Description

A SaaS conversion in the wealth management space?

Shares of St. James’s Place plc (“SJP”), the UK’s leading wealth management business, declined 50% after a fee structure change caused near-term earnings to decline 50%. Multiple subsequent one-off issues including a surprise £426 million regulatory provision, a 70% dividend cut, deletion from the FTSE 100 and MSCI DM indices, and macro headwinds further pressured the stock. As veterans of SaaS conversions know, the long-term economics remain largely intact, and in this case I estimate just a ~6% decline to long-term earnings power. By 2030, once the economics from the fee structure transition have normalized, I estimate cash earnings power of £720 million, which at a 15x forward multiple, in-line with inferior peer Quilter at 15x, implies £22 / share of value by year end 2029 including £2 / share of interim capital return, equivalent to a >200% gross return and 25% five-year IRR. Aware of the attractive valuation, SJP has been aggressively repurchasing shares over the last few days at ~20% of daily volume. In addition, I expect eventual FTSE 100 re-inclusion.

How we got here

Until recently, SJP had an excellent track record, compounding at 22% annually from 2009 through 2021, trading at >20x earnings, and sustaining over three decades of uninterrupted net flows growth as they expanded their adviser and client base. Then the following happened:

• Fee Structure Change: On July 31, 2023, new UK regulation known as “Consumer Duty” that promotes greater pricing transparency went into effect. In anticipation, SJP in late July announced fee reductions for long-term customers, however in September SJP announced a CEO change, and in October surprised investors with a major overhaul of its fee structure that included further fee reductions, removals of controversial early withdrawal charges, and unbundling charges between advice, products, and funds. As part of the overhaul, SJP also eliminated upfront product charges and is grandfathering in £50 billion of AUM from the legacy charging structure that temporarily does not earn management fees. The transition also requires £150 million one-time pre-tax implementation costs for tech system upgrades, spread mostly between 2024 and 2025. The new fee structure goes into effect mid-2025, and, in conjunction with the implementation costs (not backed out of adjusted cash earnings), created an ugly earnings outlook with consecutive annual declines through 2026, the first full year with the new fee structure. Between July 2023 to February 2024, earnings estimates for 2026 declined by ~50%, and SJP shares declined by ~50%, relative to a ~20% increase for Quilter.

• Provision: In February 2024, SJP announced a £426 million pre-tax provision (£324mm post-tax) for non-compliant customer service, specifically related to instances where SJP advisers did not meet with customers for periodic advice reviews, or did not maintain evidence that they met customers. The provision relates to 2018 – 2023 and reflects costs for refunding advice fees, simple interest at 8%, and administrative expenses. Some investors and analysts are concerned that the ultimate provision will be significantly larger than expected, e.g. RBC’s price target reflects a 25% probability of a £1 billion dilution event. From February to July 2024 shares declined by 17% and underperformed Quilter by 43%, implying ~£1.5 billion of underperformance.

• Dividend Cut: In conjunction with the provision news, SJP surprised investors by reducing their capital return from a 70% payout, distributed entirely via a dividend, to a ~50% payout through 2026, distributed via a £0.18 annual dividend and the balance via a share buyback, effectively implying a ~70% dividend cut.

• Index Deletions: Given the price action, SJP in May was deleted from the FTSE 100 and MSCI developed market indices.

• Macro Headwinds: The Bank of England raised interest rates from 0.1% in late 2021 to 5.25% by August 2023, while UK inflation also spiked, which reduced net flows across the sector as customers had less savings available to invest, and more savings were deployed into high-yield cash accounts.

Why the stock is cheap

I believe the stock overreacted to the above negative developments and is attractive at current levels. Key highlights include:

• Hidden Asset from Gestation AUM: Under the legacy fee structure, new inflows to pensions and investment bonds (similar to annuities) do not earn product management fees for the first six years, but contractually start earnings fees after six years, with no added costs. As of 6/30/24 SJP had £50 billion of gestation AUM (27% of total), which is expected to contribute £296 million of cash earnings once matured. This creates a valuable embedded source of future earnings growth that is not captured by conventional sellside analyst valuation methodologies which typically rely on near-term P/E multiples. Some analysts use DCFs, which capture the gestation AUM benefit, but then use mid teen discount rates and ~10x exit P/Es to lower their price targets.

• Overreaction to Fee Structure Change: While 2026 earnings estimates declined by ~50% under the new fee structure, roughly consistent with the 50% price decline and 70% relative underperformance, I estimate the reduction to long-term earnings power once all gestation AUM is online is ~6%. The earnings reduction relative to the legacy model is higher initially because under the new charging structure SJP is no longer earning an initial margin on new business since they removed upfront product charges, while the legacy gestation AUM is a drag on earnings until it gradually matures over six years. I view this akin to a SaaS transition where a short term revenue slowdown is generated by license revenue being replaced by SaaS revenue recognized over time.

• Provision Manageable: I believe the provision is reasonable as it seems like an amount that should be statistically knowable, is underpinned by an analysis performed by an independent party appointed by the regulator, and the regulator would likely have objected if they thought the provision was insufficient. There is an added element of conservatism in that SJP will seek recovery from advisers in cases where advisers had more pronounced gaps in record keeping, but the provision does not reflect any benefit from this recovery. Additionally, SJP’s new CEO, Mark Fitzpatrick, was incentivized to set a conservative provision as this was his first major decision as CEO and any future provision increases would reflect poorly on him.

• Fee Structure Sustainable: Under the new fee structure SJP will charge average recurring fees of ~1.65%, and estimated average upfront fees of ~2.50-3.00%, which translates into a blended all-in fee of ~1.95% assuming a 10-year amortization period for the upfront fees, which is modestly below the industry average of ~2.10% based on data from UBS’ latest adviser survey. It is also worth noting new business is often referral driven and customers do not typically price shop between providers. Furthermore, industry supply / demand dynamics are favorable with customers growing at a 7% CAGR since 2016, vs a 1% CAGR in adviser headcount, and the advice market is still underpenetrated with just ~7% of the adult UK population paying for ongoing advice. While the notion of paying ~2% for wealth management when there’s cheaper DTC options may seem silly to financially savvy VIC readers, my research suggests that many customers in the UK are less financially literate than in the US, do not have the knowledge or time to manage their finances, and also struggle understanding the UK’s more complicated and frequently changing tax and pension system.

• Potential Acquisition Target: SJP could be an M&A target for financial sponsors or strategics interested in obtaining a leading presence in the UK wealth management sector, though we believe the likelihood of a deal near-term is lower until SJP transitions to the new fee structure and completes remediation of the advice servicing issue.

• Technical Tailwinds: SJP will be eligible for promotion to the FTSE 100 at the next quarterly review once the share price increases to ~£8.15. Additionally the pending acquisition of Hargreaves Lansdown (£5.2 billion market cap) is expected to close in Q1’25 and SJP may benefit as legacy Hargreaves investors reinvest their proceeds.
  
  
  

• Macro Improving: UK inflation has been slowing and on August 1st the BoE cut benchmark interest rates for the first time recently to 5.00%. Futures expect sub-4% rates over the next year, which may provide a tailwind for inflows and investor sentiment for the sector.

• Capable CEO: New CEO Mark Fitzpatrick, who was previously CFO and interim CEO of Prudential plc ($24 billion market cap) and one of the youngest ever partners at Deloitte, is well regarded in the industry and seems like the right candidate for the CEO role. He has a statesman-like demeanor, seems liked by advisers, and is focused on improving the business, remediating the provision issue, and transitioning the company to the new fee structure.

While SJP’s stock has rallied 27% since H1’24 earnings which revealed stronger than expected net flows, a new cost savings plan, and guidance of nearly £800 million cash earnings by 2030, I believe there is still significant room for upside. Assuming ~2% net flows, ~5% average market returns, a 50% initial payout ratio increasing to 70% long-term, and a 15x cash P/E exit multiple, I estimate £22 / share of value by year end 2029, equivalent to a >200% gross return and 25% five-year IRR.

Management also seems to share similar views considering since late August when SJP commenced their £33 million buyback tranche (future tranches will be larger) they have been aggressively repurchasing shares at ~20% of daily volume and are on track to complete the tranche within the next few weeks, despite having until year end to do so.

Catalyst

Over the next 12-18 months shares should benefit from continued net flows and AUM growth, progress remediating the provision, transitioning to the new fee structure, greater investor appreciation for the embedded earnings growth from gestation AUM , FTSE 100 re-inclusion, investor reinvestment of Hargreaves proceeds, and declining interest rates.