Description

Long CAB Payments – 450p price target

CAB Payments is an emerging market secular growth story hidden inside an ancient UK regulated bank. Specifically, Crown Agents Bank (CAB) was established in 1833 to handle treasury disbursements from the British Crown to the various British colonies scattered across the globe. Given the extensive geographic spread of the British Empire, CAB established a local presence and trading relationships across 119 countries, notably in frontier markets in Africa. Today, whilst CAB is a UK domiciled bank, it is not a traditional lending institution but instead a hybrid between a foreign exchange trading venue and a cross-border payments platform. The company overwhelmingly makes its money via bid-offer spreads (“take rate”) on FX conversion between developed market currencies (USD, GBP, EUR) and a large array of emerging and frontier market currencies in Africa and the Caribbean such as the Nigerian Naira, Kenyan Shilling, and West African Franc. CAB is not a retail remittance company, but rather a B2B payments platform as much of its FX flows consist of official sector aid payments (think United Nations agencies) and corporate payments from the US and Europe into emerging markets. The average ticket size is US$ 100,000.

The CAB thesis has two components – a near term trading proposition and a medium term investment proposition. The near term trading thesis is that the CABP stock has been under severe pressure since its broken IPO in early July at 330p. The issues behind the IPO’s failure are several:

1)The London IPO market has been struggling to gain traction for years post Brexit and UK equities are significantly out of favor with investors: in July 2023 UK equity funds suffered their 26th consecutive month of outflows. The same week in which CABP IPO-ed Morgan Stanley noted that the UK equity market appeared to be the cheapest asset class globally. Essentially if one were trying to find new public equity investors, the UK is probably not the best place to go looking. London’s equity market problems have also been extensively chronicled in the press:  https://www.thetimes.co.uk/article/how-do-you-fix-london-s-struggling-stock-market-tbvftzlm

2) London-listed fintech and payment stocks specifically have been a veritable landmine field for investors in the past 5 years. Finablr, WAG payments, Network International all stumbled badly from their initial flotation prices, sometimes for very good reasons (Finablr was a fraud) and sometimes just for being in the wrong jurisdiction. Network International is a good business (IMHO) and was bought out by private equity earlier this year albeit decently below where it listed in 2019.

3) The CABP underwriting syndicate appears to have significantly overestimated investor appetite for the stock, badly placed the shares, or both – all of which resulted in an incessant wave of selling from literally the first minutes of trading through today. The poor placement attracted opportunistic short selling, as the market sensed weak hands after the 30 day stabilization period ended. As the stabilizing agent Barclays purchased almost 50% of the shares that traded during July, leading to the (correct) perception that the stock suffered from the dynamic of over-allocated IPO holders trying to sell into a market with limited buyers. The absence of buying by Barclays after the stabilization period finished resulted in further share price declines in August. This dynamic was particularly exacerbated due to the sellside research blackout period (information vacuum for potential new investors), lower summer trading volumes (lack of investor attention), and a lack of index demand.

However, the stock should transition from having effectively zero support during July and early August to becoming a more normal security in the near term due to FTSE 250 index inclusion, the end of the research embargo and more traditional sellside support, and valuation upside with 2024 earnings coming into view:

August 16: IPO research blackout period ends, including for US clients. One would expect to see sellside initiation notes to lead to increased investor education on the name.

August 22: Notification of indicative index membership changes to the FTSE 100 and FTSE 250. UK index specialists that we have spoken with expect CABP to be included in the 250, with 7-10mm shares required to be bought by the index community.

August 30: final announcement of the FTSE All Share Index Annual Review (formal inclusion notification)

September 13: Company releases 1H’23 results. The company has already previewed the results in a trading statement, noting that 1H trading unsurprisingly remains in line with expectations given that the IPO happened in July. 2024 guidance will most likely be a topic of conversation on the results call and is roughly estimated by us at 30p EPS. Management is generally well regarded, presents well, and has long-term compensation targets that include total shareholder returns indexed to early July levels (e.g. well above current pricing).  One would expect investor price targets to re-anchor on 2024 earnings growth and multiples, and 15x estimated 2024 EPS implies a 450p price target, +80% from last trade.

September 15: index changes take effect, although shares will have been purchased in the period leading up to this date

Medium term proposition: CAB genuinely appears to have a better mousetrap for emerging / frontier market correspondent banking flows. Correspondent banking is when one bank accesses financial services in another jurisdiction (another country), typically in the form of cross border payments. For official and institutional payments this means electronic money transfer from the sender’s bank account in Country A to the recipient’s bank account in Country B, generally in a different currency, requiring a correspondent banking relationship between the banks to ensure settlement, reconciliation and currency conversion (e.g. the banks have to be able to trace money flows in the event of error, as well as for KYC/AML regulatory compliance). This is a pretty straightforward process within the developed markets, but becomes considerably more complicated in frontier markets as most developed market banks do not have direct correspondent relationships with any bank in, say, Senegal. Furthermore, in the last 20 years the cost of regulatory compliance has increased exponentially, leading most banks to dramatically reduce their number of correspondent relationships as the revenue generated in most currency corridors does not begin to cover the costs. Today roughly 80-85% of emerging and frontier FX payments are done by the legacy correspondent banking system although developed market banks are increasingly retrenching and ceding the payment flows to emerging market specialists like CAB.

To illustrate CAB’s value proposition we’ll use a hypothetical US-centric transaction. A corporation or aid organization in the US wishes to send money to Ghana to pay local employees (perhaps in the oil and gas industry) or for aid payments. Both employees and aid recipients will be paid in the local currency, the Ghanaian Cedi. In the hypothetical example the US entity is based in Atlanta (an aid organization) and instructs its local commercial bank (Regions Financial) to send USD to a specified account in Ghana and convert it into Cedi. Regions Financial is not a small community bank. However, it is based in Alabama and consequently does not have any correspondent banking relationships in Ghana, no direct means of sourcing Cedi for conversion, and no real desire to do any of this on a regular basis. However, Regions wishes to be a full-service commercial bank for its clients and will comply with the request. What actually happens is that Regions sends the money to a large US multinational bank (e.g. Citibank), who has direct relationships with a large African bank (e.g. Absa in South Africa), who in turn has a relationships with local banks in smaller African countries (e.g. Ecobank Ghana). Multiple correspondent banking transactions occur and each step carries fees and settlement risk. The example is somewhat stylized but is indicative of the expense and operational difficulty with cross border FX payments to frontier markets, greatly exacerbated as developed market banks increasingly pull back from correspondent banking activity while the money flows themselves continue to grow. Correspondent banking relationships in Africa specifically fell by 20% between 2011 and 2019.

As a B2B payments player, CAB does not interact directly with either the US entity or the end-recipient of the funds in Ghana. Instead CAB has relationships and deposit accounts directly with the local African banks given its history and in-country exposure. CAB increasingly has relationships with the larger developed market banks themselves. CAB presents itself to Regions (or Citi) as a single-step money transfer option to Ghana via its electronic FX and payments platform. The key advantage offered by CAB is that it can source a given local currency at very competitive rates because it has multiple trading relationships with local market banks (liquidity providers), who themselves source the currency from the local central bank. In the prior example Regions simply accesses CAB’s platform to convert USD into Cedi at tight bid-offer spreads and then sends it to EcoBank in Ghana same-day with zero settlement risk. CAB makes money on the difference between what it paid for the Cedi from its local liquidity provider and the rate received by Region’s customer, generally around 0.50%. CAB management estimates that traditional correspondent banking fees are more than 5%, or 10x more expensive. Furthermore, given the multiple correspondent banks involved in the transaction the end user has little to no visibility on the progress of the transaction in the old system, which can be highly problematic when payments dates have to be specific (i.e. for payroll). Finally, as a regulated UK bank, CAB offers an attractive counterparty profile for developed market banks from both a credit and regulatory perspective.

The opportunity:  The global cross-border market is US$ 271 trillion, of which the majority represents payments within the developed markets (i.e. OECD markets). CAB’s target is emerging markets excluding Russia and China, primarily located in the Middle East/Africa and to a lesser extent Southeast Asia and the Caribbean/Latin America. Their target markets represent US$2.3 trillion in cross-border flows (0.9% of global volume) and aggregate volume expected to grow at a 4.2% CAGR from 2022-2027.

The blended bid-ask spread or take-rate of their target market is 0.28%, yielding a target revenue pool of $6.6bn. CAB had a 1.3% share of the target market revenue pool in 2022.  CAB’s revenue growth is expected to come from taking share from large developed market banks in a very large addressable market, rather than depending on underlying growth in cross-border flows (although that is likely as well).  As a side note, the terminology of “take-rate” is typically used in the payment industry to denote a purely volume-based revenue stream with limited risk to the payment company, as distinct from capital markets style revenue derived from prop trading or market making. CAB employs the verbiage “take rate” because the overwhelming majority of its FX transactions are back-to-back on its electronic platform with no FX risk to CAB itself, although the company does employ some market-making activity in high volume currencies with very small risk limits.  Frontier and emerging markets are obviously well known for currency market volatility, or sudden devaluations in the local currency exchange rate versus “hard currency” like EUR, GBP and USD. Interestingly for CAB, this volatility generally represents right-way risk, as the company typically is sending hard currency into markets that are starved for it. In other words, when a local FX devaluation happens, CAB is often able to earn surplus returns by buying the local FX extremely cheaply from USD-starved local banks with whom it has relationships and selling it developed market participants (i.e. the take-rate expands because they are able to source currency from the banks who need USD the most, given their presence within the local banking systems). The main point is to note that CAB’s revenue streams actually have more in common with those of a merchant acquiror or exchange rather than a capital markets firm despite making money on bid-ask.

Since the creation of its global electronic FX trading platform four years ago, CAB’s revenue has been growing at a 65% CAGR although the company is guiding for more modest 35-40% topline growth for the medium term. EBITDA margins are 50% and are expected to modestly expand to 55-60% in the medium term as the business has natural operating leverage. EBITDA to cash flow conversion is 80%. The near term sources of revenue growth are simply continuing to organically take share in cross-border payment flows from the legacy correspondent banking network. In part this is due to the larger correspondent banks proactively ceding the business to CAB via entering into wholesale/white labeling relationships where CAB provides the FX trading conversion and cross-border payments for the banks’ own customers. In the earlier example Region’s customers neither know nor care that Regions could utilize CAB’s platform to move and convert the money, they only know that it is cheaper and more reliable. To this point, CAB signed 3 of the top 20 largest global banks in the last 18 months and is in the process of acquiring a Dutch payments license to be able to directly serve large European banks. CAB is also expanding its bank-oriented sales force and opening a Singapore trading desk to provide 24 hour continuous coverage.  We have refrained from providing a medium term share price target because extrapolating 35-40% revenue growth plus operating leverage for a few years in a huge TAM makes for ridiculous numbers and ends up sounding like the infamous open-sourced ARK excel model… not that we have any more credibility. But in general the stock could be a multiples higher compared to its trading price in a few years.

In summary CAB appears to be an open-ended payments growth story, which is among the most beloved investor themes in the market. However, it’s also a regulated UK bank, which is hands-down the most hated investor theme in the market. It’s also traded on the London stock exchange, which apparently is where securities go to die. We’ve basically concluded that all the company needs to do is hit its growth target for 18 months before it re-rates substantially, although we do keep a 15x P/E ceiling given its status as a bank (albeit one based almost entirely on fee income). 

Other concerns: if JP Morgan doesn’t want to do this type of business how can it be good for CAB?

The primary issue for large European and US banks is that the cost of regulatory compliance has grown so high that small or episodic volume in frontier markets are unprofitable; the cost and operational burden to a European bank for keeping updated compliance records on a bank in Senegal is just too high compared to the revenue.  CAB’s origins are in its relationships with local banks in frontier markets, and they are able to spread the regulatory cost over much larger and consistent volumes – they are effective a big player in small markets. CAB is a regulated UK bank, which means that has built out industrial strength regulatory and compliance functions, making it a preferred provider to development organizations who worry about counterparty and AML risk. The fact is that developed market governments and supranational agencies like the United Nations want continued money inflows into frontier markets, they just want the payment provider to be using the most up-to-date screening technologies to adhere to  KYC/AML rules. Furthermore, developed market banks want to have the ability to offer frontier market FX conversion and payments to their domestic clients if clients need it, but banks only want to deal with large reputable firms; CAB’s regulated bank status gives them comfort in this regard. CAB has the scale to afford this required investment in its markets while it does not make sense for others to do so.

The Nigerian Naira: In February 2023 a new government was elected in Nigeria and announced a desire to implement a more free-floating exchange rate (as opposed to the system of exchange rate controls for certain transactions). Since 2021 the gap between the official Naira exchange rate and the parallel market exchange rate used offshore has been very significant, allowing for market participants with extensive relationships in Nigeria to source currency at the parallel rate and sell it at the higher official rate (legally, we would add). Exchange rate liberalization announced by the new government implied that the two FX rates would converge and result in a significantly lower take-rate on NGN payment flows. CAB management was very aware of this dynamic and has guided for Naira-related revenue to fall from 23% of the total in 2022 to 7% of revenue in 2023, decreasing further in the future as other currency corridors grow. Despite management including “full normalization” of the NGN take rate as the base case for their guidance, there is some residual skepticism by investors that management has not fully accounted for it given the move to a free-floating Naira was formally announced on June 14th (3 week prior to the IPO). The reality is that management had been planning for this eventuality since the February elections and the NGN take rate decline is a large part of why revenue is guided to grow at 30-35% in 2024 instead of the 65%+ CAGR seen in the prior 3 years. Furthermore, despite Nigeria removing the currency peg in June, substantial differences have persisted between the official rate and the parallel rate as the central bank has repeatedly intervened in the official rate to prop up the currency out of fear of inflation. In other words, the spread between the official rate and the parallel rate has narrowed but not collapsed to parity. Hence, if anything, CAB’s guidance regarding the Naira is probably conservative.

https://www.bloomberg.com/news/articles/2023-07-19/nigerian-central-bank-is-losing-a-battle-to-close-naira-rate-gap?sref=6okYcPM8

Catalyst

index inclusion, earnings