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High-yielding income play with capital upside

Shares in a small-cap stockbroker and financial services outsourcer look primed to re-rate

High-yielding income play with capital upside

I have always taken the view that it's best to run profits on winning holdings until the rationale behind the original investment no longer holds, or if the valuation has become too rich. But even if I exit a holding, it pays to keep an eye on events with a view to exploiting a future buying opportunity.

This is relevant to me right now because I banked profits on Aim-traded stockbroker and financial services outsourcer Jarvis Securities (JIM:305p) early last year ('Decision time', 23 Feb 2015) after the shares had doubled in value following my original buy advice ('Solid income buy', 25 Feb 2013). At the time I noted that the higher rating offered less margin for error, and one where the risk:reward ratio was no longer favourable. In fact, the company had experienced a slowdown in trading in the second half of 2014, in line with the experience of many stockbrokers, which had prompted analysts to rein in their profit forecasts for the 2015 financial year.

In the event, the company still managed to lift adjusted earnings per share (EPS) by 7 per cent to just shy of 25p last year, and maintained the dividend per share at 16.5p, although this was not enough to arrest an earnings multiple contraction that has sent the share price drifting back to around the 300p mark. To put the current valuation into some perspective, and based on Jarvis turning in flat adjusted pre-tax profit of £3.5m on revenue of £7.7m in 2016, as analyst Nick Spoliar of house broker WH Ireland predicts, the shares are now rated on 12 times EPS estimates. When I banked profits in February last year they were rated on 19 times earnings. Moreover, the board has since raised the payout, having declared aggregate quarterly dividends of 17.5p this year, up from 16.5p in 2015, so the rolling 12-month dividend yield is now 5.7 per cent, up from 3.75 per cent when I advised selling.

Of course, we need more than just a modest rating and a decent dividend yield to spark a share price recovery, which is why I have been sitting on the sidelines, patiently waiting for a catalyst to appear. Bearing this in mind, there could be one looming round the corner. Let me explain.

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 Jarvis now has cash under administration in excess of £150m, 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 addition, the company has a retail broking division that provides cost-effective and flexible share trading facilities, and a popular one, too, having grown client numbers from 60,000 to 100,000 since the start of 2013. Jarvis's main products are: ShareDeal-Active, a low-cost execution-only service for nominee and certified accounts, individual savings accounts (Isas), and self-invested personal pensions (Sipps); and X-O, a low-cost 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.

In terms of the revenue mix, gross interest earned on broking accounts and cash in its bank account for over two-fifths of the company's annual revenue of £7.6m with the balance earned from fees and commissions. This means that small moves in bank base rate have a major impact on the interest income earned by Jarvis on its cash under administration. But, with Bank of England base rate at record lows, and the governor of the central bank doing his level best to keep them there even if the ongoing strength of the UK economy is at odds with his downbeat economic outlook, then realistically Jarvis's top-line and profits are not going to benefit from higher interest rates anytime soon.

So, the other way of producing meaningful revenue growth, and generating the incremental profit needed to attract investors support and expand the earnings multiple the shares are rated on, is for Jarvis to win significantly more business. There is a real possibility of this now happening.

 

Potential earnings catalyst

In mid-May, the board announced a non-binding heads of agreement with a financial services company to launch a new automated wealth management service on behalf of a third party. Jarvis's role is to provide administrative services including account opening, maintenance, trading, and trade settlement.

Under the terms of the proposed agreement, the service will operate from 2017 and Jarvis will receive a fee based on assets under management, subject to a monthly minimum. Based on the forecasts provided to Jarvis, I understand that the contract is forecast to produce revenue of £277,500 in the first year, rising to £943,750 by year three. Should the contract continue beyond the minimum three-year term the revenue forecast for the fourth year is £1.67m. These estimates are based on the experiences of similar new entrants to the automated wealth management market, and have been provided by the company for guidance only. Of course, there are costs involved to execute the administrative services provided by the company under the proposed arrangement. Jarvis's board anticipates its costs will increase by 50 per cent of any revenue earned, so there is a decent profit margin to be earned here.

True, there is absolutely no guarantee that the heads of terms will become a formal agreement, but Jarvis's management team are clearly working on making this happen given that the board has not made a London Stock Exchange announcement to the contrary. The outcome is highly price-sensitive too; as Andrew Grant, managing director and chairman of Jarvis, notes that: "This is an excellent prospect for Jarvis. The automated wealth management market presents huge opportunities in the post RDR world, and complements the administrative service we offer. We see this as a growth area and... it has the potential to significantly increase Jarvis's profitability, as well as adding a qualitatively different revenue stream to those we already have." Having founded the business more than 30 years ago, Mr Grant is a majority shareholder in the company, so he has a vested interest in Jarvis formalising the contract.

The point being that the upside is not factored into WH Ireland's forecasts, which point to a modest rise in revenue to £7.8m in 2017 to lift pre-tax profit and EPS to £3.6m and 25.6p, respectively. In other words, expect upgrades if the contract is landed. I would flag up that in Jarvis's half-year results, the board noted that "it continues to acquire retail and commercial outsourcing clients, daily average volumes continue to be higher than all of 2015, and client assets under administration continue to grow at a healthy rate."

Add to that a pipeline of outsourcing opportunities as corporate clients look to take advantage of the cost advantages of Jarvis's business model, and the board has been confident enough to raise the third-quarter dividend per share from 4.25p to 4.5p, and recently hike the fourth-quarter payout from 4.25p to 5p (ex-dividend on 17 November). This is a pretty good indicator that current trading is at least in line with WH Ireland's forecasts. The company is well funded, too, as net funds of £12.1m is a tidy sum in relation to its market capitalisation of £33.5m, and supports a strong working capital position.

 

Target price

The bottom line is that Jarvis's shares have been de-rated to a level at which the rising payout now provides very strong dividend support, and the rating is clearly far more appealing given the earnings multiple has contracted from 19 times to 12 times since I advised selling last year. Moreover, if the company can land the contract for the new automated wealth management service, then I would expect a decent share price re-rating as analysts upgrade their earnings forecasts, and significantly so for later years.

Frankly, the downside risk looks limited and the upside from sealing the above contract, or for that matter any other awards in the pipeline, is effectively in the price for free. On a bid-offer spread of 300p to 305p, and offering 25 per cent upside to the lower end of my target price range between 375p and 400p, I rate Jarvis's shares a buy.