Inter-dealer broker Tullett Prebon issued its half-year results at the end of July and it would be fair to say these lived down to the market’s very low expectations. While equities tend to be bought and sold electronically, other assets are less easily traded and inter-dealer brokers help this happen by providing liquidity. In recent years, as you might imagine, this has been a very tough business to be in.
The reasons a company can struggle fall broadly into two categories – the first being ‘cyclical’, which means the problems are down to the business or its wider sector going through an unhelpful part of the economic cycle and so things may be expected to improve over time. The other category is ‘structural’ and these problems can be far more hazardous to a company’s health.
certainly structural issues are the ones investors view with far more concern because these can make it look as if a company is about to drop into a bottomless pit, never to emerge. The impact of the internet on businesses such as Blockbuster and HMV is a textbook example of a structural issue seriously wounding a company – and Tullett undeniably has a few such problems of its own.
Foremost among these is the aggressive regulatory environment the company faces – not least because it is so involved in trading derivatives, which have been at the root of so much of the financial mayhem of the last decade. There have also been concerted efforts to force all trading to be done electronically as this is seen as more transparent and less risky – though whether it is practical is another matter.
At the same time as its business and volumes are being hit by these concerns, Tullett has also had to cope with an environment of extraordinarily low volatility. High volatility may not be to everyone’s taste but, for a company that makes a margin on every deal it facilitates, high volatility means more trades and so higher profits. For Tullett, the on-going low volatility is very bad news indeed.
Investors can often convince themselves a company’s problems are all structural and that nothing is cyclical. However, while we are firmly of the opinion the current low volatility cannot last for ever, we would also acknowledge some of our less successful decisions historically have come from buying too early and a company’s problems turning out to be far more structural than we had initially thought.
Trinity Mirror, for example, may have come good for US in the end but, although we bought it low, for an uncomfortable period of time it traded lower. While trinity’s structural issues were fairly obvious, however – it is easy enough, for instance, to envisage a world two decades hence where nobody is reading newspapers – we believe the structural outlook for Tullett is not so bleak.
Ultimately, there are certain things that are hugely difficult to put on an electronic exchange – whether that is because they are non-standard in nature, because businesses don’t want to reveal their positions or because the contracts are time dependant and simply lack liquidity. You have to know people who know people who can source and find individuals to take the other side of your trade.
Thus, while Tullett is clearly facing some structural pressures, it seems likely that, when all is said and done, a base level of business will exist. The key questions then become – what is that level and what are you paying for it? It is time to look at some numbers, among the starkest of which is that Tullett’s sales have fallen by £225m – that is, 24% – over the last five years.
Some effective cost-cutting has seen profit margins fall by a lot less but profits are still down from £170m to close to £100m this year – so how much further could they go? Let’s assume Tullett’s sales fall another 30% from this point. This would put them down around the £500m mark – a total fall from their £950m peak of c.50%.
The business’s average profit margin over the last 11 years has been in the region of 15% but it never does any harm to play it safe when making these sorts of assumptions so let’s bring the company’s margin down to 10%. That leaves it making £50m of profits a year but, in such circumstances, how realistic is it to assume Tullett could maintain even that 10% profit margin?
Well, in 2004, the company made profits of £50m on sales of £400m so – the wiping out of a decade of growth aside – there would certainly be an element of déjà vu. On that basis, the shares would trade broadly on 10x profits and, in the meantime, investors would be being paid a 7% yield by a business with very low levels of debt.
Actually, Tullett has no debt but we are still playing things safe and, anyway, investors should not lose sight of the fact this is a business that will always require a significant level of regulatory capital. By way of adjustment therefore, we will mentally erase the company’s net cash position although, even then, you are not left with an especially risky balance sheet.
In summary, Tullett Prebon would appear to offer investors reasonably low levels of risk, a very negative structural scenario already baked in to the price and the prospect of being paid 7% to wait for things to come good – plus a free option on the volatility on which some of the business’s profits (precisely how much is open to debate) depend eventually picking up from current generational lows.
History would suggest that is a pretty heady combination of factors and, on average, these kinds of ideas do well. Yes, over the last five years, you would have looked pretty silly had you bought Tullett Prebon any time the shares were at current levels because effectively they have gone nowhere. Nevertheless, when looked at in value investing’s trademark unemotional and disciplined style, we still think the business is a very interesting prospect.