Industry consolidation amongst the market beta plays

Tuesday, 9th October 2018 09:30 - by David Harbage

Reports in the media over the weekend suggests that the UK-focused banking group Lloyds are talking to asset manager Schroders about forming a joint venture to manage private client monies. The parties have been tight-lipped – Lloyds saying nothing through official sources, but Schroder advising the stock market that it is in discussions with Lloyds with a view to working closely together in the wealth sector.

The proposal is that the clearer would place its circa £14bn worth of affluent and higher worth private clients’ monies into the new venture, with Schroder providing the operating platform and investment management expertise. The prospect of the FTSE100 fund manager taking on Lloyds’ c. £110bn of insurance-based funds (which, until this year, had been managed by Standard Life Aberdeen) would represent a major, step-change opportunity to accumulate assets under management (AUM). Economies of scale naturally arise from increased size, as lower ad valorem charges can be applied which in turn can attract additional new mandates. 

Lloyds Banking Group had already expressed the wish to broaden its spread of earnings and, with geographical diversification not being contemplated, financial services such as wealth management and insurance were highlighted as key areas for expansion in a strategy plan published at the beginning of 2018. In similar vein, Schroders wished to expand its reach beyond institutional funds and its existing Cazenove client base to encompass the lower value, but higher volume, retail market. Combining the bank’s personal customer base and distribution channel with the fund manager’s product proposition, capability and well regarded brand makes eminent sense.

Whether such a deal would be good for shareholders – which would be determined by the terms and synergy pronouncements - remains to be seen. Since its 1 January 2018 high of 72p, Lloyds stock appears to have lost positive momentum, no doubt because its business and prospects are so closely tied to the domestic economy (housing market and the consumer in particular). Although a natural beneficiary of wider margins emanating from rising interest rates (seen in both overnight Bank and longer term debt yields), Brexit concerns have overshadowed such traditional drivers of sentiment towards banks. Investor perspective and confidence could enjoy a positive change via a higher focus on AUM revenue which is typically invested in global, non-sterling funds.

Lloyds shares were last at this sub-60p level in 2016, but prima facie they look inexpensive: on a price-to-earnings multiple of 7.8 times the broker consensus forecast for this calendar year’s earnings per share (EPS) of 7.4p. Paying out 45% of this to shareholders would equate to a dividend of 3.3p or yield of 5.5%. Although analysts expect a flat (no increase in) profit picture in 2019, some progression in dividend is anticipated to take the income yield to 6%. The company’s recent EPS-enhancing, £1bn spend on buying back its own equity recently concluded and in the absence of any other corporate activity (Schroder or other), the exercise could be repeated next year. Buy-side broker opinion remains supportive: of 22 institutions publishing research, 12 say Buy, 6 are neutral Holders and 4 recommend a Sale.

Schroder is regarded as possessing greater growth potential and, as a consequence, its equity is not as attractively valued. Leaving aside its ‘A’ non-voting shares currently valued at almost £1.4bn, the core stock (worth £6.7bn in total) stands on a PE ratio of 13.3 times based on flat profits this year, but on a market average multiple of 12.7 times for 2019 in anticipation of a 5% advance in EPS. The dividend yield is currently 3.8%, almost twice covered by earnings, and is forecast to rise to 4% in 2019. Making the proposed tie-up work for both sets of shareholders may be a little tricky in terms of incurring short term expense but, as a commercial prospect, it makes a lot of sense. Current sentiment towards the UK’s second largest asset manager is reasonably positive – as measured by those who research and pronounce on the industry – there are 7 institutions proffering a Buy recommendation, 8 are neutral and just one broker suggests a Sell.      

A bolder strategy could be to acquire – or, in more politically correct corporate language, merge - with an asset manager or even a life assurance company. Regulatory hurdles and combining management culture might render such a deal as a step too far but, on financial grounds, such engineering could be attractive. For instance, the life assurer (and passive asset manager, via its index-tracking AUM offering), Legal & General does not feature a high price tag. The £15.3bn market capitalised group is set to deliver profit progress akin to Schroder in 2018 (flat) and 2019 (up 4% or so), but is not rated so highly; next year’s forecast 31p of EPS equates to a PE multiple of 8.3 times and a 55% pay-out ratio is likely to mean a 6.8% yield next year. Broker appetite for the stock is reasonable, rather than overwhelmingly positive (providing headroom or opportunity for opinions and buying appetite to change, favourably), with 10 Buyers, 4 Holds and 4 Sell opinions.   

Owning an asset that can appreciate and generate higher revenue has appeal to the long term investor and, when markets appear undervalued (towards the bottom of the range of their normal pricing), to the opportunist trader. Possessing above average beta, fund managers and insurance companies can outperform a rising market – but such gearing means that such a stock can also suffer more greatly than the average company share or index in a bear market. When economic or market conditions lead to a slowdown in turnover or profitability, company management will redouble efforts to enhance shareholder value by considering corporate activity. This could boost EPS, via cost control or synergy benefits, or to seek an upward re-rating of the equity prompted by a re-assessment of the company, transformed by product profile or a more efficient balance sheet.    

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.