Stockwatch: A nice dividend and potential to surprise

Can FTSE Fledgling-listed currency manager Record grow earnings more impressively, or is this mainly a steady income stock?  It enjoys an operating margin over 30% and key directors have strong shareholdings. Yet, despite their entertaining profits growth, the attraction has mainly been substantially all earnings paid out.  

I drew attention three years ago at 37p on an historic yield of 4.6%, suggesting the then strong cash flow profile and business growth prospects implied potential to recover the kind of payouts - 4.6p per share - Record had made in its 2010/2011 financial years.  

But, inclusive of special dividends since 2017, the latest prelims to 31 March 2018 show a total payout of 2.8p up from 2.6p and pre-tax profit of £7.3 million, as if bumping along on a multi-year trend (see table below).  

Some of this does reflect investment in people, but you are quite guessing as to what extent is needed just to maintain competitiveness given assets under management growth varies according to dollar/sterling perspective.  

Shifting towards performance-oriented fees

Management had previously made a virtue of being oriented to fixed management fees than performance fees (liable to be volatile hence result in a lower stock rating), yet the current narrative turns this on its head.  

Record is moving towards performance fees on its Passive Hedging product which constituted about half of management fees in the last financial year to 31 March 2018.  This is expected over time "to match or exceed foregone management fees", although that's quite speculative given Record will be charging a lower management fee - as if pressure is coming from clients to pay according to results.  

Three years ago, performance fees constituted just £0.5 million and applied to just two mandates in dynamic hedging, and in the last two financial years no performance fees have kicked in.  Without a track record it's more uncertain how profits may pan out.  

I'd been attracted in a macro sense: currency volatility appearing to rise after central banks' loose monetary policies peaked, offering scope for active currency managers to profit – in Record's case, by helping clients with risk-reducing hedging or capital return strategies. It does not bet on foreign exchange markets like some banks do, revenue is strictly fee-based. 

The 2015 results were promising: pre-tax profit up 18% to £7.7 million on revenue up 6% to £21.1 million, with a more diverse spread of clients and products; although the table shows this macro theme hasn’t worked for materially higher profits.

Three years ago, Passive Hedging (within the service mix) was relatively low-margin, accounting for nearly three-quarters of assets under management, and its £8.1 million fee contribution had risen from 28% to 40% of total management fees, versus £9.4 million for Dynamic Hedging which had slipped from £11.9 million as a result of cutting fee rates, with Currency for Return stable around £2.8 million.  

Management fees for Passive Hedging have grown 56% over this time period to £12.6 million, but Dynamic Hedging fees have continued to decline, to £5.1 million in the last financial year, with this side experiencing net outflows.  Currency for Return fees rose 80% to £1.8 million last year if down on the 2015 result.  Multi-product fees are constant year-on-year at £4 million but, overall, it’s a mixed performance profile and quite tricky to anticipate.

Dividends need cash flow cover not just earnings

Moreover, the 2018 cash flow statement shows net cash inflow from operations down from £7.1 million to £2.7 million, the £6.8 million paid out as dividends being supported by £7.9 million proceeds from "sale of money market instruments", with £10.2 million remaining on the balance sheet.  

This is distinct from a reduction also in financial year-end cash from £19.1 million to £12.5 million, and mind this is not altogether free cash as a buffer that needs retaining for regulatory purposes.  

The board has still been confident to spend £10.4 million buying back shares, which explains why 2018 earnings per share (EPS) has nudged up 4.1% to 3.03p despite pre-tax profit down 7.6% to £7.3 million.  

Yet such a profile calls into question the durability of special dividends unless the revised approach to fees structure pays off.  While the 2018 ordinary dividend rises 15% or 10% "like-for-like" when adjusting for fewer shares issued, the special dividend has reduced 44% to 0.5p with the total distribution rising from 2.6p per share to 2.8p i.e. 7.7%.

Source: Company REFS                    Past performance is not a guide to future performance

5% benchmark yield, EPS should be better than forecast

If the cash flow profile improves a 2.4p ordinary dividend (as forecast) looks fair enough, equating to a prospective yield over 5% at the current 47p share price.  It should be covered by earnings better than the 1.0 times implied by the EPS projection of 2.5p, which doesn't make sense given shares issued have reduced 10% to 199 million after last July’s buyback.  

If £8.4 million pre-tax profit is realistic then EPS should be more like 3.5p, implying a forward price/earnings (PE) ratio of around 13 times.  

Even if EPS is flat at around 3p, then the dividend should hold according to payout policy: that interim/final dividends will be paid equally, also that the board will continue to return any excess of earnings over ordinary dividends (and capital needs) by way of special dividends.

"The total distribution for any year will be at least covered by earnings..."

Brexit risks estimated low in overall context

Some 90% of revenue is sourced from clients outside of the EU27 countries, hence even if the EU plays awkwardly with regard to financial services access the risk is relatively low in context.  

"The group intends to take all reasonable steps to maintain its ability to continue to service current EU clients and to gain more EU clients in the future," says Record.

"We have made sufficient progress with contingency plans to achieve this objective, no matter what the outcome of negotiations, including any transition period." 

This is interesting given financial services stocks may fall if the EU maintains a hard line on market access, as if Record would then represent better value.  

Swiss expansion is underway having opened a Zurich office to enhance relationships and support growth there.  Also, in terms of development initiatives, a multi-strategy currency fund has been launched and a new segregated multi-strategy mandate in Australia.

What are the board's expectations for the current year?

The chairman doesn't offer specific insight about how the new financial year has started, although a Q1 update should be given (as last year) at the AGM later in July.  Meanwhile, there's a suitably vague stance, that "foreign exchange markets will continue to be impacted by ongoing geopolitical developments and instability... such developments provide opportunities to engage with current/prospective clients to (help) meet their objectives... I look forward to further opportunities and growth in the year ahead."  

The chief executive then elaborates about fund specifics but similarly avoids setting expectations. 

Overall, Record is likely to enjoy support from a circa 5% yield and the business is positioning to improve results, its stock currently rising.  This could be a transition phase, which is why I draw your attention again.  

According to risk preference you may prefer to await the Q1 update.  Speculative buy.