Manx Financial Group - Exploiting Change

http://www.mfg.im/

Manx Financial Group Logo

With tightening regulatory rules and ongoing reputational issues affecting the major UK banks, there has been a growing market for smaller 'challenger' banks such as Manx Financial Group (LSE:MFX). ManxFG has made significant progress over the last year in moving into profitability, plus growing its loan book, and that progress has been reflected in a large share price increase since 2013 - that is a trend that could well continue through the latter part of 2014 and 2015. ManxFG shares are currently priced at 13.50p hence the group is valued at an undemanding £13.8m. The market has found it difficult to value ManxFG thus far as a result of a material number of outstanding warrants, and legacy issues affecting the group, but the picture is now becoming clearer, and the group is undergoing a phase of appreciable growth.


The technical picture for ManxFG is bullish as it stands. The share price has consolidated over the past few months, but that bodes well when the price next breaks-out as it tends to lead to exaggerated price movements. The share price is actually down quite considerably year-to-date, but that is because the ManxFG entered the year on a high. Importantly, volumes have picked up since H2 2013, and those elevated volumes have been maintained through 2014 to date. The shares still trade above the long-term uptrend formed off the two minor lows, and that suggests a share price rise towards 20p should 15p be broken in due course. A comparison with ManxFG's closest LSE-quoted peer is shown, and price movements have largely been in tandem up through to 2013 as a raft of positive company and sector news helped lift operational performances. However, for no obvious reason, 1PM's share price has materially outperformed so far this year - that disparity could be set to narrow. The tradable spread on the shares is decent, spanning 13.25p-13.75p.

The free float of the company is less than 50% due to a number of director shareholdings (and former director shareholdings). Former director Arron Banks holds a 29.72% stake in the company, and a large portion of that was accumulated between 2012 and 2013. Chairman Jim Mellon holds a further 17.3%, Lynchwood nominees hold 10.3% and Island Farms Ltd hold just over 4%. Low ownership from the well-known institutions is likely a result of ManxFG's low market cap. The board is highly experienced with Jim Mellon in particular holding a large number of roles at other quoted companies. A potential positive indication for the future, is that director David Gibson bought £13.75k worth of shares in April at 13.75p.

Although I do not cover a large number of financial services firms - due to many being difficult to value and there generally not being a great deal of value - ManxFG has a business that is relatively simple to explain, albeit it may not be in structure. ManxFG is the parent company for three wholly owned subsidiaries, and it's an independent banking group based on the Isle of Man (IOM) with main operations in the IOM and mainland UK. The heart of the group is Conister Bank - a digitally driven bank that does not have a bricks and mortar presence. It is fully licenced and provides a 'variety of financial products and services', which include savings accounts, personal loans and loans to small and medium-sized enterprises (SMEs). Since it does not have an on-ground presence, ManxFG forms partnerships with mainland companies who have a larger presence, and utilise their expertise - profits are then shared between the two parties.

How do retail banks make profits? Simplifying it, it's easy to understand. The banks take in deposits from customers and promise to pay out an interest rate (say, X). The bank then loans out the cash to other customers such as those listed earlier, and it charges an interest rate on that (say, Y). The interest rate that the bank charges the people/businesses it loans money to, is higher than the rate at which it pays out in deposits (X<Y). The bank therefore receives more in interest income than it gives out in interest expense, and there is a resultant profit. The impact of a rising interest rate (which appears likely to come into effect over the next year) is relatively unclear. First off, any rate rise is likely to be small and it also impacts both sides of the coin. The interest rate on both money being loaned out and money being taken in, tends to equalise any effect. However, it is often the case that the interest rate increase for depositors falls short, as banks don't often ratchet up the rates they pay out by the full extent of any central bank rises. Thus, profit can actually be slightly boosted (or at least, largely unaffected), assuming the economy is buoyant and demand for loans stays high. The current economic environment supports that scenario.

The second business within the group is an independent financial advisor called Edgewater Associates with the final business being Conister Card Services (CCS) - a prepaid card division. CCS is immaterial at the current point in time, but Edgewater contributes fairly materially to profits, and a final payment for that acquisition of that business was made earlier in the year. However, the bulk of growth is being contributed by Conister Bank and that is the business that investors should predominantly focus upon.

It's therefore worth focusing on the figures that ManxFG delivered last year:
- Net interest income grew to £8.26m vs. £5.54m the year before
- Net trading income tracked higher to £6.4m
- Through lower administrative costs, post-tax profits rose to £1.09m
- That equated to 1.12p in basic EPS and 0.78p in diluted EPS
- Loan-to-deposit ratio improved by 5% to 97.1%. Targeting 100% by 2015

Those are some of the headline figures, although there are of course numerous other important figures that I'll cover later. At this early stage it's important to point out that the post-tax profits were not impacted by tax payments due to the presence of past tax losses that were used to offset any tax payments. That is likely to be the case again in 2014, and means that profitability is inflated upwards. Notwithstanding that, only Conister Bank is subject to tax, and the IOM tax rate for the business only stands at 10% currently, so the obscured impact is low and excludable on this occasion - that is especially the case since there is still a deferred tax asset on the balance sheet.

The balance sheet is sufficiently strong with total assets equalling 1.1x total liabilities. In the case of banks, there are large figures on the balance sheet under the terms "loans and advances" and "customer accounts", which call under the receivables and payables section and relate to the deposits and loans given out. For ManxFG, these stood at £75.82m and £78.12m respectively. In addition to that, there is net cash/for sale financial instruments of £7.11m. A £4.2m cash balance and £9m in quoted UK government treasury bills offset £6.07m in loan notes - it would be good to see those continually paid off. The deferred tax asset stood at £394k, up from £380k.

Using the figures bullet-pointed earlier, ManxFG is trading on a basic PE ratio of 12.7, which is pretty unremarkable in itself. However, the PE ratio rises to 17.3 on a diluted basis, so the situation is actually quite complex. The results for 2013 were also impacted by an impairment charge against a loan, but given the nature of the business, that is to be expected, hence it would be wise to not class it as an exceptional item. There is one point to recognise at this juncture - the company is growing rapidly, with the loan book up 30% in 2013, much higher than the 19%/year average that the company has been growing on. It therefore deserves a respectable rating, especially since it returned to profitability and has a trailing return-on-equity of 12.7% (albeit the return-on-assets is low). Given that there is no dividend, a PE ratio between 14 and 16 is probably fair for the current point in time, with incremental upside dependent upon further rates of progress.

ManxFG also compared very favourably against its peers.


In the table above, I have compared ManxFG alongside four other peers, with the closest being 1PM. The sizes of each business varies substantially, and the group is the smallest of the comparators in this case. That said, the 1-year price performance is very impressive, with the share price doubling over the course of the past year. Does that mean that all the upside has been missed? It appears not. The trailing basic PER is the lowest of all comparators (although it's important to remember the dilutive effects of the warrants/options that are still outstanding). The trailing CA/TL is also the lowest of the comparators, but it is still a robust position to be in. The key numbers to take note of are the consensus 2014 and 2015 PERs, which average 17.1 and 14.9 respectively. These numbers can be used as benchmarks. There are other peers including Private and Commercial and Renovo, but their financial performances are less clear as it stands.

As a side point, it's clear that valuations for these sorts of companies can really run away with themselves if market sentiment picks up and forecast growth rates are strong. 1PM is trading on a very lofty trailing basic PER of 40.7, albeit that falls to 18.4 in 2015. That is a sign that the market is very willing to back promising companies now, in anticipation of future returns. That is despite 1PM not having a dividend, similarly to ManxFG. Part of the reason for ManxFG's comparably low valuation is likely down to the lack of market forecasts and broker coverage of the group - quite why there is no coverage is difficult to answer.

Commenting on the transformational 2013 results, Chairman Jim Mellon commented: "I believe that we have now turned the corner to ensure that this year's performance is not just a one-off, but sustainable, providing a stable platform for enhanced future profitability." That statement is crucial in being able to form forecasts, and indeed the 2013 results benefited from a much enhanced operating cost: income ratio and previous restructuring efforts. The board were "confident that 2014 will show further strong growth".

Taking a look at the interim and final figures, it's impressive to see than H1 2013 profitability was £0.26m, and H2 profitability was £0.81m, especially since that trend is likely to continue - it represents an excellent financial run-rate heading into 2014. I'll therefore consider two profit scenarios for 2014, which could prove too conservative and are unlikely to prove too optimistic. 102.1m shares in issue have been used for the basic calculations and an estimated 141.1m shares in issue have been used for the diluted calculations. The lower case scenario incorporates an averaged £0.8m of profit for both halves of the year (£1.6m in total, so a £0.7m, £0.9m split would suffice). Since there is a deferred tax asset to offset payments this year, that drops through to 1.57p in basic EPS and 1.13p in diluted EPS. Those give PERs of 8.6 and 11.9 respectively, which are low given the rate of growth being shown. A fully conservative (i.e. the base case) PER of 14 at the diluted level comes to 15.8p, which is higher than the current price. Assuming £2m in profits for this year, the EPS figures come out at 1.96p and 1.42p respectively, which translate down to PERs of just 6.89 and 9.51. Those are once again very low.

However, the dilutive effects include warrants and convertible loan notes, and the bulk of these are unlikely to be exercised this year and since EPS is calculated off the number of 'weighted average shares in issue', it's a point to consider. That means that the reported basic EPS will be towards the higher end, and the market will react favourably to that. To cater for that, it's appropriate to use the average EPS figure as a reference level. At £0.8m per half and using a PER of 14, the averaged-EPS suggests a price target of 18.9p. At £1m per half and using a PER of 14, the averaged-EPS suggests a price target of 23.7p. Taking note of the rate of growth and understanding that the market could assign a PER of 18 (and potentially even higher given that this is using the averaged-PER), then the high side averaged-EPS price targets are 24.3p and 30.4p respectively. In essence, there appears to be very material upside even in the lower-case scenario. 2015 EPS should be even higher.

There is of course the caveat that these dilutive warrants and options could come into effect sooner than anticipated. That is a risk to consider, but it does not appear to damage the positive outlook for the shares. What are slightly disappointing are the terms that certain directors of ManxFG lent money to the group on in the past. Admittedly the company was loss-making and in need of a turn-around, but the warrants attached to various loans look on the high side. For example, alongside a combined £1.75m convertible loan from Jim Mellon (which accrued interest at 7%/9%) were warrants for 8.3m warrants at an exercise price of 6p (i.e. nearly £500,000 worth). These warrants are one of the main reasons why shareholders face future dilution, so that is not impressive. So whilst it can be argued that the financial position of the company is now much better, the number of warrants distributed looks high and that does dampen some positivity.

Putting that slight deterrent aside, understanding the drivers of growth within the company are key. The background driver remains an ever-improving UK economic recovery, and an IOM recovery within that - that will keep demand for loans high, especially given that numerous larger banks are turning away customers in preparation for new tighter regulations such as Basel III, which is due for full adoption in 2019. Basel III "tightens the definition" of regulatory capital through requiring banks to hold a minimum total capital plus conservation buffer of 10% - ManxFG state that they are already meeting the requirements, which should allow them to pick up part of the market share that the larger banks may drop. A second driver is organic growth, and that effort is underpinned through Conister Bank's market penetration being "no more than 1%" within the IOM, hence there is plenty of opportunity. That falls alongside a further driver, which is increased technological innovation and implementation within Conister. That will allow the company to compete more readily and on a larger scale than before. Whilst the group is mindful that competition will probably continue to arise as major banks lose market share, they are no doubt well positioned to capitalise upon the opportunity that is presented. Crucially, they intend to seek out that growth without compromising loan quality, and intend to focus on the high quality customers. Despite the rapid growth in 2013, impaired loans/advances only totalled £4.3m versus £5.4m in 2012, and unsurprisingly that was in the Grade C (highest risk) loan category. The bottom line is that, as a total percentage of loans given out, the percentage fell.

News flow in 2014 to date has continued on a positive trend. A new partnership was entered into in January, which sees Conister Bank provide £10k -> £50k loans to SMEs via Corporate Asset Solutions who would pre-vet potential clients. Furthermore, in June, the company released an upbeat trading update in which they announced that total group assets rose through £100m during the period (versus £93.7m at the end of the year), which suggests solid growth of at least 10% during the half - that level is expected to be maintained and exceeded throughout the rest of the year. The company also commented upon expecting a 'marked uplift' in profits against H1 2013, which supports the idea of greatly boosted profits yet again this year, plus it announced a further joint venture for a paybreak service targeting online customers. In addition, legacy outstanding cash balances from a discontinued part of the business were collected, which will capture the attention of investors, even though it is merely a temporary inflation of earnings. ManxFG finally noted, "the group anticipated making an announcement shortly with regard to a new join venture focusing on insurance premium and asset backed finance for the UK professional business sector."

Therefore, despite the inevitable dilutive impact of future warrant exercises, Manx Financial looks good value at the current point in time. The share price is not factoring in the significant uplift in profits that will be felt this year, and that is probably down to a lack of broker forecasts and coverage of the stock. The wider economic picture for the bank is highly positive, with the rise of challenger banks (such as MFX) creating a very good opportunity to gain access to lucrative market segment that was previously not accessible for smaller banks. Driving internal operational efficiencies and organic growth continues apace, and that bodes well for an increasingly bright future over the rest of 2014, 2015 and potentially beyond. The shares look to be trading at a major discount to peers on a 2014 forward PER and 2015 forward PER basis, and the balance sheet is robust. From a chart perspective, the outlook is also bullish and an initial target of 20p looks wholly achievable before year-end. 25p is a secondary target dependent upon performance. ManxFG appears well positioned to exploit a growing market opportunity and one that is changing in their favour. I have therefore put a Buy tag on Manx Financial Group at 13.5p.

UPDATE (19/09/14) - I have added a £7,500 slot to Manx Financial at an ask price of 13.5p in recent days. The drop was unwarranted and the recent results were encouraging

UPDATE (01/10/14) - I have removed the above slots, not for company-specific reasons, but because the markets are looking weak and this is part of portfolio risk management. I remain bullish on ManxFG, but have banked a minimal ~4% profit for the time being and await re-entry in the near future

8 comments:

  1. Hi el1te.

    I have been in OPM for 8 months now and it has been a great ride. I do like the look of MFX!

    CraigJ

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  2. It is interesting because the regional banks are booming at the moment and the national banks are still prospering but are losing ground in some parts. I mean, just look at Metro bank and OneSavings bank as proof that there is life outside the big ones that have an oligopoly. Past banking problems have been caused by big bank dominance so this can only be a good think I think

    Rick

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    Replies
    1. The banking market needs stability and increased competition will bring stability if these smaller banks meet the new reg requirements.

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  3. We(Conister Bank) focus on the financial needs and aspirations of the Isle of Man Community

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    Replies
    1. We need more banks to focus on their customers :0)

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  4. excellent report
    tiger

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  5. What incredible research you've done here, and all summarised beautifully in just a few hundred words and a few graphics. Superb, as always.

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  6. Looks interesting at 12.25p. Going to dip my toes in the water tomorrow. Excellent site El1te. Keep up the good work!

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