Managing and administering pensions isn't exciting, particularly at a company level. Spreadsheets and impending old age are the order of the day. It is, however, important. We were reminded of this in the wake of former chancellor Kwasi Kwarteng’s mini-Budget, when the UK’s £1.5tn defined-benefit pension system had a mini-meltdown, and the fragility of liability-driven investing was laid out for all to see. While this drew plenty of unwanted attention to the sector, it also underlined the powerful role of pension advisers – and the need for trusted advice.
A boutique with big clients
The pensions industry is dominated by three consultancies: Aon (US:AON), Mercer (US: MERC) and Willis Towers Watson (US:WTW). But Tellworth fund manager James Gerlis is among those who see UK small-cap opportunities in the sector, too.
XPS Pensions (XPS) is a boutique firm that administers pensions and offers actuarial and investment advice. Since listing as Xafinity in 2017, it has more than tripled its client base and doubled its profits, and analysts expect growth to accelerate over the next two years.
Some of this optimism is less to do with XPS itself than the market it operates in. Come rain or shine, defined-benefit (DB) pension schemes – where employers promise members a specified pension on retirement – can sow problems for businesses. Meanwhile, the defined-contribution market – where workers’ and employers’ contributions are invested in order to buy a pension at retirement – is still growing rapidly.
As such, XPS is largely independent of the economic cycle. It was unruffled by the pandemic, and trading is still going strong. Organic revenue growth sat at 13 per cent in the six months to September, while its adjusted operating profit climbed by 19 per cent to £15.2mn. Following a recent upgrade, management expects revenue for the full year to be £163mn-£165mn, representing year-on-year growth of 17-19 per cent. Given that 90 per cent of XPS’s revenues recur, financial year 2024 is also set to be busy.
Boutique consultancies are becoming more popular with companies, according to Gerlis. “Historically, pension trustees would have tended to use one of the Big Three. Increasingly, though, the specialist boutiques are being viewed as better places to go for complex actuarial advice. XPS has the potential to win a lot of business, if it can keep growing that credibility.”
Worries about conflicts of interest are fuelling this trend. “The larger competitors also have fiduciary advisory businesses,” said Gerlis. “So they will be trying to sell services to, say, BT, at the same time as they are advising the pension trustees about the BT pension. There’s a growing awareness among trustees that there can, at times, be conflicts of interest if you're on both sides of that advisory relationship. XPS is purely pensions. That's what they do, that's all they care about.”
‘Care’ is also important. A company such as XPS “is going to give its full attention and love to that consulting relationship,” said Gerlis. “Larger companies have lots of large relationships already, and you might get lost in the mix.”
Clients certainly seem convinced of the logic. In November 2021, XPS secured a contract with BT (BT.), which has the UK’s largest corporate pension scheme. Assuming all goes well, this win will bolster the group’s standing in the sector, and could usher in more big clients. From an investor perspective, it also attests to the quality of XPS’s advice, which can be hard to assess in such an impenetrable industry.
Structural growth drivers
It’s not the case that work is simply being reallocated, however. Demand for pension services is actively growing. “DB pensions in particular are really complex, and now there’s increasing amounts of regulation around them,” said Gerlis. “That means trustees need more and more advice to make sure that they are running schemes in the right way.”
One example is ‘guaranteed minimum pension’ (GMP) regulation. This relates to a 2018 High Court ruling, which requires schemes to equalise the effect of unequal GMPs between men and women dating back 30 years. There is plenty of other work out there, too. The sharp rise in gilt yields over the past year has boosted DB scheme funding levels, creating more options for companies – particularly when it comes to buy-ins (transferring some scheme assets to an insurer) and buyouts (transferring all assets and liabilities to an insurer). A flurry of listed companies – including Coats (COA) and TT Electronics (TTG) – have announced pension buy-ins in recent months, and buyout activity has surged, too.
Liz Truss also proved useful for XPS. The fallout from her mini-Budget put “heightened focus on the asset allocation of pensions, and again, made the role of someone like XPS really important”, according to Gerlis. “They come in and check how a pension scheme is set up and make sure that the assets are invested safely.”
Growing demand is all well and good, but not all professional services firms are skilled at turning clients into cash. Thankfully, XPS is. Invoices are typically sent out every month, with payment expected 30 days later, and the majority of its debts are paid on time – only 5 per cent are more than 90 days late, which is when losses are most likely to be incurred. Its speedy cash collection, combined with the fact that it has very little ‘work in progress’ (referring to work done but not yet billed for) on its balance sheet, means cash conversion has exceeded 95 per cent for the past three years.
This compares very favourably with a law firm such as DWF (DWF), where work in progress accounts for about 20 per cent of sales, and which has a high and growing number of overdue debtors.
Possible potholes
Now for the less good news. Margins are roomy at XPS, but margin growth has been a sticking point. This is partly because the success of the company relies on recruiting good actuaries, and good actuaries don’t come cheap – particularly given the state of today’s labour market. Staff costs as a percentage of revenue have been creeping up over the past few years and this, in turn, has suppressed margin growth. The group has also had professional indemnity insurance and IT costs to contend with.
The white-collar job market does seem to be cooling, however, which is likely to ease XPS’s cost pressures. Another lever the group can pull relates to productivity. “Actuarial consultants are charged out on a day rate,” said Gerlis. “The more these consultants are utilised, the better the return for XPS. And the strong demand environment that we're seeing at the moment, particularly since the mini-Budget wobble, will really help with that.”
XPS hiked its fees by 7 per cent in the first half of the year, which should push revenues higher in the second half “as more contracts are renewed at higher, inflation-linked rates”, Liberum analysts note.
Less easy to talk away is the big discrepancy between XPS’s statutory and adjusted profits. In the year ended 31 March 2022, exceptional items totalled 37 per cent of the group’s adjusted profit before tax. While many of the adjustments related to the amortisation of acquired intangibles, a big chunk – £3.9mn – related to share-based payments. These have been consistently high over the past few years and mean-adjusted figures should be taken with a pinch of salt.
Last but not least is the strange episode of June 2019, when shares crashed by 40 per cent following a mild profit downgrade. What happened – and could it happen again?
The mismanagement of expectations was partly to blame. The year before, XPS had acquired financial adviser Punter Southall and forecasts got ahead of themselves. While the group only missed consensus targets by 3.6 per cent, it led to 2020 earnings per share estimates being downgraded by 12 per cent, and investor confidence was shaken.
Illiquidity exacerbated the problem. Trading in XPS shares was very weak in the days before it reported, and when results day hit – and blue-chip investor BlackRock sold down its stake – volumes rocketed. Although Schroders and Norges Bank bought the dip, the shares have only just recovered all the ground they lost on that day in June.
Ultimately, the episode is a useful lesson in the dangers of small-cap investing, and it’s not impossible that something similar could happen again. However, Liberum analysts argue that “after a prolonged period of niggly downgrades, the market is now believing in the story again and signs of a rerating have started to emerge”. Given XPS’s burgeoning reputation, excellent cash flow and resilient client base, it’s easy to see why.
