Low risk of sustained operating losses. 60%+ of Cenkos’ cost base is typically Staff Costs. The company has neither financial debt nor any material lease liabilities. If revenue is cyclically depressed, management can quickly scale back the cost base by firing people. They did so in FY19. Revenue hit an all time low of £25.9m largely due to Oct-19 Brexit-deadline uncertainty. Cenkos spent £1.3m to remove £3m of annual fixed cost. The business broke-even despite the revenue trough and, pro forma for the cost savings, may even have shown up to ~£3-4m of net profit. Taken to the extreme, if needed the business could be scaled back to just a handful of key members of personnel and still operate profitably until the market recovered, at which point they could scale back-up. This characteristic of the operating model suggests that the probability of a multi-year period of losses is low.
Low risk of future liquidity issues. Cenkos currently holds £22.4m in cash. It has another £4.2m in liquid current financial assets. I estimate that the current minimum cost base, pro forma for the restructuring, is ~£20-23m. Current liabilities were £13.5m as of Jun-20. The business currently has significant excess cash to cover any future surprises. Coupled with the flexible operating model, and barring any stupid management decisions, I view the risk from future liquidity issues as low. On mismanagement risk, I take comfort from the businesses’ long term average (highly liquid) Current Ratio of 1.9x and trough of 1.5x. Management have always left plenty of water between the ship and the rocks.
No evidence of adverse structural shifts. My investment thesis is fundamentally based on reversion-to-the-mean. A key risk is therefore that the next 5 years could be significantly worse than the last 5-10. Brexit and Covid-19 do present uncertainties in the near term – your guess is as good as (or likely better than) mine as to the specifics of how those play out – although Brexit has already been weighing on performance since 2016. I see little evidence that the appetite for UK listings, equity raises, corporate finance advice or corporate broking will be materially worse in the future than experienced historically. I also see no reason that, with their Top 3 market position and strong brand, Cenkos cannot continue to win a healthy 10-20% of AIM transactions while maintaining their other activities. The risk from obsolescence, technological shifts or disintermediation is also low. Assuming a long term required earnings yield of 10% and given the excess cash, current prices suggest that the market is expecting less than £1.6m of sustainable earnings power (I apply the 10% yield to current EV given the large net cash balance). That seems extremely conservative given the business’ long term track record, their strong market position and the cost savings already achieved in FY19.
Personnel. Losing key people could create problems for the business. I take comfort from the levels of insider ownership as well as the “eat-what-you-kill” compensation structure. Jim Durkin (outgoing CEO) holds c. 9% of outstanding shares. Founder shareholder Nick Wells, the Head of Corporate Finance, holds c. 4%. Founder Andrew Stewart, while no longer an employee, holds 9% and re-acquired the majority of his shares as recently as Dec-19. Other employees own a further 35%. All variable compensation is subject to a 3 year deferred vesting period (“Golden Handcuffs”). Cenkos also structures key deal-maker compensation with low base salaries and big performance-related bonuses. For example in FY19 Joe Nally, founder shareholder and Head of Natural Resources, earned a base salary of just £54,000 (less than a first year Investment Banking analyst at a Bulge Bracket!) and total compensation of £132,000. In FY18 he earned £812,000. Clearly this is an attractive proposition for “rainmakers” inside the firm as well as potential future hires. It is also likely to deter weaker deal-makers from joining / staying with the firm.
Regulatory Risk. As a regulated entity this is an inherent risk to the business. Overall the track record to date is positive, although in 2016 Cenkos was fined £530,000 by the FCA for its work on Quindell’s listing. Since that event the business has tightened its compliance processes and implemented the FCA’s remediation recommendations. The subsequent record has continued to be positive and I see this as an inherent risk that I can live with. I again take comfort from the levels of insider ownership. In some ways, having a minor but public failure in recent memory may actually serve to further mitigate some of this risk. One tends not to put their hand on a hot stove twice. More generally, the strength of the balance sheet, the flexibility of the business model and the reduced fixed cost base, means that Cenkos are very well positioned in terms of solvency testing. As of 1H20 Cenkos had a capital resources surplus of £15.8m over and above its Pillar 1 regulatory capital requirement.