Description

Summary Thesis

The online CFD trading industry has gone through a massive regulatory transition over the past 2 years. Throughout this period, Plus500 shares have been highly volatile as the actual effect of the regulations on future earnings power was hard to predict and a number of unrelated factors have occurred concurrently (high comp from crypto craze, advertising restrictions in middle-eastern markets and poor communication around market P&L) which bears have automatically attributed to the negative impact from the regulatory changes.  However, we have now annualized the regulatory changes in Europe so we can look back at a full year of post regulations earnings power and get strong conviction on what the business looks like going forward. The one remaining overhang is that Australia is about to enact similar restrictions to what Europe has done. However, Australia is a much smaller part of the business (c.15% of revenue) and the proposed rules have already been published so this is well flagged and being incorporated into estimates. The lesser significance of this region combined with the fact that we now have the experience from seeing the European outcome means that this can easily be modelled and once this adjustment is behind us, regulatory risk for this company will have subsided.

On current year (2019) estimates, which we believe Plus500 is highly unlikely to miss, the shares are on 3x EV/EBIT and 6x P/E. Rolling the current run-rate of business forward to 2020 we estimate shares are on just 2x EBIT. For comparison, London listed peers IG and CMC are on 6x and 8x forward EBIT respectively. 

Through the combination of a dividend and buybacks Plus500 is returning 12% of its current market cap to shareholders this year and we expect this to be sustained at mid-teens % cash return for the following years as well (on current market cap). 

Finally, following the H1 results, we saw the first purchase of shares by the company’s founder, Alon Gonen, since the IPO in 2013. We believe this is a major positive signal. 

Sequence of events of the past couple of years

The story below is quite wordy, but it can serve as a background for understanding how Plus500 shares have come to be where they are and why the opportunity exists. 

In December 2016 Plus500 shares dropped 36% as several European regulators announced proposals to regulate the sale of CFDs and binary options to retail traders.  The proposals were later adopted by EU wide regulations under ESMA. Whilst the new rules included certain restrictions on promotions and negative balance protections, the main effect on Plus500 were the leverage restrictions on major FX pairs and equity indices. For retail traders the company had to reduce the leverage offered on major FX pairs and indices from 300:1 to 30:1 and 20:1 respectively. This was going to have a major effect on revenue and earnings with the key variables being lower ARPU as spreads & premiums are earned on lower notional trading volumes, churn as customer balances would last longer due to slower losses with lower leverage, customer acquisition numbers as it was unclear whether people would still find the product as exciting, customer acquisition costs as we didn’t know how the competitive landscape would evolve, and finally market P&L as it was unclear whether the company would incur more losses from the fact that it doesn’t hedge its exposure from customer open positions. All that only applied to retail customers so the additional major variable was figuring out what proportion of the customer base would convert to professional status and be exempt from the new restrictions. The debate around the ultimate impact was going to hang over the shares for a while as we await a comment period, an implementation period and finally the lag until actual results would be reported. In the meantime, the ultra bears argued the entire business model would break down and Plus500 would disappear while ultra bulls argued that with the underlying growth of the industry and market share gains the company will come  out of the tunnel with similar earnings power as prior to the regulations. 

However, both sides were much too early (as it is only now that we can actually see how this is playing out). During 2017 the company started boosting guidance as business continued as usual and the crypto trading boom began. Revenue rose 47% y/y in H2 2017 and more than doubled y/y in H2 2018 (Q1 was +284% and Q2 +52%). The shares followed suit and more than recovered from the regulation driven drop. After this huge rally, we finally reached the point where ESMA’s restrictions were being implemented (August 2018), but now in addition to the hit to retail revenue the company was lapping the massive comps from the crypto trading boom (which had fully deflated by then) so the revenue and earnings drop would look far worse on a year-on-year basis than if the regulations had gone into effect over the 2016 earnings base. 

The company tried to help investors with an underlying earnings projection by making some basic assumptions around how many customers would convert to professional status and what the likely revenue drop would be from the remaining retail customer base as well as assuming continued growth in revenues from outside the EEA. The 2019 EBIT derived from this exercise was c.$350m.  This is where the sell-side consensus settled. 

Q4 of 2018 saw an uptick in volatility which helped the company finish the year strongly and increased confidence that at annual results the $350m EBIT guidance would be reiterated. However, when the company finally communicated, FY19 guidance was cut to $250m and the shares cratered. Communication around the reason for the cut was incoherent to express it mildly. The company tried to use Q4 as a baseline for the projection, but Q4 was very strong (EBITDA of $107m) as volatility in the quarter drove a big market P&L gain which couldn’t be extrapolated for the FY so they scrambled to explain that market P&L needs to be extracted as it tends to neutralise over time. The whole market P&L discussion drove renewed scepticism around the company’s business model and days later it became public (via a press article and then an admission from the company) that there was wording in its 2017 annual report that claimed there were no market P&L gains or losses in 2017 when in fact there was a large loss.  The wording was simply copied from prior year annual reports (when this was true), however the large crypto swings caused in H2 2017 did cause the company a loss that year (which it recovered in H1 2018). Although the reported numbers were correct, the wording in the annual report gave a misleading picture of how the company managed risk during the crypto volatility and bears saw themselves vindicated in claiming the company is misbehaving.

The reason we see all this is as just terrible communication is that the reduction in guidance had little to do with any of this. There were 3 factors that caused the $100m cut in EBIT guidance:

1. Converting eligible retail customers to professional status took longer than anticipated. At the time of the original guidance in summer 2018 they expected 40% of EEA revenue to convert to professional. However, at the of Q4, that only stood at 30%. That’s a difference of $40-50m in annual revenue

2. During H2 2018, Google and Facebook banned CFD trading adverts in the Middle East for unlicensed operators. This caused a halt to growth in ROW revenue for Plus500 that was not anticipated at the time of the original guidance. This caused an additional $40-50m annual revenue shortfall and the ROW revenue run-rate at Q4 was only 2% higher vs the summer run-rate when guidance was for 25% growth. 

3. Not knowing how the competitive landscape would evolve, Plus500 guided to keeping its marketing budget unchanged from the summer guidance despite the revenue reduction. Therefore the c.$100m revenue shortfall above drops straight to the bottom line

Interestingly, the decline in EEA retail revenues resulting from ESMA was in line with the original guidance. 

Then, 1Q 2019 had record low volatility leading to $28m in negative market P&L and hence very low reported revenue and profitability. This further fed the bearish narrative that the company will struggle to make any money in the new environment and the shares dropped by 1/3 again. Consensus EBIT expectations for the year were reduced further to c.$180m.

Where we are today

On August 13th the company reported H1 results and Q2 KPIs. The results showed very strong progress on several fronts. It is important to note that Q2 was a very average period with 2 months of low volatility (April & June) and 1 month of slightly higher vol (May). This was also apparent in the roughly flat market P&L for the quarter (+$1m).  

• $54m of EBITDA, which is slightly above the $200m run-rate required to achieve market expectations

• Total actives of 108k which was the highest number in company history excluding the 2 quarters of crypto boom, showing continued strong engagement of the customer base

• 26.2k new customers, which was up 24% y/y and 23% Q/Q. It was the highest number since ESMA came into effect

• Lowest customer churn in company history at just 16%. Over the past 4 quarters churn has averaged 20% compared to c.30% pre-ESMA. The lower churn bodes well for future growth prospects

• AUAC (avg customer acquisition costs) was $956, down 25% y/y and 22% q/q. Commentary implies this is sustainable as competitors have struggled post ESMA

• Customer deposits on the balance sheet increased 41% at end of June vs end December which bodes well for future revenues

Revenue from retail customers in the EEA region in Q2 was $31.5m or an annualised run-rate of $126m which represents strong growth over the Q4 2018 exit rate, demonstrating that the company is able to return to growth in the customer segment where bears have concentrated the short thesis. 

With this report we have seen 4 full quarter of post ESMA results (actually 11 months, but it’s close enough for drawing conclusions). For each quarter the company has reported revenue from spreads & premiums, market P&L and profitability. Given that market P&L drops through to earnings at 100% margin, we can compile the following table:

This allows for several conclusions:

• Revenue from spreads & premiums is stable at $90-100m per quarter with some variability depending on market volatility 

• Market P&L was positive in the period showing that there is no constant negative carry post ESMA despite the leverage restrictions

• Company profitability is trending firmly at the $200m level where market expectations have settled

We now have conclusive stats on all the unknown variables mentioned earlier, including the levels of ARPU, the declining churn, continued strong number of new customers, falling customer acquisition costs and stable market P&L. 

We expect the business to return to growth from the current run-rate

The reasons for this are:

• After the big decline in ARPU from EEA retail customers due to the leverage reduction, we now expect this to slowly become a positive for revenue through higher number of active customers as traders that would have historically been burnt out due to rapid losses are now still in the system and are added to the new customers which continue to come in. 

• There is still an ongoing process of converting retail customers to professional which leads to higher ARPU post conversion

• We understand the company is actively working on new marketing channels in the ROW markets where Google and Facebook have shut them out in H2 2018. As this starts to show results, ROW revenue growth will reaccelerate

• With the escalation of the US-China trade war and generally increasing macro concerns, volatility is increasing which bodes well for Plus500

• We expect AUAC to be sustained at the Q2 levels which will drive higher EBITDA margin 

Additional considerations

• Plus500 founder, Alon Gonen, has purchased $14m worth of shares in the 4 days post H1 results. This is the first time since the 2013 IPO that he has purchased shares in the open market. Several other insiders including the CEO and CFO have also bought shares post results. We see this as a very strong positive signal and a confirmation that the company believes the whole ESMA regulatory impact risk is now behind us and the outlook is strong going forward

• M&A: there have been rumours that Plus500 is looking to buy Gain Capital (also discussed here on VIC). Depending on the price paid of course, we would view this very positively as it would enable the company to apply its best in class customer acquisition platform to the potentially huge US FX trading market. We also believe Plus500 could significantly improve Gain’s non-US business and there would be significant cost synergies   

Catalyst

• Delivering continued strong results and further cash returns to shareholders
• M&A