Argentex (AGFX)

Thought I would post some thoughts on Argentex. The write-up is my contribution to an investment group in which I am a member. We meet every month or two (currently virtually, but previously face to face) to discuss shares. Each meeting sees everyone chip in with their research.

Welcome any feedback or extra info on Argentex (or Alpha FX) – what have I missed? I will publish future write-ups here as well. Anyone else wish to publish their share research?

Thanks
Maynard

ARGENTEX (AGFX)

Share price: 142p
Market cap: £161m

Headline attractions

  • High margins
  • High ROE
  • Strong forecast growth
  • Relatively moderate valuation
  • Quality/GARP share?

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Management

Has attractions: Co-CEOs founded AGFX (2011), late 30s, own 12% each, did not sell at IPO (2019).

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Not sure what to make of the FD perhaps being the ex-auditor. Pacific Investments was an early AGFX investor and remains a shareholder.

Business

“Argentex is a foreign exchange broker providing execution and advisory services…

The Group operates as a Riskless Principal, matching each client trade with a corresponding trade at one of its Institutional Counterparties. Revenue is derived solely from the difference in exchange rates at which it buys and sells currency (the ‘spread’). The business assists customers with foreign exchange transactions which are related to genuine underlying business needs. It does not engage in speculative trades for its clients, nor does it offer margin trading, spread betting, CFDs or similar products and it does not speculate with its own funds as principal.”

Riskless Principal

“a trade in a security that involves two orders, with the execution of one order dependent upon the receipt or execution of the other”

Revenue and clients

Revenue earned through the spread. E.g. AGFX can buy 1.12 EUR at GBP 1 from institutional counterparty, and sell 1.11 EUR at GBP 1 to clients. Clients are corporates with import/export transactions.

Competitive ‘moat’

“Argentex believes it differentiates itself through the level of service and human interaction provided as well as the price, speed and flexibility of execution and settlement, which all occurs within a highly regulated environment. Customers are attracted to the Group’s efficient, professional and regulatory compliant foreign exchange service which assists them in their financial planning and achieving certainty of financial outcomes. A guiding principle behind Argentex’s approach is that the less time clients spend dealing with foreign exchange, the more time they have available to spend on the day to day running of their business.”

Business has been profitable “every year since incorporation

Drawback

Alpha FX operates a similar business and issued this profit warning on 30 March 2020:

“The acceleration of COVID-19 coupled with the oil price collapse has led to unprecedented falls in the value of certain currencies and accordingly has meant that 223 (MP note: total clients = 648) of our clients saw their forward contracts deviate significantly in fair value. These clients have therefore been required to pay Alpha margin in order to fulfil their contractual obligations with the Group and keep their contracts open. However, one client faced with working capital shortages in its own business, requires more time to settle its outstanding payment obligations of £30.2m to the Group. To support this client, we are in the process of negotiating a payment plan, which has created a temporary shortfall in the Group’s own cash for use as collateral.”

Clients can therefore face margin calls when currencies move against them.

Margin calls arise from forward contracts. Forward contracts represent 70% of Alpha FX’s revenue and 45% of AGFX’s revenue.

Collateral is important to AGFX (and Alpha FX):

“as a Riskless Principal, the Group (AGFX) has to collateralise forward contracts with its Institutional Counterparties.”

“Increased levels of business from existing customers and the on-boarding of new clients by the sales team remain the key drivers for growth, but, in tandem, the available capital collateral available to the Company ultimately determines how much FX throughput, and therefore revenue, can be generated.”

Alpha FX raised £20m at 680p for extra collateral. Price before warning was £10. I suppose what happened to Alpha FX could happen to AGFX.

The associated IPO documents carry two identical risks.

Identical risks

1) Liquidity risk arises if the Group is unable to deposit margin required by its Institutional Counterparties

2) The Group may incur losses as a result of credit risk

(Full details below at the end of this write-up)

Repeat business

Two-thirds of revenue came from existing customers last year:

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Post-IPO staff remuneration charge

Pre-IPO accounts show 3-year PBT total of £22.7m — all going to staff:

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But post-IPO staff pay arrangements have changed. IPO document shows adjusted 3-year PBT total of £15.0m with the post-IPO structure:

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Post-IPO figures therefore not directly comparable to pre-IPO results. Note that SharePad takes the unadjusted pre-IPO figures and excludes the profit share:

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Cash flow

Large working-capital movements that even out over time:

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Suggests cash conversion will fluctuate from year to year.

AGFX books revenue once the contract is agreed, but can collect the cash months later when the (forward) contract completes:

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Balance sheet shows large working-capital numbers versus revenue of £21.9m.

Derivative financial assets: £12.5m:

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Amounts payable to clients £8.6m, and total trade and other payables of £16.3m:

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Important to understand what is going on with these entries — I am not sure at present.

AGFX capitalises certain in-house software developments costs rather than expense through the P&L:

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Does not have major financial implications to reported profits, but questionable policy given business is not developing software for sale. Alpha FX applies the same capitalisation policy.

Employees

Staff improve their revenue productivity markedly as employment tenure lengthens:

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Remunerated through commission:

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Staff who have been with the Group for more than one year” suggests the work/culture is not for everyone.

AGFX revenue per employee was £520k for 2019 (£21.9m/42) versus £347k for Alpha FX (£35.4m/102).

H1 results November 2019 — Peak margins to decline

“Argentex continues to experience high operating leverage, with operating margins at Group level of 43% (underlying 46%) for the interim period. These margins are considered to be at their peak given the current premises is at capacity, and the ratio of experienced and seasoned front office staff driving revenues.

Argentex is expecting to commit to a new leasehold premises for FY2021 and take advantage of the new space to invest in both front and back office staff. Consequently, operating margins are expected to reduce from the current peak and stabilise in the medium and longer term, though the addition of more high calibre staff will also provide more opportunities for growth in pursuit of the Group’s medium- and long-term goals.”

Trading update April 2020 — 30% revenue increase

“Argentex is expecting to report a c.30% increase in revenues to c.£29 million for the 12 months to 31 March 2020 (2019: £21.9 million), with Foreign Exchange (“FX”) Turnover exceeding £12bn (2019: £10.8bn). The Group continues to experience very strong growth in customer numbers, adding 450 new corporate clients during the period, while corporate clients actively trading increased by 12%

FY 2020 results published 3rd August

(will mention in meeting)

Early verdict

  • Dynamic growth small-cap — significant market opportunities
  • Favourable entrepreneurial/young leadership
  • Attractive headline numbers and perhaps valuation
  • Do I understand the accounts? Not sure.
  • Staff pay post-IPO? Not sure.
  • Will future FX movements test AGFX’s controls? Maybe.
  • Are significant client margin calls likely? Not sure.

IPO documents

Identical risks (1)

1) Liquidity risk arises if the Group is unable to deposit margin required by its Institutional Counterparties

AGFX

The Group operates a matched-principal brokerage model, meaning it executes a matching trade with its Institutional Counterparties on receipt of client orders.

The Group has facilities with the Institutional Counterparties. These facilities enable the Group to book both forward and spot contracts on behalf of its clients. The Institutional Counterparties mark-to market all of the Group’s forward contracts at the end of each business day.

To calculate the level of margin required, the Group’s Institutional Counterparties mark to market the Group’s net currency positions (meaning foreign exchange positions favourably affected by market movements are offset against those adversely affected).

As a result, the Group is able to benefit from exchange rate movements when it has positions on both sides of the market (e.g. a depreciation in the euro will negatively impact the Group’s long euro positions, but at the same time benefit its euro short positions). This results in a net claim payable to (or claim on) the Institutional Counterparties. If a net claim is payable, the Group is required to deposit margin with its Institutional Counterparties on the following business day.

The Group funds margin due to its Institutional Counterparties through client margin calls and its own funds. When the Group makes a margin call, clients have one business day to deposit margin with the Group.

The Group benefits from the fact that trading terms with its Institutional Counterparties are generally more favourable than those offered to its clients, and it only has to fund its net FX exposure with its Institutional Counterparties (i.e. if two clients make equal and opposing trades simultaneously its exposure is nil).

Liquidity risk is primarily driven by:

  • a sudden sharp movement in exchange rates when a currency is net long/ short; or*
  • an over-extension of hedging facilities.*

If the Group were unable to meet its financial obligations when due, this would have a material adverse effect on its business, results of operations, financial condition and prospects.

The Group has a liquidity policy in place to mitigate any such risks which provides that:

  • weekly stress tests are carried out that subject the Group’s net currency positions to simulated significant FX market volatility;*

  • robust margin call terms are maintained with clients;*

  • an over extension of hedging facilities is managed through internally mandating a minimum amount of free cash to be placed against each hedging facility extended; and*

  • the Group’s balance sheet must be well capitalised with cash so that in the event that they are called for margin collateral by Institutional Counterparty but unable to call on their clients as they have granted them a ‘hedging facility’, they are able to fund the position.*

Alpha FX

Alpha operates a matched-principal brokerage model, meaning it simultaneously executes a matching trade with its Banking Counterparties on receipt of client orders.

The Group has facilities with the Banking Counterparties. These facilities enable the Group to book both forward and spot contracts on behalf of its clients.

The Banking Counterparties mark to market all of the Group’s forward contracts at the end of each business day.

To calculate the level of margin required, the Group’s Banking Counterparties MTM the Group’s net currency positions (meaning foreign exchange positions favourably affected by market movements are offset against those adversely affected).

As a result, the Group is able to benefit from exchange rate movements when it has positions on both sides of the market (e.g. a depreciation in the Euro will negatively impact the Group’s long Euro positions, but at the same time benefit its Euro short positions). This results in a net claim payable to (or claim on) the Banking Counterparties. If a net claim is payable, the Group is

required to deposit margin with its Banking Counterparties on the following business day.

The Group funds margin due to its Banking Counterparties through client margin call and its own funds. When the Group makes a margin call, clients have one business day to deposit margin with the Group once called.

The Group benefits from the fact that trading terms with its Banking Counterparties are more favourable than those offered to its clients, and it only has to fund its net FX exposure with its Banking Counterparties (i.e. if two clients make equal and opposing trades simultaneously its exposure is nil).

Liquidity risk is primarily driven by:

  • A sudden sharp movement in exchange rates when a currency is net long/ short; or*
  • An over-extension of hedging facilities.*

If the Group were unable to meet its financial obligations when due, this would have a material adverse effect on its business, results of operations, financial condition and prospects.

The Group has a Liquidity Policy in place to mitigate any such risks. The Liquidity Policy provides that:

  • weekly stress tests are carried out that subject the Group’s net currency positions to simulated significant FX market volatility;*

  • robust margin call terms are maintained with clients;*

  • an over extension of hedging facilities is managed through internally mandating a minimum amount of*

Alpha’s free cash to be placed against each hedging facility extended; and

  • Alpha’s balance sheet must be well capitalised with cash so that in the event that they are called for margin collateral by a Banking Counterparty but unable to call on their clients as they have granted them a ‘hedging facility’, they are able to fund the position.*

Identical risks (2)

2) The Group may incur losses as a result of credit risk

AGFX

The Group is exposed to credit risk if a client fails to deliver currency at maturity of the contract or fails to deposit margin when a margin call is made. In either scenario, the Group’s policy is to immediately cancel the trade through booking an equal and opposite trade (in order to reverse the original contract). The Group is therefore exposed to the movements in the exchange rate of the total value of the contract since the trade was booked, or since the date of the last margin call, up to the date of cancellation. However, the Group has a credit policy in place to mitigate any potential losses arising from a client failing to settle; in particular, the Group assesses the creditworthiness of clients and, where a hedging facility has been extended, puts in place strict limits (typically limited to 3 per cent. or 5 per cent. of the value of the contract with a client). If a client should fail to make payments to the Group when due, this could have a material adverse effect on the Group’s business, results of operations, financial condition and prospects.

Alpha FX

Alpha is exposed to credit risk if a client fails to deliver currency at maturity of the contract or fails to deposit margin when a margin call is made. In either scenario, Alpha’s policy is to immediately cancel the trade through booking an equal and opposite trade (in order to reverse the original contract). Alpha is therefore exposed to the movements in the exchange rate of the total value of the contract since the trade was booked, or since the date of the last margin call, up to the date of cancellation. However, Alpha has a credit policy in place to mitigate any potential losses arising from a client failing to settle; in particular, Alpha assesses the creditworthiness of clients and, where a hedging facility has been extended, puts in place strict limits (typically limited to 3 per cent. or 5 per cent. of the value of the contract with a client). If a client should fail to make payments to the Group when due, this could have a material adverse effect on the Group’s business, results of operations, financial condition and prospects. A discussion relating to credit risk and credit risk management is set out in Note 16 to the historical financial information in Part 4 of this document.

Thanks Maynard, that analysis is very useful. I have a small position in Argentex. However, I have resisted the temptation to increase it because, like you, I do not really understand how the working capital works. As I remember it, they raised new money at the IPO because they required cash for extra collateral in order to grow. My concern therefore - will they get to the point where growth will again be constrained by lack of cash for WC? I am waiting for the full year results to try to get a few more clues on how WC might develop in the future, but as you point out the past has been very lumpy.

I had not picked up on the Alpha FX profit warning, and possible impact on AGFX.
Bill

Hi Bill,

Thanks for the reply.

Quite possibly. As the business grows, more collateral is needed to satisfy the counterparties. But I am not sure of the relationship – e.g. whether to double revenue requires a doubling of cash working-capital. I suspect the Alpha FX warning surprised a few of its shareholders who were not aware of the client margin-call risk. I too will look at the FY results to try to understand what is going on.

Maynard