Description

I’d like to introduce VIC to a $3 billion gem that's been wonderfully operated for years, leading to above-average returns on capital which I believe will continue for at least another decade. Close Brothers is a UK-based financial company that lends in niche markets and has built an array of moats by doing everything you’d want a financial company to do. Statistical valuation: under 11x earnings and 4% dividend, but beyond these I’ll provide a SOTP valuation since they have 3 very different businesses: a lending business, a market-making business and an asset management business. Here are the key points:

- In 2009-2012 the company went through what I’d term a ‘strengthening’ (a turnaround that transformed it from being good to being great). ROE for the entire company has risen from 9-10% in 2010-2012 to 17-20% in recent recent years

- ROE for its banking business is even higher and the NIM is about 8%

- The company officially and explicitly avoids growth for growth’s sake. There are no growth targets for managers

- They keep lending standards constant. When there’s more competition, they lose volume, redeploying earned capital to strengthen existing operations or explore new niches

- Management is on the ball, conservative and communication is frank and detailed

- Over the past decade, EPS has steadily grown, the dividend has grown with it and so has the stock price, but thankfully it’s still cheap.

Overview

CBG was already a decent bank pre-crisis but in 2009 it decided to refine itself in the following ways: divestment from inferior lines of business, diversification into lines that are more niche as well as lines that are less cyclical, increasing conservativeness, building moats by emphasizing strong client relationships and building technology platforms where appropriate (to strengthen back-office operations and widen moats).

The company has 3 businesses:

1) Banking: £7 billion of predominantly secured loans mainly to SMEs but also consumers, across 20 niches. These are two-thirds backed by deposits. The average loan maturity is 14 months while liability duration is 23 months.

2) Securities (Winterflood). Winterflood is a UK market-maker offering about 15,000 securities. It has over 600 customers including retail brokers, wealth managers and institutional asset managers

3) Close Brothers Asset Management. This business provides financial advice to private clients in the UK as well as investment management, including managed portfolios and managed funds that are distributed either via their 110 advisers or via third parties. AUM is £12 billion

Banking

The banking business represents 80% of operating profits so it’s worth analyzing in more detail. It is divided into 5 segments that are further subdivided into nearly 20 sub-segments. Though retail (consumer) lending represents 40% of the book, it is very specific and targeted - as is all their lending, in fact.

Here’s a graphical overview to make things simpler:
[chart almost a year old; there have been a couple of changes since]

Before diving into the details I’ll start with a general overview. Close Brothers aims high in many ways:

- At CBG, the decision to lend rests on two 2 factors: underwriting criteria + return targets. There are no growth targets, no competing purely on price, i.e. no commoditized lines that are well-served by the big banks like mortgages, overdraft and credit cards. Still, loan book CAGR over the past decade has been 13% (varied between 4-20%). The lending they do is conservative in many ways: consumer loans are all secured + very conservative; commercial loans are also secured, property loans are only made to carefully selected developers; almost all the loans have under 5 years until maturity (60% under 1 year); 75% of their book has LTV of 70 or less. In commercial, the company intends to stay focused on SMEs, in which they believe, and which remain somewhat under-served by the banking sector. Plus they have a long history of extending into specialist areas that large banks particularly don’t serve well. Most underwriting is local and manual yet a couple of business lines are the complete opposite: built on sophisticated platforms. Offerings are often customized and/or client-driven. CBG aims to be there for clients when competition may pull back and this generates high repeat business and loyalty.

- Intense focus on all the following: hiring/training people the right way; service; having a local presence; technical expertise in niches where they lend; continuous improvement of operations. CBG selectively expands into new niches where it can deploy such skills. Managers have lots of authority: their job is business-like and CBG is committed to them by standing by them through the cycle and not shifting lending standards aggressively. This helps all parties involved in the long run.

- Funding: CBG ensures funding is conservative and is focused on making it cheaper, CBG’s funding is the most diverse of any specialist UK bank and they want to keep it that way. Corporate deposits represent 1/3 of funding with maturities of 3+ months. Retail deposits, another 1/3, are fixed-term 1-5 year. The company also has senior unsecured debt and they do securitizations as well, where they aim for great relationships with key investors. Liability duration is 21 months vs. 14 months for assets. The company last year decided to invest in a new deposit platform which will allow them to offer a wider range of savings products and to compete online thanks to a modern interface.

Asset Finance and Leasing (~29% of loan book)

The asset finance segment is comprised of a few sub-segments, but even these are further subdivided. The company has counted 14 niches here (e.g. renewable energy, print, recycling). Each niche has been created/strengthened by recruiting specialists experienced with the equipment and then training them in finance. Meetings are always face-to-face with the SMEs. Their understanding of customers & their assets means they can win even if competition is cheaper. Also, because CBG sees the customer’s business from the same angle, it can be more flexible in its decisions. This segment is now slowly expanding into Germany and Ireland. The strategy is to test out the same niches in a different country and keep whatever sticks without compromising their standards.

Invoice Finance (~8% of loan book)

This is a segment which includes a random mix of things in addition to invoice finance:

- Actual invoice finance: WC facilities vs. a basket of receivables. They created a platform called Ideal in order to automatically finance these receivables. There is no comparative software - it can connect with over 250 accounting software suites! That plus great service gives them a competitive edge. Average client life is 5 years vs 3 years for the industry.

- Asset-based lending: PP&E, inventory, but especially receivables (93%)

- Novitas, a recently acquired business that basically finances legal fees for divorce cases. The company only lends if they’re confident regarding legal precedents and the amounts involved vs. the probability of winning is attractive. They take out insurance in case the other side has a problem coming up with the money. Since the acquisition, CBG has already grown the business, expanded into more general litigation financing (but only for cases of 3rd party disbursements) and is now even cross-selling lawyers for the asset management business.

- Brewery rentals: the company is the 2nd largest owner of kegs and casts in the UK, it rents them and takes care of maintenance & cleaning. This business serves Germany too.

Premium Finance (~13% of loan book)

Premium finance allows ~2 million individuals and companies to pay insurance premiums in installments. The product is sold through a network of nearly 2,000 insurance brokers. The differentiating factor here is the great relationships between CBG and the brokers (15-year relationship on average). A contract is 3 years minimum and usually CBG is the only provider to the brokers. The average account manager has 10 years experience in insurance, so just like in the asset finance business, there is great understanding of the domain, great service and nice relationships. Technology is also a differentiating factor here: lending is done through an automated process which reduces costs for all 3 sides. Furthermore, brokers provide CBG with data that CBG processes (for example to predict customer behavior) and uses to create advice for the broker on how to maximize revenue. This is not linked to the financing in any way, it’s a free service that helps brokers grow. This work is performed by a centralized analytics department that serves all of CBG’s businesses.

Motor Finance (~13% of loan book)

The Motor finance Segment writes car loans (and some motorcycle & light commercial vehicles) through 7,000 independent dealerships in the UK and Ireland. Underwriting is local, manual and careful. They only do used cars and manage risks by carefully selecting the dealers (good dealers sell good cars), vehicles and customers they’ll do business with. CBG is very nimble with cars, down to the color. Customers are typically loyal to the dealers, low-middle income but not subprime. There are many dealer types but most are what one might call “tiny” or “small”. The smaller the dealer, the more they benefit from CBG’s help.

80% of loans are hire purchase loans (similar to rent-to-own) which means there’s a decent deposit, low LTV, loan never underwater and car is typically 5 years old. The rest are mostly PCP (Personal Contract Plan) loans: cars typically 3 years old, customer less risky. In PCP there’s lots of competition these days.

In this segment too, CBG employs people with expertise who build strong relationships with dealers. They keep standards the same through the cycle (didn't even alter anything in the wake of 2008-2009) and this means that in recent years market share has declined because of the competition. This way of doing business and the fact that we’re talking about used cars means that this segment acts as a hedge in downturns.

Property (~24% of loan book)

CBG provides short-term financing for residential development projects by carefully selected developers with good track records and with whom they seek to build trusted relationships. This is done through two separate brands: the first brand/business finances new construction and the other (Commercial Acceptances) does refi & bridge loans at auction. Due to CBG’s expertise and long-term relationships, their differentiating factor is that they can provide a quick yes/no answer, they lend through the cycle and attract like-minded (conservative) clients. In the sub-10mm sector they are 2nd in the UK with a 20% share. They only do senior secured debt on SFHs intended to be owner-occupied. In this segment, like in many others, good staff is critical and an advantage.

Securities (Winterflood)

Winterflood is a market-maker that was bought out by CBG in 1993 but has kept its own branding. It makes markets in more European stocks than any other company and also deals in North American equities, ETPs, commodities and bonds. They also have their own trading platform and order routing system. In the 2010-2012 period, Winterflood went through some losses and divested itself of non-core assets. The turnaround was completed as of 2014. This division’s profits will likely fluctuate with capital market conditions; there’s not much else that is notable here except that I’m sure it’s intelligently managed like the other businesses. Winterflood represents about 10% of CBG’s operating profits.

Close Brothers Asset Management

The AM business also represents 10% of operating profits. Between 2010 and 2013 this division too went through a turnaround to re-focus and become a wealth and asset management business that caters to affluent & high net worth investors.

As part of this effort, they stopped serving institutions, sold their offshore services & fund administration businesses, embarked on an effort to acquire clients from financial advisors who were exiting the market as a result of regulatory change, launched in-house funds including multi-manager and passive funds and built a new advisory technology platform through which they now offer the same propositions to all clients so as to gain efficiency. Their acquisitions were on average done at ~2% AUM.

The business is still growing now, both organically and through selective acquisitions (mostly where the manager stays on). They’re also moving assets from third party management under their own management and in 2017 they finished moving all accounts onto their new platform. The company offers self-directed accounts, discretionary management through funds and/or separately-managed accounts, tangential services such as estate & tax planning and more. The funds seem to be doing well relative to peer group averages but of course these statistics are not necessarily indicative. I am confident, however, that there is a culture of conservatism and diversification in this business and therefore no risk of, for example, over-allocating to a toxic asset class at the wrong time.

Putting it all Together..

Throughout the organization, management compensation is tied to metrics that are ideal for a financial company (ROE, LTV not exceeding a certain level, employee engagement metrics and more). As mentioned before, growth is not a target. It’s clear that HR is a huge priority at CBG in every way, as are value-adding IT systems (and conversely, also, the idea of staying away from IT where human contact is better).

CBG seems focused more than ever on building moats in well-defined niches, on understanding small businesses and high-net-worth clients and building relationships with them and on maintaining a prudent financial position. With all businesses having been transformed as of, say, 2013, they seem to be firing on all cylinders.

Growth is still on the horizon in many of the areas they operate in:

- In Ireland and Germany they are expanding by testing out various niches very slowly (In Germany for example, they started with the brewery business and then got an introduction from a manufacturer that led them to an asset finance opportunity.

- In property, Novitas, premium financing, invoice financing and brewery, CBG sees above-average growth. They also now have the Technology Services business that offers financing for IT infrastructure.

- Asset Management is growing too

- Winterflood is growing and diversifying as they build Winterflood Business Services, which provides outsourced execution services to UK fund managers

- Deposits are poised to become cheaper thanks to the new deposit platform

The portion of shareholders’ equity attributable to the banking business is £735 million and that business is generating £174 million after tax which means 24% ROE. If we value it at 2.5x book that’s £1,838 million (which corresponds to about 10.5x earnings).

For the other two businesses, if we assume £2 million of the group-level expenses are attributable to each, Winterflood generates £20 million which at 15x gives £300 million and Asset Management generates £16 million, which at 15x gives us £240 million (this corresponds to a valuation of just about 2% of AUM).

Now, 1573p is not that much more than the share price. But.. we still didn’t consider one important thing: CBG is doing everything described above while paying out nearly half of its earnings, which gives the stock a dividend yield of 4%. That’s a lot for a company growing like this. EPS CAGR has been 11% since the turnaround began in 2010. In the most recent 3 years EPS grew in the 4-6% range yet even that’s a lot! If we assume 5-6% growth going forward + 4% dividend, we get 9-10% total yield in a company that is constantly improving its moats, possesses certain counter-cyclical sub-segments, has put in place many mitigating factors in case of recession, and most importantly, with only $3 billion of market cap, has lots of growth runway ahead. Not too shabby in my opinion for a stalwart stock in 2018.

Risks

The main risk is recession (whether due to global macro forces or Brexit). Here’s a quote from 2007: "We are not sorry to see the probable end of easy credit and we believe that this change in climate could see an increase in acquisition opportunities and also benefit our conservatively financed Banking division". Following that quote, their securities and asset management businesses suffered but were refocused and turned around as detailed above and I believe that due to the refocusing of both the securities and AM businesses, these two will suffer much less in the next downturn. Sure, there will be less trading and AUM will shrink but the new focus, especially high-net-worth clients in AM, should be helpful. As for banking: profits turned back up quickly after the downturn and there was no substantial need to adjust anything. With banking being even stronger and unique nowadays, I’m not that worried.

Catalyst

- Any events that give them an opportunity to gain share from competitors, accretive M&A, finding new niches or more opportunities in existing ones

- It’s not clear now what else would lead the market to value this company higher. In the meantime, you get paid a nice dividend for waiting + the stock will have to keep up with growth