An exciting play on the pensions market

What can’t be dismissed, however, is XPS’s consistent and high rates of growth: over the past five years, the annual increase in the top line has averaged 21 per cent, while operating profit and net income growth have averaged 22 and 30 per cent, respectively. The question today is what can this niche firm offer investors with a long-term view?

After a decade in the doldrums, rising interest rates and the resulting rise in bond yields have caused something of gold rush in the pensions industry. While the growth in pensions transfers to the insurance sector have set some regulators’ nerves jangling – particularly in the aftermath of the liability-driven investment (LDI) crisis in September 2022 – pensions funds’ demand for highly specialised actuarial advice is creating significant opportunities for the likes of XPS.

At the last count, the company was advising 81 clients with £1bn or more in pension assets, and blue-chip instructions are growing: this week, XPS was appointed to provide consulting and administrative services to John Lewis’ partners pension trust, which counts 74,000 active partners and 160,000-plus members.

As well as helping to administer funds and making sure that members receive their distributions, annual reports and regular correspondence, XPS offers actuarial advice and helps funds to prepare for the transfer of liabilities to the insurance company that wants to take them on. This is a process of considerable administrative complexity that is bound by many fiduciary requirements, requiring considerable time and costs, meaning any competition to XPS must clear a high bar.

However, the market is fragmented and riddled with conflicts of interest in a way that has allowed an acquisitive player to build a decent mid-tier position just below the sector’s largest players, for whom actuarial advice is sometimes of secondary importance. XPS now reckons it is the “biggest” mid-tier company in the sector. Getting to that point has meant bolt-on deals – the latest addition being consultancy Penfida – involving £26mn of capital put toward buying new businesses since the company listed on the stock market in 2017.

The growth engine

In the 12 months to March, revenues were split across five divisions, with the bulk recorded in actuarial services (which grew 24 per cent to £77.4mn) and pension administration (which climbed a tenth to £57.5mn). Despite its smaller size, administration is often the route into more lucrative consulting for XPS and having large clients such as Peugeot, BAA and IBM on the books confers a great deal of credibility in the company’s services. Cross-selling and increased demand for actuarial services is reflected in the group’s adjusted operating profit margin, which climbed from 20.8 to 22.1 per cent in the latest financial year.

At that level the impact of operational gearing becomes apparent as revenues rise, and management expects that this will continue into next year.  

The bulk annuities market is still the biggest single driver of growth for the company and the outlook for the remainder of 2023 looks overwhelmingly positive. According to trade consultancy AON, the bulk market this year looks set to exceed its previous peak of £43bn reached in 2019, since the first half alone saw over £21bn of defined benefit pension fund transfers. If interest rates stay 'higher-for-longer', as many economists and investors are predicting, then more pension funds will have the incentive to outsource the liability-matching exercise and lock in improved returns. The mirror image is true of the insurance companies where hardening rates and better returns are creating the surplus capital needed to fund the transfers. So far, so virtuous circle, and XPS could be in line for at least 18 months of growing earnings in this scenario as the pipeline of advisory work expands in response to more pension transfers.

The risk factors

A key risk is that something like the LDI crisis – in which a sell-off in UK gilts, further magnified by forced selling, sparked a liquidity crisis at some pension funds – could cause considerable disruption to the market. The insurance industry is the other side of the coin for the pension funds and if their spare capital generation begins to fall away, either through a serious bout of disasters causing a rush of claims, or interest rates taking an unexpected fall if the economy steers onto a deflationary path, then the operational gearing that underpins XPS’s performance could easily reverse and hit the income statement.

Income stability will therefore be paramount, which is why the administration business remains critical; no matter the economic cycle, pension funds must be administered and comply with fiduciary standards. For XPS, this represents a defensive stream of income that can anchor the rest of the company.

Another risk to consider is whether further expansion will dilute a business that prides itself on its close-knit interpersonal relationships with clients and between staff. While there are economies of scale that a bigger firm can achieve, the threat of corporate anonymity eroding its culture and reputation can’t be overlooked. If XPS is close to its ideal size – in inverse relationship to the service it can offer its customers – then how will earnings continue to grow at such a rapid pace? This remains something of an open question, although we suspect the bolt on-acquisition programme will continue to add to XPS’s capabilities.

What we do know is that business is sticky. Shore Capital analysts point to the quality of the company’s income streams, around 90 per cent of which are recurring, have an element of inflation uplift built into the contracts and are conditional on changing pensions regulations. This means the company achieves a high level of total return on a low capital base, because its main expense is people.

This has also given brokers reasonable confidence in raising their forecasts. Earnings per share for the current financial year have been upgraded three times since the start of 2023, while expectations for the year to March 2025 are today 50 per cent higher than they were in June 2022.

At 16 times Shore Capital’s forward earnings estimates, XPS’s valuation is broadly comparable with a consultancy company such as Elixirr (ELIX), which has also posted strong earnings, and faced some doubts about the enduring strength of its end-markets. Companies may have superficial similarities in selling advice for a price, but unless the product is highly specialised and in-demand, it will be seen as a slightly commoditised product, which XPS's certainly isn’t. In addition, investors have the comfort of a dividend yield that tops 4 per cent, and while there may be greater income plays available, few come with the company’s solid growth profile.

Investors will gain a more detailed insight into current trading when XPS publishes its half-year figures later this month. Calling a buy ahead of these represents a risk, but given its current trajectory, there’s little reason to doubt XPS will again pass its tests with flying colours.