Amidst the pessimism of Brexit, it is possible to find high quality companies trading at attractive prices in the U.K. One of these companies is Equiniti Group (LSE:EQN), a £800m market cap. and £1,143m EV, provider of technology solutions for complex and regulated administration activities in the U.K and now in the U.S due to their acquisition of Wells Fargo's Share Services ("WFSS"). The company is trading at an undemanding valuation given it operates in an oligopoly and has been gaining market share, has extremely high client fidelity, 90% revenue visibility and high cash flow conversion. In addition, there is embedded optionality if the company is able to roll-out and cross-sell new products to their share registry business in the U.S.
The investment thesis is based on the following points:
1. Undemanding valuation for the quality of company and stable earnings growth.
The company is on track to earn £121m of EBITDA this year placing the company on 9.4x underlying EV/EBITDA and an normalized P/NPATA (normalizing earnings for the statutory tax rate for comparison purposes as the company prefers to use a cash tax rate) of 13x which is arguably too low for a company with high earnings visibility, high cash flow conversion and on conservative estimates, will be able to comfortably grow EBITDA at 4% p.a., driven by top-line growth and slight margin expansion, with additional upside optionality in their WFSS business.
The nearest trading comparables are Computershare and Link Administrative Services ("Link") which are both listed on the Australian Stock Exchange. While not completely comparable due to a different business portfolio mix to Equiniti (i.e. neither of them provide Pension Solutions), they remain a useful point of reference. Computershare is the dominant share registry provider globally and trades on an FY19 EV/EBITDA of 12.5x and a P/E of 19.9x on the back of strong earnings growth in the growing mortgage services business. Their registry business has declined at a CAGR of 2.6% between 2014-2018 and in the U.S. and U.K, they have lost market share to Equiniti, though the business remains high margin and extremely cash generative. We believe a large part of Computershare's valuation is underpinned by the registry business as the mortgage servicing business is a significantly more competitive business to be in, with lower margins and larger number of competitors.
Link is the second largest provider of registry services in Australia behind Computershare and is the largest provider of share registry services in the U.K (by the number of issuers). In addition, they provide fund administration services, asset services and data analytics. The company trades on an FY19 EV/EBITDA multiple of 11.8x and a P/E ratio of 17x.
2. Gaining market share in their Investment Solutions business. The Intelligent Solutions will continue to benefit from increased regulation and digitization.
c. 27% of revenue in 2018
The Investment Solutions division offers a broad range of services, including share registration, administration of Save As You Earn ("SAYE") schemes, Share Incentive Plans ("SIP") and executive compensation programs for c.1.2m employees. The division also provides share dealing , wealth management and international payments to corporate clients and their employees as well as direct to customer.
The key pillar of this division is in its share registration business which provides listed companies with core services including maintaining the company register, corporate actions, AGMs, and voting. The industry is dominated by three main players, with the largest player by number of issuers being Link, following by Computershare and Equiniti (by the number of registered shareholders managed, Equiniti is likely the largest). Equiniti is the largest registrar for the FTSE 100 and 250 accompanies with c.55% market share and c.40% respectively and has been gaining market share. While the division is low growth, the revenue here is very sticky, with the average client being with Equiniti for over 20+ years. This division is also extremely cash flow generative and with minimal working capital requirements. We forecast a long-term top-line organic growth rate of 2-3%, driven by 1% growth in the registry and corporate action business and a faster growing rate their share plan and other business in addition to slight margin expansion. Within this division, the company generates revenue from:
Each listed company is required hold a certified share register which is a list of active owners in a company's shares. This list is required to be updated on an on-going basis. While a company can provide this service themselves, due to the complexity of this task, it is more economical to out-source this work to a third party. Companies contract share registrars on contracts which normally last between 2-3 years. There is a high probably the client remains with its existing provider given the risks involved in changing platforms, as reflected in Equiniti's high client fidelity. The majority of contracts are done on a price per shareholder basis, which in the U.K is £1/shareholder. The company also charges for additional services it provides. Contract pricing in the U.K. has been relatively stable and none of the three providers have had real incentive to reduce pricing given it is already relatively low compared to the U.S (US$6/shareholder) and Australia (A$5/shareholder). Earnings growth here has been driven by volume through market share gains and growth in the number managed registered shareholders, a shareholder who holds shares directly with a company and in the share registry (see the risk section for a further overview of registered shareholders). Equiniti has out-executed its competitors and they have consistently gained market share at the expense of both Computershare and Link. In addition, they are generally chosen as the registry provider for new IPO's in the U.K.
Another revenue source from their share registry business comes from "investor-paid" fees. Shareholders transacting directly with the share registrar are required to pay transaction fees, similar to when transacting shares with a broker. For example, when an employee receives shares in a company, they will likely receive it directly with the company/ share registrar and when this employee wants to see out of these shares they will need to pay the registrar a transaction fee. The company has been able to raise the pricing here slightly.
When a company undertakes certain corporate actions, such as capital raisings, acquisitions or demergers, the share registry of a company changes and registrars charge companies a fee to manage this work. This fee income has high incremental margins, reflecting the high fixed cost base of the registry business but is extremely lumpy and dependant on the level of corporate activity. The amount a registrar charges depends on the type of the action and the level of complexity involved. Equiniti's corporate actions revenue has grown over time as they have gained market share in the share registry business.
Share plans and others
Leveraging their relationship in the share registration business, the company cross-sell its additional products such as administrating SAYE and SIP schemes as well as other services in their intelligent solutions division (the average revenue per FTSE 100 client was c.5x of share registration revenue reflecting the purchase of additional services). SAYE and SIP schemes involves administrating employee remuneration programs on behalf of employers such as administering with-drawls and the exercise of options. The share plan business is growing at a faster clip at than the registry business as there has been a rising level of employee participation in the U.K though, but this space is more competitive with 6 key players as opposed to 3 in the share registry business. As a share registration provider, Equiniti does have the advantage of being able to bundle and sell both registry and SAYE/SIP schemes to its clients and a substantial number of their registry clients also purchase share plan services which makes sense as both involve managing a listed of registered shareholders. Other revenue includes their execution-only brokerage services, Selftrade, and providing international payments solutions for its clients but of which we expect low single digit organic growth.
c.30% of revenue in 2018
The Intelligent Solutions division provides specialized software and service solutions targeting complex or regulated processes. The division has 3 core service lines; complaints, case management and regulatory services, credit servicing and data analytics. To support operations in this business, the company also runs an offshore call centre in India. Clients from this division are generally large blue-chip clients which have a pre-existing relationship with Equiniti through their share registry business. Being predominately project-based work (c.70%), the division has experienced lumpy growth, having grown organically 4.3% between 2014-2017 but achieved an organic growth rate of 42% in 1H18. Total growth rate over the period of 2014-2017 has been higher at 11.6% as the company has undertaken a number of bolt-on acquisitions to grow the service offering of this division. The division will benefit from two broad based themes: increasing regulation and mutualization. Increasing regulation is a common theme globally and legislation such as such as MiFD2 and GDPR have forced companies to seek help from companies like Equiniti to help comply with these regulations. For example, Equiniti partnered with Microsoft and HPE to provide a document management solution to help clients manage and store documents in a GDPR compliant manner. Mutualization is also a growing theme as companies choose to outsource their non-differentiated workload to help cut-costs. As a result, Equiniti's contracted revenue base (currently c.30%) has grown on the back of this as companies increasing outsource their work to Equiniti (i.e. BPO or providing a software platform).
As the division is project-based, it is difficult to forecast the top-line growth rate on a year-to-year basis. However, given the trends above, there is ample room for management to grow this business. We believe the business can organically grow, on average, between 4-5% a year though this may prove to be conservative as management have guided for a "high single digit to low double digit growth rate" for this segment, however this likely includes some bolt-on acquisitions. Margins have grown nicely for this division, from 18.2% in 2014 to 26.5% in 2017, due to company securing higher margin project work and a software sales growing as part of the revenue mix. We forecast margins to remain flat to slight up which should be conservative given software delivery and management has grown as the percentage of the revenue mix.
3. Wells Fargo opportunity is underappreciated by the market.
c.16.5% of revenue in 2018
The acquisition of WFSS was closed on the 1st of February with a total cost of US$281m (acquisition price: US$227, transaction costs: US$26m, CAPEX: US$28m) equating to an EV/EBITDA of 10.5x which falls to 7x in FY20 post cost synergies. To fund the transaction, Equiniti raised £117.8m of net proceeds at a price of £1.90p per share and drew down additional debt facilities. The acquisition was negotiated off-market and resulted from an initial conversation between Equiniti and WFSS discussing a technology sharing partnership. Wells Fargo Bank and Equiniti will retain a strategic alliance post-transaction with Equiniti utilizing Wells Fargo for all major services (i.e. depository services) and Wells Fargo will continue to provide banking relationships.
WFSS is the U.S.'s second largest share registry with 22% of the market by the number of shareholders served (by number of issuers served WFSS is ranked third with a market share of 10%) and generated US$104m in 2016 (includes share registry services and interest income). The company boosts clients ranging from Berkshire Hathaway to J.P Morgan and has the highest net promotor score across the industry. The U.S. registry market, while significantly more competitive than the U.K market, is 7 times larger than the U.K market by the number of corporate issuers. The company is generally one of the higher priced registrars and they instead choose to compete on service. This has historically worked well for them as they have been able to win market share at the expense of Computershare and American Registrar & Transfer ("AST"), winning over clients such as Mastercard and P&G, and has achieve a revenue growth rate of 6% p.a. between 2014-2016. The company has ample room to gain market share as it is now able to target clients which they previously weren't able to being part of Wells Fargo Bank. Equiniti will now also be able to serve companies with a dual listing on both the U.K and U.S. exchange. In addition, there is US$10m (£8man) of anticipated cost synergies by the third full year of ownership (2020) driven by the migration of WFSS's legacy system which is currently run by an SunGard and dates back to the 1980's to Equiniti's Sirius platform and the automation of some back-office functions. The target cost synergies look conservative given the costs that both Computershare and Link are able to take out of their acquired businesses.
As of 1H18, the integration of the U.S. business remains sounds and within budget. However, revenue for the first 5 months of ownership declined 6% driven by lower corporate actions (3% of the decline), pricing pressure (1.5%) and client loss (1.5%) - percentage declines are higher on an ex-interest income basis. On the other hand, margins grew substantially due to strong cost management and EBITDA rose 5.6%. Looking forward, the WFSS's business (ex-interest income) should be able to grow comfortably at 2% organically a year throughout the cycle driven by market share gains and offset by some slight pricing pressure from their smaller clients. The WFSS business also generates interest income from its client balances and in 2016 generated c.US$7.6m (£6m) of interest income from US$900m (£692m) of client balances and will benefit from interest rate normalization in the U.S. We estimate, on a conservative basis, that every 25bps increase in Fed funds rate will add c.US$1.1m (£0.9m) in interest income assuming that only 50% of the client balance is exposed to the rising rates. There is significant latent earnings power if U.S. rates continue to rise on its forecasted trajectory. EBITDA margins should comfortably reach c.27% in that time driven by cost synergies, rising interest income and general operating leverage. After the Sirius platform has been integrated into WFSS by the end of 2020, the company will be able to generate cross-sell additional services to its clients (i.e. share plans services). We estimate the opportunity here as c.£15m of additional revenue at high incremental margins. In addition, the company will eventually look to cross sell its technology in their Intelligent Services division to clients in the U.S. We have not factored in any of these additional product sales in our valuation.
As a non-core asset in a large group, the WFSS business was under-invested in as demonstrated by their use of a third party provider to operate their registry platform. With additional investment and management focus, we believe that the business will continue to gain market share and in the medium-term, begin cross-selling additional products to its existing client base. There is significant embedded optionality in this business which is not priced in at current valuations.
4. The market have over-reacted to the company's growing accrued income balance and use of invoice factoring.
Accrued income has grown from £7m in 2015 to £33m in 2017 and to £46m in 1H18 which has raised investor concerns about overly aggressive accounting policies. However management have largely address this in their 1H18 presentation and highlighted two points (1) no income is accrued without a contract in place and (2) bad debt has been minimal (FY17:£0.3m) given the blue chip nature of clients. In addition, the increase in remediation work (which is billed in arrears), software sales (where revenue is recognized upon implementation milestones and billed at the end), and the growth in corporate action income has contributed to the accrued income balance. As a consequence of an increasing accrued income balance, the company has utilized a £20m invoice factoring facility, of which, £15.7m was utilized in FY17. The use of the invoice factoring facility artificially inflates the operating cash flow number and was not taken favourably by the market. Due to long payment terms for some project types, management had used this facility to manage working capital. As of 1H18, the invoice facility has declined by £5.9m and management have flagged the balance is on a downward term. Given the strong market reaction to the use of the facility, we view that management will likely wind down the facility as the company's strong cash generation largely negates the need for such a facility.
BUSINESS DIVISION OVERVIEW
Investment Solutions / Intelligent Solutions / WFSS
c.24% of revenue in 2018
The Pension Solution division offers administration and payment services to pension schemes, as well as pension software (typically for in-house administration), data solutions, and life and pension administration for c.9m pension scheme members. Clients include both corporate and government clients and their pension scheme members. The pensions administration space is a growing industry (c.5% p.a.) and has significant macro tailwinds supporting it (i.e aging population, out-sourcing, increasing regulation). However, the space is a lot more competitive than both the Investment and Intelligent Solution space. Equiniti is 1 of 5 companies competing in a fragmented market, with no competitor holding a significant market share. Equiniti has avoided competing on price and as a result, seen both contract losses in this business and a reduction in scope of work with 2014-2017 revenue down 1.1% CAGR and 1H18 revenue down 7.5%. There are some positive signs the business will return to growth given their recent contract wins (i.e. UK Atomic Energy and Surrey & Sussex Police). Management have flagged that the division should trough out in 2018 before returning to growth in 2019.
The pensions division also includes their 51% ownership of MyCSP, a JV with the government (25%) which runs a contract to administer pensions for the Civil Service Pension Scheme. The remaining 24% is owned by employees. The business generated revenue of £40m and profit of £6m in FY17 and the contract was recently renewed and management expects the contract will run until at least December 2021 (the initial contract only ran until early 2019) removing significant market overhang. We do not expect the company to lose this contract given the government ownership and the complexity of transferring 1.5m scheme members onto a different platform.
We conservatively model pension revenues to decline 10% in 2018 and to remain flat in 2019 before returning to 1% p.a. organic growth. However, we acknowledge that revenue can grow at a faster rate given recent contract wins. We assume flat EBITDA margins at 17.0%.
c.2% of revenue in 2018. Includes interest from U.K business only.
As a share registrar, the company generates interest-related revenues through the administration of client balances, including corporate actions management and dividend payments. As at 30 June 2018, they held £1.7b of client balance having grown from £1.3b in 2015. Interest income in the U.K will continue to grow as Equiniti continues to gain market share in its registry business and if rates continue to rise in the U.K.
- Capital expenditure between 7-8% of revenue
- Slight negative working capital reflecting growth in the Intelligent Solutions business
- Cash tax rate of 13% in 2018 and 2019 and rising to 17% in 2020 onwards (as guided by management)
Using a DCF approach with a WACC of 10%, a 2022 EV/EBITDA exit multiple of 11.5x and an EBITDA growth of c.4% CAGR, we value this company at £2.60/share, implying a P/Normalized NPATA of 15.4x . While a 18% discount to intrinsic value is not a significant discount to intrinsic value, for a company with a highly defensive earnings base, steady organic growth and ample bolt-on acquisition opportunities, it is an acceptable margin of safety. An exit multiple of 11.5x was used as we estimated the Investment Solution (including interest income) and WFSS business worth 12x EBITDA, Intelligent Services business worth 11x EBITDA and the Pensions Solution worth 8x EBITDA.
After the near term WFSS integration costs, the company will generate an underlying FCF yield of c.9% in FY19, providing them with ample opportunity to pay down debt or increase the dividend (payout ratio is currently 30%). The company is quite acquisitive and have undertaken a number of bolt-on acquisitions since IPO. In their prospectus, management have stated that they expect c.2% of top-line growth to come from acquisitions and we expect management to undertake further accretive M&A upon reaching their target net debt leverage of 2 - 2.5x EBITDA (1H18: 2.8x). We have not factored any additional acquisitions into the valuation but looking at historical bolt-on acquisitions, this can easily add 2-3% to growth.
Recent transactions in the industry:
May 2018: Computershare acquires the employee share plan administrator, Equatex, for EUR 355m (US$420m). Equatex generated revenues of US$79m and underlying EBITDA of US$22m. Acquisition multiple of 19x EV/EBITDA, reducing to c8x EV/EBITDA after expected cost synergies.
July 2017: Xafinity Plc acquires Punter Southall Group, a UK-based company providing actuarial advice, pension consultancy and pension scheme administration, for £143m. Punter Southall reported revenues of £51m and EBITDA of £11 in 2016. Acquisition multiple of 13x EV/EBITDA.
June 2017: Link acquires UK-based Capita Asset Services from Capita for an enterprise value of £888m. Capital Asset Services generated revenue of £316m and an EBITDA of £72m. Acquisition multiple of 12.4x EV/EBITDA, reducing to c.10x after expected cost synergies. Capita Asset Services's shareholder solutions (share registry and share plans) business generated revenue of £89.
May 2016: Permira Advisor's acquisition of Tricor Services for HKD 6.5b (US$834m). Tricor provides a broad range of services across Asia, including accounting and financial reporting, share registry management, administration services and business advisory. Acquisition multiple of 15x EV/EBITDA (MergerMarket est.)
Aside from the usual business competitive risks mentioned above, there are two major risks involved in the U.S.:
1. Implementation risk in the migration of WFSS to the Sirius platform
To properly integrate the WFSS business into Equiniti's Sirius platform requires migrating all the data onto their new system of record. This is a difficult, time consuming task which involves some risk (a similar risk in which companies face when they change registry service providers). Management announced they were pushing back their platform transition date in their 1H18 call to 2019/20 as opposed to having it completed in 2019. This was in response to clients indicating they wanted access to new product that WFSS was previously unable to provide. As a consequence, management have refocused their priorities on creating these products before migrating their platform. While this might impact the roll-out of certain products such as share plan administration as management will unlikely build these complex technologies on a legacy platform, simpler services such as KYC complaints, proxy services and asset reunification services can be built and integrated on the legacy platform before being transferred onto the Sirius platform. While the delicate procedure of data migration has been pushed out until 2019/20, poor implementation of this transition could disrupt service and impact client retention.
2. Shareholder attrition in the U.S. and low cost disruption from Broadway in the U.S. market
The U.S. market is significantly more competitive than the U.K and client churn is higher, providing both an opportunity and a risk. The market is also more fragmented with a larger number of players. The key players in the market are Computershare, AST, Equiniti-WFSS, Continental Stock Transfer & Trust ("CST") and Broadridge Financial Group ("Broadridge").
Low cost competition
Broadridge has appeared as a low cost competitor in the U.S. market and has competed aggressively in the small and mid-tier share registry market and has even won over some larger clients, including Walt Disney and Spectra Energy. Broadridge's key competitive advantage is its ability to service both the registered shareholder base and the Street Name of any U.S. listed company via its monopoly control of the Street Name shareholder base. Broadridge is able to offer a single-source solution for Issuers that need transfer agency, proxy distribution, AGM and related services and already services the large majority of all publicly traded company.
Street Name / Nominee Accounts
A majority of publically-traded shares are not registered in the companies' record in the name of their ultimate beneficial owners. Instead, a substantial majority of all public companies' shares are held in "Street Name", meaning they are held by broker-dealers or banks through their depositories. Most street name shares are registered in the name "Cede & Co" which holds shares on behalf of its participants broker-dealers and banks (the "Nominees") which in turn hold shares for their clients, the individual beneficial owners. Nominees are legally required to delivery proxy materials to beneficial owners and request voting instructions. The SEC requires public companies to reimburse Nominees for this expense. As a complex, but non-core function, nominees outsource this administrative process to a third party and Broadridge has emerged as the predominate supplier of this service.
The number of registered shareholders are declining with an increasing number of shareholders trading with brokers as opposed to directly with the company. Broadridge has estimated that currently 2% of the U.S. shareholders are held in Street Name and that over the next 2 decades, the percentage of registered shareholders will fall to below 1%. All else being equal, this implies a mid-single digit decline in registered shareholders per year. This is not a new phenomenon and has been an issue over the past decade and between 2014-2018, Computershare's U.S. registry business declined 1.6% CAGR. Total U.S. share registry, corporation action and employee plans revenue declined 0.2% CAGR in the same period. This is at odds with WFSS's long term record in which they were able to grow total revenue 6% CAGR between 2014 to 2016 and prior to that management have stated the business was able to achieve "single-digit [revenue] growth".
Shareholder attrition is significantly more pronounced for registry agents which predominately serve smaller companies in the market and they face an increasingly difficult position as larger companies choose Computershare and WFSS as a service provider and smaller companies which require less functionality and service choose Broadridge. This is in addition to the organic decline in their registered shareholder base which is more prevalent in small companies. Registrars which manage the registry for large corporates are relatively better positioned as registered shareholders are created during spin-offs, M&A transactions involving a scrip action and stock grants to employees in remuneration plans. New IPO's are also a source of registered shareholders and it has been an increasing trend that smaller companies choose Broadridge whilst larger companies choose either Computershare or WFSS. As such, larger registry providers are more resilient to the general industry decline compared to smaller players.
In addition, consolidation has been a theme in the share registry market and Computershare themselves became the biggest player in the U.S. by acquiring BNY Mellon's share registry business in 2011. This theme will continue as Pacific Equity Partners look for an exit from their 2008 buyout of AST and as CST's will likely look for a merger as their registered share base declines. In the next 20 years, the large players will benefit from consolidation and we will likely see only 3 dominant registrars - Computershare, Equiniti-WFSS and Broadridge.
Equiniti is relatively better positioned than most other U.K companies for Brexit given their nature of work. However, if Brexit were to cause a recession in the U.K, this would impact the level of corporate activities (less M&A though offset by capital raisings), fewer employee share plans, and business's delaying some project work in their Intelligent Solutions business. Less project work will be offset by increased mutualization as companies seek to cut-costs.