Businesses often bemoan the cost of the regulatory burden, and with some justification. You don’t have to be an advocate of laissez-faire economics to realise that red tape hits the bottom line. According to the National Audit Office, “51 per cent of UK businesses think the level of regulation in the UK is an obstacle to success”. And yet there is a flipside to that assertion. As the volume and complexity of regulations governing a host of commercial activities has increased, so too the chances of leveraging specialist expertise.
The challenge for government is to decide which regulations are vital for the efficient and equitable running of the economy as opposed to those which are duplicated and/or superfluous. That could represent an uphill task, not least because some cynics might argue that it is in Whitehall’s interest to keep matters as complicated as possible.
In recent years, the UK government has set a target for the cost of new regulation over the life of a new parliament. During the current cycle (2019-24), ministers were aiming for no rise whatsoever, but by the end of last year the cumulative increase had amounted to an estimated £17.2bn. The government last year decided to ditch its Business Impact Target in favour of a system that seeks to limit costs at the outset rather than record them once a policy path has been chosen. That suggests the extent of future regulatory-driven cost increases will become more difficult to judge. So much for transparency.
The regulatory challenge to business models
As we shall see, one man's misfortune is another man's opportunity. But those in the former category can find their business models upended: the risk of reprimand has the power to change business behaviours.
Thumb your way through Vanquis Banking Group’s (VANQ) annual report and in the 'principal risks' section you will learn that the group is potentially “exposed to financial loss, fines, censure or enforcement action due to failing to comply with legal and governance requirements”. Vanquis is by no means an outlier on this basis, but the continued presence of this message is ironic given that the company has already altered its commercial activities in response to regulatory oversight.
The company, formerly known as Provident Financial, completed its rebranding in the early part of last year following the closure of its consumer credit division in response to an investigation by the Financial Conduct Authority (FCA) regarding the sale of unaffordable loans to borrowers. The bank subsequently adopted a lower-risk profile by refocusing on “mid-cost credit” products. The reincarnation is now complete, but the response to the FCA probe serves to underline how regulatory risk can pose a threat to – or perhaps even invalidate – a company’s business model.
Finance is an obvious example of a sector now under stricter supervision. The banking industry has been operating under enhanced oversight ever since the global financial crisis, as highlighted by the Basel III (and now Basel IV) international banking regulations developed by the Bank for International Settlements. Meanwhile, the growth of the asset management industry has given rise to questions over the interaction between traditional banks and investment funds, some of which remain unresolved. That's to say nothing of the increasingly strict supervision being given to a variety of financial service sub-sectors.
Complexity across a range of industries
However, the reality is that regulatory frameworks have expanded and grown more complex across a range of industries beyond financial services. Many might automatically point to, say, the pharmaceutical industry – after all, the challenge presented by the drug approval process is widely appreciated. And although clinical trial applications still constitute a significant proportion of the global regulatory affairs market, advisory services now encompass a diverse range of issues, ranging from health and safety to product registration.
But commercial applications have also proliferated. Professional legal services companies have been boosted by tightened employment law and data protection provisions, while insurers offering indemnity products have also benefited. Companies such as Experian (EXPN) have seen their B2B activities expand due to increased regulatory complexity, while others such as Halma (HLMA) have profited from enhanced health and safety strictures.
Contrary to government rhetoric, the regulatory burden keeps mounting. Last year the Financial Services and Markets Act was finally passed into UK law. Among other things, it gives regulators – the FCA and Prudential Regulation Authority (PRA) – the right to incorporate digital assets into the existing financial services regulatory framework. The Act will govern the way that companies operating in the UK can market crypto products, including a provision linked to a 24-hour cooling-off period for first-time investors. The new regulations mean crypto firms must ensure that people have the appropriate level of knowledge when dealing in the assets. It will also provide a stream of consultancy work for specialist legal teams.
Leaving aside domestic legislation, many constituents within the FTSE 100 have deep global footprints, so the question of other jurisdictions is to the fore. Conveniently, there are bodies such as the Organisation for Economic Cooperation and Development (OECD) that set global regulatory standards, recommendations and convergence criteria, the imperative for which has mounted due to the rise of digital commerce and evolving environmental, social and governance (ESG) demands.
The question of digital security
Aside from the evolution of specific regulation linked to the fintech sector, there is another technical imperative to take on board. Companies and regulators alike are increasingly turning to artificial intelligence (AI) and machine learning in the face of mounting compliance issues. AI systems can analyse vast reams of data in real time, for business activities ranging from daily transaction volumes to financial transfers. Improved capabilities in this area have become more pressing since the UK government passed the Economic Crime and Corporate Transparency Act. Anti-money-laundering and counter-terrorism financing are now prime issues for corporate UK, but there are many other corners of the compliance market in which AI could have a transformative effect.
The pressure to maintain compliance with industry standards has also been building due to issues over digital security. As commerce has steadily switched to digital channels, so too the requirement to guard against data breaches, which, it could be argued, is intertwined with regulatory change. The General Data Protection Regulation (GDPR) regime provides a case in point. It could even be argued that the proliferation of cyber security businesses and technology is both a cause and symptomatic of a stiffened regulatory regime.
The compliance imperative shows few signs of flagging. It has emerged that the FCA and PRA are even considering areas outside of financial misconduct as grounds for regulatory action – the list keeps on growing. Although it's undeniable that regulatory risk can give rise to challenges for an individual company, it also presents wider commercial opportunities. The growing prevalence of regulatory affairs is certainly worth examining from an investment angle, not least because the advisory services that have proliferated in their wake are non-cyclical in nature and, like many types of advisory role, they tend to support strong margins.
Experian: cash through complexity
In this week's FTSE 350 review, we underline that Experian’s status as a beneficiary of regulatory complexity makes it “well positioned to compound shareholder returns”. There’s clearly mileage to be had from the UK's ever-changing anti-money-laundering (AML) and know-your-customer guidelines. Any financial institution or company regulated by the FCA is required by law to carry out these checks, with the goal of reducing illegal financial activity.
Experian provides AML checks as part of what might best be described as a bespoke arrangement with its corporate clients, understandable considering that compliance matters don’t fall under the one-size-fits-all category. It also reflects the opportunities that are being presented through an “evolving digital landscape”.
The incentives for companies to take a robust stance are clear enough given the threat of punitive actions by regulators, let alone the danger of reputational damage. Unfortunately, keeping up to speed with regulatory changes can be expensive and time consuming, so outsourcing and/or automating these processes is often the preferred option.
We outlined the investment case for the group in March 2020, just in time for the pandemic; the point at which B2B momentum from the group’s ‘big data’ platform was to slow appreciably. In recent times, the group’s core subscription services have had to contend with tighter credit markets, but B2B organic revenue growth has remained positive, with its consumer bureau activities outperforming the credit issuance market, helped along by new product initiatives.
In terms of the valuation, the shares are up by 31 per cent since our pandemic assessment, so a consequent forward rating of 29 times adjusted consensus earnings looks a little stretched. The shares change hands broadly in line with the broker “overweight” target price, albeit this is minimally above the five-year average. However, it’s not difficult to appreciate why the stock is receiving such support. The cash margin of 34.4 per cent is in line with the five-year average, as is the return on equity at 29 per cent.
Safety in numbers at Halma
The Grenfell Tower inquiry provided a tragic example of how public policy is often reactive, rather than preventative, in nature. Subsequent regulatory change eventually loaded remedial costs on the construction industry, but the effects have been felt across a range of industries. We have seen reforms to the regulatory framework for fire safety in buildings in England, and the government has even proposed changes to how fire safety standards for furniture and furnishings are regulated. Unfortunately, it takes a tragedy of this magnitude to move the dial when it comes to additional health and safety regulations.
Distasteful as it may seem to some, any tightening in the legal framework surrounding health and safety not only loads costs on certain businesses, but also provides new business for others. Halma, a FTSE 100 constituent that we have consistently lauded for its robust track record, provides a case in point.
Halma is essentially an umbrella group for a range of software/hardware companies, many of which are founder-led, operating in the safety, environmental and healthcare markets. The lion’s share of its sales are generated outside of the UK and from industries that are typically subject to stringent regulatory and safety requirements. This last point increases barriers to entry, effectively reducing incentives for competitors entering the market and thereby potentially supressing Halma’s margins. The group’s interim adjusted trading margin for the six months to 30 September 2023 stood at a healthy 20 per cent.
Its focus on acquiring businesses with “high returns and positive impact in global niche markets” is complemented by a high level of R&D spending relative to sales. This has contributed to an implied return on sales of 18.7 per cent at the half-year mark, broadly in line with the five-year average. But despite the consistently high outlays – intangibles account for 99 per cent of net assets – it remains highly cash generative. Investec estimates that free cash flow per share will increase by 75 per cent between FY2023 and FY2026 to 91.5p a share, even though the latest cash conversion rate came in short of the long-term target.
It should be noted that Halma’s activities stretch well beyond safety-linked activities, as sustainability-related demand is on the rise, which again tends towards the non-discretionary, mandated side of affairs. The order book remains well above the historical norm for the business and the solid book-to-bill ratio implies that new orders are keeping up with billings, a noteworthy feature given that the group has had to contend with serious supply chain issues.
The group’s share price slumped last May, just before it confirmed its 44th annual dividend increase. This reversal may have been prompted by a fall in reported profitability for FY2023, albeit one linked to the non-recurrence of a disposal gain in the prior year. Perhaps the shares clicked into reverse on concerns that Halma would struggle to hit its inorganic profit growth target given the expected trajectory of interest rates, as well as its acknowledgement at its full-year results last June that return on sales for the year would be slightly lower than analysts had expected. Nonetheless, like Experian, investors are still being asked to sing for their suppers. A forward rating of 27 times adjusted earnings is pricing in substantial earnings growth – largely on the back of M&A – so even though it’s undoubtedly a quality stock with compelling structural drivers, it is probably best suited to investors with lengthy time horizons. And that’s no bad thing.
Testing times at Intertek
There are obviously more favourable multiples on offer elsewhere. The question is whether they’re justified from a fundamental basis, and/or if the stock has been subject to a sector-wide markdown. Unfortunately, that isn’t always immediately obvious. It’s now more than 18 months since we included Intertek (ITRK), a provider of bespoke assurance, testing, inspection and certification services, in our investment ideas. At that point, we opined that “regulation relating to ESG issues is on the rise, and companies need to show they meet a broad range of quality standards. Increasingly, they are also expected to demonstrate an understanding of the risks and footprints throughout their supply chain, and issues associated with products following their sale”.
That says it all. The secular drivers of the testing, inspection and certification market are familiar to us all. Regulatory and compliance standards are essential to ensure market access and consumer trust across export-led growth markets ranging from automotive to healthcare. The evolution of supply chains and the acceleration of that process in the wake of the pandemic is also throwing up challenges for companies engaged in the sector, as is the heightened focus on sustainability – and the governmental mandates arising from net-zero initiatives.
The group’s share price has dropped 8 per cent since then, and is now 31 per cent adrift of its five-year high of September 2020. The forward rating of 18.9 times FactSet consensus is in line with those of global sector rivals, although it boasts a superior return-on-equity and growth metrics. It’s also worth mentioning that the forward dividend yield is touching 2.7 per cent. The moderately good news is that, after hitting its highest level of organic sales growth in a decade, the group’s marginal profitability appears to be recovering on the back of successful pricing initiatives and positive operating leverage. It should also be helped along by reduced depreciation and amortisation charges in future.
Revenue growth for 2023 is forecast to come in at more than double the modest five-year average rate of 2.9 per cent, and the rise in the top line is being outstripped by an increase in cash profits (Ebitda). Shore Capital succinctly sums up near-term prospects as being subject to the contrasting influences of positive tailwinds and “competitive pressures”, with organic sales growth of c4-5 per cent “sustainable with acquisition gains on top funded by cash generation”.
One of the more pleasing aspects of the group’s financial performance has been its ability to turn trading profits into free cash flow, a possible reflection of a relatively capital-light structure. M&A is a feature of the Intertek business model, so leverage is always a pertinent consideration, although the group – partly due to its cash generative qualities – can easily meet its interest obligations. Net debt should be broadly in line with Ebitda, and the group’s liquidity ratios indicate that it’s well equipped to meet its current liabilities.
