Hargreaves Lansdown (HL): could be a multi-bagger?

Hi Maynard,

Marmite alert - Hargreaves Lansdown could be a multi-bagger?

The Investment Cycle

From a newscast of 22 Feb '22:

Looking ahead, the Bristol-based firm said it will ramp up investment in order to deliver on a “significant growth opportunity” in the wealth space, as it competes with FTSE 250 constituent AJ Bell and with interactive investor, which is set to be acquired by FTSE 100-listed abrdn.

To do so, Hargreaves Lansdown plans to invest in its platform, “notably on technology spend and key capabilities” over the next five years. The stockbroker has initiated a programme of strategic investment of GBP175 million over 5 years, starting with GBP35 million this year to June 2022, plus GBP10 million of dual system costs.

“Earnings reduction for this year and next is likely to be 10% to 15%. While this is an amazing business, still taking share, the cost of reacting to competitive threats is significant, and the profitability and growth outcome not above current expectations,” said Shore Capital analyst Ben Williams.

HL’s price reduction since this newscast is -46.5%.
Share Price reduction since all time high (May 19) -60%+ (as you mention here).

I wonder whether the benefits of HL’s increased investment cycle will be reaped over the next decade, and the current price weakness is a reflection of the market’s short-termism and lack of appreciation of the investment cycle?
:point_down:
HL. capex is currently £15.6m ramping up to £45m in 2024
AJB capex is currently £3.5m ramping down to £2.2m in 2024.

{In detail, HL’s investment plan is Over the 5 years from FY22 to FY26 we will undertake Investment Spend of £175 million to deliver on our strategy split as follows (FY22 c£35m, FY23 c£65m, FY24 c£45m, FY25 c£25m and FY26 c£5m).}
{Cost savings to fund 80% of the HL. investment spend, they say}

(Just for interest AJB distribution costs were £11.1m annually, HL. marketing costs 28.3m annually)

The projected absolute difference in £ capex spend between HL. and AJB is just incredible.

  • If the enhanced capital investment plan which HL. announced in February is justified (incremental rate of return > cost of capital), if makes me worry for AJB, which is attempting to offer to both the D2C and D2B/fin advisors, on what seems like a frugal / shoestring capital investment budget. (I believe HL. offers to just the D2C market).

(For context HL. is roughly 4x larger than AJB).

Share Overhang

There appears to be a share overhang for HL. from Lindsell Train, which is currently holding 60.6m shares /12.7%, down 5.76m shares over the past 3 months. This may cause future share price weakness if selling continues.

Also, if the founders decide to reduce their holdings there will be share price weakness.

On the other hand, the FCF yield is currently 7%, when historically it has been 3%ish. Possible opportunity?

Conclusions

The investment thesis depends on:

  1. the investor’s competitive analysis between HL., AJB, ii/ABDN et all

  2. whether HL. capital investments will bear fruit (incremental returns>Cost of Capital), so increasing the HL’s value/share price.

  3. the credibility of the statement that capital investments will be 80% funded from savings elsewhere within the business.

  4. whether operating margins will increase along with customer retention increasing along with client acquisition increasing, to allow the client base of 2.1m projected for FY24 to be 2.6m by the end of FY26 (June year-end). If so, this leads to a double-whammy of positive share price drivers (revenue and operating margin).

  5. is the overall market size still growing? If so, how long will it continue to do so? Market participants tend to not compete so much on charges if the market is growing. Lack of cut-throat competition is necessary for super-normal profits.

I don’t hold HL or AJB or ABDN, and won’t until the share price gets a little more solid with the share overhang resolved. I don’t mind missing some profit.

Mr Blobby

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Hi Mr Blobby,

Many thanks for the super write-up and welcome to the forum!

The counter-argument could be HL has a grandiose budget for a bells-and-whistles service while AJB can provide a similar service in a much more efficient manner. I do wonder if some of this spend is catching up on past under-investment. HL for example does not offer a Bed & ISA service:

We’re currently working on a new, digital process which will make it easier for you to do this. We aim to make it available in the new tax year.

But for now, you can sell investments in your Fund and Share Account online and then separately move the money to your ISA or SIPP. You can then reinvest the cash.

But AJB does:

Log into your account and from within your Dealing account portfolio page, select the ‘Bed and ISA’ button. You can then choose the investments you want to sell in your Dealing account and buy back in your Stocks and shares ISA or Lifetime ISA. Once you have submitted your request, we will place the Bed and ISA transaction within 10 working days, and you will receive two contract notes confirming the orders.

One of HL’s targets from the Capital Markets Day slides was reducing calls relating to password resets by 90k. I know HL has 1.7 million clients, but how good is the IT when at least 90k calls a year are about password resets?!

Some might say Nick Train selling could a contra-indicator :slight_smile: Personally I would not worry too much about share overhangs; fund managers and founders can sell for all sorts of reasons that may not be due to the underlying business. Once the overhang clears, the price may be higher.

FCF may be a little wobbly for the next few years following the investment spend. But there is a 4%-ish dividend income, and HL says the payout will grow by 3%pa for 2022 and 2023. If nothing else the £9 price looks very interesting from a ‘quality/income’ point of view.

HL’s strategy involves moving up the customer ladder and attract greater fees from supplying ‘augmented advice’. Providing advice does not sound quite as scalable as running the funds platform business, and the move may be a reaction to lower-cost competition. The current crop of Youtube experts prefer Freetrade (and similar), perhaps due to affiliate links:

My general impression of HL is the fees are high, the fund performances are not great, profits rely on client inertia and the service is not as great as it once was. I don’t like the Woodford mess either. But customer numbers continue to increase so maybe those are not really issues!

Maynard

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Hi Maynard,

Thank you for the reply.

I’ve looked into this further, and I now understand the problem with HL, despite it’s outstanding metrics:

Operating profit margin has been reducing since 2013:

Year Op TT margin
2004 23.2
2005 26.0
2006 33.0
2007 41.0
2008 48.0
2009 53.6
2010 53.7
2011 64.7
2012 67.8
2013 71.5
2014 71.3
2015 67.3
2016 67.0
2017 68.0
2018 64.5
2019 62.7
2020 61.0
2021 58.0
2022 53.0

Why? Well the sales mix has been changing - there has been larger growth in lower margin products:

Margin% 5 year CAGR Revenue (£k) % of 2021 revenue
27 39.52% Stockbroking 36.0
27 15.71% Mgt fees 4.9
72 10.20% Cash 8.0
41 9.61% Platform fees 36.9
74 6.60% HL Funds 9.6
47 -9.08% Other 4.6

Platform fees have reached a level which cannot be increased at a rate much more than inflation imo. Stockbroking trading fees seem high to me also.

HL’s share of the UK broking market has increased considerably, to the point where I don’t really feel it can be improved without HL being accused of being anti-competitive (I am no expert in competition law, however):

Year % of UK Stockbroking volumes
2013 18.0
2014 22.5
2015 24.1
2016 26.9
2017 30.1
2018 32.5
2019 34.5
2020 41.3
2021 43.3

The aforementioned change in sales mix means that operating profit per employee has been reducing, despite revenue per employee increasing:

Year Op TT per emp (£k) Rev/employee (£k)
2008 88.2 184
2009 117.5 219
2010 143.0 253
2011 199.2 323
2012 229.2 363
2013 263.3 400
2014 262.0 451
2015 217.7 434
2016 225.3 337
2017 248.2 370
2018 187.5 291
2019 185.2 296
2020 204.1 335
2021 199.7 344
2022 170.1 381

Market Size

Is the market increasing in overall size, as claimed by HL? This would allow future growth in high margin product lines.

Using HL’s figures from their annual reports, it isn’t really clear at all:

Year HL. AUA (£bn) Market size (D2C) (£bn) Market size (Direct Wealth) (£bn) Market size (Direct Wealth+Cash) (£bn)
2021 136 289 ? 3,000
2020 104 210 ? 2,400
2019 99 222 1,000 2,400
2018 92 206 1,100 2,400
2017 79 190 1,100 2,400

Future Growth Opportunity with HL Funds?

What about growth in HL’s high margin funds business (74% operating margin)? Well, for the past 4 years revenue hasn’t been growing:

Year HL Funds revenue (£k)
2016 44,100
2017 56,500
2018 67,200
2019 68,300
2020 63,600
2021 60,700

Conclusions

Having looked at HL. in more detail, I think it had it’s heyday in 2014 when operating margins were increasing (71.3% vs 53% now) along with increasing operating profit per employee of £262k (now £170k).

HL. seems to be losing it’s competitive advantage and I would suggest this is the reason for their enormous 5 year investment plan. Smacks of desperation, maybe?

I therefore can understand it’s de-rating of the past couple of years, and withdraw my bagging recommendation!

Structural problems, such as the reduction in the % fee chargeable to active funds, disruption from new entrants, and how large the operation is relative to the UK markets have taken the shine off HL.

I also struggle with the external funds HL recommend / don’t recommend. Let’s not go down that particular rabbit hole!

Have a good day!

MrBlobby

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Hi MrBlobby
Thanks for the commentary.

I was a holder of HL until recently and remain keen to buy back in.

My fundamental reason for selling was a belief that the company’s Stock Broking revenue (£67m in FY19, £232m in FY21) is about to surprise to the downside, which will result in the company missing FY22 guidance.

That makes it a dangerous holding in the current market environment.

So once the bad news is out of the way I’m keen to re-assess the situation, and hopefully buy back in based on the following:

  • I see the Recurring Revenue streams (primarily Platform and Fund management fees) as relatively stable, even if AUA is likely to have declined recently as a result of market weakness.

  • As Maynard pointed out much of the company’s strength lies in its customer’s inertia.
    As someone who uses HL myself I can attest to this. I think the client support is top class, with rapid, knowledgeable responses, which I highly appreciate. I can’t envisage myself moving despite the relatively higher fees.

  • The average client age was last reported as 45.8 and the average client value was £80.2k. That leaves a lot of years of easy growth, even without onboarding new clients, especially with ISA allowances remaining at £20k pa.

image


  • I think there’s going to be some nice interest income upside in FY23.
    For context, the interest rate was 0.75% for nearly all of FY20, when interest income was £91m.
    In H1 FY22, when the BOE interest rate was 0.1%, interest income was £12m.
    We’re now back up to 1.0%.

For caution I’ve assumed a material increase in operating costs in FY23 - where staff costs are unsurprisingly the largest component, and will presumably be more impactful on the smaller players - which will result in an operating profit of £330m (= c.50% OP% margin)

That still looks good versus the current EV of c£3.8b.

As always there are a lot of assumptions in my numbers, though I hope I’ve been cautious enough in my outlook to leave more upside than downside. I’ll no doubt be able to re-assess when the FY results are released in a few months, but that aside I still see HL as a quality operator with plenty of long term growth to come.

Cheers
A

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Hi abtan

Yes. HL is an interesting proposition. All good points.

It’s nice to see the average client age reducing slightly half-year on half-year. I had missed that!

So, going forward, overall operating margin won’t expand, imo. That ship has bolted the stable door! :thinking:, but volume of business will increase over time, and it could be argued ‘owners cash profit per share’ may also increase by 10% p.a. + over the coming years:

If, for example I was looking for a 10% fcf yield, this should be achieved within 3 years (based on fcf also increasing +10% p.a.) :

TIDM FCFf (m) Capex (m) Deprec. & Amort. (m) FCFf with maint cap Shares in issue (m) FCFf per share (p) Price ps (p) 10% Price paid fcf growth p.a. % Years to 10% fcf yield @ 120522
HL. 306.4 18.2 15.1 309.5 474.3 65.25 839.2 83.92 10 3

In the above example, I’ve treated the recently announced investment plan as relating to incremental revenue, it’s arguable, and in truth it’s probably a mix of maintenance capex and incremental revenue capex.

Having said that, if 80% of the £175m investment plan is funded from savings however, that would ‘only’ be an additional £7m p.a. (relative to a fcf of £300m+, currently).

In a similar vein to yourself, I think I’m going to wait until the reduction in AUA are announced before buying - it may cause a share price wobble which could presage excess returns in the future.

I’ll leave you with a few charts - I appear to have gone down a rabbit hole on HL. this morning :crazy_face:.:

And then to confuse it all, HL’s erratic increase in client numbers vs AJB’s consistent increase in client numbers:

Whether you like AJB or HL, both have impressive economics.

If one can see the D2C market size increasing, HL may be a buy and AJB vs HL competition a less important factor.

HL seems to have more in the tank, to boost marketing if required. Perhaps their limiting factor was IT, rather than marketing spend, hence the capital spending programme?

It’s on the watchlist, anyways!

MrBlobby

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Hi MrBlobby
Thanks for continuing the discussion.

£HL. actually put a TU out this morning confirming the (unsurprising) decrease in AUA - down 6% since December 31st, and only down 0.5% YOY.

What surprised me was the confirmation that everything was so far going according to plan.
What that means I’m not really sure as I can’t find any indication of what current year expectations are.
It’s worth noting that revenue in the Jan-Apr period that was reported today is down 41% vs last year.

With presumably stable operating margins going forward, upside is therefore expected to come from revenue growth:

  • a natural rise in customer deposits (presumably from annual ISA allowance/Pension transfers);

  • the expected increase in stock market valuations, and;

  • increasing interest income (as mentioned in today’s update)

All the above should offer downside protection in the coming years, with increasing customer numbers, if they happen, a nice bonus on top.

Thanks for all the graphs, and specifically your table showing the 3 year 10% FCF yield target.
Cashflow is the #1 thing I look at, so it was interesting seeing this. Personally I think the FCF yield is high enough now for a purchase, so my finger is close to the Buy button.

Cheers again
A

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@MrBlobby I prefer your original multi-bagger prognosis!

Also, I think your % new clients chart has the wrong data for HL (no idea about AJB).

Here’s are the numbers I have plus a few other bits for context:

Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
AUA (£bn) 26 36 47 55 62 79 92 99 104 136
Clients (millions) 0.43 0.51 0.65 0.74 0.84 0.95 1.09 1.22 1.41 1.65
# new clients (thousands) 45 82 145 84 100 118 137 133 188 233
% new clients 12% 19% 29% 13% 14% 14% 14% 12% 15% 17%

So % new clients has been consistently mid-teen other than 2014 where it reached almost 30%, very probably because that was when RDR was introduced, so lots of people moved from their financial adviser to DIY via HL.

Personally, I think the most incredible stat is that # new clients just keeps going up, despite HL already totally dominating the market (although obviously there’s a sort of viral effect going on here as HL becomes more widely known and used by friends and families).

It will be interesting to see how much of the advised market it can hoover up as its AI advice systems come online. Also, if AI advice leads to better client outcomes, it will be interesting to see if AUA per client starts to go up and of course if retention rates go up even higher.

Disclosure: I have about 4% of my portfolio in HL so my glasses may be rose-tinted.

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you’re welcome!

Hi John,

I would be in good company if I purchased a few, then?

From the growth in client numbers maybe the D2C market really is increasing in size, as HL. suggest?

Apologies if there was an error. Just remember - To err is human, to forgive is devine.* :grinning:

MrBlobby

'* a quote fromAlexander Pope, 1711,An essay on criticism Part II

On expectations, HL. are expecting to ‘operate with positive jaws’. What’s the problem?

I expect a trading update from Roy Schneider, from the other side!

At the risk of being considered mildly obsessive, whoever built this machine is a genius:

Disclosure: Bought a few this morning.

MrBlobby

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