Description

Summary

UK-based IG Group (Bloomberg ticker: IGG LN) is a high quality, well-managed business that trades at a very reasonable multiple relative to its growth potential.  The company is debt-free, has approximately 15p per share of excess cash on its balance sheet and generates substantial free cash flow.  At 208p, IG trades at roughly 15x my FY07 (May 2007) earnings estimate, and 11x FY08.  While IG is not in deep value territory, I believe investors are paying only a modest multiple for outstanding earnings growth (30-35% for the next few years), and cheap options on attractive new markets and smart capital deployment.  As management capitalizes on these opportunities, investors should appreciate the earnings potential and revalue IG accordingly.  I believe that one year from now IG could trade for 320p, which represents a 17x multiple on FY08 earnings (ex-interest income) of 17.5p plus approximately 23p of excess cash per share, or more than 50% above the current stock price.

 

IG’s core business is providing spread betting, mainly on financial markets but also on sporting events, to retail investors and professionals.  In addition, the company offers contracts for difference (CFDs), binary bets and foreign exchange trading.  These instruments are essentially simplified derivative products for which IG makes a market.  While spread betting and CFDs largely originated in the UK, they are expanding worldwide at a rapid pace.  So is IG.  Yet the company remains largely unappreciated, despite being the largest player in the UK with 26% compound revenue growth over the last four years, as IG is not easily defined.  It’s not a broker, though it has many broker-like characteristics; nor is it a gambling company (incidentally, it accepts no US customers, unlike most UK-based gambling firms).  Instead, IG is a rather unique business that I believe is attractive for several reasons:

 

1.        IG operates a scalable, very profitable business model that earns high returns on capital and generates substantial free cash flow.

 

2.        The company has sizable growth opportunities around the world that it has only just begun to exploit; meanwhile, growth in its core market, the UK, continues to exceed expectations.

 

3.        Barriers to entry are considerable, as IG possesses industry leading liquidity, scale and product breadth, in addition to IT and human capital advantages.

 

4.        IG has an experienced management team that, through meaningful stock ownership and performance incentives, is strongly motivated to grow earnings rapidly.

 

5.        Management has several alternatives for value creation, including continued organic growth and prudent capital deployment in the form of stock buybacks and opportunistic acquisitions.

 

Overview

IG was formed in 1974 by British investor Stuart Wheeler so that he could place spread bets on gold prices.  Since that time, IG has expanded dramatically, and today the company enables customers around the globe to trade virtually any financial product, currency or commodity through spread bets, CFDs and binary bets.  IG has been publicly traded twice, most recently since its March 2005 IPO, which followed a 2003 leveraged buyout.  Trading in financial products, primarily individual stocks, indices and currencies, represents approximately 90% of the company’s sales.  Such trading is usually fairly short-term, as clients thrive on volatility.  As a result, market environments like May and June 2006 are ideal for IG as trading activity surges.  Sports betting through spread bets and binary bets constitute the remaining 10% of sales.  With a well-established brand and a reputation for innovation, IG is the largest spread betting firm in the UK and one of the leading providers of CFDs worldwide.  Since these instruments are generally not available in the US, many investors are unfamiliar with them.  The following links should help:

 

Spread bet: http://www.igindex.co.uk/content/as_index.html

 

CFD: http://www.igmarkets.com/content/sites/igm/en_GB/sh_cfds.html

 

Binary bet: http://www.binarybet.com/content/sites/bin/en_GB/ab_index.html

 

Spread betting is primarily a UK phenomenon, while CFDs are common worldwide and gaining popularity.  In general, these products are attractive to customers for several reasons: (1) no stamp duty or capital gains taxes, (2) low transaction costs as there is no broker fee for spread bets and only a modest commission for CFDs, (3) the ability to make leveraged trades and generally lower margin requirements and (4) easy to go long or short.  What clients lose in terms of outright ownership (voting rights, for instance), they gain in greater flexibility, leverage and lower costs.

 

IG’s business model is relatively straightforward.  The company generates revenue from three sources: (1) spreads and commissions, (2) interest income from client deposits and financing and (3) risk profits generated by the portion of IG’s book that is unhedged, i.e. profits from taking the opposite side of a client’s trade.  Risk profits are usually low, since the company hedges its book aggressively.  While this reduces potential trading profits, it also minimizes losses and enables IG to generate more stable profits. 

 

Risk management is therefore a core activity.  In its financials business, IG hedges in two ways.  First, the company benefits from natural hedging, i.e. having two clients on the opposite side of a trade.  This is the best scenario because it’s free.  It is also increasingly prevalent as IG’s book grows.  Second, when natural hedging is unavailable, IG goes directly into the capital markets to hedge positions, which is costly but efficient.  As a result, loss making days at IG are extremely rare, unlike at many of its peers.  It is harder for IG to hedge its sports business, where the company is more of a traditional bookmaker.  The recent development of sports betting exchanges, however, has introduced the prospect of laying off some risk in these forums.

 

Merits

1.        IG’s business model is highly scalable (easy to add new customers and products), very profitable (EBITDA margins near 60%) and not capital intensive.  Net income-to-free cash flow conversion approximates 100%.  Importantly, incremental margins are very high (roughly 80%).  Consider the company’s expansion into Australia, where IG generated nearly £4 million of revenue in FY05 and around £9 million in FY06.  Because most back office functions are handled from the company’s London headquarters, IG needs only a skeleton crew in Australia.  As IG expands, it should be able to replicate this approach and continue to improve margins.

 

2.        IG has significant growth opportunities worldwide in its core financials business.  Australia, the company’s largest market outside the UK, has gone from zero to approximately £9 million of revenue in three years.  Revenues in that market continue to grow more than 100% annually as IG’s client base grows and customers graduate from trading just stocks to a mix of stocks, indices, currencies and commodities.  It doesn’t hurt that Australia is the largest gaming market in the world on a per capita basis.  Management believes that Australia can be 25-30% the size of its UK business in 12-18 months, which implies potentially £25 million in revenue by FY08. 

 

But Australia is only the beginning.  IG has a two-pronged international expansion strategy that involves (1) establishing a direct presence in certain markets, as the company did in Australia and (2) partnering with local brokerages through introducing broker or white label deals.  Today, the first category includes Australia and Singapore (opened May 2006), with likely expansion into Germany (currently an introducing broker arrangement) and Italy.  Germany is an especially intriguing market as it is quite large and under-penetrated, yet has a wealthy, financially sophisticated investor base.  Some industry experts think that Germany could one day rival the UK in size.  Meanwhile, category two includes numerous partnerships around the world, with notable arrangements in Ireland (growing rapidly as IG has recently displaced Cantor Index as the partner of choice for Ireland’s major brokers), South Africa and China (very small today, but obviously lots of potential).  The icing on the cake is that IG’s core market, the UK, is still growing rapidly – in fact, north of 30% in FY06.  This implies that investors today are paying very little for an attractive portfolio of potentially sizable new markets, despite management’s excellent track record of capitalizing on growth opportunities.

 

I would be remiss in not pointing out a final low probability, yet Holy Grail-esque opportunity: the US.  Today IG conducts no business in the US, nor does it have any customers there.  With the exception of FX trading, IG’s products are not approved for trading in the US.  Should this ever change, perhaps after the rest of the world continues to embrace spread betting and CFD trading, the US could be enormous for IG.  In fact, US regulators seem somewhat more receptive to IG-style trading.  For example, Hedge Street, a CFTC-regulated entity, now offers limited futures and binary trading in certain products.

 

3.        Barriers to entry are high.  First, liquidity, scale and product breadth are critical.  IG literally makes markets in thousands of financial products (far more than any competitor), which provides a more compelling customer experience.  With greater size and scale comes greater profitability, as the company benefits from natural hedging.  Second, the technology and human expertise necessary to support the business are costly and complex.  Management believes the investment necessary to replicate its IT platform exceeds £10 million (beyond the reach/appetite of most competitors), while building a team of expert “dealers” (i.e. market making traders) is challenging and the learning curve is steep.  To illustrate, both Ladbrokes and William Hill attempted to enter the market several years ago and failed, eventually selling their businesses to IG for nominal amounts.  Another example: for the last three years, IG has essentially had a monopoly in the binary business.  City Index, a large competitor, has tried to roll out a competing product for nearly two years without success.  In short, IG has a lead over its competitors that is only widening.

 

4.        IG has a seasoned management team with shareholder-aligned economic interests.  Management currently owns 13% of the stock outright.  In addition, management has incentive compensation based on normalized EPS growth.  The maximum payout comes with 50% annual EPS growth over a three year period, so management is quite motivated to grow profits.  From our due diligence work, it is clear that IG’s management is viewed as the industry’s premier team.  They are consistently credited for solid execution and are characterized as entrepreneurial and professional.  In May, when the company released preliminary FY06 results, IG announced that its CEO, Nat le Roux, is retiring and that the company’s CFO, Tim Howkins, is taking over.  Rather than be concerned, we are actually pleased with this change given Howkin’s experience at the company (seven years as CFO in what is a very quantitative business) and strong reputation among investors for competence and candor.  Besides, le Roux had made it clear that he did not plan on remaining CEO long after the IPO, having been at IG for fourteen years, four of those as CEO.

 

5.        IG has multiple ways to create value for shareholders.  Most obviously, the company can grow earnings organically, which is management’s top priority.  Beyond this, however, management has the flexibility afforded by a debt-free balance sheet with approximately £50 million of excess cash and substantial free cash flow generation.  The company currently pays a modest dividend (management has earmarked 50% of earnings for dividends), while buybacks are likely in the medium term.  Another attractive use of capital could be the acquisition of a competitor.  Such an acquisition could be substantially accretive, since IG would simply transfer the business to its own IT platform, thereby eliminating the need for the acquired company’s back office.  Moreover, the acquired clients would have access to the full breadth of IG’s trading platform (the industry’s most comprehensive), making revenue synergies a real possibility.  To its credit, IG’s management has thus far avoided a pricey deal, though it has evaluated several opportunities.  This gives us some comfort that management is disciplined about deploying capital.

 

Financial Projections

Data in millions of GBP, except per share data

FYE: May*

 

                                                FY05       FY06       FY07       FY08

Revenue                                   62            86            111          133

   % Change                                           38%        29%        21%

 

EBITDA                                   35            51            69            88           

   % Margin                           56%        60%        63%        66%

 

EPS (p)**                               6.8           10.2         14.1         18.2        

   % Change                                           49%        39%        29%

 

Free Cash Flow                      14            37            50            63           

 

P/E Ratio                                                                15x          11x                         

FCF Yield                                                               7%          9%

 

* FY06 is May 2006, for which management has pre-announced revenues and EBITDA.

** This analysis assumes no buybacks or other balance sheet maneuvering.

 

Risks

1.        A severe downturn in global markets could dampen enthusiasm for IG’s products.  Mitigating this risk are several factors, however.  First, IG’s customers are more interested in volatility than market direction, and it’s just as easy to go short on a spread bet or CFD as it is to go long.  Second, the company’s revenue mix is diversified across products: individual equities 35-40%, currencies 20-25%, equity indices ~20%, binaries: ~5%, fixed income, commodities, etc ~5%, sports ~10%.  Third, IG is increasingly exposed to various geographic markets, which insulates the company from a country-specific downturn.  Interestingly, during the 2001-03 period of global equity market weakness, IG consistently grew its client count and revenues.

 

2.        IG is regulated by the FSA in the UK and, to a lesser extent, by other regulators around the world.  Especially in the UK, where the company’s spread betting products have favorable tax treatment, a meaningful change in regulatory scrutiny could adversely affect the company.  Our conversations with the company and other industry players, however, have given us comfort that no major changes are on the horizon.  In addition, since IG prohibits US customers, there is no risk of lost business from changes in US regulation.

 

3.        Risk management errors are possible, especially in the company’s sports operation, where hedging is difficult.  Yet sports is a relatively small business for IG, and adverse results are unlikely to move the needle.  Much more important is the company’s financials business, where IG fortunately has vast hedging experience.  Furthermore, management has consciously chosen to hedge aggressively, which should help to minimize potential losses.

 

4.        Some insider selling is likely this summer when management’s lock-up expires.  While this obviously doesn’t affect the company in any fundamental way, the optics are unhelpful.  Management has suggested that some organized share sale is likely.  Given that most company insiders have not had the opportunity to monetize any of their holdings since before the company’s 2003 LBO, I don’t believe such a sale is unreasonable.

 

Disclaimer: I own this stock and may buy or sell at any time, without notice.  This is not a recommendation to buy or sell the stock.

Catalyst

IG is not so much a catalyst-driven story as it is a good, well-managed business trading for a very reasonable price relative to its growth potential. Having said that, there are a few catalysts to watch for:

1. Full year results in late July. This will be a detailed discussion of the positive results pre-announced in late May. Most important will be commentary on June and July activity, which I believe has been quite strong.

2. Germany. This could be a huge market, so any traction from establishing a direct presence would be a major positive.

3. China. Clearly this market has enormous potential, but to date IG has been hampered by various regulatory hurdles. To the extent the Chinese government relaxes regulations (perhaps after Hong Kong watches Singapore morph into a large, pan-Asian market?), IG should benefit significantly.

4. Acquisition. As discussed above, an acquisition at the right price executed successfully could result in a step function upward in earnings power.