Dramatic moves: it's been an interesting week

Wednesday, 14th December 2016 09:30 - by David Harbage

Stock exchange listed companies are obliged to advise investors of the prime risks which could adversely impact their business within their annual report and accounts. Believers in some degree of ‘efficiency’ in markets’ ability to price risk assets, such as equity, reasonably well would rely upon analysts’ primary research and fund managers’ secondary investigation of these companies - which would include close scrutiny of these risks.

Companies with a main market listing are obliged to disclose considerable amounts of financial data (notably trading accounts), leading retail investors to become complacent to the risk of significant potential movement in share valuations. Essentially, such private individual shareholders may assume that the professional investment community – made up of corporate brokers and fund managers – are very close to company management and are unlikely to be surprised.

Developments over the past week might suggest otherwise as double digit % moves, both ‘going north’ and downward in a number of FTSE350 index constituents, captured City headlines. Last Friday, the US media giant 21^st Century Fox made an opportunistic bid for the UK’s largest (by market capitalisation) media company, Sky, offering 1075p per share. Fox, largely owned by Mr Rupert Murdoch, has maintained a 39% stake in Sky for many years and its offer appears to be something of a well-timed cheeky attempt to take full control. Investor sentiment towards the satellite broadcaster has waned over the past year, in the face of concerns about the group’s major expense in acquiring TV sporting rights (notably English Premier League football), the escalating cost of maintaining its customer base (competition with BT in telecom & broadband) and a low presence in mobile communications.

 A year ago Sky shares were valued at 1123p and, despite profit projections for the year to 30 June 2017 barely changing, the stock touched a one year low of 754p earlier this month. A perusal of broker research issued over the past two months suggests a consensual fair value for the stock should be around £12, and a 20% premium for control would argue that a predator could be required to pay £14.50p. Institutional investors have already voiced displeasure over the 1075p price, demanding a more robust defence from Sky’s independent directors rather than ‘waving through’ what appears to be a cosy corporate deal.

However, while the Sell side community remains broadly positive (currently proffering 15 Buy recommendations, 4 Hold and 7 Sells), this is no ordinary trade sale or takeover. The current 9% shortfall in the share price, relative to the offer, reflects the not inconsiderable regulatory and political hurdles. These include the ‘fit & proper’ test of the predator’s directors (by reference to the Murdoch organisation’s history in UK media) and the issue of foreign ownership of UK assets. Bottom line, Fox has until 6 January 2017 to come up with a more realistic bid and, ahead of that, Sky stock looks to be underpinned at the current £10 price.

By contrast with that 30%+ jump in equity worth, the share prices of three leading stock exchange listed financial derivative firms CMC Markets, IG Group Holdings and Plus500 experienced a fall of the same magnitude last week. This major retreat was prompted by the UK’s Financial Conduct Authority (FCA) announcing a consultation on measures designed to enhance consumer protection in the Contracts For Difference (CFD) market. At the same time BaFin, the German financial supervisory authority, is investigating the same issue (CFD retail market) in that country. As a consequence, the market expects to see a more tightly regulated industry featuring a reduction in margin or gearing allowed to inexperienced, unsophisticated investors which would lead to a significant reduction in revenue for the firms.

Of the aforementioned companies, CMC Markets and IG Group have full premium listings on the London Stock Exchange (although CMC only came to the market in February of this year) whereas Plus500 is listed on the junior, more lightly regulated Alternative Investment Market (AIM). Each company has already made initial noises to its stakeholders and will have to provide a full response to the FCA by the 7 March 2017, but it is not easy to estimate the impact on their respective businesses – and therefore, the worth of their equity – going forward.

While some facts are known, such as the extent of the customer base likely to be impacted (essentially domestic, as opposed to overseas, clients), other pieces of critical information are not. UK clients represent a major part of CMC and IG’s revenue stream, whilst this is not the case for Plus500 who advise that approximately only 20% of their income is so derived. However, what is typically disclosed is the extent to which a small proportion (perhaps 5% or less) of clients make an overwhelming (probably 30% or more) contribution to revenue and profit of these companies. These are probably experienced, financially literate or qualified traders who are not the kind of clients that the financial regulators are aiming their protective measures towards. Accordingly, although their ability to trade might be inhibited by a reduction in the leverage a firm is allowed to offer (whereby the client is unable to borrow, to take positions, against a deposit to the same extent as is currently allowed), those traders would continue to use CFDs. By contrast, retail clients with little or no experience with CFDs and other geared instruments (such as spread bets) might well be deterred. In the absence of having a breakdown of the firm’s client databases, it will be difficult for analysts to make credible assessments of their future revenue and equity worth.

This is borne out when looking at brokers’ responses to the changing trading environment. In the case of CMC Markets, only two of the five investment houses publishing research have issued an update – both on the 6 December. Numis have downgraded their view on the company, from a Hold to a Sell recommendation (and reduced their target price from 190p to 140p), while RBC Capital Markets have initiated coverage with an Outperform call and a 315p valuation. As might be expected from a more widely owned, established business, there has been a little more broker activity surrounding IG Group, the industry leader and FTSE250 index constituent. But not a lot, with Numis and RBC again issuing a note on December 6^th; the former changing their Hold opinion to an ‘Under Review’ one, while RBC anticipate performance in-line with the wider financial sector and suggest a price target of 865p. Barclays’ equity research published a more positive ‘Overweight’ piece (with a 950p projection of fair value) on the following day, although one might wonder if the recommendations had been written before or after the FCA’s pronouncement.

In the past week, the consensus of broker forecasts for profits in IG Group’s trading year to the 31 May 2018 have been cut by 18% - to 43.7p – which puts the shares on a PE (price: earnings) ratio of 10.3 and, on the basis of paying an unchanged (relative to the current year) dividend of 32.4p, a heady dividend yield of 7.1%. Analysts have similarly applied the ‘red pencil’ to their estimates for future earnings at CMC Markets, via a 22% reduction in the year to 31 March 2018 to 14p per share. This would put the stock market newcomer on a PE of 6.7 times and, assuming a maintained dividend of 7.8p, an attractive income yield of 8% at the current 95p price.         

What of Plus500, an AIM listed stock which divides opinion amongst professional as well as retail investors? The writer could only find one published broker monitoring the company: Berenberg Bank, whose research (culminating in a Buy recommendation and an £8 price target) has not been updated since April 2016. Having said that, considered wisdom suggests a 20% reduction in anticipated earnings per share has been effected over the past week, reducing the estimate for calendar year 2017 to 74.4p. This puts Plus500 stock on a forward-looking, price-to-earnings multiple of just 4.4 and, assuming that a 60% pay-out ratio is maintained, a dividend yield of 12%.

The stock market’s treatment of these interesting if complex product firms reflects the opaque, akin to a ‘black box’, nature of their business models. Investors do not appreciate uncertainty, and clarity is probably at least six months away – when the FCA report their findings on the industry and make recommendations. The ‘bargepole treatment’ of neglect is therefore likely to continue in the short term. Almost certainly, fear has resulted in an over-reaction in equity valuations and the writer believes that the strongest will survive and thrive – if only at the expense of the weaker players being unable to compete.  

As a final aside, another dramatic fall in a FTSE250 company took investors by surprise today: Paysafe shares fell 30% between 11am and noon, before recovering in the afternoon to end 17% lower at 305p. Responding to a piece of research written by a little known firm with a short position in the stock, Spotlight Research, which suggested that the payments company has been facilitating illegal gambling in China, the company says the allegations are ‘factually inaccurate’. There may be more to emerge – on the basis of ‘there’s no smoke without fire’ – but it seems extraordinary that a share price can move by such a magnitude, merely on flimsy chatter. Reminds one of the market adage, ‘buy on the rumour and sell on the fact’.     

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.