FinnCap – Going Nord

For those who like their investing to be more Hygge than Scandi-thriller, the Danish expression “It is difficult to make predictions, especially about the future” can provide some useful insight. Wouldn’t it be easier and safer to be able to accurately predict company performance based on what has already publicly happened rather than what may or may not be disclosed in the future?

Opportunities to do just that are surprisingly common, for example Wey Education’s customer pre-payments presage recognised revenue, and strong performance at B&M Stores was reported well ahead of UPGS’s resilient UK discounter revenue. But what about a company where most of their sales are a matter of public record?

FinnCap (LON:FCAP) have literally nothing to do with Finland (pictured above) or indeed hats, but rather is an investment advisor and broker specialising in services to UK listed smallcap companies. Their year end is 31st March and their revenue comes from four areas: Retainers, Public Transactions, Institutional Stockbroking and M&A Advisory. Data was collated jointly by @LeoInvestorUK and @DangerCapital with input from WayneJ.

Retainers

FinnCap currently receives retainers from around 125 clients. Around 80 of these are in the capacity of NOMAD and the list is freely available here. Many of the remainder are as broker, joint broker or financial advisor for UK listed companies and these clients can be identified in a trawl of RNS statements. Despite natural churn, client numbers and fees have been stable for some time and so this is a source of recurring and relatively predictable revenue.

No net loss of clients has been observed and so a repeat of the revenue seen in the first half can be predicted with high confidence giving a total of £6.5m for the full year.

Transactions

These transactions consist of fundraising in the form of primary placings, secondary placings, debt negotiations and buy-side M&A. Most are a matter of public record with new deals published in real-time by the issuers via RNS, and a summary available on their website. Commission levels and their share of the cake is, of course, variable and relatively opaque, but in most cases, total transaction costs are eventually made public in the issuer’s accounts or other disclosures. In some cases, there can be uncertainty about which period revenue should be recognised, though this is not currently a material concern.

Overall it has proven possible to model these revenues with a good level of confidence. Major transactions in H2 have included fundraising for Ideagen (IDEA), a secondary placing in Quartix (QTX) and more recently, fundraisings for Evgen Pharma (EVG) and Chaarat Gold (CGH), although the full tail of transactions has been analysed. Using a model validated against reported H1 revenues, H2 is currently running at similar levels.

With high activity levels and nearly a month left to go before the year-end, eventual full-year revenue looked to be in the range of £19.5m to £22m. Following Wednesday’s trading update it seems the outcome will be around the top end of this estimate, although I have noted a caveat around Cavendish’s Spring Home Buyers deal later.

Institutional Stockbroking

This mainly consists of market-making activities. Every trade is published and although the market maker is not reported at the trade level, the market makers for each stock and who is the “house” broker is again in the public domain. Net revenue (revenue for short) from market-making could be split into two categories: The spread made while providing liquidity, and the incidental profit or loss on the float of shares they hold in order to do this.

The market-making float is specified on their balance sheet. My model achieves a good fit against the last three half-year periods and forecasts a moderate increase in this float at the year-end. Using opening and closing share prices I see increased gains from share price movements, giving a full-year contribution of around £0.4m, contrasting with a loss in the previous year of around £0.2m.

The profits on market spreads are related to the trading volume. My model achieves a reasonable fit for the previous two halves (adjusted for profits or losses as above) and forecasts that H2 revenue is running around 10% behind H1. While I am less confident here than elsewhere, the risk is apparently on the upside with my model significantly underestimating profitability in earlier periods.

Stand-out issuers for market-making have been Avacta (AVCT), Omega Diagnostics (ODX) and Synairgen (SNG), each of which ten bagged or more in the period and also saw exceptionally high volumes. Xeros (XSG), Tremor (TRMR) and Ideagen (IDEA) also performed well. In terms of volume Avacta were particularly strong in H1 and, although is now covered by 9 market makers, maintains a relatively high spread and is not traded on SETS outside of auctions. FinnCap acts as NOMAD (and therefore usually the principal market maker) for all of the above issuers and my model considers these and their other NOMAD clients as a proxy for all of FinnCap’s market-making activities.

Based on the above my central estimate was for £5.8 in the full year. Wednesday’s update specifically mentions “good growth in year-on-year…trading revenue”, but this is already well ahead of the previous year’s £3.5m and so I will leave my estimate unchanged.

Sell Side M&A Advisory

This is a speciality of their Cavendish Corporate Finance subsidiary and includes a higher proportion of work with private companies, with investors reliant on the deals they choose to disclose for marketing purposes and transaction values harder to come by. Only less half of transactions and value from H1 could be reliably identified from public statements. Furthermore revenue levels have also proven to be relatively lumpy although there is some correlation with activity in public markets.

Still, the overall trend appears to be positive, H1 got off to a reasonable start, the outlook was strong at the time of those results, and a jumbo Spring Home Buyers deal completed in H2. This leads me to estimate a relatively wide range of between £7.0m to £9.5m net revenue for the full year. Wednesday’s trading update said:

After a quiet Q3, the M&A team in Cavendish has delivered a strong performance to date in Q4 with the successful closure of a number of deals before the announcement of the UK Budget.

The reference to a quiet Q3 leads me to question if the Spring deal (that apparently completed in November) will instead be categorised under the “Transactions” reporting segment. It is also possible that revenue recognition is was delayed until Q4.

The reference to the budget implies there are a large number of small private sales by owners keen to avoid mooted increases in capital gains tax. While these can now be expected to dry up, I again see revenue (including Spring) being at the top end of the range.

Segments and Teams

The above headings are used in segmental reporting, but sometimes the company’s commentary talks in terms of teams and a degree of distinction remains between Cavendish and the rest of the group. The following approximately summarises the situation:

Other Income

In the first half of FY 2021, a gain of £0.7m was recognised on their investment in PrimaryBid following an agreement to sell a majority share. No analogous gain was made in previous years or expected in future ones and this was excluded from underlying profit metrics.

Despite increases in company valuations, gains on shares and warrants accepted as part-payment for services are unlikely to be material given that their total valuation was less than £0.5m at the end of H1. They hold significant amounts of cash, but in the current environment, it earns negligible interest.

Costs

Fixed costs have been guided to reduce year on year. Staff costs, including variable remuneration, have consistently come in at around 62% of revenue. Amortisation will be unchanged, but although this is the second year of IFRS 16, office consolidation will have affected depreciation somewhat. The tax charge has proven slightly unpredictable, but the longer-term average appears to be just over 20%. Exceptional costs related to the office move will not recur.

Reporting Timetable

While a mild profits warning was issued on the 27th February 2020, I believe the timing of the neutral-strong year-end trading update on 4th April 2019 is more typical. Wednesday’s early update was forced by trading being materially ahead of expectations set by Progressive Equity Research in November.

Preliminary results are to be expected in early July along with the revenue numbers for Q1. Importantly this will trigger Progressive to produce a forecast for FY 2022. The annual report and confirmation of the AGM date is likely around the turn of the month. The H1 trading update may come with the AGM, or soon after in October. Interim Results are likely in mid-November before the cycle repeats.

Longer Term

FinnCap have a good and improving reputation with CEO Sam Smith a well-known figure in the city. Revenues have been on a rising trend helped by the acquisition of Cavendish during FY 2019. This is despite genuinely difficult market conditions in the full year to March 2019 and 2020, which were plagued with political uncertainty. Overall, they have been clearly outperforming direct competitors, even before Wednesday’s update.

In November the CEO wrote:

Having completed the integration of Cavendish, we are now moving into a key phase of our strategy – carefully seeking bolt on acquisitions in adjacent sectors which align with our culture and further our vision of building a more broadly-based group, focused on servicing growing companies’ needs.

Subsequently, they engaged a third-party broker suggesting an acquisition could be imminent. FinnCap’s experience of giving advice on M&A should put them in an ideal position to take maximum advantage of any acquisition opportunities.

Also in November, they announced that “finnCap Analytics” was being set up, a team targeting larger institutions and hedge funds. They hope that this diversification into large cap equities will ultimately support their smallcap business as well. Existing teams are also being grown, with areas that have been performing well highlighted in Wednesday’s trading update.

More immediately, their fundraising pipeline looks particularly strong, as evidenced by a number of statements from their clients implying more capital may be needed. Market-making will also remain especially profitable while volumes are elevated.

Listed Competitors

Within the smallcap space their primary listed competitors are Arden, Cenkos, Numis and WH Ireland. Arden has in my view failed to reach scale and is perhaps more of a takeover target than a serious competitor. Cenkos has a similar market capitalisation to FinnCap but has been gradually losing customers for a while and some see them as tainted after having brought many Woodford-backed companies to the market. Numis is a much larger broker that mostly deals with larger clients. WH Ireland earns a third of its revenues from wealth management and appears to be spread too thin to consistently make profits.

However, it must be admitted that Arden, Cenkos and Numis all look cheap on a price/book, price/earnings and/or EV/EBITDA basis. Again, their closest direct competitor is probably Cenkos. Despite both companies reporting several new deals in the past few weeks, Cenkos has taken off whereas FinnCap has been left behind, especially before Wednesday’s trading update. The most likely explanation for that seems to be Cenkos’s more active following on advfn and elsewhere.

Risks

Since most of FinnCap’s profits come from helping clients to execute transactions of various kinds, their performance is dependent on the overall level of transactions in the market. While it would be naive to think the current market conditions will continue forever, IPOs and takeovers show no sign of abating in the short and medium term.

FinnCap operates in a competitive market and there is a particular risk that larger competitors decide to muscle in on their action. The reputation of the AIM market has significantly improved in recent years and perhaps this is why medium-sized brokers have been more willing to get involved with market placings there. However, at the moment there appears to be more than enough to go round and FinnCap have been effective at leveraging their existing relationships as NOMAD or research provider to win more lucrative capital markets business.

The good news is that the public nature of these transactions means the dedicated investor who tracks these will get an early warning when the cycle starts to turn.

Conclusion

I’ve summarised estimates for FY 2021 here:

The company’s adjusted EPS excludes both and share-based payments and ignores dilution and so I’ve included it for completeness only. Their adjusted EBITDA also excludes share-based payments whereas in this case I prefer to include them.

My estimates on the 1st March were prior to reading the Progressive note which I see implies a considerably increased depreciation charge, likely due to office fit-out costs. When factored into my model this higher non-cash cost balances out the higher revenue leaving EPS unchanged.

I have also reworked my cash calculation – given that the loan to fit out the new office is long term I think counting the cash net of that loan as free cash builds in sufficient prudence. Progressive previously forecast net cash of £9.8m so with EBITDA now running £2.8m ahead of that, I now see £12.6m free cash.

This level of profitability and cashflow should very comfortably support a final dividend of 1.2p that would be consistent with their targeted 30/70 interim / final split and a total of 1.7p for the year.

Using my more conservative adjustments, a share price of 28p gives a P/E of 7.2, a dividend yield of 6% and an EV / EBITDA of 3.9x. In my view, this continues to look too low for a company with such strong momentum and prospects. There also remains potential upside to my forecasts.

Footnote

This article was first published (slightly modified) in Small Caps Life. Had FinnCap not got in first with their trading update, subscribing would have allowed you to buy at 25p / share and then sell at 30p immediately after their strong trading became public. We’ll try to be quicker next time!