CMC Markets Thesis
Welcome back.
Exams have concluded meaning that I’ve got more time to dip my head in the stock market.
A bit of change (again) in the newsletter’s format. Once my exams were finished I spent my time researching a stock that my python code flashed up - CMC Markets.
So this week, I’ll be sharing my bull thesis with you. I won’t give away my valuation and process - that’s a closely guarded secret…
What I will show is the rationale for the upside and it’ll also give you a glimpse into potential macroeconomic events we may experience in 2022.
Prepare yourselves for some Wallstreetbets degeneracy. Any criticism is warmly welcomed. The bits you really wanna look at is the Thesis and Risks to Thesis. So, here it goes.
CMC Markets
Outline of the business
Who are they?
CMC Markets plc is a UK based company listed on the LSE. Founded by brothers Peter Cruddas and Baron Cruddas, Lord Peter Cruddas (owns 56.7% of shares outstanding) currently serves as the CEO. The company first went public in February 2016.
The firm provides online and mobile trading services for both institutional and retail clients. Clients can trade various markets, with the potential to trade forex, markets, indices, equities, commodities, and treasuries. Further, the company offers institutional and retail clients the ability to trade financial products of underlying assets in the markets previously listed.
CMC also offers b2b Whitelabels, grey label, and API connectivity to corporate clients. The latest corporate client to use CMC’s b2b Whitelabel offering is Australia and New Zealand Banking Group, CMC is acquiring 500,000 of the banking group’s clients.
The company segments its operations into CFD, spread betting, and stockbroking. The firm further segments the business lines into retail and institutional clientele.
Where the ‘Dough’ Comes From
CMC generates the lion’s share of its revenue from its CFD segments, in particular from retail clientele.
Focusing on the CFD arm; money is made on the difference between the buy and sell prices of an instrument called the spread. A percentage is taken on trades called commission fees. Money is made through financing client positions i.e. borrowing on margins, positions being held overnight.
The firm makes money from its stockbroking arm through charges on trades made by its clients. The firm also earns fees through FX revenue from clients trading international shares and interests on deposits.
The Team At The Helm
CEO - Lord Peter Cruddas is the founder and CEO of the company, with significant skin in the game, owning 56.7% of shares outstanding. This equates to £417m of stock. As Forbes valued Lord Cruddas at ~£800m, a huge portion of his wealth is aligned with shareholders.
My concern is that, with over 60% of the shares outstanding owned by insiders, it could create liquidity issues for outsiders (us) in the event of firm-specific issues. Further, the lack of free float and therefore liquidity surrounding the shares could result in the slower realisation of value by the market (if there is any value to be realised in the first place).
CFO - Euan Marshall was appointed CFO in 2019. I would have liked to have seen Euan with a more specific history working in financial reporting before joining CMC Markets, however, this is mitigated by the fact that Euan has been working at CMC Markets for more than 11 years in finance.
Economic Drivers - What Determines the Firm’s Fate
For me, economic driver’s are the key variables that determine the company’s top-line and bottom line, and to a certain extent, the company’s price. For instance, the number of franchises will be an economic driver for McDonald’s and therefore, the expected number of franchises will be a driver of McDonald's stock’s price.
The economic drivers of CMC Markets that I’ve identified:
Trading Volume of The Market
Without the luxury of a Bloomberg Terminal, I’ve had to use the trading volume of various indexes as a proxy for the market trading volume. The indexes investigated were: NYSE Composite, SP500, FTSE100, and FTSE250. Though, I did manage to get the trading volume of the LSE as well. It was found that the SP500 trading volume had the strongest correlation with CMC Market’s revenues, a correlation of 0.834. The NYSE Composite index I could not use as the data published from yahoo finance is the same data as the SP500 trading vol data (I know, what a joke). For comparison, FTSE100, FTSE250 and the trading volume of the LSE had correlations of 0.268, 0.709, and -0.567 respectively.
As such, the trading volume of the SP500 as a proxy for market trading volume is used as an economic driver as part of the modelling. Revenues of the leveraged business segment are most sensitive to the trading volume of the markets.
It’s also worth commenting that this driver sheds some light on CMC Market’s client base, suggesting that they mostly trade/speculate on financial products in the American markets rather than the British markets.
Further, trading volume as an economic driver makes intuitive sense. The firm makes money on fees charged to clients trading, the more trades the more money for the firm. If the market trading volume is up, it results in clients trading more and therefore an uptick in the firm’s revenues.
No of active clients
This driver is defined by management as a client who’s purchased at least one share or has made at least one trade on any financial product in the last 12 months.
Not too much to comment on this apart from it giving an idea of client engagement, perhaps a bit of a flattering one since the benchmark of one trade over the 12 month reporting period is a low hurdle.
Level of Client Money
Management defines this as the total segregated CFD client money held by the group. I think this is a better metric for client retention than “no of active clients” because it represents only clients with economic influence. As management rightly mentions, it's also an indicator of future trading potential.
Effective Tax Rate
The only claimant that supersedes preferred stockholders; the government. Of course, this is an economic driver for every company. However, I think it's a deceptively pertinent one in the case of CMC Markets due to the board’s dividend policy of paying 50% of profit after tax as cash dividends. Due to this dividend policy, I conjecture that the next dividend is a significant factor in the firm’s valuation and therefore the government’s slice of the pie is a significant variable to valuation.
Thesis - Buckle Up Buckaroo!
I think the market is pricing the stock inefficiently.
A significant part of the stock’s undervaluation is due to the expectation of the next dividend payouts: the expected dividend, ie this year and next years results are in line with market trading volume continuing its current quietness. This is an irrational expectation. As we’ve seen in recent news, the Fed is poising itself to increase interest rates drastically over the next FY in an attempt to curb the “transitory” inflation. Other central banks will be following suit - When it rains on the priest, it drips on the parish clerk.
It was observed that, on the announcement of the last FOMC meeting transcripts which indicated the central banker’s intentions of increasing interest rates, zombie stocks as a collective hardly budged. This is indicative to me that the market believes the central banks are crying wolf, therefore, pricing in an unrealistic expectation, or that the ramifications of the interest rate hikes will cause little price movements. Thus, as a result, expect the markets to be quiet.
It’s my assertion that the central banks will start to taper aggressively, contrary to market expectation, resulting in great volatility in the stock market, thus increasing trading volumes and therefore increasing CMC Market’s revenues outside of what the markets are expecting and currently pricing.
Rationale for The Modeling and Valuation
Evaluating the Effects of The Economic Drivers - The Top-Line
Starting with the top line. Since market trading volume is a key economic driver and our proxy is the SP500 trading volume, as it correlates with revenues, significant changes in trading volume are likely to significantly affect revenues.
In the company’s latest trading statement, its leveraged trading revenues halved in H1 2022 when compared to H1 2021, resulting in a 45% decrease in group revenues. Management had this to say about it:
“H1 2022 leveraged net trading revenue at £101.0 million (H1 2021: £200.4 million) down 50% as a result of a decrease in market volatility resulting in lower client trading activity and client income retention reverting towards guided levels.”
Well, let’s take a look at the SP500 trading volume, shall we? Note the H1 2022 results report to the half-year ended 30 September 2021. From yahoo finance, SP500 trading vol for H1 2022 was $418,718,490,000 compared H1 2021 $601,264,140,000 - a YoY decrease of 30.4%. This decrease in group revenues due to a downtick in market trading volume is somewhat buffered by the group non-leveraged business segment whose revenues hardly budged, decreasing by 8.8%.
As we anticipate the next trading statement which will be the full-year results, covering a period up to the 30th March, how has recent trading volume been looking?
In the last few months (highlighted in blue) which will be incorporated in the H2 2022 results (and full-year results), (in particular January) volume has been low.
As a result, the interim dividend has been slashed significantly due to the reduction in revenues from H1 2021: 9.20p to H1 2022: 3.50p.
This tremendous downturn in trading volume explains the significant devaluation in the company’s stock we’ve seen since September. See below:
Should the trajectory of trading volume were to continue over the next few months, further depression of the stock price is expected due to reduced dividends paid to investors.
Moving onto the level of client money, whilst it’s an important economic driver and indicator for the group’s quality of service, it's actually a double-edged sword as a predictor for firm valuation. What drives the company’s performance is the volume of trades brokered by the group - the level of client money gives little indication of this. For instance, a client could have £10,000 sat in the account and make zero trades over the year, equally he could make many.
Looking at the numbers, the metric does correlate with increases in group revenues but not decreases in group revenues:
Observing the graph, you can see that there is little relation in downturns of revenue. This is positive, as it suggests that client AUM retention is sticky but gives little indication of downturns in revenue.
Thinking about it intuitively, it does make sense. If clients see that markets are volatile they’ll fund their accounts with more capital to trade the markets, trading the markets causes revenue to increase - increase in client money and revenue correlate but it’s not the cause, I believe it’s the result of increased trading volume in the markets. What this relationship does mean is that when the markets are volatile again, greater revenue will likely be captured due to customer AUM stickiness implying that more capital will be traded by the group.
Continuing with the top line, no of active clients plays an important role in the group’s revenues. Unsurprisingly ‘no of active clients’ is extremely strongly correlated with revenues; a correlation regression of 0.895.
Intriguingly, ‘no of active clients’ is strongly correlated with the trading volume of the SP500 (our proxy for market trading volume), a regression of 0.835. This makes intuitive sense. From a behavioural perspective; if clients observe that markets are volatile, they are more inclined to speculate on the swings of the market in the attempt to trade the volatility, therefore one can expect dormant clients to reactivate their accounts, and CMC’s marketing team having an easier time onboarding clients; when the markets are volatile, it’s the “zeitgeist” to trade it.
How does this square with the latest trading results? No of active clients are down 9% in H1 2022 compared to H1 2021, not an as significant drop as implied by the strength of correlation with trading volumes of the SP500 and the decrease in revenues. However, in CMC Market’s public history, it has not been observed how its revenues and economic drivers behave in huge downturns of market trading volume, only huge upturns in market trading volume therefore we can’t understand how a downturn in market trading volume will affect the no of active clients. Further, since management defines the no of active clients as:
“Individual clients who have traded or held CFD or spread bet positions with CMC Markets on at least one occasion during the financial year.”
For clients who only signed up for the zeitgeist to trade market swings, as the market volatility dies and they stop trading for the rest of the year, the client will still count as an active client, therefore we can expect “no of active clients” to appear stickier than expected and not as flattering on first glance.
The Bottom Line
Effective tax rate is a pretty simple driver to understand. I shan’t comment on it. Management is good at giving their expectations of what the effective tax rate will be for the financial year in their annual reports. In the 2021 annual report, they expected the effective tax rate to be similar in 2022 at about 20%.
In the latest results H1 2022 the effective tax rate has been 22.7%, a bit over 10% out of management's predictions. The increase in tax rate is due to increased revenue income from Australia which has a higher corporate tax rate than other regions.
Risks to Thesis
Time to remove the punchbowl
The interest rate hikes could be so severe that the devaluation due to the increase in the discount rate could offset the increase in valuation due to the increase in revenues as a result of the increased trading activity in the markets. I think this is the most likely scenario, however, the company is discounted at its WACC of 8.3% which is determined by the expected cost of equity. As of the company’s latest results (H1 2022), they had zero long term borrowings, thus an interest rate hike will have zero impact on the WACC.
Though, it would increase the opportunity cost of risk-free investments, therefore, reducing the PV of its dividends which is what this thesis is built upon.
Using the model for sensitivity analysis, the WACC (the discount rate used) will have to increase by 10% to 18.3% before the investment breaks even implying that the central bank would have to increase the interest rates by 8%. Whilst this is an unlikely scenario, it’s a scary one. If this did occur it wouldn’t matter what heavily discounted equities one would buy, we’d certainly enter a bear market…
Turning off the Liquidity-Tap
The Liquidity-Tap, which has been open since the GFC and has been gushing since March 2020 when COVID-19 first hit, could be turned off in the Fed’s attempt to curb the “transitory” inflation. This could be extremely consequential to the thesis. Decreasing liquidity in the markets will increase the frictional costs to the retail traders and fundamentals will begin to matter. Over the course of the pandemic circa £217,200,000 of client money was acquired. It implies that some £200m of client capital has only known cheap transaction costs, tight spreads, and rallying equities. Once it becomes apparent that the markets aren’t always this easy, I expect a significant amount of newly acquired clients over the pandemic won’t stick around, thus reducing the level of client money. As pointed out earlier, client money is a predictive indicator as it measures clients with economic clout and is a predictor of future trading potential. With a reduction of client money, even if the trading volumes of the market are off the charts, best case it will offset any gains in revenue as a result of heightened trading volume in the markets.
And that’s a wrap
I hope you enjoyed the thesis. Any criticism in how I’ve argued it is welcome. If not, then I can only conclude that the stock will go to the Moon - money printer goes brrrtt!!