Stockwatch: Director share-buying justifies optimism here

by Edmond Jackson from interactive investor |

Shares have drifted, but the investment rationale looks modestly delayed rather than knocked off course.

Does a company dropping an acquisitions strategy imply its growth story is going stale and that the shares should justifiably be de-rated?  Might it also imply that the situation could be higher risk if they have bitten off more than they can chew, or, on a simpler level, target prices have got too high to add worthwhile value?  

Acquisitions are the key, especially for "consolidators" – listed companies that have targeted a fragmented industry, saying they create value by way of a dominant market position, integrating smaller firms.  

Reported financial growth has most momentum when they are doing deals, yet examples abound where organic growth doesn't deliver anywhere near the same impetus after the takeover music slows or stops.  Active investors are prone to move on, and there's a self-fulfilling drop in the share price.

It's essential to consider if there's been any shift in strategy that marks a watershed moment; whether a stock's risk/reward profile has changed, because if an acquirer is over-stretched, this classically is a chief source of wealth destruction on the stock market. It's all the more enticing because a share price fall can bowl a low price/earnings (PE) ratio in an historic context of impressive growth, and directors close to the action are buying, although they may not see the wider context.  

Presently, I don't think that's the case at AIM-listed AFH Financial Group (LSE:AFHP) whose share price is currently around 290p, down 30% from an all-time high a year ago.  More likely its targets are getting pricier as the fragmented industry of independent financial advisers (IFAs) gets bought up.  It's cooled on acquisitions before, in 2016, yet the table of results shows uninterrupted growth.  In context of its strategic goal to become "the leading financial planning-led wealth manager in the UK," it appears just over half-way there.

Source: TradingView Past performance is not a guide to future performance

Has heightened Brexit uncertainty hit investor behaviour?

Yesterday, AFH issued a business update which said it is ceasing further acquisitions in the current financial environment – as if Brexit is doing damage, which is worth noting for other investment management type shares.  The uncertain political and economic conditions of 2016 have returned "and will influence investor behaviour for the foreseeable future," the firm said, although it's unclear quite whether that's a foil for wanting to get off the acquisitions treadmill than end up stressed.

It's some turnaround given a 13 September announcement said that after raising £15 million last July, two IFA businesses had been acquired for a maximum £7.2 million and "we continue to undertake due diligence on the pipeline of acquisition opportunities that were referenced in the placing announcement and look forward to updating the market in due course."  

Those deals took total funds under management to over £5.6 billion, in context of a target for £10 billion, and revenue – forecast at £79 million up from £51 million last year – is targeted at £140 million.  Yesterday, AFH cited £10.3 million total committed acquisitions spend since July's capital-raising, albeit a £17.1 million gap between initial consideration for seven acquisitions made in AFH's current year and maximum due over the next three financial periods.  

Vendors get greedy, and a stock de-rating

Yesterday's update did not anticipate any further funding "from the equity market in the foreseeable future," (you could quibble on precise language if so inclined) but broadly they reckon they can cope from working capital.  

The problem is higher acquisition prices: they don't say this directly but note the need for "an element of arbitrage to exist between the company and the acquisition target where the multiple paid for acquisitions is below the multiple as which the acquirer's shares are traded, both to ensure accretion for existing shareholders and to compensate for any inherent risk in acquiring businesses."  

Given AFH's historic PE multiples have de-rated from a 30-45x range, to about 20x, if asking prices have risen in deals then, yes, AFH is currently squeezed.  A cynic would say the game is up, at least until a harsher economic climate mitigates vendors' expectations and/or AFH's rating can rise again.  I think some caution is justified given financial stocks may well stay pressured in the Brexit environment; more positively in the short term it could reduce "earn-outs" (final instalments on takeovers) required.

Management did reaffirm its financial targets, even if it is hard to see how they can be delivered without resuming acquisitions in future.  Fifty have been made since listing on AIM in 2014.  That, together with organic growth, boosted revenues by some 400% and earnings per share by 600% - the kind of dynamic to entice stock market investors, hence the chart reaching 415p a year ago.  See in the table below how the annual average historic PE multiple gained a racy 30-45x.  Admittedly, it's lower on a forward-looking view, albeit with the risk of some de-rating whenever growth momentum slowed.  

It also appears AFH shares have been caught in two macro headwinds: the market slide in the second half of 2018 had the share price down at 311p by May this year, followed by a rally to 385p. However, it has been downhill after, hitting 267p earlier last month.  Yes, there has been the US/China trade tiff hitting markets – financial shares especially – and now Brexit coming to a head, although management throwing in the towel on acquisitions could be seen as a reaction to investors getting nervous at the pace of deals. Remember, AFH's equity has de-rated partly in respect of higher risk.    

AFH Financial Group - financial summary                
year ended 31 Oct     2013 2014 2015 2016 2017 2018
Turnover (£ million)     10.8 15.0 21.0 24.1 33.6 50.7
IFRS3 pre-tax profit (£m)     1.1 0.9 1.6 2.0 3.5 7.8
Normalised pre-tax profit (£m)     1.0 0.9 1.6 2.0 3.5 7.8
Operating margin (%)     9.9 6.0 8.4 9.3 11.1 15.7
IFRS3 earnings/share (p)     4.2 3.1 5.5 6.6 10.3 6.6
Normalised earnings/share (p)     4.1 3.1 5.5 7.2 11.2 14.6
Earnings per share growth (%)     375 -24.9 77.1 30.9 55.6 30.4
Price/earnings multiple (x)               19.7
Annual average historic P/E (x)       41.6 46.0 29.2 32.8 46.5
Cash flow/share (p)     4.1 8.5 9.7 11.5 14.1 8.6
Capex/share (p)       15.4 37.0 23.1 30.3 68.7
Ordinary dividend per share (p)     1.0 1.3 1.5 3.0 4.0 6.0
Dividend yield (%)               2.1
Covered by earnings (x)     4.1 2.4 3.7 2.4 2.8 2.4
Net tangible assets per share (p)       4.3 -41.1 -5.0 -14.9 -45.2
Source: historic Company REFS                

Non-executive director buys into the price drop

The consensus earnings per share (EPS) projection is for earnings to more than double to 30.5p in AFH's current year to end-October, then high-teens growth to 35.6p in 2019/20.  If that's fair, then the 12-month forward PE is sub 8 times based on a proven operating margin of 17% and nearer 25% targeted. There's also a 3.6% prospective yield, which initially looks attractive value.

Indeed, on 23 September a non-executive director bought £25,000 worth of shares at 290p, increasing his holding by 17% to 58,223 shares, perhaps reflecting belief in value than merely respecting best practice for non-execs to own a stake, as they do after appointment.  This follows his buying £50,000 worth at 320p on 9 August, so you could say he's mistakenly averaging down, although such sums imply genuine belief in value.

Forecasts already assume an extent of earnings growth consolidation after the current year looks in the bag: interim results to end-April had shown strong all-round growth – rates over 50% - and yesterday's update re-affirmed "the business has continued to perform well."  A full trading update is due early November.

A cautious than screaming 'buy'

You could say my coverage of AFH has been late to the party: initially backed at 345p in June 2018 on the basis of plenty more scope in a fragmented sector: "it's possible to envisage AFH at least doubling in size, taking its stock over 400p even if its rating eases somewhat."  

Stalling on acquisitions has checked this despite it being prudent for now.  The stock did indeed carry on rising to 415p that September, and my rationale has been compromised also by a couple of downdrafts in financial stocks.  

But I continue to like financial planning as a relatively dependable sector with good margins, where clients may prove sticky to their funds in a downturn, although remember that asset manager revenues link to funds' underlying value.  Last June, I suggested "buy the dips, mindful of long-term risks" and I think this still applies. 

Significantly, and despite regular announcements this year about options exercising, directors and senior managers haven't sold stock.  If you saw concerted selling and hefty debt, then that would definitely be a 'sell' sign when an acquisitive group calls a halt to deal-making, but AFH's debts are negligible and there are no excess trade payables.

To quibble: the table shows a drop in cash flow per share after 2017 versus high capital expenditure (not unusual in itself during an investment phase), and the last interim results showed cash generated from operations down from £3.5 million to £765,000 before tax.  It's not what you want to see and internal house-keeping like this is likely another reason for stalling acquisitions.

Altogether, I see changes that justify some de-rating in AFH shares currently, but the investment rationale looks modestly delayed rather than knocked off course.  Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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