Description

Long STM Group PLC (“STM”)

Warning: This is a very illiquid stock and hence this trade is only suitable for PAs and small funds.

Introduction

STM is a £24.5m market cap financial services group listed on the AIM segment of the London Stock Exchange. STM’s main segment provides pension fund solutions to expats in the UK. On the 8th of March 2017, as part of the Spring Budget 2017, the UK government announced a regulatory change that effectively forced a large portion of STM’s pensions segment in run-off mode, causing a share price drop of ca. 25%. We think at around 40p, STM provides an excellent investment opportunity. We show a large margin of safety on a take out basis along with an ongoing 11.8% FCF return on market cap with 27% of net cash to back growth projects and capital return.

Main segment: Qualifying Recognised Overseas Pension Scheme (“QROPS”)

QROPS were the ideal product for expats that built a pension in the UK and wanted to retire elsewhere. If planned properly it could save drawdown, inheritance and withholding taxes, while increasing portability of assets and investment flexibility. After being a UK non-resident for 5 years, the laws of the locality of the pension fund (along with relevant double tax treaties) will determine the applicable tax regime. Example: a US expat in the UK upon leaving the UK, would transfer pension benefits to a Gibraltar QROPS, move back to the US, wait at least 5 years and then draw his/her pension from Gibraltar, residing anywhere in the world whilst enjoying tax efficiencies. STM is the largest player in this market with 10.7k policies outstanding.

QROPS: Impact of regulation, variant perception and valuation of segment

Unfortunately, the sudden regulatory change introduced a 25% transfer tax unless the transfer is to an EEA country with the resident living in the EEA, Australia or New Zealand (see here for details).

This has put a sudden stop on the non-EEA growth of the QROPS segment, however, the market misses that most of the revenue of this segment comes from existing and grandfathered policies through annual recurring charges. Furthermore, this revenue is extremely sticky with a very low historical attrition rate of 2 to 3 percent. We observe that STM is left with a robust expected annuity stream going forward and believe this cash flow is undervalued by current market prices. Management has stated that each new QROPS client won has an expected fee generating life of 20-25 years and we believe this is conservative as this product will likely survive post the death of the pensioner due to associated inheritance tax efficiencies (effectively turning it into a trust for his or her heirs).

For valuation purposes we look at the Self Invested Pension Plan (SIPP) market in the UK. A SIPP is basically an onshore version of a QROPS with hence a much larger addressable market. It started out as a fragmented market but has been consolidating since, and today ca. 90% of the whole market is taken by the top 5 providers. The ongoing consolidation provides a very consistent context for acquisition multiples. A SIPP/QROPS typically comes with a set-up fee and an annual management fee which is recurring. Our market research confirms a robust floor value for a SIPP at around 2.7x of the annual management fee (see here for an example).

As discussed above, compared to a SIPP, a QROPS has a longer duration as it’s also an inheritance tax wrapper which means it is very likely to survive beyond the death of the pensioner. More importantly, QROPS also feature a lower attrition rate of 2 to 3% vs. 5% for SIPPs resulting in a ‘client average life’ of around 15 years for a SIPP vs 20 to 25 years for a QROPS. Finally, QROPS have a structurally higher annual management fee resulting in a higher gross margin. Taking these 3 effects into account, we see at least a 30% uplift on a multiple of revenue basis - so with an average annual recurring QROPS revenue for STM of £763 per policy we get: £763 x 2.7 x (1 + 30%) = £2,674 value per QROPS policy.

We will stick to a base case valuation of £2,000 per policy for conservatism.

Valuation of other segments

L&C - SIPPs

In 2016 STM acquired London & Colonial (L&C) for a total consideration of £5.38m. L&C provides SIPP, QROPS and Life bond management services. The QROPS and Life segments are being integrated in the existing equivalent STM segments and the onshore SIPP business will be a new growth opportunity for STM and hence can be categorised as a new segment. They have 2,000 policies at the moment and for our base case valuation we simply apply the 2.7x revenue multiple as per above.

Corporate & Trustee Services (CTS)

This a roll-up of CTS providers that never took on enough scale and effectively is in run-off mode. Before the growth of QROPS business this used to be the main segment of STM  - but since the GFC this business has suffered and revenue has been depleting accordingly. We estimate pro-forma revenue to be around £4m for FY 2017. There are some PEs that are rolling up CTS providers - our market research has yielded a revenue acquisition multiple range of 0.5x to 1x. We will use this range with 0.75x as our base case.

STM Life

This is a business that converts a portfolio of securities into life annuities to achieve tax efficiencies. Because it’s purely set up as a wrapper there is no mortality/underwriting risk here so it’s basically an AUM type business. Whilst this business has not been very profitable, we think this business has further growth potential. The integration of L&C Life has basically doubled the revenue of this business and allows it have more scale and operational leverage. Total AUM is now ca £600m. Our market research suggest that for a revenue acquisition roll-up, this business should fetch around 3x revenue. However to be on the conservative side we use a range of 1x to 2x, and 1.5x in our base case.

Other divisions

Other group activities involve accounting/advisory services conducted through a mainland Spanish entity and accounting/company secretarial services conducted in Gibraltar for insurance company clients. We value this segment at zero.

Break-up Value Analysis

Putting it all together we arrive at very attractive take-out returns of between 1.6x and 2.2x:

Break-up value

The above break-up value calculation shows why STM should be extremely attractive as an acquisition target. An acquirer would be able to pay a 25% premium (offering about 50p) and still make significant returns in all scenarios. We already mentioned consolidation in the SIPP market and believe a bid for STM could be highly accretive for one of the consolidators.

Cash Flow Analysis

We see a pro-forma 2017 EBIT of £3.26m for 2017, with FCF at £2.90m. We base this off the following assumptions:

1. EEA-QROPS production will remain at the 2016 runrate (as per management guidance) with the overall attrition rate being at 3%.

2. SIPPs outstanding remain constant at around 2000 (whilst competitors are growing at 5%).

3. The Life Segment grows with the same amount of policies as in 2016 and the L&C additional revenue is ca £2m.

4. CTS and ‘Other’ segment provide zero profitability.

5. We assume a £0.75m benefit from cost cutting initiatives that were announced earlier upon the acquisition of L&C in 2016 (we understand this number to be conservative given that STM is now also cutting cost on the QROPS side).

For the EV calculation we add back the loan note and contingent consideration for the L&C takeover and also adjust for required regulatory capital. We understood from management the regulatory capital required for the business is £9m, with the integration of L&C Life providing a subsequent £3.2m relief in 2017. This results in an EV of £17.8m and EV/EBIT ratio of 5.5x for 2017. FCF/MC stands at 11.8% and adjusting for 6.7m net cash bring us to a solid 16.3%.

In terms of UK listed comps the most comparable company is Curtis Banks. This company also happens to be one of the consolidators in the SIPP market and trades on a pro-forma PE multiple of around 18x. This compares well to the pro-forma  2017 PE multiple of 9.4x for STM.

Flow analysis

Other upside/points

1. STM is the market leader in QROPS (we estimate ca.15% of the total market) - hence they will be in a good position to tuck in the smaller players at attractive multiples, especially now this market is in runoff. There is a mechanical economy of scale here at play as small players are subject to a minimum capital hurdle - which gets released upon an acquisition by a bigger player. Management has indicated that they would use net cash to pay attractive multiples for the acquisition of smaller QROPS businesses that are now looking to exit the market. They are currently looking into this.

2. Attrition rates for QROPS could become lower as people “hang on to” the old beneficial regulatory framework - switching/amalgamations will occur much less often than before.

3. Management (+friends and family) holds a sizeable interest of around 23% of the company.

4. STM has a decent dividend history and management has indicated that they would like to maintain a progressively increasing dividend

5. On the 24th of May 2017 STM provided an update as part of their 2016 AGM. Two additional sources of upside were mentioned that have not been taken into account above: a) international SIPP sales have been accelerating (we assume run-off only for the international business)  b) Gibraltar and Malta business teams have been downsized which will provide for extra profitability of the run-off of the QROPS policies.

6. They have a couple of growth projects (UK SIPPs and an Australian QROPS business), these seem decent opportunities that do not present undue risk in our view.

Conclusion

A break-up value analysis of STM shows a high liquidation value. This gives the stock an appropriate margin of safety and also makes the company an attractive acquisition target. In the meanwhile we are making a 11.8% FCF yield with net cash equal to 27% of the MC still available for distribution and investment.

Risk factors

Regulatory

Growth projects / acquisition risks (although we see a large insider base to mitigate this)

Catalyst

Consolidation of QROPS sector

Takeover by a larger SIPP provider, e.g. Curtis Banks

Dividends / buybacks