Tullett like it is - Structural issues are a concern but not necessarily terminal for a business


Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

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.



Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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