Description

We believe Hargreaves Lansdown PLC is a timely and compelling short.

The company’s shares are liquid ($12B market cap), expensive (40x earnings), and tremendously vulnerable as two deep-pocketed global competitors/disruptors are set to aggressively attack HL’s core market in early-2020.

The Business

Hargreaves Lansdown PLC (LSE: HL/, “HL”) is a leading retail investment firm in the UK.  Known colloquially as a “funds supermarket,” HL offers an online investment platform for individuals to manage both their retirement and non-retirement portfolios under a single umbrella (a “one-stop-shop” model).

HL is the #1 retail investment platform in the UK with approximately 1.2 million clients and a little more than 100 billion GBP of assets under administration (“AuA”).  These assets can be broadly broken out into three buckets:

• One-third of assets are Individual Savings Accounts (“ISA’s) – similar to 401(k)’s or IRA’s in the US.

• One-third of assets are Self-Invested Personal Pensions (“SIPP’s”) – which are gradually replacing traditional pensions in the UK.

• One-third of assets are non-retirement assets including shares, funds, cash, and other products.

HL’s most important revenue source is the platform fee of 45bps charged to retail clients on AuA.  In addition, HL earns commissions on trading and on fund subscription/redemption activity, as well as fees on certain of its products such as its multi-manager fund portfolios and its Active Savings product (a portfolio of short-duration CD’s).

HL is particularly known for two of its offerings.  The first is its “Wealth 50” list of highlighted fund managers.  Fund managers covet inclusion on this list as it often leads to substantial retail inflows from HL’s client base (an estimated 40% of HL’s AuA, or 40+ billion GBP, is invested by HL’s clients into funds on the Wealth 50).  The second is HL’s multi-manager fund portfolios, which HL assembles (often using managers on its Wealth 50) to build a diversified portfolio of funds that clients can select for their accounts. HL’s highest margin products are its multi-manager fund portfolios (8% of assets but 15% of revenues).

HL is considered a proxy for actively-managed funds as only 10 of the 56 funds on its Wealth 50 list (18%) are passive vehicles.

Thesis #1: No Longer The Only Game In Town

HL was founded in 1981, and – to its credit – over the last 20 years the company has fully capitalized on its first-mover advantage amidst the shift to “direct to investor” (i.e., retail) online investment platforms.  From the time of its IPO in 2007 to 2019, HL grew AuA from ~6 billion GBP to ~100 billion GBP, a compound annual growth rate of +23.9%. UK investors have rewarded the company for this growth with a premium valuation multiple of 40x earnings.

Our bearish investment thesis has three legs to it.  The first leg is that HL’s robust growth is a thing of the past as numerous new competitors have entered the market causing HL’s growth to structurally stall-out.  In recent years, the list of legitimate competitors has exploded, with HL a notable outlier as its 45bps platform fee is the most expensive in the industry (BestInvest is 40bps, AJ  Bell YouInvest is 35bps, Fidelity is 35bps, Charles Stanley Direct is 35bps, Barclays is 20bps, others such as Interactive Investor, IG, DEGIRO, Halifax Share Dealing, The Share Centre, Alliance Trust Savings, HSBC, and Saxo Markets charge varying flat fees plus commissions that can total 12bps to 30bps depending on account size).

These lower-priced firms, often backed by considerable resources (YouInvest’s parent AJ Bell is publicly-traded with a $2 billion market cap, Interactive Investor is backed by JC Flowers, bulge-bracket UK banks like Halifax, HSBC, and Barclays each have their own platforms) are aggressively spending to grow – walk through a couple tube stops in London and look at the advertisements, and you’ll quickly get the picture.  Their goal is to steal market share from HL, and the evidence shows they are succeeding. In HL’s first nine years as a public company, its AuA growth annualized +27.7%. In the most recent four years, annualized AuA growth has slowed by nearly 1,200bps to +15.8%.

The more recent picture is far worse.  In the firm’s latest reported quarter (Q1 FY2020, quarter-end Sep 30, 2019), HL disclosed headline net inflows of 1.7 billion GBP.  However, 900 million GBP of inflows were one-time “back-book transfers” from JP Morgan and Baillie Gifford.* Another 300 million GBP of inflows were from HL’s Active Savings product, which is being run for zero profit as HL attempts to scale that business.  On a like basis, we calculate true underlying net inflows as only 500 million GBP against 1.2 billion GBP of net inflows in the prior year quarter, a year-over-year reduction of -60%.

A clear progression can be seen over time.  Net inflows were more than 20% of AuA in FY2010 and FY2011.  Net inflows were high-teens in FY2013 and FY2014, low-double-digits from FY2015 to FY2017, and high-single-digits in FY2018 and FY2019.  These most recent numbers show underlying net inflows falling to the low-single-digits.

This is an ominous sign.  We view HL’s growth as structurally challenged – no longer the first-mover with a clear field ahead of it, HL today faces vigorous competition from many fast-growing peers who are larger, stronger, better-resourced, and more aggressive than ever before.  On the current trajectory, we see HL’s underlying growth rate from net inflows hitting zero (and then going negative) within a handful of quarters as the marketplace has simply changed. With the structural shift in HL’s growth profile, we believe HL no longer merits the super-premium valuation multiple the market accords it.

*In 2013, the UK’s Financial Conduct Authority (the “FCA”, similar to the SEC in the US) published the conclusions of its Retail Distribution Review.  The new rules stipulated that fund managers distributing their own funds had to comply with a series of new regulations to lessen conflicts-of-interest.  As a result, a number of players decided to exit the business and entered into back-book transfer agreements with firms like HL to send over clients in exchange for fee payments, generally three years’ worth of profits.  The vast majority of these back-book transfers are in the rearview mirror, and we expect minimal inflows from back-book transfers after calendar year 2020.

Thesis #2: The 800-Pound Gorillas

That alone would make for an interesting short thesis.  But, in our view, a far more serious threat looms.

The second (and most important) leg to our thesis is that Vanguard and Robinhood are both set to enter the UK market in Q1 2020.  Vanguard plans to launch a competing UK “direct to investor” investment platform in early-2020 with an aggressive marketing campaign and a price point nearly 70% below HL’s fee structure.  Robinhood, fresh off the back of a $373M Series E funding round that valued the company at $7.6 billion at the end of October, has notified the market it will soon bring its zero-commission model to the UK as the first step in its international expansion.  We believe the simultaneous entrance of Vanguard and Robinhood into the UK represents an existential threat to HL’s business and could be devastating for HL’s economic model (and share price).

Vanguard’s entry into the UK with a one-stop-shop investment platform has long been rumored.  In 2017, Vanguard tested the waters with the launch of a non-SIPP platform in the UK that attracted billions of GBP in assets, despite its limited functionality and minimal marketing.  The demand for a comprehensive UK platform (ISA’s, SIPP’s, and non-retirement assets under one umbrella) has been so strong that Vanguard was compelled to set up a website and e-mail list (we signed up) to notify interested parties of the timing of such a launch.  Web traffic scrapes show this Vanguard page has at times drawn more traffic than the home pages of competing UK investment platforms that are already live.

On December 1, 2019, Vanguard announced to its list (including to us) that Vanguard would be launching its SIPP product in early-2020.  The platform fee will be 15bps, charged on the first 250,000 GBP of assets with zero charges on assets above that level. In contrast, HL charges 45bps on the first 250,000 GBP of assets, 25bps on assets between 250,000 GBP and 1M GBP, and 10bps on all assets above 1M GBP.

We had anticipated the SIPP announcement would be forthcoming, as in mid-September the top-tier marketing firm AML Group disclosed it had been chosen as the lead creative agency for a concurrent, aggressive marketing campaign launch for the Vanguard brand in the UK and across Europe.  A key part of the brief was Vanguard’s “direct to consumer” platform.

Vanguard’s December 1 announcement caused a two-day decline in HL’s stock price.  As investor attention shifted back to Brexit and the UK election, however, the release was quickly forgotten.  In a way, it reminded us of Robinhood’s announcement that its no-fee trading platform would launch in the UK in Q1 2020 (20% of HL’s revenues come from fees such as brokerage commissions).  With all eyes on Brexit, and HL seen as a beneficiary should the UK experience an economic and stock market recovery, investors have been quick to shrug off the impending threats.

Our view is quite different.  To us, the dual-launch of Vanguard and Robinhood in the UK in Q1 2020 is a total disaster for HL.  We are based in the US. We have watched Vanguard wreak carnage on active asset managers over the last decade both in outflows and relentless fee pressures.  We have watched the deterioration in fees (all the way to zero) at Schwab and TD Ameritrade following Robinhood’s success in the US. In our view, British investors do not yet comprehend how bad things can get for the incumbents when these two well-financed disruptors launch in their market.

Our bet is they soon will.  For HL, we think Brexit optimism will prove transitory as investor attention shifts to a permanently ruthless new competitive landscape that threatens to break HL’s business model.

Simply put, we think Vanguard and Robinhood will be “game over” for the HL growth story.

Thesis #3: There’s Never Just One Cockroach

The third leg to our thesis is that “there’s never just one cockroach.”

Our investment thesis (and this write-up) are centered on a competition thesis.  We think that will be the key driver of stock underperformance for HL on a go-forward basis.

That said, it’s hard to ignore the cockroaches.  For an enterprising short activist (i.e., not us), the source material on HL regarding conflicts-of-interest, insider dealings, ongoing federal investigations, and misleading and/or ripping off middle-class British investors would make Jim Chanos’s heart full and Carson Block think it was Christmas morning (which today it is).

In no particular order, here are a series of facts concerning HL:

• For years, HL has been the biggest and loudest cheerleader for Woodford Investment Management, the now-maligned UK investment manager that plowed money from its supposedly safe “UK Equity Income” daily liquidity, open-ended mutual fund accounts into illiquid, unlisted, speculative early-stage assets before freezing withdrawals in 2019 following years of underperformance and client withdrawals.

• 70% of Woodford’s remaining assets are from HL clients, all of which are still gated.

• HL kept Woodford on its Wealth 50 list even after virtually all other firms had dropped Woodford.

• HL received favorable pricing from Woodford, at least some of which appears not to have been passed on to HL’s clients.  HL claimed “price is not the determining factor for inclusion in the Wealth 50.” Margins on HL’s multi-manager funds (many of which include Woodford) are higher than any other HL product.

• Following the Woodford debacle, HL claimed its Wealth 50 list does not constitute recommendations and that HL is not a fiduciary.  According to HL’s website, the Wealth 50 is “a list of what we believe to be the best funds available to UK investors” and “are our favourite funds” following HL’s “rigorous research.”  An estimated 40% of HL assets are invested in funds on the Wealth 50 list and fund managers covet inclusion due to the expectation they will receive substantial retail fund flows (i.e., HL clients follow HL’s “advice”).

• HL disclosed to the FCA that its Wealth 50 list is approved in a one-hour meeting, or about one minute per fund.

• On May 15, 2019, HL’s Chief Investment Officer Lee Gardhouse sold 550,000 GBP of HL shares.

• On May 16, 2019, HL’s Head of Research Mark Dampier sold 5.6M GBP of HL shares.

• On May 22, 2019, HL’s co-founder Stephen Lansdown sold 171M GBP of HL shares.

• On June 3, 2019, Woodford froze its UK Equity Income accounts and gated all its investors.

• From June 3, 2019 to June 6, 2019, HL’s share price slumped -15%.

• Until recently, HL included multiple Lindsell Train funds on its Wealth 50 list.  Lindsell Train has consistently been HL’s largest or second-largest institutional shareholder with an ownership of as much as 11%+ of HL shares, depending on the quarter.

• HL’s Head of Research sits on the Board of an Invesco fund managed by Neil Woodford’s protégé Mark Barnett, while a different Invesco fund is on the Wealth 50 list and other Invesco funds own shares in HL.  HL appears to still be promoting Mr. Barnett as recently as a few weeks ago in spite of the conflict-of-interest.

• HL’s Head of Research has since announced his retirement from the firm.

• The FCA has announced an investigation into “wealth” lists and the UK Parliament has set up a Treasury Select Committee to look into the Woodford affair.  The Select Committee requested written responses to a lengthy list of questions from HL.

• As part of the Select Committee’s review, a letter was published indicating HL has been slow-walking the release of clients wishing to transfer to other platforms in the wake of Woodford freezing redemptions.

• The Financial Times recently published an article that the FCA is investigating multi-manager funds with ties to Woodford and highlighted the exposure that HL has to these vehicles.

• HL’s senior leadership, rather than accepting responsibility, has attempted to shift blame to Woodford via frequent and loud public critiques in the media.

To recap.  HL pumped the funds of its largest institutional shareholder, leading its clients to invest in those funds which then turned around and purchased more shares of HL.  HL pumped the funds of Woodford even as other recommendation lists fled, while at the same time receiving discounted fees from Woodford. Billions of pounds of HL client assets are now frozen in Woodford vehicles.  Prominent HL executives blew out of millions of pounds worth of HL shares less than three weeks before Woodford froze its funds, causing HL’s share price to slump -15% in three days. HL’s Head of Research gets paid to sit on the Board of an Invesco fund, while recommending another Invesco fund on the Wealth 50, while other Invesco funds own shares in HL.  Both the FCA and the British Parliament have launched wide-ranging investigations into wealth lists and the Woodford affair, with HL receiving detailed question lists from Parliament and the Financial Times recently reporting HL is a prime target for the reviews.

Through all this, HL has declaimed any responsibility for the negative outcomes while charging its clients the highest fees in the sector and slow-walking the exits of clients who wish to leave.

Maybe these are all coincidences.  Maybe HL has made a series of honest mistakes, and none of this is a big deal.  But all these events are from 2019, not some time in the distant past. And every few weeks, another cockroach seems to appear.  We don’t know how far down the rabbit hole an enterprising analyst would need to go to find the cockroach motherlode. But as they say, there’s never just one…

Risks

The key risk to our thesis is that both Vanguard and Robinhood have dud launches.  We don’t have any particular insight on Robinhood, but we have watched Vanguard meticulously prepare for its launch and have conviction it will be well-received.

Vanguard has been nothing but methodical in preparing for a full-blown UK launch.  Vanguard first tested the UK waters in 2017 with a non-SIPP platform. Vanguard began building a UK e-mail list in 2015, and began building a SIPP e-mail list in 2018.  Vanguard has invested heavily in its UK platform, earning the industry’s highest marks for quality from consumers (according to a 2019 survey by Which?, Vanguard was ranked #1…and the top complaint received was that Vanguard did not offer a SIPP product).

Vanguard has moved carefully, learning from the botched release of the Barclays platform (Barclays rushed the launch of its “Smart Investor” platform in 2017; it was widely seen as a technology disaster with some clients locked out of their accounts for months, leading to customer defections).  Vanguard hired the gold standard IT firm to help with its platform and hired the gold standard financial services marketing firm for its brand campaign. Vanguard intends to launch an aggressive marketing campaign not just in the UK, but across Europe. Vanguard has attracted billions in assets from customers already, many of whom likely also have SIPP’s that can be quickly transferred to Vanguard.  These facts engender confidence that Vanguard is going live because it is ready and the odds are in its favor.

Another risk to our thesis is if UK markets rocket higher.  We are positive on the UK economy following the Tory victory on December 12.  HL is undoubtedly a beneficiary of rising UK security prices (and its shares have been strong the last 4-6 weeks).  Could this offset the market share losses and fee compression from Vanguard and Robinhood entering the market? Perhaps.  We don’t think it likely, and point to the US where asset managers continue to plumb new lows even as equity markets reach fresh highs.  But if we are wrong, then our thesis could prove wrong too.

Conclusion

Following the post-election pop in UK markets, we think it a compelling moment to be short HL.  The singular focus on Brexit has distracted investors from the upcoming existential crisis HL faces from the one-two punch of Vanguard and Robinhood.

This is a direct play on the shift from active to passive that has already transformed the US and is about to slam into Europe.  It is a play on fee compression. It is a play on share/asset losses to two aggressive, well-resourced, A-class peers entering HL’s core market.  We simply don’t see how this ends well.

And then, of course, there are the cockroaches.

In the US, many active asset managers trade for under 10x earnings.  If HL starts to see material fee compression and asset outflows, where is the floor?  The outflows and fee pressures could last years or decades, like it has in the US. HL’s shares could trade to 15x earnings, or 12x earnings, or even 10x earnings.  If we assume fees compress from 45bps to 30bps on the way towards 20bps – and that net inflows go flat or negative – HL’s share price could easily fall 80-90%. That would represent 10 billion GBP of equity value wiped out.

From our seat in the US, we have watched Vanguard dismantle its actively-managed competition.  UK investors, sanguine to the threat because “UK investors simply prefer active managers” (a refrain we’ve heard a dozen times or more in our due diligence), are in for a heck of a wake-up call.

HL is loved, expensive, and feeling the joyous uplift from The Brexit Election two weeks ago.  We think this happy moment won’t last much longer. The competitive cracks are already showing, and that’s before the competitive tsunami crashes down.

We believe there is a good chance HL becomes a permanently structurally broken story beginning in 2020.  Its shares are not pricing in anything close to that possibility today.

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds a short position in this security. Author may sell short additional shares, or buy to cover some or all of Author's shares, at any time. Author has no obligation to inform anyone of any changes to Author's view of HL/ LN. Please consult your financial, legal, and/or tax advisors before making any investment decisions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in HL/ LN. READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE. As with all investments, caveat emptor.

Catalyst

• Vanguard's entry into the UK
• Robinhood's entry into the UK
• Continued trajectory of declining growth due to emboldened competition causes a rethink of HL's super-premium valuation multiple
• Cockroaches