Close Brothers Group (CBG): worth at least £20 per share

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:

  1. 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.

  2. 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:

  1. 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.

  2. 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.

3 Likes

Hi Perlican6,

Many thanks for the great post and welcome to the forum!

CBG is not a company I am familiar with, though I note it offers motor-finance similar to one of my holdings (S&U)… so perhaps I should follow it. Seems like the mooted £3b valuation is dependent mostly on the banking division trading at 2x NAV, the suitability of which is something I just don’t know.

I guess this leads on to a wider discussion abut capital allocation, and whether boards in general should drop dividends on occasions when the shares appear blindingly cheap to instead conduct a buyback.

I suppose some investors will say managers should concentrate on managing their business and let investors decide on valuation matters. Indeed, the track record of many FTSE 100 buybacks has not been great. And some investors do actually invest for income and want dividends. Maybe CBG should also stop agreeing new loans and buy back even more shares?

I would agree that a buyer could realise value at WINS and CBAM, and give greater clarity to the market on the banking side. All depends on whether management has the urge to dispose. The CEO was appointed only in 2020, and in 2021 set out his strategy which included :point_down::

Asset Management and Winterflood are valuable components of the group with a solid contribution to Group AOP, strong ROEs and attractive growth potential

So no immediate prospect of a radical overhaul. The new CEO has been a CBG Banking director since 2013, so is perhaps used to CBG’s culture and therefore likely to enforce sensible lending decisions but I suspect not consider capital allocation in a manner you wish :frowning:

Maynard

As a Close Brothers shareholder, I don’t have anything against buybacks because I also think the share price is materially below fair value. But I wouldn’t want management to cut the dividend to fund those buybacks because I also like dividends, as I’m sure do many other shareholders.

I don’t agree that there are no synergies between banking, asset management and market-making.

The market-making business, in particular, is countercyclical. So in 2008/2009 and 2020, Winterflood produced exceptional profits which provided a buffer so the pro-cyclical banking business could continue lending through those downturns, and being a reliable source of lending at all times is a key feature of Close Brothers’ offer.

As for asset management, I’m sure that business benefits from being part of a 140yr-old bank. Some people like that sort of provenance. And when the bank is making loans to small and medium businesses, it must be pretty easy to cross-sell customers from banking into asset management, wealth management and fixed-rate savings and ISAs.

So yes, I’m happy for CBG to do buybacks in addition to dividends, but I think breaking the business up could do more harm than good.

2 Likes

Who are the so called big shareholders who seem to require dividends…they are the ones who will say YES/NO to any serious proposals.

Hi Anley101,

Thanks for the post and welcome to the forum!

CBG’s 2021 annual report lists these major shareholders:

CBG shareholders

Maynard

Neither dividends nor share buybacks are a panacea, the latter increasingly misused as a signal of ‘shareholder friendliness’ irrespective of the share price’s relationship to intrinsic value. And many shareholders who would not support a cut to the dividend to fund a buyback would be completely supportive of one to avoid a dilutive equity raise, even though it is two sides to the same coin.

Rather, it is the Board’s responsibility to allocate capital to maximise shareholder value. And where the discount to intrinsic value is persistent and now also so extreme, then the Board should be doing share repurchases even if at the expense of cutting the dividend. I would also argue this extends to using capital that would otherwise be reinvested in the loan book, as long as it offers a better return, without disproportionately damaging the long term prospects of the loan book, for example by losing primacy with intermediaries.

I disagree with the points raised on Winterflood and Asset Management.

What makes CBG a reliable source of lending is its capital adequacy position, which has always been well above the regulatory minimum and will be moreso once its IRB application gets approved. Its total capital ratio is now 17.5%, 6% above the regulatory minimum which on £9.3 billion of risk-weighted assets equates to £550m or roughly 6.5% of their loan book. In addition, over the last 15 years the banking business has generated an average net pre-tax yield (ie profit before tax / average loan book) of 4.4%, with no loss years. That is 11% of loss absorbing capacity in addition to the 1.3% average impairment ratio already factored into the average yield of 4.4%. By contrast, Winterflood’s profits were roughly £50m on average during 2020 and 2021 – a cyclical peak – or 0.5% of the bank’s loan book. To put all that in perspective, the bank’s impairment ratio has never exceeded 2.6%, neither during the GFC nor Coronavirus. Therefore, I do not think it is Winterflood’s countercyclical earning capacity that is supporting the bank’s lending during downturns.

As for Asset Management, there may be some benefit in the name but no more than any of the other big players. As for cross-selling, Management acknowledge there may be some limited opportunity (p. 57 of transcript to Investor Event, June 2021) but the bigger picture is this is fundamentally a scale business and CBG is a smaller player. The business is requiring more and more investment in digitisation for eg and they are not getting the same leverage on this in their margins as their peers.

Ultimately these businesses combined account for about 15% of my estimate of total intrinsic value and neither business is detracting from the core banking business, either in terms of capital requirements or disproportionate management time. However, the persistent undervaluation of CBG’s share militates for their divestment to release value for shareholders and facilitate a rerating of the banking business.

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That says it all…BID PROOF and thank you for taking the time to find the info.

Announced today that RBC is acquiring Brewin Dolphin, which I cited as a comp to CBG’s asset management business. RBC is paying a 22x p/e as compared to the 12 p/e BRW was trading at when I posted and as compared to the 10x multiple I used to value CBG’s asset management business. CBG is 1/3 Brewin Dolphin’s turnover so I am not suggesting it would fetch 22x, but 15x is eminently possible, which would add an extra ~£100m in value, or 66p per share.

The FT article says: “There has been a wave of consolidation across the UK’s £1.8tn wealth management sector, as mounting technology and compliance costs heap pressure on smaller players to seek economies of scale by combining with other firms.”

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NatWest exploring £3bn Tilney Smith & Williamson bid, according to Citywire
As a long term Close Brothers shareholder - who has been expecting them to be bought for years - maybe this is the market moment?

Also Raymond James bought Charles Stanley in January.