragged down commissions given the adoption of ‘payment for order flow’ (PFOF), where brokers earn income from market makers by routing client orders to said market makers. This threat is however relatively mitigated in Europe. PFOF is deemed controversial as it might give rise to conflicts of interests by creating the incentive to route orders to the market maker that pays the highest commissions instead of the market maker that provides the best execution. PFOF appears to be in breach of (or might cause to breach) existing MIFID regulations. PFOF has already been banned in the UK and the Netherlands and the European Commission is currently aiming for a Europe-wide ban.

FTK is not the only broker to offer zero-commission models. There have been plenty of other competitors offering zero-commissions (e.g. eToro, Trading212), though all earn income via ‘hidden charges’ such as high FX charges, ‘maintenance’ / inactivity charges, etc. These competitors tend to be less transparent than FTK. Regulations has increased for such ‘hidden charges’-models and will probably continue to become stricter.

To be clear: FTK is definitely not the best online broker. There is plenty of room for improvement. There are several other brokers with better platforms and offerings, but all cater to a different market (segment). eToro is one of the largest and is perhaps more suited for large(r) accounts. It’s desktop web interface and mobile app are good, but a bit less intuitive than FTK’s. They also have some added costs, such as withdrawal fess, which are burdensome if you target retail consumers. AvaTrade and Interactive Brokers are also good brokers, though AvaTrade is focussed and CFDs and one large complaint from retail clients regarding IB is that its trading platform is ‘too complicated’. In addition, both are not the cheapest. I could continue, but the point is clear (I hope); FTK’s target market (so far) has been retail clients, so the user experience has to be good and intuitive, its offering has to be broad and – most importantly – the product and service have to be cheap. Given these targets, FTK is generally deemed to be one of the best online brokers to trade with.

An interesting development which might eventually lead to serious competition is the entrance of online banks into brokerage services. Companies such as Revolut provide a wide variety of services to many millions of clients (credit, payments, insurance, international transfers, etc.). Offering brokerage services is a natural extension. Though these companies will probably not have the scale (and as such competitive pricing) to match FTK anytime soon, the potential combination of an overall broad banking and insurance related offering on an efficient platform might eventually attract a large client base. 

While I certainly acknowledge the threat from competition, I remain confident in FTK’s future growth potential. The main reason for this is FTK’s focus on scale and efficiency since inception. FTK clearly understood that in a continuously integrating and consolidating market such as Europe, where online trading penetration has long-term tailwinds, overall brokerage commissions have been too high for too long. The market was ripe for disruption and badly in need of commoditisation; in a market where the product is a commodity, the lowest cost ‘producer’ wins. And that is exactly how FTK was build, i.c. to be the most efficient player. Sure, there will always be (new) competition, but it’s a large market and many incumbents will struggle to attain proper efficiency.

FTK distinguishes itself from its competitors given its proprietary IT system. FTK has been able to offer very attractive fees thanks to its improving cost profile. All infrastructure is integrated in-house. In addition to fully automated execution, settlement and clearing of orders, the system allows for efficient onboarding (AML/ KYC, fiscal / regulatory reporting, etc.). Thanks to its banking licence and easily scalable infrastructure, FTK can swiftly incorporate new (banking) products and services (insurance, mortgage, etc.). Most online brokers have outsourced a large part of their IT system and offering, notably banking services, and have less ability to pressure costs. FTK can achieve significant economies of scale as it continues to efficiently expand its offering and user base. The company has so far been able to drastically reduce its overall cost per transaction (from c. € 1.40 in 2019 to c. € 0.70 in 2021) and should be able to continue to do so. 

Financials

Once the headwinds of high yoy comps subside, FTK should be able to continue to grow revenues for the foreseeable future:

• FTK has been gaining market share over the years (now ~5%). Attractive commissions in combination with an increasing offering and efficient cost base are driving an attractive flywheel effect. FTK’s attractive commissions drive user growth, generating revenue and operating leverage. Part of this increased efficiency is reinvested in further improving the platform and offering, which drives user growth. Many competitors are struggling to achieve this flywheel effect, and FTK should be able to continue to grow at a more rapid pace than its direct peers;
• Another important driver of growth is the under-penetration of online brokerage in many end-markets where FTK is operating. Structural trends such as digitisation and inflows as a consequence of changing pension and insurance regulations should continue to drive an increase in the penetration rate. Mature markets such as the Nordics and the Netherlands boast c. 40% penetration, while markets such as Germany, Austria, Italy, France (i.c. the largest part of revenue) are at an estimated 10% penetration. As a back-of-the-envelope calculation, assuming a roughly 35% penetration in Germany, France, Spain, Switzerland and Italy results in an addressable market of roughly 100m clients, compared to c. 25m today. At a stable market share, that would imply ~5m clients vs. 2.3m (total) today. This is assuming a stable market share and excluding continued growth in mature markets. FTK’s target of 7.5m accounts in 2026 doesn’t seem a stretch;
• There are (other) initiatives by FTK to improve monetisation. Though these initiatives could have a significant impact on earnings, I’ll be conservative and exclude their impact in my back-of-the-envelope calculation. These initiatives include partnerships regarding ETPs (enlarging the offering) and margin loans made available to all DeGiro customers (from ~250k to ~1.3m). In addition, higher ECB rates will have a material impact: FTK estimates +€ 30-50m profit before tax should the ECB depository rate continue to rise.

In terms of margins, 2022 will see a jump in profit margins, mainly from synergies resulting from the combination with DeGiro, some operating leverage, higher interest income as well as lower variable compensation (which fluctuates with FTK’s share price). Overall, this is the picture:

This is rather a conservative forecast in my opinion:

• FTK has been so far pretty good at hitting targets on the # of customers. The company has been able to grow the number of accounts notwithstanding the bad environment. FTK is targeting 7.5m customer accounts by 2026. My assumptions are very conservative compared to this target;
• According to the company, trading activity from retail investors is ‘at record low’ in 2022. Notice the big decline in # transactions / customer account (but keep in mind 2020 and 2021 were exceptionally good retail trading environments for FTK and the company never expected this to continue). FTK will nevertheless generate record revenues and profits this year. Nonetheless, I assume this KPI will remain low for the foreseeable future;
• On the margins. I assumed the 2023 ebitda margin to drop as variable compensation should ramp up again as markets improve. I remain conservative on the longer-term, assuming only gradual operating leverage. FTK is targeting LT ebitda margins in line with peers, which is >60%. I have no reason to believe this is not achievable should they sustain a high customer account growth and expanding services;
• The forecast also excludes benefits from several monetisation initiatives and the potential benefits form higher ECB rates.

Valuation 

Looking at it a few different ways:

• Historically (past 5y), FTK traded at a 17x-20x forward p/e. A higher interest rate environment should command lower multiples, but then again FTK’s earnings are positively correlated with higher interest rates (as we see this year). Also, earnings growth should remain >25% p.a. over the medium- to longer-term. Looking forward to 2024, and assuming a 15x forward p/e (on 2025 earnings), results in a market cap (undiscounted) of c. € 2.3bn, compared to € 680m currently. Even at today’s historically low multiple, FTK share price should be able to compound >25% p.a., though I believe the multiple will rerate as the company continued to grow and diversify its product offering, and sentiment improves;
• A basket of European peers is currently trading at an average forward p/e of c. 19x, with direct peers Fineco, Nordnet and Avanza at c. 23x. A discount to these peers is justified, given their more diversified offering (good in times of uncertainty) and higher profitability, but FTK’s derating appears nonetheless very harsh compared to this peer group;
• FTK will start to generate a good amount of cash flow going forward. The company has been guiding for € 1.0-1.5bn cumulative FCF for the period 2022-2026 and a steady capital return policy in the form of dividends and buybacks. My estimates for FTK’s FCF generation are much lower. Assuming 65% FCF conversion (which should be higher going forward) to 2023 ebitda results in c. € 110m FCF. A 3% growth rate and 10% discount rate results in € 1.6bn equity value (no debt – liabilities to customers is netted with cash balances and receivables from customers). This assumes only 3% growth indefinitely, indicating we don’t pay anything for future growth and we get the current business at a large discount.

FTK has grown very rapidly over the past few years, and the relatively recent acquisition of DeGiro was transformational. My (rather simplistic) take on the special audit from the German regulator is that the rapid growth and current size of FTK warranted increased regulatory scrutiny. FTK is not a small company anymore. News that the regulator performs an audit is never taken as positive, but an audit was performed and some shortcomings were identified. We don’t know the exact details, but these shortcomings appear relatively easy to address. Perhaps too optimistic, but this looks like growth pains to me. 

I believe the main risk to the thesis to be a prolonged period of market and economic uncertainty. Strong pressure on (European) consumer spending would certainly have an impact. In that case, there’s no reason why forward multiples couldn’t go down another 30%, or more. 

I might be too early here. 2023 will be another relatively tough year from a consumer sentiment point of view. Also, Bloomberg consensus still seems too high. Nonetheless, I remain optimistic. FTK has been sold off aggressively this year, partially for good reasons, though its performance during this difficult year has been resilient and gives me confidence on the growth story. I believe that investors oversold FTK and that the stock should rerate back at some point to a more reasonable multiple, reflective of its growth potential. For what it’s worth, management has been rather actively acquiring shares over the past few days. Looking out a few years, the share price could double or more as the valuation becomes less reflective of sentiment and more of FTK’s growth.

Catalyst

Continued user growth and operating leverage

Improving consumer sentiment