In my previous article I hopefully helped explain some of the reasons why CMC Markets got down to a sub £370m (130p) valuation. Since then it has issued a major profits warning following a weak August, with the share price currently around 105p (£300m market cap). In this second part I try to explain why this is far too low.
Lord Cruddas
Firstly, lets look again at Peter Cruddas. Yes, he’s a maverick. Yes, he’s old fashioned and stubborn, and yes, to address the title of my earlier article, many would say he is not a “good man” and should stay “down”. But look what he’s achieved:
His father worked at Smithfield Market and Peter went to Shoreditch Comprehensive where he left without qualifications. From this modest background he got a entry-level job in the city, taught himself trading and in 1989 founded CMC with just £10,000. At the peak he was worth close to £1bn.
His path hasn’t been smooth one, for example in December 2016 fraud-enablers BaFin announced that German retail investors could no longer lose more money than their deposit, a measure then taken up by the ESMA in 2018 and the FCA in 2019. Cruddas’ stubbornness proved an asset, his political connections were apparently not required, he picked himself up again and CMC’s profitability recovered even before the onset of COVID.
In contrast, Stuart Wheeler, founder of main rival IG Group, was educated at Eton. Older, richer and better connected, he had a head start on Cruddas and perhaps inspired the latter. Wheeler donated £5m to the Conservative party in 2001, became UKIP treasurer in 2011 (the same year Cruddas become treasurer the Conservative Party) and then two of them, together with John Mills, were the major donors and co-treasurers for the Vote Leave campaign.
In a world where the richest person presents himself as a psycho (legal note: psycho is a friendly term where I was bought up, not at all implying in any way psychopathy), Lord Cruddas seems to me to be relative sane, well balanced and trustworthy. He also continually says things he shouldn’t, making it difficult to believe he could successfully hide anything untoward. Perhaps his only crimes are following in the footsteps of Wheeler too closely, and for being an ill-educated barrow boy who doesn’t understand the limits of what he can get away with.
Hipster Millennials
So, what of staff morale? Clearly the short notice and poor communication around the new working arrangements is not best practice, but reviews on Glassdoor acknowledge that working from home two days a week was an “unofficial” policy rather than a contractual entitlement. Changes requiring staff to be more present in offices have been widespread in recent months, and the balance of power between employer and employee has shifted massively, especially in the tech space.
The type of employee allegedly complaining can be relatively easily deduced from the detail of the reviews. For many “free cereal” is the predominant perk, identifying them as the hipster types who would otherwise be “forced” to pay £4.50 for it in a café. Many come across as entitled twats, with my favourite example being one that reports an “unhealthy power dynamic” because their manager tells them what to do. Another complained about equality / diversity policy by lamenting that the “CEO is 70 years old and still allowed to make executive decisions” and is “a privileged white capitalist”. More than a couple are under the cute impression that HR are there to help them rather than help the employer do whatever they want. Others appear to be fully replaceable with AI (“Advice to management: foster a culture of trust by empowering employees to make decisions and take ownership of their work”). Many complain about being underpaid, including relatively new starters.
If anything, the bad news is that despite the complaints, all are shown as current employees. As I identified in part one, CMC Markets is overstaffed with people working on failing and non-productive projects, at least at the margins. The good news then is that claims many candidates declined offers after the WFH policy change seem fairly credible, and better still at least 30 redundancies were reportedly announced in early August. Let’s hope those bastards at HR help Cruddas root out some of the slackers in the process!
What does CMC Markets actually do?
The first thing to understand here is that, on a revenue basis, they have abjectly failed in their aim to diversify into “investment” as opposed to “leveraged trading”, with the mix broadly unchanged over three years. All they have really achieved is moving ANZ B2B investment accounts to B2C without losing too many along the way. This means CMC remains overwhelmingly exposed to speculative trading volumes in their markets which have progressively ground lower post-COVID.
Where they have made good progress is in growing their B2B leveraged trading side – B2B net trading revenue share has increased from 11% in their full year 2020 to 22% in FY2023. Further launches to come mean that momentum may have further to run, even in current market conditions.
The other thing CMC does is collect interest on cash – cash posted as margin by clients, regulatory cash, and free cash. Income increased from £0.8m in FY2022 to £13.9m in FY2023. For scale, PBT fell from £92m to £52m in the same period. In their Q1 update they confirmed this trend continues as might be expected.
What is likely to happen next?
Trading volumes are at multi-year lows and so are likely to rise in the longer term. The extent to which is somewhat dependent on interest rates – lower rates tending to encourage activity. B2B trading revenue may continue to see underlying growth independent of market activity.
In the short term, it is volatility that drives trading activity, especially on the B2C side. Again, volatility (for example, as measured by the VIX) is currently on the low side versus recent history, and is sure to spike unpredictably in future. A shareholding in CMC may therefore act as a hedge for sudden market events that would cause the value of other investments to fall.
CMC’s objective of increasing more stable (and thus more highly valued) investing revenue may yet be achieved in the longer term.
Costs
There appears to be considerable scope to cut costs. As I showed in the part one, unavoidable regulatory / legal costs finally seem to have stabilised, but staff costs have been growing exponentially. However many projects are now claimed to be approaching completion, and failing that surely abandonment. Whether or not these investments ever yield an economic return, as the projects move to a maintenance phase (or are dropped) costs should normalise, provided new projects are not started. For example, the web UI at IG hasn’t been noticeably changed for at least 5 years, and many prefer to use the older version that dates back closer to 15 years and which would surely be dropped if it required significant maintenance. Mobile phone apps require more work to keep up to date, but even the situation there is far more stable than it was 5 years ago.
In 2023 alone CMC claimed that an increase in costs of £36m was “mainly because of the significant investments in people and technology to deliver our diversification and growth strategy”. If this had not taken place (or all had been capitalised) then profits would have been around 50% higher, without any near term downside.
Quite apart from that, as I covered above, there is already concrete evidence that the company has realised that costs are out of control and need to be reigned in. Salaries in tech jobs are now stable or even falling which should also relieve the upwards pressure.
Capital structure
CMC Markets is ridiculously over capitalised. The disadvantage of this is that it has encouraged unproductive investments and overpriced buybacks. But it also means there can be no worries that CMC would have any issues funding working capital outflows in the event of a sudden increase in activity. It also supports the high (6.5%+) dividend yield pretty much as long as the company chooses, and pretty much regardless of actual cash flow, albeit their policy for ordinary dividends is to pay half of profit before tax. It also means there is virtually no chance, absent serious fraud, of the company failing. Indeed, the company is now trading at a significant discount to tangible assets, and these are overwhelmingly highly liquid. There is no debt, no inventories to worry about and even lease liabilities are minimal.
Excess liquidity is massive for a £300m company, as this table from the last annual report shows:
On a regulatory basis they claim to have an capital adequacy ratio of 369% on a requirement of £88.6m. This compares with 206% for IG Group. Assuming 200% is ample then CMC could immediately return £150m to shareholders compared to the £350m market capitalisation. If you take the view that trading volumes will not recover in the near term and B2C investing AuM has now stalled then £200m could be returned without impacting activity.
The risk comes back to Baron Cruddas then: will he make good use of this capital (well priced buybacks, productive investment, special dividend)? Or will he let it sit idle, or worse, fritter it away?
The good news is that with real interest rates about to become positive for the first time time in nearly 15 years, money sitting “idle” is not the problem it once was. And to the extent you argue shareholders get the spare cash for “free” because it isn’t fairly valued by the market, shareholders get the full benefit of higher nominal interest rates. Another positive development is that the cash has been accumulating overall, even after dividends, and even considering that half of the recent buyback was effectively thrown away. And finally, 62% of this cash belongs to Peter Cruddas and his wife: However stubborn he is, he won’t want to gratuitously waste it, and could easily need it one day e.g. to buy a football team or a newspaper.
Valuation
The fundamental valuation is a factor of 1) excess capital (and how likely it is to be deployed productively – cash in my hand being the most productive) and 2) likely future earnings (and how risky they are).
Many of the aspects of this are an each-way bet:
- Interest rates stay high ⇒ interest income higher, but trading activity lower
- Success in unleveraged / building investment assets under management ⇒ higher regulatory capital, so less excess capital, but higher and better quality earnings
- Trading activity reduces further ⇒ lower earnings, but lower amounts due from brokers and so more excess capital
- Failure of various projects ⇒ earnings fail to rise, but lower ongoing costs
- Higher stock market volatility ⇒ higher earnings, but a lower market valuation of those earnings
For simplicity and conservatism I will take the previous consensus broker forecasts for FY 2024, assume that the weakness reported today reverses in 2025, but that the projects required to deliver previously forecast FY 2025 growth fail to materialise, costs are not cut (but nor do they grow), and that from then on there will be a sufficient gentle improvement to cover any cost increases. Also that interest rates remain at current levels, consistent with longer term averages. In order words, underlying EPS is 14.6p from the year to March 2025 ever onwards.
On the cash side, on a risk weighted present value basis I assume that £120m of the £150m (closer to £200m under the above scenario) of excess capital is returned, or alternatively, that’s the value of the incremental earnings it achieves (i.e. all earlier investment is wasted). Modelling as a special dividend the market capitalisation falls by £120m, or 43p a share.
Interest received would be hit, perhaps by £20m pa (5.4p), leaving earnings of 9.2p on a share price of 62p (105p – 43p), a PE of 6.7x. The short term dividend yield would be 7.4%, but would rise to the earnings yield of 15% over time, assuming no further capital misallocation.
In terms of upside, a £30m reduction in costs (broadly reversing FY2023’s increased investment, but retaining the deliberate increases made in previous years) would give an extra 8p of EPS for a PE of 3.6x (earnings yield 28%). Alternatively (although potentially concurrently), even a short term spike in trading activity would increase EPS significantly and likely improve the rating of the share, resulting in a fast multi-bagger for investors. Finally, the upside should it turn out that investments in CMC’s offering were successful after all is virtually unlimited.
The downside is protected by tangible asset coverage which would actually improve after any cash return and is likely grow modestly over time from retained earnings. The profits warning that I previously feared for October has now been published. Regulation impacts seem unlikely following earlier changes. Although the CFO has resigned they’re staying until January, so clearly doesn’t think any nasties will be discovered before then. The worst case is probably irrational falls in the share price, followed by Cruddas getting upset, taking the company private and offering minority shareholders a pitiful premium.
Timing / Trading Strategy
All of the above arguments have substantially held true for the last five weeks at least, yet the share price kept grinding lower. However, the share price seems to have bounced off the lows following today’s profits warning and is now well supported by tangible book value of around 120p. It seems reasonable to assume that I have not been the only one watching this closely for an entry point, potentially resulting in quite a sharp turn for a stock that appears quite technically oversold.
The other factor to consider is the FTSE 250 index reshuffle. The institutional index rebalance desks will have been increasingly selling as it became ever more certain that they will be ejected in a couple of weeks. This will have been adding to, or even largely responsible for the recent selling pressure in thin markets, likely through programme trades executed on the order book.
CMC Markets promote themselves to customers (and prospective staff) as a FTSE 250 company and this may also form part of Cruddas’ self-image. In an earlier draft of this article (which has been substantially complete for two weeks now), I suggested that some attempt may be made to keep them in the FTSE 250: another “leak” to Sky News along the lines of the Managed Separation story in November 2021, mooting of a secondary US listing, a Funding Secured-style announcement, or a planted share tip. In retrospect it now looks to me a bit like the July update understated the risks in the hope the share price would hold up enough to avoid relegation. But I now believe there is no reason to sugar-coat the outlook.
In summary, I believe the worst of the selling pressure is over, all the bad news is in the market and that the share price may have bottomed. As a buyer it was frustrating not to have seen a bigger reaction to what was clearly a severe profits warning, but this in itself is often a bullish sign.
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