I have been positive on the company for over 20 months now, having initiated coverage last year when the price was 220p ('Solid income buy', 25 Feb 2013). In this time the board raised the payout per share from 11.25p to 14.5p last year and guidance is for a payout of 16.5p in 2014. On that basis, the shares offer a decent 3.4 per cent yield, the appeal of which is augmented by a policy of paying out dividends on a quarterly basis. The next payment of 4.25p a share will be made on 11 December and the shares go ex-dividend on 20 November.
It was the attractions of a rising income stream and a policy to pay out two-thirds of EPS as dividends that first sparked my attention in Jarvis. Indeed, the company has paid out almost 24p in dividends to shareholders since February last year. Undoubtedly, it has appealed to other income investors, too, who will find the progressive quarterly payout an attractive home for their cash.
It's therefore important that Jarvis can maintain the profit momentum to support its dividend policy. And that's exactly what it has been doing. Having raised revenues almost 8 per cent to £3.75m and pre-tax profit by 10.5 per cent to £1.68m in the six months to the end of June 2014, the company is bang on target to achieve analysts' full-year estimates of revenue of £7.5m and pre-tax profit of £3.3m. On that basis, expect EPS to rise to 23.6p, up from 21.6p in 2013.
Implications of the economic back drop
But markets are forward looking, so that earnings news is already in the price. What we need now is a catalyst for Jarvis's shares to make further headway. The most obvious is an unexpected boost to earnings.
Bearing this in mind, there is one important factor not priced into Jarvis's current valuation: a potential profit windfall from rising UK base rates. As regular readers of my articles will be aware, I have set my stall out that the Bank of England will raise bank base rate next year, albeit rises will be in small steps and the tightening cycle will be far less severe than we have historically been accustomed to. That's because after five years of austerity and below inflation pay rises, consumers have far greater sensitivity to interest rate rises than they did before the financial crisis.
That said, the tide seems to be turning in favour of employees again, a point that at least one member of the central bank's rate setting committee has picked up on. In fact, with unemployment falling to 6 per cent, its lowest level since 2008, and employment levels in the UK at record levels, there is an increasing risk that delaying the inevitable first rate rise will allow wage inflation to take hold much sooner than the dovish members of the central bank's Monetary Policy Committee (MPC) anticipate.
Indeed, on a quarterly basis, UK private sector wage inflation is now running at double the 1.2 per cent consumer's price index (CPI) in September. This has prompted hawks such as Martin Weale, one of the nine wise men on the MPC, to vote for a bank base rate rise now even though inflation is currently undershooting the central bank's 2 per cent target rate.
There is logic to this thinking as economists should be far more concerned with future inflation expectations and what core inflation will be in two to three years' time as the transitory factors that have led to the current benign environment unwind. For example, the strength of sterling in the first half of this year is estimated to have depressed CPI by 0.5 per cent and has contributed to the fall in CPI from a summer high of 1.9 per cent in June. A near 30 per cent slump in the Brent Crude benchmark oil price since mid-June has simply acerbated the fall. However, since the start of July sterling has given up all its gains and more against the US dollar, and so is unwinding some of that price deflation.
Moreover, if the US dollar continues its upward march as investors warm to the idea that the US Federal Reserve will normalise interest rates, and the UK unemployment rate drops further on the back of a strengthening of the domestic economic recovery, then the twin effects of a tightening labour market (fuelling private sector wage inflation) and the absence of one-off commodity price falls, are set to reverse the fall in CPI by this time next year. Commodity prices are dollar denominated so the effect of sterling weakness against the greenback is inflationary in local currency terms.
If this scenario plays out, with the caveat that the higher probability of the eurozone entering a triple-dip recession could make the MPC more cautious, then I would expect the MPC to act well before then by making its first move to raise base rate from its record low. This would be very positive for Jarvis Securities. Let me explain.
Income windfall from clients' deposits
On the corporate side, Jarvis provides outsourced and partnered financial administration services to a number of third-party organisations, including advisers, stockbrokers, banks and fund managers. The company has more than 25 institutional clients, including asset management group Franklin Templeton and Goldman Sachs. These financial institutions are attracted by the convenience of outsourcing time-consuming and laborious back-office/administration functions.
It's proving popular as cash under administration increased by a third since last year to £143m, having averaged £70m between 2010 and 2012. These funds are placed on short-term deposit of less than one year with triple-A-rated banks. In relation to Jarvis's annual profits of £3.3m, this means that very small moves in bank base rate will have a significant impact on the interest income earned by Jarvis on its cash under administration. Gross interest earned on broking accounts and cash in the bank account for over two-fifths of Jarvis's revenues with the balance earned from fees and commissions.
It's worth flagging up, too, that the company's retail broking division continues to prove very popular - client numbers have grown at an annual average rate of over 13 per cent since in the past five years - so the deposits held on share trading accounts by these customers is far higher now than it was when Bank of England base rate was last at a normal level.
Importantly, the potential profit upside from higher interest rates is not yet built into analysts' earnings estimates for 2015.
Valuation
Currently, consensus is for Jarvis to increase revenues by £200,000 to £7.7m in 2015 to underpin a similar sized increase in pre-tax profit to £3.5m and lift EPS to 25p. On that basis, the dividend per share rises again to 17.3p, which means the shares are trading on 19 times forward earnings and offer a 3.5 per cent prospective dividend yield.
However, the company has net funds of £9.5m on its balance sheet, or the equivalent of 86p a share. So, on a cash-adjusted basis, the shares are priced on a more reasonable 16 times 2015 earnings estimates, a rating that could look a bargain in 12 months' time if the Bank of England starts tightening monetary policy.
In the circumstances, I believe that Jarvis Securities' shares are worth buying on a bid-offer spread of 470p to 485p and I have a target price in the range between 580p and 600p. Please note that I last reviewed the investment case when the share price was 520p ('Cash-rich income play', 28 Jul 2014).
I have published 41 investment columns since the start of October, all of which are available on my IC homepage...
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