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OPINION

Cash rich income play

Cash rich income play
July 28, 2014
Cash rich income play
IC TIP: Buy at 495p

A case in point are shares in Aim-traded stockbroker and financial services outsourcer Jarvis Securities (JIM: 520p) which have more than doubled since I initiated coverage at the time of the full-year results almost 18 months ago ('Solid income buy', 25 February 2013). I last updated the investment case when the price was 458p ('Making record highs', 4 March 2014), targeting fair value of 535p. At the end of April the price got to within pennies of that target, so a pull-back was understandable as some investors who bought decided to bank the healthy gains. That consoldation period now appears to be over and I feel the fundamental case for investing remains strong enough to warrant another buy recommendation. Other investors clearly are thinking the say way, too, as the company's share price moved up 18 per cent post a bumper set of results at the end of last week.

Solid income stream

One of the key attractions of Jarvis Securities is that the company pays dividends on a quarterly basis in March, June, September and December with the aim of returning two thirds of post tax earnings back to shareholders. So, with pre-tax profits surging by 30 per cent to £3.07m on revenues up 17 per cent to £7.1m in 2013, then the board lifted the full-year payout from 11.25p to 14.5p a share, a dividend covered 1.5 times by EPS of 21.9p.

The progressive policy has continued this year as the second quarter dividend was raised from 3.5p to 4.25p, which means that the first half payout of 8p a share is up 23 per cent on the same period of 2013. Factoring in a 4.25p payout for the third and final quarters means the full-year dividend of 16.5p is set to rise 16 per cent year on year. On that basis, the prospective dividend yield is pretty healthy at 3.2 per cent. The third-quarter dividend is paid on 11 September and has an ex-dividend date of 20 August.

It's worth noting, too, that with the Isa limit for shares being increased to £15,000 in this year's Budget, and shares on the Alternative Investment Market eligible for inclusion in Isas following the rule change last summer, then income seekers will find the progressive quarterly income stream at attractive home for their cash.

Importantly, there is scope for even higher dividends in the future. That’s because the company has just released half year results to end June which showed that revenues increased almost 8 per cent to £3.75m to lift pre-tax profits by 10.5 per cent to £1.68m. Analyst Nick Spoliar at broking house W.H. Ireland is pencilling in full-year revenues of £7.5m and pre-tax profits of £3.3m, so half his full-year forecasts are already in the bag. In other words, if the current momentum in the business is maintained there is a real chance that Jarvis will post an earnings beat and exceed W.H. Ireland’s EPS estimate of 23.6p.

The key performance indicators are certainly pointing in the right direction as pre-tax profit margins rose 100 basis points to 45 per cent year on year, revenue per employee increased by more than 2 per cent to £186,800 and client numbers surged by almost a quarter, exceeding the company's target of 10 per cent growth and accelerating from the 13 per cent growth in the same period of 2013. It's reasonable to expect the momentum to be maintained, too.

Higher retail trading volumes

On the retail side, Jarvis offers two main products: ShareDeal-Active, a low-cost execution-only service for nominee and certified accounts, Isas, Peps and Sipps; and X-O, an online share trading service enabling clients to trade for a flat fee of £5.95 per trade, one of the lowest rates in the market. Boosted by the launch of X-O, retail client numbers have been growing strongly at an annual average rate of almost 14 per cent since the ongoing bull-market started in early 2009, and with very little advertising.

It's hardly a surprise that the retail side has been growing strongly in the past year given the heightened interest in IPOs from retail investors. The flotation of Royal Mail, in which Jarvis gained some positive press exposure for its low-cost execution only share dealing services led to "unprecedented demand for new accounts". Importantly, such high profile offerings not only lift transaction volumes, but offer an opportunity for Jarvis Securities to gain clients and entice new traders into the stock market.

In fact, the company now will in excess of 60,000 retail clients ranging from multimillionaires to day traders and screen-based dealing now accounts for half the business by volume. The unit has also been benefiting from exposure to the retail pension market, having launched its first low-cost execution-only Sipp product. Recent developments also include a new online trading platform which is in the final stages of testing.

In my view, the new platform can only help boost client numbers further given it will enable customers to manage more aspects of their accounts online, improve response speeds and ease of navigation. It will also improve profitability by reducing staffing costs proportionately as client numbers grow. Moreover, having invested to improve its IT systems, the business is now able to continue to grow its client base without any significant further changes to its online platform, nor any further capital outlay. The net effect is that the marginal cost per trade will continue to trend down which in turn will improve profit margins as the business scales up further.

Strong growth in corporate and retail businesses

It's also worth noting the robust growth on the corporate side. To recap, Jarvis provides outsourced and partnered financial administration services to a number of third-party organisations, including advisers, stockbrokers, banks and fund managers. The business tailors its administration processes by offering a bespoke service to meet the needs of each organisation and has built up a strong reputation for flexibility and cost-effectiveness.

Jarvis now has more than 25 institutional clients, including asset management group Franklin Templeton and Goldman Sachs. These financial companies are attracted by the convenience of outsourcing time-consuming and laborious back-office/administration functions. In the past year alone, the company has won mandates from brokerages Panmure Gordon and Daniel Stewart, Dartmoor Investment Trust and two of Chelverton's investment trusts.

As a result cash under administration has surged by a third in the past year to £143m. To put this into some perspective, it averaged around £70m between 2010 and 2012 and was around £110m at the end of last year. These funds are placed on short-term deposit of less than one year with triple-A-rated banks, a fact well worth considering given the hawkish comments made by Mark Carney, the governor of the Band of England, on the next move in the bank's base rate.

Indeed, as soon as interest rates start to return to more normal levels, as one would expect when the UK economy hits escape velocity and is strong enough to withstand monetary tightening, the increase in interest income on the £143m of funds on deposit will provide significant profit upside to Jarvis and from a much higher base than a few years ago.

To put the profit potential here into some perspective, gross interest earned on broking accounts, cash in the bank and overdrawn client accounts for around 43 per cent of Jarvis Securities' revenues with the balance earned from fees and commissions. Clearly, with cash under administration now almost five times higher than in 2008 when Bank of England base rates was last at 'normal' levels, and the number of retail trading accounts double that of five years ago, then even small changes in short-term interest rates will have a material impact on profits.

Attractive rating and positive technical set up

In the circumstances, I believe that the profit enhancement from a likely change in monetary policy aside is yet to be factored into the company's valuation. I also feel that at the current level the shares are attractively priced even without factoring in the upside potential from interest rate rises within the next six months.

That's because the business is highly cash generative and even after investing in new IT systems, and paying out £1.74m of dividends in the past 12 months, net funds still increased by £800,000 to £9.5m in the 12 months to end June 2014. This equates to 86p a share, or a sixth of the company's current market capitalisation.

Strip this sum out from W.H. Ireland's conservative fiscal 2015 pre-tax profit estimate of £3.5m on revenues of £7.7m, and the shares are only trading on 17 times cash adjusted earnings estimates of 25p a share. That’s not a punchy multiple for a business that has lifted EPS by over half in the past couple of years and raised the dividend by over 60 per cent too.

Furthermore, having drifted back since late April to the 200-day moving average at around 450p, the strong share price bounce post the half-year results is a pretty good signal that the test of the long-term trend line has been successful and the consolidation period is finally over. In addition, with the reading on the 14-day relative strength indicator (RSI) around 60, a continuation of the upmove and a move through this year's 530p share price high looks firmly on the cards.

For good measure, the trend-following moving average convergence divergence momentum indicator, known as the MACD, has bottomed out has produced a buy signal. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) of the share price from the 12-day EMA. A nine-day EMA of the MACD, called the 'signal line', is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.

In the circumstances, I believe that Jarvis Securities' shares are well worth buying again on a bid-offer spread of 500p to 520p and I have upgraded my target price to the range 580p to 600p. That's marginally above WH Ireland own target price of 560p, a valuation that doesn’t look unreasonable assuming Jarvis Securities continues to deliver robust earnings growth as I anticipate. It could even prove a conservative target if the company beats analysts conservative earnings forecasts. Needless to say, offering upto 15 per cent potential upside, I rate Jarvis Securities' shares a decent income buy.

■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'