Description

"We believe that Homeserve is not for the faint heated and is uninvestible for most funds but the very high risk variety or activists.”

Stephen Rawlinson, analyst at Whitman Howard, quoted in Financial Times, October 23^rd, 2013

Unrelated to Homeserve specifically, but goes to state of mind, so I hope you will allow it: 

"This FSA action is indeed truly frightening."

David Einhorn, quoted on January 26^th, 2012

LONG HOMESERVE.

Summary:  In an ebullient market, fresh value longs can be hard to find. A good place to look is where the universe of buyers is limited for some reason that is likely to prove temporary: for example where significant headline risk deters all but those who can afford to ignore marked to market changes, or where the threat of imminent forced selling deters the usual bottom fishers.  Homeserve PLC is a business of slightly above average quality, not expensively valued, with a founder CEO still holding 12%, and meets both these criteria.  Any day now, the regulator of its core UK business might issue a fine, customer redress order, or conceivably even a regulatory withdrawal which would materially affect its ability to continue operations.  Sometime over the next few months, its biggest shareholder might face significant customer redemptions causing forced selling of up to 28% of shares outstanding.  If these prospects intrigue you, rather than causing you to lose your breakfast over your shoes, after further investigation of the risks you might conclude - like me - that the most likely scenarios see the business surviving and investor abstinence abating.  Even if the UK business is permanently impaired, considered a less than 5% probability, there should be some residual value in some of the international businesses, though investment losses would probably be incurred.  

Introduction:  The business model, the business–as-usual valuation and prospects should all be quite simple to grasp from company filings.  Therefore I spend the bulk of this write-up covering the context of the regulatory threats.  The summary section “What are the risks?” is probably the easiest way to skim this idea in 2 minutes. 

• Why is this a good business?
• How the company makes money
• Other shareholders
• Valuation
• Why might it be cheap? 

• What do we know about the ongoing FCA investigation?
• Ofcom investigation as a case study
• What did Homeserve allegedly do wrong?
• Timeline
• Negative implications for management
• Explanatory factors, and positive conclusions for management
• Inferences from senior management change

 2.  Feared forced selling by largest 28% shareholder, Invesco, over the next few months.

• What are the risks?
• What does paradise look like and why might we get there?
• Additional management context
• Additional materials

Why is this a good business?

Company description: “We provide home emergency and repair services to over 4.9m customers across established businesses in the UK, USA, France (Doméo) and Spain. We also have developing businesses in Italy and Germany.  Our business is built on developing long-term affinity relationships with utility companies and appliance manufacturers.” 

The business model is asset light (net working capital + PPE of £64 million generated more than £100 million adjusted pre-tax last year), capable of generating rapid growth in new international markets (more than half its customers are now outside the UK and international top line is growing at mid-teens) as newly-signed utility partners allow rapid distribution of product through their existing marketing infrastructure.  If the risks of selling and administering consumer insurance products are appropriately handled, and the price/value proposition is clear to consumers (e.g. France with 88% retention rates vs. sub 80% elsewhere), this business can combine high returns on capital with the predictability of a consumer subscription model. 

A positive outcome here would see a return to highly cash-generative growth with decent capital allocation by an aligned management.  When such businesses run smoothly, they don’t typically trade at average multiples (except for periods of crisis – global or company specific – this business has tended to be valued in the public market above 20x post-tax or 15x EV/pre-tax.)

How the company makes money

1. Core economic logic: saving consumers the search costs for competent, non-gauging, tradespeople (plumbers, electricians, gas repair workers) who show up on time during domestic emergencies.
2. Consumer fear of uncertainty – the premium chargeable for peace of mind.
3. Economies of scale for utility businesses with large installed household customer base.  The marginal cost of adding Homeserve marketing and billing to their existing fixed cost base is trivial when compared to the revenue-sharing opportunity.

In historic reality: these profits were probably augmented by: 

4. Selling options.  The worst UK winter apparently for 100 years in 2010/11 which led to an escalation of consumer complaints over emergency repairs and some damage to the company’s brand reputation could have been managed differently: by running extra capacity, and reporting lower profitability, in normal years.  Though I am not alleging wrongdoing or bad faith by management, and understand that these risk/reward trade-offs are typical for most businesses, a cynic would view historic earnings as under-reserving for the potential risk of a once in a hundred year event happening, well, once in a hundred years.  However new investors, after the risk event occurs, can benefit from a chastised and more risk-averse management.
5. Possible, but as yet unproven, infractions of UK regulations in the marketing of consumer financial services products, allowing historic earnings to be higher than they would have been for a 100% compliant business.

Page 27 of the presentation below shows the financial business model, outlining the components for revenues and operating profit:

http://www.homeserveplc.com/download/prelim-results-presentation-2013.pdf

“Wait a minute, judging by your recent VIC submissions, you’re not even smart!  Apart from you, does anyone actually smart think that this is a business worth investing in?”

Some arguably smart, large investors tried to catch the falling knife when initial concerns about FSA/FCA (UK regulator) interaction with the company first hit the stock price in Q4 2011.  For example Pennant Capital held 3% of shares outstanding between March and May 2012, before selling once the formal FSA investigation was announced.  Marathon Asset Management (London-based value investors, subject of Edward Chancellor’s book “Capital Account”) has held a small stake for years and then increased significantly during the major sell-off a couple of years ago, to its current holding of 7%.  Funds managed by local investor Neil Woodford of Invesco originally held 14% of shares outstanding at the 2004 IPO, before increasing to 29% after the problems surfaced in Q4 2011 and the stock price was cut first in half, then to a quarter of its prior valuation.  This particular position is the subject of feared forced selling, unrelated to company fundamentals, see point #2 below.

What is the current valuation to normalized earnings? 

Assuming any potential regulatory action only addresses legacy issues, leaving current operations in tact, I think normalized pre-tax earnings should be £85-100 million, or £60-75 million for post-tax free cash flow (note catch-up IT infrastructure spending over the next 2 years).  This assumes that the UK business is successful in its stated goal of stabilizing customer numbers around 1.9 million, having suffered a significant drop from its 2010 peak of 3.26 million.  Due to ongoing uncertainty affecting the UK business, somewhat offset by international growth, earnings could be significantly below normalized levels for the next two years at least, even in a positive operational outcome.

That puts EV/adjusted operating income at 8.4-9.8x and P/FCF at 10.8-13.5x. (EV does not include any fine/customer redress further than existing company provisions).  Dividend yield is 4.6%.  Given the business model, there is not a lot of balance sheet protection, so the margin of safety – if it exists at all - could only be argued for on the discount to earnings power.  Therefore we need to spend a lot of time looking at the nature of the risks that have depressed the earnings valuation over the last couple of years.

Skimmers may wish to jump to the section: “What are the risks?”

Why might it be cheap?

The current valuation above shows that cheapness is relative, not bargain basement. There are two reasons that a buyer of this stock now can have some expectation that they are accessing a somewhat inefficient market price:

1.  Cloud of regulatory threats deters many rational investors, likely only to return if the all-clear is given.

2.  Feared forced selling by largest 28% shareholder, Invesco, over the next few months.

1.  Cloud of regulatory threats deters many rational investors, likely only to return if the all-clear is given. Investing in a consumer financial services company that might get shut down by its regulator any day while you sleep is not a soothing proposition. Many professional analysts and investors refuse to invest in complex situations involving regulatory uncertainty due to the career risk that a losing investment would present.  The headline risk alone might be too much of an obstacle to making this investment in the last two months of a strong year in the stock market – a professional investor compensated on annual performance might be unwilling to risk blowing up a good year by a lousy headline, even if the stock price drop proves temporary.

Ever since May 7^th, 2010, when Ofcom (the UK regulator for communications) first wrote to Homeserve alerting them to customer complaints about telesales activity, regulatory scrutiny paid to the UK business has been heightened.  A casual glance back at the stock chart shows two points when mounting regulatory risks seriously spooked investors:

i) the company announcement on October 31^st, 2011 that they were temporarily suspending all telephone sales and marketing activity after their independently commissioned report by Deloitte found that “sales processes did not meet the Company's required standards”.  The stock opened down 50% that day.

ii) the launch of a formal investigation by the FSA on May 18^th, 2012 which was announced in the May 22^nd, 2012 Annual earnings call.  The stock opened down 30% that day.

What do we know about the ongoing FCA investigation?

A £6 million provision was announced on 21 May 2013 specifically to cover the costs of the FCA investigation, “put together based upon advice from advisors. We said it's a combination of three things, which is our internal cost, which obviously we can't be precise on. Plus our external legal advice; again, we can be precise on and the balance is made up of the fine.”

Q4 2013 Earnings Call, 21 May 2013

Management has stated that the two major issues relate to the way in which combined policies were sold, affecting 80,000 customers, and how customer complaints were resolved, affecting 48,000 customers.

Really the largest item that Deloitte found in terms of their telesales review was around combined polices and in a very small number of cases where customers were not fully clear of the pricing that was being closed for the new policy. So, the way it works is that a customer with a couple of policies on a call would -- the member of sales staff would say, you're paying a certain amount of money, what we will do is we will give a credit for the unexpired term of those existing policies and then upgrade you to a wider range of combined policies and give you a credit against that premium. So, it is actually quite a complicated process and that requires more visibility of the ongoing pricing versus the previous pricing on the terms and conditions for those new policies. So, that was the main area. So, we think it's limited, but in total they were no more than about 80,000 customers that were upgraded to a combined policy over the course of last year.

11/10/2011 Business Update Call

We did have a higher level of complaints over the last winter period than the winter before, principally because there are massive customers calling to say the temperature is minus 18, my pipes are frozen and I have got no water. Actually, we can't do anything about that until the pipes have thawed. So, it was different issues last winter that the one before. So, it was around claims handling and hence the reason for putting in place the extra 140 staff. The issues the winter before were getting our engineers on to customers' driveways and hence the things that we did like purchasing more four wheel drive vehicles and having tire wraps, we equipped them with snow chains, to get the vehicles moving. So, there were a total of 48,000 complaints in the period, and the exercise that's going on is to go back and look at any that weren't handled in the compliant way.
11/10/2011 Business Update Call

Customer redress for some historic issues which would be covered by the FCA investigation have already started, with a £24.2 million provision in FY 2012 made “addressing the issues in the UK include our estimated cost of re-contacting and, if appropriate, compensating customers who may have suffered any detriment as a result of the way in which complaints have been handled or their policy purchased.  In addition, there are redundancy and reorganisation costs, costs related to reviewing and improving our controls and governance and sales and marketing materials and the ofcom fine.” 

Customer redress at management’s iniative should be complete by March 2014:

“In November 2011, we commenced a number of business improvement initiatives, which were consistent with the feedback received from our Supervisory team at the FCA. These initiatives focused on our sales and marketing, controls and governance and complaints handling issues. Our customer re-contact exercise is the only initiative still to be completed and this is progressing as planned.  We are now close to completing the review of the complaints that were received during winter 2010 and we are also making progress in contacting customers who may have suffered detriment as a result of the way in which they were sold their policy. This exercise is expected to be completed by March 2014.”

www.homeserveplc.com/download/Preliminary_Results_22_May_12.pdf

Homeserve Membership Limited is still an authorized company, regulated by the FCA, with current permissions to conduct various regulated activities, and no recorded disciplinary history to date:

http://www.fsa.gov.uk/register/firmRegulator.do?sid=130877

In November 2012 the FCA’s predecessor, the Financial Services Authority (FSA), issued its joint largest retail fine of £10.5 million to CPP for mis-selling.  In August 2013 the FCA announced an agreement with CPP and 13 retail banks to conduct a customer redress whose maximum value would be £1.3 billion. http://www.fca.org.uk/news/consumer-redress-agreed-for-mis-sold-cpp-insurance

Regulation applied to any potential fine should be no more than 20% of relevant revenues plus interest, and this percentage would only apply in the most egregious case.  Note that the largest fine by the FSA to date was £160 million, to UBS in December 2012 for Libor rigging.  See: DEPP 6.5A The five steps for penalties imposed on firms:

http://www.fshandbook.info/FS/html/FCA/DEPP/6/5A  

Lastly, although the FCA seems well resourced with an annual budget of £432 million, the dramatic spike in major issues currently commanding its attention (e.g. Libor scandal, alleged FX manipulation, proposals for asset management industry reform), they certainly should be somewhat distracted right now, which probably means that either any resolution of Homeserve’s case will be long delayed, or that a decision might be made with undue haste.  Clearly this presents both threats and opportunities for the company.  Despite the uncertainty having lasted for longer than management at first expected, it might still drag on for years.

OK, since the FCA investigation is still open and uncertain, let’s use the completed Ofcom investigation as a case study.  What can we learn about management from this? 

On 19 April 2012, Ofcom - the independent regulator and competition authority for the UK communications industries - fined Homeserve a then-record £750,000 for silent and abandoned calls.

http://media.ofcom.org.uk/2012/04/19/homeserve-fined-750000-for-silent-and-abandoned-calls/

The total cost of this matter to the company, including the fine, customer redress and third party advisor costs appear to have been less than £6.3 million.

http://www.homeserveplc.com/download/HYR_2012.pdf

What did Homeserve allegedly do wrong?

“Under Ofcom's rules, there is a limit on the number of abandoned calls that companies are permitted to make to consumers. Ofcom's investigation into HomeServe found that the company exceeded this abandoned call rate on 42 separate occasions during the period 1 February and 21 March 2011. This resulted in an estimated 14,756 abandoned calls being made to consumers.

Ofcom rules also prohibit companies from making repeat calls to specific
numbers within the same 24 hour period, where a call has been identified by
AMD technology as having been picked up by an answer machine. Ofcom found that
HomeServe made an estimated 36,218 calls in breach of this rule.

Ofcom's Consumer Group Director, Claudio Pollack, said: "Our rules are there
to prevent consumers suffering annoyance, inconvenience or anxiety from silent
or abandoned calls.  We hope today's fine will send a strong message to all
companies that use call centres that they need to ensure they are fully
compliant with the rules or face the consequences."”

http://media.ofcom.org.uk/2012/04/19/homeserve-fined-750000-for-silent-and-abandoned-calls/

Timeline

• 7 May 2010, Ofcom wrote to HomeServe to alert them of consumer complaints and “to impress upon HomeServe the importance of compliance with the then 2008 guidelines and the potential consequences of failure to do so”.
• 20 May 2010, HomeServe‘s Senior Legal Counsel, responded to Ofcom.
• 16 August 2010, Ofcom wrote an e-mail to HomeServe informing it that Ofcom was continuing to receive complaints about silent and abandoned calls allegedly generated by or on behalf of HomeServe. This e-mail requested responses from HomeServe to several questions.
• 23 August 2010, Senior Legal Counsel, on behalf of HomeServe, replied saying that he would respond shortly.
• 31 August 2010, Ofcom e-mailed Senior Legal Counsel to determine whether the issues had been discussed and whether he could provide Ofcom with an update.
• 1 September 2010, Senior Legal Counsel responded to the effect that he was awaiting publication of Ofcom‘s revised statement of policy which he believed would be published in September and HomeServe would seek to be compliant with that statement.
• 25 September 2010, UK Parliament approved an increase in the maximum financial penalty available to Ofcom to use to combat silent and abandoned calls, from £50,000 to £2 million.  Management might well have been slow to adjust from what was historically in practical terms a mere nuisance issue.
• 20 December 2010 (following the publication of the revised guidance on 1 October 2010), Ofcom published an open letter about the new 24 hour policy, the threat of enforcement action should this and other elements of our persistent misuse policy not be complied with and the increased maximum penalty level for persistent misuse which came into effect on 25 September 2010.
• 1 February 2011 to 21 March 2011 – the “relevant period” was subsequently identified (Ofcom took the preliminary view that it should impose on HomeServe, a penalty under section 130 of the Act in respect of its persistent misuse of an electronic communications network or service between 1 February to 21 March 2011.)
• 28 March 2011, Ofcom contacted HomeServe on a further occasion to inform it that Ofcom intended to conduct an investigation into HomeServe‘s call centre operations over the Relevant Period.
• 6 July 2011, Ofcom issued the section 128 notification to HomeServe. Legal framework: Ofcom may impose a penalty if a person notified under section 128 of the Act has persistently misused an electronic communications network or an electronic communications service.
• 8 August 2011, HomeServe submitted its representations to Ofcom on the matters set out in the section 128 notification (the “August 2011 Representations”).
• 29 September 2011, Ofcom determined that further information was required, and issued the Second Information Request to HomeServe
• 12 October 2011, HomeServe responded to the Second Information Request.
• 26 January 2012 Ofcom issued to HomeServe the Provisional Notification of the possible penalty.
• 23 February 2012, HomeServe submitted its written representations to Ofcom (the “February 2012 Representations”).
• 19 April 2012, Ofcom fined Homeserve a then-record £750,000 for silent and abandoned calls.

Further background on “persistent misuse of an electronic communications network or electronic communications services”:

http://stakeholders.ofcom.org.uk/binaries/enforcement/competition-bulletins/open-cases/all-open-cases/cw_905/HomeServe.pdf

Negative implications for management

1. The compliance environment was weak.
2. Even after a regulator raised its concerns, for some time management did not act to ensure compliance.

1.  “HomeServe was in possession of a report from 10 February 2011 onwards which unequivocally stated there was non-compliance at (its third party telesales operator), and that, among other things, the compliance environment was weak.”

2.  “In May, August and September 2010, Ofcom contacted HomeServe‘s Senior Legal Counsel and during the course of this contact Ofcom raised its concerns about a number of silent and abandoned calls complaints it had received. This suggests to Ofcom that senior management were aware at this time, that Ofcom had concerns regarding HomeServe‘s compliance with the persistent misuse provisions.  However, we nevertheless maintain the view, having considered all of HomeServe‘s representations, that:

 a) members of HomeServe‘s senior management were aware of the relevant contravention; 

b) it continued for some time after they were so aware;

c) for at least a significant part of the time they were so aware, HomeServe did not take the matter sufficiently seriously (nor was action expedited) and take enough care to ensure it was in compliance; and 

d) responsibility and culpability attaches to HomeServe as a result.”

“the awareness of senior management of the relevant contravention and that at least for a significant part of the time they were aware, did not take the matter sufficiently seriously (nor was action expedited) to ensure that HomeServe was compliant.”

http://stakeholders.ofcom.org.uk/binaries/enforcement/competition-bulletins/open-cases/all-open-cases/cw_905/HomeServe130.pdf

Explanatory factors, and positive conclusions for management

1. Consumer-facing financial services companies often view regulatory compliance, together with occasional infractions and penalties, as part of the cost of doing business.  Much of Ofcom’s correspondence with the company would not have necessarily raised alarm bells for senior management.  Barclayccard was fined the then maximum fine of £50,000 for a similar offence in 2008; Abbey National was fined just £30,000 for “persistant misuse” in March 2008.  These are trivial sums when compared to total revenues. 
2. Management did eventually take significant action. 

• One day after the Ofcom matter was made public by the issuing of the Section 128 notification, on 7 July 2011 the UK CEO Jon Florsheim resigned from the board and announced he would leave the company in August, to be replaced by company veteran Jonathan King.  King had formerly run UK operations, was moved to grow the US business, and today remains in place as UK CEO.
• “Ofcom is of the view that Home Serve has taken all such steps as we consider appropriate for securing that its notified misuse has been brought to an end.”

3. Regulatory investigations by the FSA/FCA – as the authorizing regulator – should in theory carry much more weight for management’s attention, than infractions involving telesales technology.  Therefore a weak compliance environment in one area of the business should not necessarily be damning for the compliance culture in general. 

Conclusions of Ofcom case:

• Management made some mistakes, but cleared them up effectively without causing incurring major financial impact.
• Management should become more risk averse in future, due to the brand fallout of consumer complaints and from media coverage of regulatory scrutiny.  

Inferences from senior management change

The announcement on October 23, 2013 that Jonathan King, CEO of UK Membership (currently under regulatory review) is one of those hard to interpret senior management changes.  When this experienced and loyal executive was brought back from growing the US business in 2011 to fight fires in the UK, it was expected by the group CEO that he would generally stabilize and de-risk the business, then specifically manage the internal investigation and the relationship with the regulator.  Although initial signs suggested progress, maybe he has now resigned because he knows that severe regulatory action will be forthcoming. 

http://www.homeserveplc.com/news-item?item=1622116805902336

Alternatively maybe he resigned for any one of the normal innocent reasons.  He hands over to the current COO and former CFO, so succession planning appears in tact.  One sell-side analyst stated that “this was solely a personal decision and is not linked to the performance of the UK business or FCA investigation”, though this is unverifiable for now.  Some comfort might be drawn from the fact that his resignation was not immediate (remains at the business until calendar year-end and on the Board until Q1 2014).

An ardent optimist might hope instead that Jonathan King’s freshly stated career plans, “to pursue a non-executive career” might somehow include a buyout of Homeserve, long rumored* to be a takeover candidate during its two years in the valuation wilderness, due to its combination of cash generative business model, dramatic drop in valuation, and one single shareholder owning 29% - just below the threshold required in the UK for a takeover bid.  This is all idle speculation, but as much as the timing of his resignation seems odd in a negative way (prior to the resolution of the regulatory investigation he was appointed to conclude), coming just one week after the Woodford news (see #2 below) which meant a 28% shareholding could potentially became available, an optimist could infer a positive signal, and closely monitor King’s plans once he leaves the board.

* for example http://www.homeserveplc.com/news-item?item=1024407682298018

2.  Feared forced selling by largest 28% shareholder, Invesco, over the next few months.  (See risk #8 below.)

Though this stock clearly has the potential to generate quite enough price volatility of its own accord, less than one month ago the stock price dropped 10% in 48 hours on news which had nothing to do with underlying operations, but everything to do with the ownership of 29% of shares outstanding.  Open-ended funds managed by Neil Woodford, that originally owned 15% of the company at the time of the 2004 spin-off, had courageously/foolishly tried to catch the falling knife when the company disclosed its problems in 2011-12, doubling its shareholding as the stock price dropped by 70%.  Last month’s resignation of this portfolio manager put the stability of this shareholder at risk of forced selling over the next several months:

“The UK's biggest star fund manager, Neil Woodford, is to quit InvescoPerpetual to open his own fund management business in April in a move that has stunned the asset management industry.  Woodford, who personally manages funds at Invesco Perpetual totalling £24.6bn and co-manages another £6.4bn…will leave the company on 29 April after 25 years.”

http://www.theguardian.com/money/2013/oct/15/neil-woodford-quits-invesco-perpetual 

Though understandable and rational in the short term, a major discount for this feared forced selling should present a long term opportunity because:

1.  The Homeserve position represents less than 1% of Woodford’s open-ended AUM.  At some level of discount, the successor fund manager might prefer to sell some other holdings first to meet redemptions, up-weighting this investment at a discount which should be reflexive in nature.
2. Block selling to other institutions might be achievable over the next six months without the price collapse that could be feared, as evidenced by this week’s sale of 1.11% of outstanding: http://www.homeserveplc.com/news-item?item=1634031045181440   Consider that this buyer must know that there are potentially another 30 or so of these size blocks to go, so this is possible early evidence against a worst case forced selling frenzy.
3. The company’s earnings power and intrinsic value will be unaffected by this game of musical chairs in one or two year’s time.

So the current stock price should include some discount for significant uncertainty facing both the core business and almost one third of the shareholder base.  Whether this discount yet adequately compensates for the risks is addressed next.

What are the risks? 

"All I want to know is where I'm going to die so I'll never go there."  Charlie Munger

The top eight ways in which this investment could get permanently impaired, plus two headline risks

1. Regulatory threats to operations: Financial Conduct Authority (“FCA”), the regulator of HomeServe in the UK, removes its authorization to sell insurance.  Two years after management commissioned an independent investigation by Deloitte’s and showed it to the FSA (October 2011), and 18 months after the formal FSA investigation began, Homeserve is still an FSA authorized firm, and is still authorized to conduct outbound telephone selling to new customers.  If the FSA/FCA were convinced that the company had widely mis-sold insurance products, such ongoing authorization and permissions seem unlikely, though not impossible.
2. Regulatory threats to operations: FCA significantly reduces permitted UK activities, to maintaining its current customer base, prohibiting it from selling policies to new customers.
3. Large redress: FCA finds that HomeServe widely mis-sold insurance policies, for a long time (i.e. a relevant period of more than twelve months).  In addition to a fine, HomeServe UK agrees to customer redress.
4. Large redress: FCA succeeds in achieving a high response rate for customer redress. Historically, UK companies that have been forced to conduct customer redress exercises, especially for low-cost products which result in relatively low value payments, have often benefited from the fact that most customers fail to claim financial redress which is so trivial that it does not reward the necessary time and effort by the consumer.  The FCA is clearly trying to raise response rates in future: “Encouraging consumers to claim redress: evidence from a field trial” http://www.fca.org.uk/static/documents/occasional-papers/occasional-paper-2.pdf  (April 2013).  Nevertheless, it still seems likely that if the FCA does announce a targeted redress figure for Homeserve, the amount actually payable by the company would be a small fraction of the headline figure.  Historical response rates as low as 1.5% were quoted by the FCA’s own research.
5. Extremely large fine: anything over £100 million would be a shock, but depending on the associated customer redress required, potentially manageable.  If the FCA decides to make this fine a new UK record (above £160 million) it could conceivably strain capital structure (£225 million room under current debt facility).
6. Reputational damage: from media coverage of FCA fine, possibly deliberately inflamed by the FCA who might seek to exploit the announcement of its fine to try to deter customers from buying Homeserve’s products, even if it does not have the evidence required to shut them down.  In order to understand why this might be in the regulator’s interests, the context is crucial.  The FCA’s predecessor the FSA is widely blamed for its light-touch regulation as a key causal factor for the UK banking crisis of 2008-09.  While the new regulatory entity is so young it is hard to handicap how far the pendulum might swing towards heavy-touch regulation, nevertheless initial signs are that the FCA sees itself as “a very different animal to the Financial Services Authority (FSA)” (FCA CEO Martin Wheatley, July 9^th 2013) and wants to make its mark in defending consumers, even potentially going so far as to protect them from themselves.  The first research paper the new regulator released was titled “Applying behavioural economics at the Financial Conduct Authority” (http://www.fca.org.uk/static/documents/occasional-papers/occasional-paper-1.pdf) and might suggest their willingness to attempt to directly counteract the very behavioural forces which make this kind of business lucrative in the first place.  “Market forces left to themselves will often not work to reduce these mistakes, so regulation may be needed. A good example is payment protection insurance (PPI). Firms were able to earn large profits on PPI products because many buyers fundamentally misunderstood PPI pricing and the limitations in its coverage. High PPI prices allowed sellers to attract more customers by offering mortgages at cheaper rates (which consumers focused on when choosing a provider). As a result, no firm had an incentive to advertise that PPI was a poor product for many people and charge appropriate mortgage and PPI prices. This would have made the firm’s mortgage more expensive and the firm uncompetitive. Intervention was needed to solve this problem.”  This research paper includes approving comments from FCA CEO Martin Wheatley, who as one of the highest paid public servants in the UK, presumably has an interest in making as much noise as possible when he feels that the FCA should intervene.
7. Reputational damage: not wanting to tar themselves with the same brush as a disgraced, greedy seller of useless products, affinity partners sever ties.  To date, no utility affinity partner has yet done so, though for a period some did suspend new marketing activity.
8. Debt: for a business in flux, net debt of £26 million, even if very small relative to recent earnings and the £250 million debt facility expiring 2016, nevertheless represents a risk.
9. Marked to market risk:  FCA provides the equivalent of a Tyco shower curtain, demonstrating a greedy business culture, maximizing media attention by releasing a large estimate of total customer redress despite only a fraction eventually payable.
10. Marked to market risk: 28% shareholder, funds currently managed by Neil Woodord at Invesco, becomes a forced seller.

What does paradise look like and why might we get there?

1. FCA announces a fine of less than £10 million…
2. …for a very small level of historic mis-selling amongst the specific target group of combined policy customers. 
3. Customer redress has already been handled and completed by Homeserve prior to the fine announcement. 
4. All other FCA recommended measures to improve sales and marketing, controls and governance and complaints handling issues have been fully implemented.
5. The firm continues to be authorized, with no further restrictions.  Outbound telephone sales to new clients are allowed. 

Additional management context

Founder Richard Harpin aged 49 set up the company in 1994, aged 30, and still owns 39.97 million shares (value £88 million), or 12% of outstanding.  He last sold 16 million shares at £4.15 per share for £66 million in November 2010, saying at the time: “There is never a good time to sell but this is my one and only sale.”

A couple of brief video interviews with him are worth watching:

http://www.youtube.com/watch?v=cUD8BK6pVMg

http://video.cnbc.com/gallery/?video=1503601834

Personally I would have preferred to see more disclosure about the exact nature and expenses of the helicopter that he uses to commute to the office, rather than the scanty disclosures for http://harpinltd.com/ under related party transactions.  Similarly it might have been nice for this Homeserve branded helicopter to have been put to better corporate use during the exceptionally bad winter of 2010, when I can find no media evidence to show Richard Harpin grabbing brand victory from the jaws of operational defeat, like his namesake compatriot Richard Branson might have done.  No red helicopter-bearing millionaire CEO clad in plumbing overalls swooped down to fix a granny’s leaking pipes.

Still, overall he seems an experienced and driven entrepreneur, long term in his approach, with on the whole, appropriate incentives.

Additional materials

Particularly important company announcements / conference call on subject of regulatory interaction:

October 31, 2011             HomeServe plc update

http://www.homeserveplc.com/news-item?item=808263453017336

10 Nov 11            Business Update Call

http://www.homeserveplc.com/news-item?item=834140630948958

22 May 12            FY 2012 Earnings Cal

21 May 13            Q4 2013 Earnings Call

Important upcoming dates

Next week’s interim announcement November 19, 2013 might include an update on regulatory oversight. 

Disclaimer: This is not investment advice and is not intended to be distributed in any jurisdiction where it would contravene local laws.    

Header forecasts are consensus, all values are £.  Sources where not stated: company filings and Bloomberg.

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