|Shares Out. (in M):||87||P/E||10.6x||8.4x|
|Market Cap (in $M):||1,917||P/FCF||10.6x||8.4x|
|Net Debt (in $M):||250||EBIT||185||240|
RCS Capital Corp (“RCAP”) is a newly formed high-growth independent retail advice brokerage with a $1.9b market cap that trades at only 6x and 8x our estimates of 2015 EBITDA and Cash EPS/free cash flow, respectively. This represents a substantial 43% discount to its closest publicly traded peer LPL Financial (“LPLA”). We believe that a combination of transitory factors (discussed below) has created a massive dislocation in the stock price (the stock is down 50% off of its March highs) and a great entry point to own a) the #2 US independent retail advice brokerage (which has grown its Assets under Administration (“AUA”) organically at a 15% CAGR over the past several years, while generating similar growth in revenue and EBITDA) and b) a rapidly growing wholesaler and investment bank in the nascent retail alternative investment products industry for free. With recent overhangs cleared, this relatively unknown stock now represents an asymmetric risk/reward. We believe that over the next year RCAP will trade at 9-10x 2015 EBITDA and 14-15x 2015 Cash EPS, resulting in a stock price of ~$38 or nearly 75% upside from here.
Further, there are two other significant opportunities which are NOT in the above targets. The first is accretive M&A where management believes the Company’s $4.50/share in excess cash can be deployed to acquire retail brokerage platforms at 6x in the private market resulting in meaningful earnings accretion (15-20%). A second source of upside is an eventual rise in short term interest rates where a 100bps rise would generate another 20% earnings accretion. In the case where interest rates rise modestly, and RCAP deploys its cash into accretive acquisitions, we believe EBITDA and Cash EPS would approach $510 and $3.58 which at a 14-15x P/Ex implies $55 or 150% upside from current levels. Moreover, these impacts combined with healthy underlying growth will create a positive mix shift towards the Company’s highest multiple Retail segment, driving that segment to 75% of total EBITDA from 60% currently. We believe this dynamic will be the main driver behind the multiple convergence with LPLA over the medium-term.
RCAP IPO’ed in June 2013 at $20.00 with JMP Securities as the lead underwriter. At that time the company was a ~$530m market cap with only $50m of tradable float, the remaining 90% was owned by management and insiders with no outside capital having been raised along the way. The company didn’t attract much interest given the lack of comps for its Wholesale business, the lack of float and meager analyst coverage (the stock was only covered by JMP). In the fall of 2013, RCAP announced the acquisitions of retail advice platforms ICH, Summit and First Allied, and the investor manager Hatteras for total consideration in cash and stock of ~$350m. No pro forma financial information was given, and no financing was announced. Around this time the Company brought in well-regarded industry veteran Larry Roth, the former head of AIG’s and ING’s retail brokerage units, to run its new Retail operations.
The stock languished around its IPO price until the January 2014 announcement of the Cetera deal, which is the flagship operation for RCAP’s Retail franchise. The Company did not provide pro forma financial guidance at the time, but conducted a roadshow for credit investors to finance the Cetera transaction. Some investors were vaguely familiar with Cetera due their involvement LPLA and had heard of Cetera’s former head Don Marron who had previously run Painewebber’s retail brokerage unit successfully and had earned a good reputation in the industry. As part of the Cetera financing, Luxor (a well-respected distressed shop) invested in a significant RCAP convertible debt and convertible preferred, giving them a large equity stake as converted. The combination of Luxor’s involvement, the transformational nature of the transaction (Cetera is a very large player in the retail advice business), and credit crossover investors buying the equity, got people excited about the stock. Pro forma financials were released which described 250m+ of EBITDA and significant earnings power. As a result, the stock has a tremendous run from $20 to $40 towards the end of Q1.
There is a lot of detail in the following pages, but these are the main takeaways –
RCAP Retail Business Overview (60% of EBITDA)
In its simplest form, RCAP’sRetail business provides an integrated offering of technology, infrastructure, and operational support to a network of independent financial advisors, who service retail clients. RCAP’s financial advisors retain 85-90% of revenue from their retail clients, paying RCAP 10-15% for its services. By partnering with RCAP, advisors get access to a full suite of services, allowing them to focus solely on providing good performance for their clients and growing their client base. These economics are advantageous to the financial advisor, relative to traditional wirehouses (i.e. Bank of America Merrill Lynch, Morgan Stanley), where FAs generally retain only ~40-50% of total revenues.
RCAP is a scale player in the industry with the second largest network of financial advisors in the US. The company has over 9,700 advisors with collectively ~ $230bn in assets under administration. Advisors span primarily throughout rural and suburban areas, within all 50 states, through nearly six thousand branch offices covering 1.9 million clients. RCAP’s advisors focus on the “mass affluent” segment of the retail advice market, defined as investors with net liquid investments of $100k-$1m. This market is growing rapidly due to an increase in baby boomer retirees. In addition, RCAP’s target segment, the independent advice channel, is exhibiting strong growth due to market share gains from wirehouses. These tailwinds enable strong organic growth in RCAP’s retail segment, which has grown revenues organically in the mid-teens, currently has EBITDA margins ~8.4% PF for synergies, and represents ~60% of total company EBITDA.
RCAP’s platform is comprised of seven acquired retail businesses, Cetera, First Allied, ICH, J.P. Turner, Summit, VSR and Girard, and each will retain its own brand and management. The multibrand strategy allows for customized solutions tailored to a wider dispersion of clients and investment objectives, which aids in financial advisor recruiting and retention. RCAP’s retention rate runs at a healthy ~98%.
RCAP provides all the infrastructure support needed to serve clients, enabling FA’s to focus their attention on client growth, retention and new product sales. Client facing services include education, account management, client intake, reporting, document retention, automated front-middle-back office solutions, and clearing, among others. RCAP’s FA’s in turn service their own clients with traditional brokerage services, fee-based retail advice, wrap-fee programs, portfolio management services, and managed account programs, as well as access to a wide range of financial products, including fixed and variable annuities, equity and fixed income securities, and other financial products.
Retail Industry Channels
The retail advisor market is divided into five broad channels: two independent channels (independent broker-dealers and registered investment advisors (“RIAs”)) and three employee channels (wirehouse, insurance, bank). In the independent broker-dealer channel, advisors are not employees but independent contractors affiliated with a broker-dealer. Advisors rely on their broker-dealer firms for support (technology, trade execution, practice support, compliance, etc.) but are generally free to service clients as they choose. RCAP operates in this segment. In the RIA channel, RIA’s only offer fee-based advice on a set percentage of clients assets irrespective of the number of trades executed. Assets are generally held at a third-party custodian (Fidelity, Schwab, Pershing, TD Ameritrade) but managed by the financial advisor. RIAs general target a higher asset/client level versus independent broker dealers. In the wirehouse channel, advisors are employees of full-service brokerages. Revenues earned from clients are either transactional commissions or a fee based on managed asset levels. These include Merrill Lynch, MS, GS, etc. The last channels are advisors affiliated with an insurance firm, bank, or credit unions. These include companies such as AIG, RJF etc.
RCAP generates revenue through the services provided by its independent broker-dealers and its financial advisors. Advisors generate revenue through commissions and advisory fees, of which ~85-90% is returned to the advisors and recorded by RCAP as an expense on the income statement. The revenue driver of this segment is largely assets under administration (“AUA”) and the yield earned on those assets. Revenue yield runs at ~92 bps of AUA.
AUA growth is a function of three drivers. The first is net advisor additions (advisors hired less attrition), which is primarily driven by the ability of the company to attract and retain advisors on the platform. The second driver is the increase in “same store sales” which is expanding wallet share among existing clients (attracting more assets and/or selling incremental products) and attracting new clients. The third driver is market appreciation, i.e. growth in the underlying assets due to a rise in asset prices. The Company’s revenue model calls for 2-3% growth in net advisors, 3-4% SSS growth, and 4-5% market appreciation, leading to targeted organic AUA growth of 9-12%. On the expense side, management believes low double digit revenue growth will lead to 4-5% expense growth, enabling Retail EBITDA growth of 13-21%. EBITDA margins are currently running at 8.4% PF for synergies, these margins should expand to 10-11% over time as revenue continues to grow. Revenue and EBITDA growth at RCAP is superior to LPLA which currently runs closer to its target 12% EBITDA margins.At a more granular level, revenue breaks down broadly into commissions, asset based fees and other. An estimated 61% of revenue from retail advice comes from recurring sources, including asset based and advisory fees, trailing commissions and strategic partner revenues. While commissions comprise the bulk of the revenue stream, asset-based fees should grow on a relative basis as clients shift to more fee based products over time.
Retail Secular dynamics
Recent secular trends are driving increasing demand for unbiased advice from independent advisors and financial products sold through independent channels. As baby boomers reach the age of 60, the number of people expected to retire in the next 10 years will increase sharply, expanding the target market looking for investment advice. Wells Fargo estimates from 2012 to 2022 the number of retirees will grow from ~3.6m to 4.2m per year, or 44m total in the period, which demonstrates substantial growth off of the existing base. The industry as a whole has grown AUA well during the past 3 years, driven by the first cohort of baby boomer retirees in 2011. Secondly, the market meltdown in 2008, continued stock market volatility, low interest rates, and reduction in defined benefit pensions have contributed to the need for increasing levels of financial advice in recent years.The target market – mass affluent investors – is both large and expanding, and given substantial aggregate U.S. household wealth and significant investment product and advice needs, demand for retail investing advice and services is likely to remain robust. Additionally, the independent retail channel is likely to grow at a higher rate than the wirehouses, as disgruntled brokers are leaving to achieve better pay terms. Brokers who “hang their own shingle” like those at RCAP, typically achieve ~85-90% payouts versus only ~30-50% at the wirehouses (although wirehouses cover overhead while independent brokers incur these costs as an owner/entrepreneur). Demonstrating this phenomenon, organic assets at the ebrokers have grown roughly $800b in the last five years versus only ~$250b at wirehouses. Other drivers of growth in the independent channel has been brand damage at the parent banks of wirehouses exiting the crisis, investors seeking advice that is perceived to be unbiased and conflict free, and certain tax benefits to advisers that monetize their business vs retention payouts at a wirehouse. RCAP’s retail business has capitalized on these trends, demonstrating significant organic and total growth over the last several years, CAGR’ing at 15% (see table) –
RCAP is initially targeting $61m in synergies due to its acquisitions which will enhance Retail EBITDA margins by 200 bps. Synergies are expected to be fully achieved by the end of 2014. The synergies are mostly driven by increased pricing to financial product providers (such as mutual funds), i.e. they are not customer facing and therefore should have limited disruption to the day to day operations of the advisor.
Management has c