AN OPEN LETTER TO THE BOARD OF CLOSE BROTHERS GROUP
15 MARCH 2022
To the Board of Close Brothers Group:
Close Brothers is a perfect example of everything that is wrong with the UK listed market, adapting
itself like a Galapagos finch to the perverse incentives that filter through to it from the UK’s
moribund institutional investment industry. This has manifested itself in a religious adherence to
dividend payments to feed these income-hungry institutional machines, to the exclusion of all other
options for generating shareholder value.
CBG perennially trades at a discount to intrinsic value. It is now trading at the lowest multiple ever
and yet the Board continues to sit on its hands, neither buying back shares nor exploring the sale of
non-core businesses.
What is CBG worth?
CBG is worth at least £20 per share vs a current share price of £11. This values Winterflood at
£275m or 10x its cyclically average earnings, Asset Management at £175m or 10x most recent
earnings, and the core banking business at £2.6bn or 2x tangible net asset value. Let’s look at why
these valuations are reasonable.
Winterflood
Winterflood is the largest wholesale equities broker by volume in the UK with a strong market
position in UK small caps especially and an excellent track record of returns. It has averaged a 35% return on equity over the last 15 years (including a pro rata share of corporate expenses). A 10x multiple for a business of this quality is very reasonable and values the business at £275m.
Asset Management
CBG has built an attractive asset management business that currently has £18bn AUM with 8-10%
net inflows per annum since 2014 and a revenue margin of 90bps. It’s current return on equity is
30%, including its pro rata share of corporate expenses, and it has averaged 18% RoE since 2006,
including through the financial crisis of 2008-10.
Brewin Dolphin, a listed peer that operates a vertically-integrated model like CBG’s and has similar return characteristics, trades at 12x earnings. Given the smaller size of CBG’s asset management business, I have used a 10x multiple for a value of £175m
Banking
CBG’s core banking business is a collection of excellent speciality finance franchises that have
generated an average 18% post-tax return on equity since 2006, despite conservative leverage
ratios, currently 12%. Even more impressive, it has maintained that high return whilst growing loan
book 10.5% per annum over that period, and paying out half its earnings in dividends. It achieves
7.5-8% NIMs with very little volatility in its bad debt ratio, the latter having remained at 1.3% of receivables on average with a high of 2.6% in 2009. It has consistently kept its expense ratio at
around 50% over that period, which is good for a multi-line lender.
It is reasonable to assume that the current environment of easy credit that has persisted since the financial crisis will come to an end sooner rather than later, and that as in the years following 2009,
CBG will post higher-than-average returns and loan book growth as capital availability tightens.
I believe a 2x tangible NAV valuation is very reasonable for a lender with CBG’s return profile and growth. Put differently, at 18% historic average RoE, 2x tangible NAV implies a cost of equity of 9%,
very reasonable given CBG’s consistent profitability, conservative underwriting and leverage, and
loan book growth.
As a recent external benchmark, we can look at an offer that has just been made for CBG’s main
competitor, Premium Credit, in its insurance premium finance business, which accounts for 12% of CBG’s book. Premium Credit’s owners Cinven are reported to have received offers for the business
at £600m, or 2x its most recent tangible net asset value.
Valuation
Putting all the above together values the group at around £3 billion or £20 per share, as compared
to a current price of £11 and a historic high of just under £17.
What the Board should do
The Board needs to address the discount to intrinsic value. To do this it should do two things:
-
Buy back shares. Buying back shares worth £20 at a cost of £11 provides shareholders with
an immediate return of almost 100%, clearly better for shareholder value than paying dividends. -
Explore divesting Winterflood and Asset Management, which have no synergies with CBG
Banking. Both these businesses could benefit from scale advantages provided by a strategic
buyer, with Asset Management in particular being part of an industry that is rapidly consolidating. Separating these out would facilitate a rerating of the Banking business.
In considering these two actions, the Board needs to dispel two misconceptions which it holds, as
follows:
-
CBG’s shareholders ‘want’ dividends. This is not a good reason to pay dividends. It is the
Board’s role to allocate capital in a way that maximises shareholder value rather than
addressing the idiosyncratic needs of individual categories of shareholders. It is irrefutable
that when the company’s share price is £11 per share but it is worth £20 per share, then
buying back shares is a better use of capital than paying dividends. -
Winterflood and Asset Management provide valuable earnings diversification, Winterflood’s
earnings in particular being negatively correlated to Banking’s. I believe this misconception
is a subset of the Board’s religious adherence to dividends, valuing Winterflood’s earnings
profile mainly for its support to the dividend during times of penury in banking.
It is important for me to note that Close Brothers is a superbly managed business at an operational
level, with excellent returns as I have pointed out and very high net promoter scores (NPS) scores in
the banking business. Where it is failing shareholders is on decisions of capital allocation. The Board must act now to address this.
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