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ICAP Plc; Initiating coverage – 07 August 2014 

Company Overview:

ICAP Plc is a global broking firm, which operates across a range of markets including Currencies, Fixed Income, Derivatives (Swaps) and Shipping (Dry and Wet). The group is renowned today for its global reach and industry leading EBS (Electronic Broking System) platform.

ICAP Plc offers both electronic as well as voice broking services from 70 offices, which are split across 32 countries. It also acts as a primary dealer on behalf of a number of the world’s major central banks, and according to its website, forms an integral part of the global financial system.  

The group is also a  leading innovator in  trading-related compliance systems and technology that are fundamental requirements under today’s regulatory regimes across developed markets.

ICAP Plc was founded as Intercapital Plc in the 1980s by Michael Spencer, the former Tory treasurer and owner of City Index, who still remains the Chief Executive today nearly three decades on.      

Index FTSE 250 Ticker IAP.L Latest Close 345.40
Price Target 415.00 52 Week High 463.10 52 Week Low 341.00
P/E 10.5 Dividend Yield % 6.4 Dividend Cover 1.5
CEO: Michael Spencer  CFO:  Iain Torrens

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A Fallen Star: ICAP Plc

While many financial firms fell out of favour with investors during the financial crisis and the European sovereign debt crisis, ICAP Plc proved to be an exception to the rule.

During the crisis years, the group broke multiple records for volumes, revenues and underlying earnings; however, extraordinary monetary policy measures in developed markets since 2012 have reversed these effects.

With central banks dominating bond markets, an environment of ultra-low and static interest rates has led volatility levels to record lows, dragging trading activity and transaction volumes with it.

As a result, trading volumes on ICAP’s brokerage desks for the year ending in March 2014 fell to their lowest levels since the group’s published records began, while revenues also slumped to their lowest point since 2008.

The group’s deteriorating performance has added further impetus and momentum to an already declining share price. Today ICAP’s shares are down 25% from their 2013 high at 460.00 pence and are 39% down from their 2011 peak. Despite this, the group’s earnings on an underlying adjusted basis have held up relatively well.

Both underlying adjusted earnings in total, and on a per share basis, remain above their 5 Yr & 10 Yr averages and have held steady at these levels throughout the 2013 and the 2014 financial years. The management team have also kept the dividend stable at 22.00 pence per share, which represents a yield of 6.4% at current prices.

Our view is that the present moment in time represents an inflection point for ICAP Plc, which could see the groups fortunes take a turn for the better. Consequently, we are initiating coverage of the shares and have outlined our rationale for this below.

ICAP Plc Share Price Weekly Intervals

ICAP CHART WEEKLY INTERVALS

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Normalisation of monetary policy is key to a recovery in volumes and renewed earnings growth at ICAP Plc

Although extraordinary central bank policies have been a key factor in ICAP’s sliding performance, the era of ultra-low interest rates is now coming to a close in both the UK as well as in the US. Consensus estimates currently imply that the Bank of England and the Federal Reserve will each raise rates by the middle of next year (2015).

With a rising rate environment should come a recovery in trading volumes, as well as an increase in volatility across asset classes, as investors and traders readjust to a policy landscape where interest rates actually move to the up as well as the downside on a semi regular basis.

This will be positive for transaction volumes on the group’s brokerage desks and holds positive connotations for revenues and underlying earnings.

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Evolving regulatory landscape adds diversification to ICAP’s product range, revenues, profits and future potential

While the increasing weight of evolving regulatory structures within developed markets has led compliance costs to balloon for most financial institutions, ICAP has been able to benefit from some of these changes.

Some of the most noteworthy, and onerous, regulations have been the rules relating to swaps (most notably CDS) which have emerged from the CFTC, Dodd Frank Wall Street Reform and Consumer Protection Act & the European Market Infrastructure Regulations.

.CFTC & Dodd Frank Points of Note:

  • All swap trades must be carried out using a Swap Execution Facility (SEF) – a platform; bringing the trading of certain OTC derivatives closer toward the exchange model.
  • CFTC and DF rules are extended to all trades where one party to the transaction is a US institution, or a branch of a US institution. Consequently, a European bank entering into a swap transaction with a US counterparty must see that the trade is executed on an SEF and comply with US CFTC reporting requirements as well as those under EMIR in the European Union.

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European Market Infrastructure Regulations (EMIR):

  • All derivatives contracts must be reported to a trade repository
  • All interest rate and credit default swap transactions must be cleared through a central clearing counterparty (CCP)
  • All institutions trading in derivatives of any kind must implement new risk management policies, including pre-trade credit checking and minimum margin management processes for non-cleared trades, in order to minimise risks posed by the potential for a counterparty to default upon a trade.

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Most of the changes under EMIR and DF have, or will be, phased in over the course of 2013 and 2014. However, some of these, particularly those relating to minimum margin requirements, will be phased in gradually between 2015 and 2019.

In response to the evolving regulatory landscape, ICAP has launched a number of new platforms and services designed to enable trading firms to meet with their obligations under Dodd Frank and EMIR while minimising the time cost of doing this.

Traiana is the market leader for pre and post-trade reporting and transaction processing across asset classes, while TriOptima offers portfolio compression and reconciliation for OTC derivatives in line with current and anticipated regulations. Rematch enables ICAP clients to re-balance CDS (Credit Default Swaps) portfolio risks that result from “illiquid, calendar spread, net long positions”.

So far, these offerings have proved to be successful and, in many cases, have enabled the group to deepen ties with key clients.

For the year ending March 2014, post trade and information services accounted for 15% of revenues and 32.5% of trading operating profit, which highlights the disproportionately positive impact that even a small level of top line growth can have upon underlying earnings.

In addition, this contribution to earnings is likely to grow naturally over time as the regulatory response to failings that emerged during the financial crisis is yet to be fully disgorged.

This is while management believe that persistent risk aversion and scaling down of operations among many of the incumbent banks within the fixed income, currencies and commodities space is likely to lead to a number of new entrants to the market over the coming months and years. Each will represent an opportunity for ICAP Plc.

ICAP Plc Share Price Hourly Intervals

ICAP CHART SHORT TERM

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Balance sheet, dividend and valuation

On a less positive note than above, net debt increased to £787 million during the 2013 year as a result of adverse FX movements, which affected the repatriation of reserves while several exceptional items were also charged to the income statement during the period. Although the movement in net debt is largely attributable to one-off factors, it has served to drive gearing higher and therefore, increase balance sheet risk.

On the other side of the same coin, cost reductions at the group level and an improved outlook for earnings do provide scope for management to reduce gearing over the subsequent quarters. Consequently, we are undeterred by the year’s balance sheet changes.

As referenced earlier, one of the positives attached to ICAP’s shares at present is that management have avoided cutting the dividend, opting instead to keep the payout stable at 22.00 pence per share (interim + final). This equates to a yield of 6.4% based upon current prices, which is covered 1.5 X over by full year earnings.

From a valuation perspective, the group currently trades on a multiple of 10.5 X 2014 earnings. When compared with the average of 19.16 X for the financial sector as a whole, as well as the average of 15.71 X for the general financials sub-sector, the current valuation appears attractive. This is particularly the case when considering our baseline expectation that earnings at ICAP Plc will improve throughout the months and quarters ahead.

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Risks

While our overall outlook for ICAP is positive, the group does face a number of risks going into the months and quarters ahead. The most prominent of these is one of client attrition.

As banks and other key market participants continue their drive to cut costs, there is a genuine risk that some key clients of ICAP’s could internalise their trading, order matching and broking requirements. Some of these clients could also, under extreme circumstances, withdraw from certain markets completely.

Should either of these scenarios evolve into a reality, then earnings at ICAP could once again come under pressure. This would be a price negative event for the shares.

In addition to the above, ICAP also faces regulatory risk in that probes of various misconduct allegations (industry wide) are still ongoing across multiple jurisdictions. Given that ICAP has been implicated in these before, the risk exists that the group could be dragged into further scandals. Should this happen then the group would, in all probability, be liable for further financial penalties which could once again impact upon earnings.

Further from here; the group also has an above-average exposure to FX and interest rate risk, given its high level of gearing and diverse stream of revenues across multiple currencies. If not managed properly, these risks could also lead to an adverse impact upon earnings over the coming quarters.

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Summary

Looking ahead and in terms of performance, we believe that the future is bright for ICAP Plc. After multiple years of declining revenues and tepid earnings performances, the road ahead now appears to offer scope for a turn in the group’s fortunes.

Key to this belief is our expectation that monetary policies in the US and the UK will begin to normalise over the course of 2015, while the contribution to revenues and earnings from ancillary services (post-trade risk and information services) offered by the group continues to grow.

Should these expectations prove to be correct, then sentiment toward ICAP shares would be likely to improve, which could lead to a recovery in the shares. In addition to this, a return to earnings growth could also lead the current valuation of 10.5X 2014 earnings to begin an attempt to converge with the wider general financial sub-sector average of 15.71X, which would imply a substantial leg upwards in the share price.

On a cautionary note, while we are attracted to the shares and the outlook for group performance is positive, ICAP Plc still faces risks and challenges along the road ahead. Most notably in that client attrition could negate improvements elsewhere in the business, while ongoing regulatory probes also pose a threat to earnings. Despite these risks, we are undeterred and maintain our positive view.

In relation to price targets, the shares have recently touched noses with the 340.00 pence level and appear reluctant to embark upon a further leg downwards. Consequently, we expect further downside to be limited to 340.00 pence. This is while our medium to longer-term outlook sees a return toward the 415.00 pence level as more than viable over the course of the next 12 months.

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