Almost all of STM's earnings are derived from its Qualifying Recognised Overseas Pension Schemes (QROPS) business, an offshore pension scheme approved by HMRC and used by expatriates and internationally mobile employees whose tax domicile can change as a consequence of employment. STM has an office in Malta as a responsible EU jurisdiction to act as a pension hub for the business, and another in Gibraltar. Having grown the business rapidly in recent years, new business sales slowed in the first half of 2016 as economic uncertainty surrounding the EU Referendum prompted a slowdown in pension transfers from the UK.
In order to address the short-term lull in the decision-making process of potential QROP clients, STM introduced a new pricing structure at the end of April whereby the annual management charge on its QROPS scheme was cut from £900 to £750 (blended rate of £820 on all its QROPS), and it also waived the £800 inception fee for a trial six-month period. This not only made the company far more competitive as its annual management fees were at the top end of the market, but the pricing initiative has had the desired effect of pulling in new clients.
New business numbers for QROPS clients increased by 15 per cent in June over the month of May, and those for July were 28 per cent ahead of June. In fact, new business applications last month hit their highest level in the past 12 months with the uplift in new business coming from both new and existing intermediaries. STM now has 70 introducing agents on its books, although it’s too early to gauge whether this higher run rate will continue into future months and whether it will have a material impact on the full-year.
That said, analyst Duncan Hall at brokerage finnCap is factoring in 1,500 new QROPS accounts over the course of this year, albeit this is down on the 1,900 new schemes he had factored into his estimates prior to the first half slowdown. The key here is that churn rate is very low and based on the historic book of 9,700 QROPS schemes in place which have a life of 20 to 25 years, incremental schemes being added to the book under the new pricing structure should still be very profitable. Forgoing the inception fee is a small hit to take given that a QROPS customer could generate over £18,000 of revenue at a hefty operating profit margin of 33 per cent during the lifetime of a scheme.
Impact of pricing initiative on profits
Of course, lower annual management fees and the waiver of the inception fees on new schemes have an inevitable impact on profits which is why Mr Hall now expects STM's QROPS business to generate flat operating profits of £2.8m this year on revenues of around £8.5m. This is based on STM increasing the total number of schemes under management from 9,700 at the end of 2015 to 11,000 at the end of December this year. These forecasts factor in attrition of 194 existing schemes, or 2 per cent of those in place at the start of this year.
However, the upside will be seen in 2017 when the new schemes being signed up now are generating a full 12 months of annual management fees. That's because an existing book of 11,200 schemes at the end of this year would generate annual management charge of £8.23m, or £1.1m higher than a year earlier. And with the company's annual costs stable at around £5.7m, then the operational gearing of the business results in a £800,000 operating profit increase in 2017 assuming STM can maintain a run-rate of 125 new schemes a month as finnCap is factoring in. That doesn't seem an unreasonable assumption to make especially as STM has been broadening its distribution and geographic network and now has representation in South Africa, Dubai, Hong Kong and Australia to tap into growth opportunities in a wider market place.
Also, STM's Malta Pension Contract Plan is now listed on HMRC's Recognised Overseas Pension Schemes (ROPS) list and is now available to clients and intermediary partners. Prior to this listing, all STM schemes were trust based, however in civil law countries in Europe where trusts are not a familiar concept, many advisers prefer to recommend a transfer to a contract based pension. The creation of this plan was driven by feedback from existing intermediaries, so it's only reasonable to expect these agents to now introduce new clients and enable the business to gain a stronger foothold in markets where there is a preference for a contract based solution.
Significantly undervalued
The company's other businesses include: STM Life, a flexible life assurance bond whereby assets can be introduced into a wrapper and the administration is carried out by STM; and an offshore corporate and trust administration business, handling personal trust and corporate secretarial functions. These operations are expected to generate operating profit of around £400,000 this year according to Mr Hall's forecasts, so have some worth although even if we ignore them completely then STM's equity is being very harshly rated.
That's because the company now has net funds on its balance sheet in excess of £9m, a chunky sum for a company with a market value of £23.5m. Strip this sum out and the QROPS business is being valued at £14.5m, or only five times last year's operating profit. True, £3m of that net cash pile is required as solvency capital for the above Life business, and £500,000 is required as regulatory capital for STM's other operations, but as I haven't attributed any value at all to these operations then it's only reasonable for STM to get its cash back from them if they were ever sold. In the meantime they are making a modest contribution to the bottom line.
So, even after allowing for working capital requirements, then the company still has free cash of around £4.5m. That's worth bearing in mind given that STM appointed David Easton, the managing director of STM’s Gibraltar pensions business, as Head of Pensions in advance of entering the UK SIPP market. New capital adequacy requirements come into force next month and could provide the opportunity for this strategic objective to be achieved and at an attractive price for STM shareholders given that some existing Sipp providers will be looking to sell their business. Importantly, with low-yielding cash being recycled in this way, then any acquisition is likely to be significantly earnings accretive.
The bottom line
The bottom line is that although STM's first half underlying profit performance is likely to be flat, and expect a similar outcome in the second half, the company is still building up a growing recurring revenue stream from the annual management charges earned by its QROPS business, and one that should lead to a return to profit growth in 2017 when finnCap predict a third increase in STM's pre-tax profits to £3.6m to drive up EPS from 3.8p to 5p. Moreover, having adopted a progressive payout policy based on dividend cover in the range of between 2 to 3 times, then analysts feel that the 2016 payout is still likely to be raised from 0.9p to 1.3p a share, implying STM's shares offer a forward yield of 3.25 per cent. Furthermore, if STM returns to profit growth next year, then there is even greater scope for another bumper hike in the payout in 2017. In fact, finnCap have a 2p a share dividend forecast for 2017, implying a forward dividend yield of 5 per cent.
Frankly, with STM's shares priced on a cash adjusted PE ratio of 6.5, a massive discount to nearest rival Curtis Banks, Frenkel Topping and Mattioli Woods, the business cash generative, the board ready to deploy its cash pile on an acquisition, and the QROPS business posting its highest new business sales in over a year, then I feel that the shares rate a decent recovery buy at 40p ahead of the interim results on Tuesday, 13 September. My price target is 60p, the equivalent of 11 times this year’s likely cash adjusted earnings, and 9 times next year’s cash adjusted EPS estimates. Buy.
Please note that I first advised buying the shares at 35p ('Tapping into a pensions payday', 27 Apr 2015), and last rated them a buy at 40p (‘Enlightening calls’, 15 Jun 2016).
