Description

Nordnet: a compounder at a discount

• Nordnet is a consistently profitable and well-run online savings bank and brokerage with toll bridge-like qualities available at a sizable discount to intrinsic value.

• Nordnet benefits from long term growth trends in the Nordic pension and savings market and has lots of room to grow its customer base. As the company achieves greater scale (especially outside Sweden), operating margins should expand as the cost base is largely fixed.

• Longer term, Nordnet is a good play on rising interest rates, as 100 bps higher rates translates into a 14% rise in net income overall.

• The company is controlled by a Swedish family with over a century of experience in banking and asset management, and company management seems competent and trustworthy.

• Competitive pressures in key markets are moderate, and the company’s position is very strong. Nordnet is successfully building a trusted investment platform in the Nordic market.

• The balance sheet looks solid– no issues with capital adequacy here. Rumoured increases in Swedish countercyclical buffer requirements are not worrisome for Nordnet.

• Nordnet shares represent a compelling value even when using conservative assumptions - I believe there is more than 50% upside here over the next 3 years, and low risk of substantial loss.

The Economics of a Toll Bridge

Buffett tells us that the fundamental economics of a toll bridge are excellent. However, this post is not about a toll bridge. Rather, it’s about the “functional equivalents” of a toll bridge. Now, apart from the reasons Buffett talked about, what are the other reasons that make a toll bridge a very good business model?

A: There is usually no alternative. People who have to move from A to B, have to use it. The owner of the toll bridge won’t let you through unless you pay the toll. That’s the key phrase: pay the toll. Keep this phrase in mind because we will need it later.

B: Even if there is an alternative, people still prefer to use the toll bridge. That’s because in the mind of the user, it does not make sense to use the alternative. Now there can be all kinds of reasons why people prefer to use a toll bridge instead of an alternative. For example, the alternative may be too far, too crowded, too risky (crime-ridden) or too expensive. There may be other reasons as well but the key thing to remember is that the preference is in the mind of the user.

Sanjay Bakshi https://fundooprofessor.wordpress.com/2012/10/21/toll-bridge-meaning/

Nordnet’s business in brief

Nordnet (NNB SE Equity, mcap of 5.5 Bn SEK) was started in 1996 as a platform for individuals and companies to access financial tools then available only through big banks, and enable them to manage their own finances online - a toll bridge between the individual saver and the financial markets. The company operates in the Nordic countries, with the largest presence in Sweden, and is the biggest online broker /savings platform in the region. It has centralized IT operations in Sweden, and local offices in the major cities of the Nordic countries. Its strategy is to seek economies of scale through the reuse of services and functions to the greatest possible extent across local markets. It does not primarily cater to the active trader but in its own words, «the conscientious saver». Clients include everything from day traders to long term investors, however. Investors can access online trading of a variety of financial instruments (stocks, derivatives, mutual funds) through their portal, which is simple to use and designed to be immediately accessible to the amateur.

Nordnets main income sources are brokerage income and net interest income. In Sweden, the bank also provides short term personal loans (low individual amounts and high interest margins on these loans compensate for the increased risk here). Nordnet offers pension solutions in Sweden, Norway and Denmark and focuses on offering a simple and cost effective platform for clients. The pension market in the region is changing dramatically, with increased freedom for the individual to move and take control of their pension savings, and also a clearly increased need to do so - the previously common defined benefit pension schemes (outrageous by American standards) are now quickly being replaced by less generous defined contribution schemes. People will have to save more on their own, and are waking up to this fact. Nordnet provides an easy way to save, but does not offer guaranteed pension products. The total pension market in the Nordic Countries (excl. Finland) is over 8400 Bn SEK.

Nordnet’s 3 reporting segments are Investments & savings, pensions and banking. Within these segments, Nordnet basically makes money in the following ways:

• Commissions on brokerage services: 30% of income. Nordnet is competitively priced in all categories from occasional to active trader as far as I can see, and caters to several categories in this segment, although most customers are stodgy savers. Nordnet offers several user platforms:

o   Nordnet.se: easy to use, web based platform for all of Nordnet’s services. This is the platform the vast majority of customers use.

o   Nordnet Webtrader: A simple but customizable trading application.

o   Wintrade: for active traders, a more advanced trading platform with greater functionality.

o   Autotrader: customizable algorithmic trading with automatic order entry.

o   Mobile apps for iOS and Android (phones and tablets).

o   InFront: Professional level subscription based platform (I-F is not owned by Nordnet). This is what third party brokers using NN systems use as their interface, while NN provides the infrastructure.

o   Nordnet nExt API: offers customers the possibility of hooking their own trading applications up to the Nordnet systems. For sophisticated, software proficient clients.

• Fund platform fees: about 10% of income. Nordnet receives cash either from funds as distribution fees, or from customers directly (some funds aren’t free to trade).
• Net interest income on loans and financial assets: 50% of income. NN has over 20 Bn in deposits, and 6.2Bn of loans to customers as private loans(3.4 Bn) or margin loans (2.8 Bn), the rest of the money is invested in bonds. The bond portfolio return is also included in net interest income.
• Various service fees : 10%. These include foreign exchange services, trading application fees, acount fees, analysis services, newsfeeds et cetera).

Competitive environment

Nordnet is the 2nd largest online brokerage in the Nordic region. Their main independent competitors are Avanza (largest), Skandiabanken and Netfonds. In addition, Nordnet competes with traditional banks that offer similar services. Nordnet has one big advantage vs the latter category in that it is perceived as independent – Nordnet offers investment alternatives from several suppliers (over 1000 funds and ETFs), while traditional banks offer fewer products and mainly use their platforms to push their own products. In terms of thinking about a competitive advantage, there are switching costs for consumers as moving pension plans and portfolios is somewhat of a hassle (but note that this also means Nordnet poaching clients from banks etc is more difficult). Nordnet is also good at building a trustworthy brand with a modern image (I wouldn’t yet consider their brand value so strong as to call it a moat, but it’s becoming an asset for sure). There are also obvious scale advantages in this business vs new entrants. The space is pretty well consolidated with Nordnet, Avanza (AZA SE) and Skandiabanken as the top 3 independent players along with Netfonds in Norway, which is a beautiful thing when the total adressable savings market is still big and growing at a good pace. Avanza is the main competitor and most relevant peer  – it is bigger in terms of total trading market share, but significantly smaller in terms of total savings capital. It is also much more focused on Sweden, while Nordnet targets all the Nordic markets for future growth. NN says about 8m people in the Nordics transact in shares or funds every year, and that about 2m of those are key target customers for Nordnet. So the Nordic savings market, especially outside Sweden, still has great growth potential in my opinion.  These markets are still dominated by big banks, many of which have pretty bad offerings and have suffered severe reputational damage after the financial crisis. As an example, Nordea doesn’t offer its clients index funds. Not for savings accounts, and not for pension plans. The reason is what you think it is: so they can push their own crappy actively managed funds instead. That’s a form of greed and stupidity that sends customers to Nordnet (unbelievable in 2015). In the Nordics, Nordnet’s competitive position can be briefly summed up as follows:

• Sweden: The competition consists of traditional banks, as well as Skandiabanken and Avanza and the newly entered DeGiro from the Netherlands. NN has 221 000 active customers and the biggest independent player. The population of Sweden is about 10m.

• Finland: Nordnet bought eQ i Finland some time ago and is the dominant independent player in that market. Currently, NN has about 110 000 customers here. The population is about 6 million. Note that NN is not a player in the Finnish pension market for regulatory reasons.

• Norway: 66 000 customers. Biggest independent player in stocks and mutual funds, only real competitor in online brokerage space is Netfonds. Has lots of potential to grow both in this segment and especially in pension saving. Norway has a population of about 5m. In Norway, traditional savings banks still has most of the market. Most of them have a poor offering and will IMO probably lose market share in the future.

• Denmark: 47 000 customers. Growing quickly in all business segments. Competition made up of independent competitor Saxo Bank (recently partially sold to a PE firm at 28x EPS) and traditional banks.

Overall, I see competitive pressures as moderate, and Nordnet has been able to build efficient scale and a trusted brand that is difficult to replicate for new players. With only a few major independent competitors, pricing is competitive, but not irrational. I don’t see this situation changing in the immediate future. Nordnet is executing on a good strategy, and with increasing scale comes better economics. I think it’s very likely that Nordnet will strengthen its competitive advantages in the Nordic region over time and create significant shareholder value.

My assumptions and reasoning on earnings growth going forward

As mentioned earlier, the most important driver of Nordnet’s profits long term will be increased pension flexibility and saving interest as structural changes are occurring in the Nordic pension markets. The transition from rigid pension schemes and defined benefits to defined contribution will support Nordnet’s growth for years to come.

While Norway and Denmark will probably never be quite as big as Sweden (Sweden has a bigger and more financially sophisticated population), Nordnet can still grow operating income many times over in these countries.  I think the Danish and Norwegian markets have great potential, and that we are seeing the start of something big here in the first six months of 2015. As these markets scale, overall operating margins for the group will increase, too. Look at the growth in savings capital yoy, and the impact on margins – it’s already happening.

I’m more unsure of Finland, but it’s not unthinkable that pension reforms come about here too. In any case, the Finnish operations are profitable already, with 31% operating margins and 31m in EBT for H1 2015.

* Net savings growth in Sweden impacted by decrease in cooperation w/ partner Søderbergh & Co, resulting in outflows of 3.1 Bn SEK in H1 ‘15

Additionally, Nordnet is very good at creating interest and activity in its local markets through various intitatives like the social investing platform Shareville, which was launched last year under the NN umbrella and counts over 50k members (it is by far the biggest such network in the Nordic region). They have weekly podcasts and regularly schedule events where presentations on relevant topics are given to current and prospective customers. Nordnet reps are prolific contributors in Nordic financial media (I find most of the commentary to be fairly bland, but as a means of generating interest/activity and building mindshare, it’s probably effective). Nordnet also launched no-fee index funds last year, and there is already over 1 Bn SEK invested in these. These obviously don’t generate income for Nordnet directly, but they attract new customers (like myself) who spend money on other services.

The historical earnings growth has been impressive; EPS CAGR over the last 5 years (including 2015 ests.) has been 12%, despite challenging conditions: low interest rates depressed interest margins and low trading activity after the financial crisis lowered commission income. The latter has been almost flat between 2006 and 2014, finally picking up again this year. Net CI stood at 312m by Q2, I expect 600m for the FY2015, up from 478 in ’14.

Net commission income – virtually flat since the financial crisis (competition has lowered fees pr trade, too)

Growth in savings capital has been more impressive: 15% CAGR over the last 10 years (191 Bn SEK at Q2 2015).

Going all the way back to 2006, the EPS CAGR has been 6% - which is also my long term growth assumption (see valuation section). I’m probably low-balling in terms of earnings growth (and by extension ROE and target price), but a big margin of safety is always nice. While I expect the number of new customers to grow at a decent clip (the CAGR over the last 3 years has been 9%), I don’t assume operating profit per account to increase that much (3-year CAGR of 7% since Q2 2012), but economies of scale should yield incremental benefits over time.

I think it’s futile to try to model in detail how NN will grow – I’d rather be roughly right than precisely wrong.                  6% overall EPS growth in my forecast period seems plausible given the structural drivers mentioned,  the demonstrated ability of the company to grow its business and earnings, and the high likelihood of interest income rising due to higher rates in the future. What I’m effectively doing is equivalent to assuming the same net margin on total savings capital as we see today in 2018, while savings capital grows by 10%/year in line with management goals. While I believe there’s a good chance interest rates will have increased by then which means more upside, I’m not penciling that in explicitly.

Total income/savings capital % - fall in interest rates erodes margin (some pressure on commissions, too)

Historically, Nordnet has also delivered strongly in terms of operating cost dicipline. I assume total costs will rise at a 6% CAGR going forward as well for conservatism’s sake (the 10-yr CAGR is 7%, but over the last 5 years, total costs are actually about 50m LOWER), despite big investments in platform development. I further assume loan losses will rise by 10% per year, though total costs have been more or less flat over the last five years.

There are obviously risks here to take into account: interest rates could stay lower for longer, for starters. The interest rate sensitivity of Nordnet is currently such that a 1% rise or fall in the market interest rate has approximately 50m SEK impact (equal to 14% of net income). This is obviously significant. Competitive pressures could also force Nordnet to lower commisions further, but their brokerage commissions are already very competitive: The Swedish website compricer.se  lists Nordnet as one of the top 3 cheapest alternatives in virtually all categories from occasional saver to active trader. In terms of the latter point, I think it’s important to remember that Nordnet’s business model is not predicated upon being the absolute cheapest or the best in terms of execution, they just have to be reliable, accessible, reasonably priced and last but not least, have very good customer service (which they do – it’s excellent, actually).

This is the perception of Nordnet today. It is a trusted toll bridge to the financial markets, and grows its customer base primarily through referrals:  6/10 new customers are referrals from other users. That doesn’t happen unless customer satisfaction is high. Not only is Nordnet doing a good job of building a trusted brand, but the big banks are suffering for their past sins. In the good old days, your bank was your trusted  fiduciary. That perception has changed completely over the last few years in the Nordic countries. The main reason for this locally is that before the financial crisis, the big banks sold truly horrible and complex structured products to retail clients, who predictably lost all their savings. This was most common in Norway, and a huge public scandal ensued. And the worst part is that they got away with it as the courts, who don’t understand derivatives, decided they weren’t to blame (an absurd and unjust decision)! This has led public opinion of traditional banks to new lows. The banks’ advisors are no longer trusted like they used to be, and are now (correctly) seen as salesmen rather than advisors.

Nordnet on the other hand, is popular, and not seen as a regular bank. People like Nordnet, which they view as a neutral and helpful service compared to the big traditional banks. Some awards the Nordnet platform has won:

• 2015: Nordnet wins «most satisfied broker clients» award in Finland, «broker of the year» in Denmark

• 2014: Nordnet named Broker of the Year in Denmark. QSurvey names Nordnet customer service (contact center) winner in banking category.

• 2013: Named "Best Company of the Stock Exchange" by Veckans Affärer

• 2013: Named "Bank/Stockbroker of the Year" in Denmark for the fifth consecutive year

• 2012: Nordnet's website was named Sweden's best banking site by the magazine Internetworld's prestigious ranking of Sweden's top 100 sites.

• 2012: Toppenlånet loan - a private, short term loan to individuals  - launched in Sweden. At the end of 2012 it was named Loan of the Year by the magazine Privata Affärer.

These guys wouldn’t be able to compete with say IKBR in terms of best execution and the absolute lowest price, but their target customer is completely different and much less sophisticated and it doesn’t matter all that much that they can’t offer «randomized iceberg» execution at 0.2 BPS/trade or advanced option analytics. And since I’m not worried about IBKR, I’m obviously not worried by e.g. DeGiro/DeZiro or other inferior trading platforms.

Again: this business is reliant on Nordnet being a transparent, easy to use savings platform, not a high powered, best-in class trading platform, because that’s what the regular savings client is looking for. That’s how Nordnet will continue to build scale and create value for us as shareholders over time.

Valuation – base case assumptions

I assume an earnings growth rate of 6% and a ROE of about 18% (the 10 yr average) in the forecast period after 2015. I further assume the market assigns a fair P/B multiple to the stock at the end of the holding period (2018). This is equivalent to expecting the market to value Nordnet at 16x 2018 EPS at that point (seems reasonable).

My base case yields a value of 45 SEK by 2018, including the discounted value of estimated dividends.

Bull case: Using the same methodology, but with a 22% ROE (slight expansion from 2015), I get 61 SEK/share.

Bear case: ROE contracts to 13% (historical bottom levels) and stays there. Market values NN at 12x EPS in 2018.

• Probability weighting these scenarios, I end up with a fair value estimate of 45 SEK including dividends.

The P&L could look something like this if my previously listed assumptions  hold water:

Simplified base case P&L

Management, company culture and ownership

The CEO of Nordnet is Håkan Nyberg, who joined Nordnet in 2012 after being CEO of Entercard International and prior to that head of Swedbank’s internet banking activities. He has a MSc in Applied Mathematics from the Royal Institute of Technology in Sweden. Other members of management seem competent and trustworthy as well.

Remuneration of the management team is reasonable (very low by American standards), with the CEO receiving 350 000 SEK pr month in fixed pay. There is also a variable element which depends on pre-agreed profit related performance targets. Details on this can be found in the links below.

http://org.nordnet.se/corporate-governance/management/remuneration-and-benefits

35 central employees are incentivized through long term performance related share programs in total.

http://org.nordnet.se/corporate-governance/incentives/incentive-programmes

The only negative here is that I would have liked the team to own much more shares: the CEO owns a puny 20 000 shares, and the CFO owns only 25 000 as well.

The family that controls the board owns most of the company

The board, however, owns >50% of the company in total. The Dinkelspiel family is one of the most powerful families in Sweden and controls the board with the chairman and two other board members. Jan Dinkelspiel (not on the board) has worked at Nordnet for 6 years, and has been country head in both Finland and Sweden. The Dinkelspiels own Nordnet privately (there are many of them) and through E. Öhman J:or AB, the parent company of the Oehman Group, which has been involved in banking and asset management since the early 1900’s. They are long term strategic owners with no intention of selling as far as I know.

https://www.ohman.se/en/about-us/companies/e-ohman-jor-ab/

I’m including this from the AR as there have been no interesting developments in the shareholder structure since year-end.

Company culture

I’m generally wary of the concept of company culture – very few companies actually have one and if it does exist it can be bad as well as good for shareholders. But at the same time, when you do encounter truly positive company cultures, where the underlying principles are sound, the employees drink the company kool-aid with relish and it works, it’s potentially very valuable for the long term shareholder and something to take note of.

What’s special about Nordnet is the laser focus on continous improvement of the customer experience by investing in its IT infrastructure and simplifying the investment process, and its emphasis on transparency (an emphasis that is also evident in the company’s very detailed and investor friendly reporting).

"Although we are all saying the exact same thing, in terms of enhancing the digital customer experience, there is a big difference between saying and doing (…)I think the banking industry is far behind the other industries in terms of digital potential, which is a huge gap in the market for us. What we need to do with banking is to make things simple - that's the main intention for Nordnet, to make investment, savings and all those things simple."

Jan Dinkelspiel http://www.banking-gateway.com/features/featurebrave-banking-4161637/

Nordnet wants customers to know exactly how they run their business - unusual for a bank. Their tv ad campaign in 2014 is a testament to this ambition. The ad «welcome to transparent banking» which went viral illustrates this perfectly. http://digitalsynopsis.com/advertising/nordnet-norge-transparent-banking-actor/

They even have a blog called «the Transparency Blog» (in Swedish) where they answer questions on how Nordnet works, how they make money and when etc.  http://www.nordnetbloggen.se/author/transparensbloggen/

Does Nordnet have a real, positive company culture? The honest answer is that I don’t know. But it’s certainly not run like most other banks. There might very well be something special here. At the very least, the company has succeeded in differentiating itself as a modern, transparent and trustworthy alternative to traditional banks.

Little risk related to capital adequacy

Nordnet had a total capital base of 1128m SEK at the end of Q2 2015, consisting of 1083m in Tier 1 capital and 45.4m in Tier 2 capital. Total risk exposures were 7632m SEK, and as a result the capital ratio was 14.8%. Capital requirements including Pillar 1 and Pillar 2 was 714m in total. Including the buffer requirements of 2.5%, the total capital requirement was 908m, or 11.9%. In March, the Swedish regulator Finansinspektionen decided to keep the countercyclical buffer rate at 1% for systemically important institutions. And even if a countercyclical buffer requirement of e.g. 2% (152m SEK) were to be introduced for Nordnet, the company would still be in the clear with regards to capital adequacy (below: excerpt from the Q2 2015 report).

«In accordance with the European Capital Requirements regulation, Nordnet reports a consolidated position consisting of Nordnet AB (publ) and Nordnet Bank AB»:

Pre-mortem: a summary of risks and negatives. What is most likely to kill this investment case?

• Lower interest rates, especially for an extended period of time. The impact of 100 bps change in market rates is about 50m SEK, or 14% of my estimated 2015 net income. Swedish interest rates could come down further in the short term. Over time however, interest rates will normalize again (yes, really).

• Regulatory changes, for example more stringent capital requirements could hamper return on equity, in turn impacting growth initiatives and reducing dividend payments. As of today, NN is well capitalized.

• A bear market in equities would depress commission income again (probably after a brief volatility spike which generates more activity). A prolonged bear market would likely be very negative for activity.

• Failing to scale operations outside Sweden will probably make my margin assumptions too optimistic (I’m implicitly assuming pretax margins will stay above 36% -they were 38% in H1 2015. However, the growth in savings capital in Denmark and Norway is strong and will help achive this in my opinion.

• Failure to attract IT development talent could leave Nordnet with an inferior offering over time.

• Another (less important) risk factor for investor is share liquidity risk: The free float is low and liquidity is limited – about 150 000 shares are traded pr day, which is equivalent to a 550 000 dollar value.

• Technology risk: blockchain technology e.g. could change how financial markets work in the future.

Conclusions and investment recommendation

Avanzas CEO points to three factors as critical for creating long term shareholder value – and I agree:

• Growth in savings capital

• Scalability of operations

• Satisfied customers

Nordnet qualifies on all three points. I prefer Nordnet to Avanza for two reasons. Number one is that I like the fact that Nordnet focuses on growing in all Nordic markets, which I think is the best long term strategy because Sweden is already a fully developed savings market. As scale is achieved in Norway, Denmark and Finland, overall operating margins for the group should improve. Reason number two is question of valuation. Avanza trades at 23x Tm fwd earnings while NN is at roughly 14x. (I also think the majority ownership by the long term focused Dinkelspiels in NN is a plus, should the business run into trouble in the future. Avanza has a more open shareholder structure).

Nordnet is a high quality compounder available at a reasonable price. It has toll bridge like qualities, a strong competitive position and makes money in good times and bad (has been profitable every year since 2003, which is as far back as my data goes). The company is also well capitalized, and has a very long growth runway ahead for the structural reasons outlined before. It even pays a more than decent dividend.

• Including the discounted value of said dividends received, the expected annual rate of return with a 3-year horizon is a solid 15% in a base case scenario.

• Should Nordnet not revert to the historical mean profitability and instead succeed in expanding ROE modestly from 20% in 2015 to an average of 22% in the forecast period, the stock will likely double.

• Should ROE sink to the historical trough and stay there for 3 years and the EPS multiple contract to 12x, there’s downside to about 22 SEK (27%). This bear scenario is quite unlikely, but as shown in the valuation section I’ve chosen to assign it a 20% probability in my calculations of fair value nonetheless.

I think my other assumptions are conservative, so overall, this looks to be a «heads I win – tails I don’t lose much» type of situation.

I recommend buying Nordnet below 29.3 SEK for a total expected return of 15% per year.

Appendix – balance sheet, key figures, various charts and stats

Return on equity, annual since 2006 – estimated ROE in 2015 is 20% (= 10yr average).

Number of trades and average daily commissions by quarter

Composition savings capital

Historical valuation multiples

How Nordnet is organized

Analyst consensus

Useful links:

Q2/H1 Report 2015: http://org.nordnet.se/shared/stories/reports/2015/q2eng15.pdf

Nordnet Annual Report 2014: http://nordnetab.com/shared/stories/reports/2014/2014eng14.pdf

Avanza Annual Report 2014: http://investors.avanza.se/afw/files/press/avanza/201502195750-1.pdf

Avanza H1 report 2015: read the discussion on the long term outlook for the business: http://investors.avanza.se/sv/node/350

Nordnet report center: http://org.nordnet.se/invest/reports/report-center

Downloadable financial data going back to 2006: http://org.nordnet.se/invest/financials/key-figures

Link to an overview of Nordnet’s history: http://org.nordnet.se/about/how-we-do-it/history

Capital adequacy report Q2 2015 (in Swedish): http://org.nordnet.se/shared/stories/reports/2015/kt_q115.pdf

Finansinspektionens decision on countercyclical buffers: https://www.esrb.europa.eu/pub/pdf/other/decision-ccb-sweden-2015-03-16.pdf

Catalyst

Growth in new clients / savings capital

Rate increases in Sweden and the other Nordic countries

M&A: Nordnet and Avanza have been in merger discussions before. Would be a major positive since annual synergies are estimated to be equal to 25-30% of the combined net income of the two companies. I have not given the merger scenario much weight in this write-up (in fact, this is the first time I'm mentioning it) but it is a real possibility at some point. A merger would create a more investable company for institutions as well, and have stronger moats than any of the companies on their own. I'm hopeful we'll see this merger happen within a few years.