STM re-rating could have some way to go

Following recent full year results shares in multi-jurisdictional financial services business STM Group surged by 17% and have since touched levels last seen in summer 2012. With significant investment having been put into the business in the past few years, and the firm benefiting from strong operational gearing, profits are set to continue rising. With the company having been off the radar of the private investor, and following some recent director buying, I believe that the shares look like a good growth (and potentially an income) play.

The Business

STM Group joined AIM in March 2007 with the objective of growing by acquisition in the fragmented international corporate and trustee service provider industry. As it stands today the business has a wider focus, earning money by administrating assets (it does not manage funds) for international clients in the areas of retirement, estate & succession planning and wealth structuring. It has offices in Gibraltar, Spain, Jersey, Malta and Cyprus.

At the core of the firm’s recent growth is its Pensions business, which made up half of total group revenues in the last financial year. The business specialises in the administration of Qualifying Recognised Overseas Pension Schemes (QROPS), an overseas pension scheme recognised by HM Revenue and Customs into which UK pension rights can be transferred. These are typically used by expatriates and those who move around for work – people whose tax domicile can change. Launched in 2006 QROPS offer a number of benefits, including there being no obligation to buy an annuity, lower taxes on pension income, more control on investments and allowances on UK inheritance tax.

STM earns money for pensions administration via an initial set up fee and then a recurring annual fee, creating a predictable and “annuity like” stream of income. Products are marketed via its distribution network of international IFAs for a nominal cost to STM. While IFAs also traditionally offer administration services, STM has a unique selling point given the specialised nature of QROPS. The current monthly run-rate of new schemes is averaging around 250, which helps to build the firm’s long term income stream.

The second largest contributor to group turnover is the Corporate and Trustee Services (CTS) business, which has operations in Jersey and Gibraltar providing administration services. In recent years the CTS business has seen revenues fall as a percentage of the group total due to the increase in the Pensions business and given difficult trading conditions in the Eurozone, where many of the company’s clients had done business.

Thirdly, STM Life provides life insurance bonds, financial products which provide a “wrapper” in which investments, including investment funds, can be held. Again, STM provides the administration of these, earning an initial set up and annual management fee. The business has over 800 schemes and took on half of these in the last financial year.

Finally, STM has certain smaller operations which are bundled in to the Other division. These activities include secretarial services in Gibraltar and accounting advisory in Spain.

NUMBERS

STM announced a very strong set of results for 2014 in early March which showed revenues up by 19% at £15.9 million. But the real highlight was the way that operational gearing had a significant effect on the bottom line.

Pre-tax profits surged by 635% in the year to £1.7 million as operating margins rose from 7% to 14.5%. This was driven by the higher revenues and by administrative expenses only growing by 8.3% – we note that wages and salaries only rose by 4.4% despite a 9% rise in the employee headcount. Finance costs for the year were also modestly lower as borrowings were reduced by £1 million.

On the balance sheet, cash stood at £5.7 million at the period end, up from £4 million, although we note that around £3.5 million of this is restricted for regulatory purposes. Taking the firm’s £2.55 million convertible loan as debt and stripping out regulatory capital then we estimate that STM had a net debt position of around £0.4 million at the end of 2014.

The strength of the business was further demonstrated in the cashflow statement, which showed a net inflow from operations of £1.85 million, representing 108% of pre-tax profits. Notably, cash was boosted by increased efficiencies in the Pensions business, with accrued income falling by £842,000 and thus falling through to cash. Improved cash collection was seen across the business as a whole, with debtor days falling by 5 days to 110 days.

Divisional Performance

By division, the Pensions business grew revenues by 36% to £8 million, with growth largely coming from the Gibraltar operation where revenues surged by 150% to £2.5 million. The larger Malta based business also did well, growing revenues by 13% to £5.5 million.

In Corporate and Trustee Services challenging market conditions continued, with revenues slipping by £0.3 million to £5.5 million, the reduction in income coming from the Jersey business, while those from Gibraltar were flat.

Finally, STM Life saw revenues more than double in 2014, from £0.6 million to £1.4 million, with revenues from the Other category down by £0.1 million at £1 million.

Opportunities

The Pensions business is expected to continue driving growth at STM, as is rising demand for QROPS. Amongst other things, demand for such schemes is being driven by macro factors including rising global mobility and the free movement of capital. According to the United Nations the number number of Britons living abroad rose by 23% to 5 million between 1990 and 2013. We also note a recent survey from Nigel Green’s financial advisory group deVere, which suggested that 59% of over 50s are thinking about moving overseas during their retirement, up from 50% in the previous survey in 2014, with tax benefits partly being an attraction.

Green (an STM shareholder) also suggests that changes announced in the recent UK Budget may help to boost demand for QROPS. He thinks that a further reduction in the lifetime allowance (LTA) for pension tax relief – from £1.25 million to £1 million – will see a rise in transfers out of the UK and into QROPS so that pensions can become exempt from the LTA limit.

Risks

As in any financial business, changes in the regulatory environment pose a threat to STM. But one short-term issue the company will have to deal with concerns its convertible loan notes. The firm currently has £2.55 million worth of notes issued which pay an annual coupon of 7% and are repayable in 2016. However, the loans carry an option to convert into equity at a price of 26p per share before the end of April this year, with STM having the option to repay those that do not convert.

A scenario which sees full conversion would result in an additional 9.8 million shares being issued, increasing the shares in issue by around 19%. Of course the effect on earnings would be less pronounced given that the annual coupon of c.£180,000 would not be paid. With the current share price being 17% above the conversion price it seems likely that the loans will be converted. On the other hand, if the notes were fully redeemed earnings would not be affected but cash flow would be be lower in the short term, probably affecting the company’s decision to make a dividend payment (see below for more on this). Given the firm’s strong cash generative nature and solid balance sheet we do not see any issues should the notes have to be fully redeemed.

One other potential issue was announced at the start of April regarding the firm’s subsidiary STM Fiduciaire. In 2012 the Jersey Financial Services Commission investigated compliance procedures at the business which concluded that it had acted swiftly to address perceived compliance failings, with no clients having been put at risk. However, the Attorney General for the States of Jersey has informed the company that it intends to pursue the prosecution of one of STM Fiduciaire’s former employees, with STM Fiduciaire as the employer being jointly charged as a defendant. The hearing is expected to start on 23rd June with the company expecting that any potential fine will be manageable and payable out of existing resources.

Director buying

There have been two notable director purchases in recent months. Alan Kentish, Director of Business & Product Development bought £203,500 worth of shares to take his stake to 11.17% and Therese Neish, Chief Financial Officer, spent just under £40,000 to take her stake to 0.92%. Kentish bought his shares from Nigel Green (see above), who once owned around a quarter of the business but has been reducing his holding (to a current 7.9%). Award winning fund manager Gervais Williams also recently increased his stake in the business from 3.6% to 19.8% via his Miton UK Smaller Companies Fund.

VALUATION

STM Group has not really been on the radar of the private investor in recent times, but the 2014 results prompted significant interest in the shares along with a c.20% price rise. This was offset slightly following the recent action announced against STM Fiduciaire.

At the current 30.5p the company is capitalised at £16.3 million, with the shares trading on 15.5 times historic earnings. But assuming revenue growth continues then the firm’s operational gearing will continue to drive profits. Market forecasts for 2015 and 2016 currently point to respective earnings of 3.9p and 5.4p per share – 174% growth in just two years. If these forecasts are met then the shares trade on a very low 2016 earnings multiple of just 5.6 times and a price to earnings growth ratio (PEG) of just 0.15 times. If the current earnings multiple is maintained then we are looking at a potential 2016 target price of 83.7p (assuming no loan note conversion).

Dividend

STM does not currently pay a dividend. However, a carefully worded statement in the 2014 results suggested that a payment may not be a long way off: “noting the steady progress in the business, the Board hopes to re-introduce a progressive dividend policy as resources allow.”

We assume that once the issue of the convertible bond is out of the way, along with the potential fine at STM Fiduciaire, then there is a strong possibility of a dividend being paid. With no immediate need to make significant capital expenditure and with no plans to make any acquisitions, we suggest that a generous payout ratio could be adopted. For illustrational purposes, a 50% payout of free cash flow in the last financial year would represent a 5.6% yield at the current share price.

Overall, we see significant growth opportunities at STM and believe that the nascent re-rating could have some way to go.