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ICAP Plc Interim Update – 05 December 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 415.00
Price Target 415.00 52 Week High 463.10 52 Week Low 341.00
P/E (H) 13.8 Dividend Yield % 5.86 Dividend Cover 1.5
CEO: Michael Spencer CFO: Iain Torrens  

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ICAP surpasses 415.00 pence price target, although half year results prompt pull-back

Since our last update following the Scottish referendum, ICAP’s shares have continued to perform well with the resurgence in volatility that late September, October and November have bought. In early November, the group surpassed our price target of 415.00 pence before going on to reach an 11 month high at 436.00 pence.

However, the release of a slightly disappointing set of financial results for the first half in late November prompted a sudden pullback from the shares. After touching a Q4 low of 383.00 pence, the shares now appear to have stabilised once again around our price target of 415.00 pence.

Looking at the numbers, both revenues and profits fell during the first half in what management described as a challenging environment. While there were some positives to come from the update, it was hard to ignore a substantial decline in earnings per share for the period from 16.2 pence, down to 10.1 pence.

This, combined with the impact of currency market moves during the period have now led to an industry wide downgrade to full year earnings expectations for the group.

While a company suffering from downward earnings momentum is always a difficult sell, below we explain why despite the first half performance, we continue to hold a positive outlook for ICAP Plc.

ICAP Plc Share Price // 8 Hour Intervals

ICAP01DECE

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Diverging monetary policies to lead to a resurgence of volatility in FX and rates markets

More encouragingly, the group chief executive continued to sound a positive note that activity volumes in FX and interest rates appear to be picking up.

Many will remember that a significant portion of our attraction to ICAP can be accounted for by widely held expectations that monetary policy will begin to normalise in the US, and potentially the UK, during 2015.

Looking ahead, the deterioration in European inflation expectations throughout 2014 has now led to to belief among market participants that the ECB will take the opening quarter of 2015 to embark upon its own quantitative easing program.

This is while the Bank of Japan has recently announced an extension to its own program of loose policy, with the government throwing in its own form of fiscal stimulus by delaying the second round of a highly controversial sales tax increase.

Further from here, China has recently reduced interest rates for the first time in two years while indicating that it could cut rates further during the months ahead if disinflationary pressures persist, or if economic growth were to slow too fast.

All of this comes at a time when unemployment is reducing rapidly within the US economy and both wages as well as core inflation are beginning to show signs of picking up. These trends were exemplified by the most recent reading of the PCE index as well as Friday’s November payrolls, unemployment and wages figures.

Given the progress of the US economy throughout much of 2014 the Federal Reserve has now fully curtailed its quantitative easing program and expectations for a steep cycle of rising interest rates have become embedded in the investor psyche for 2015.

All of the above combined will be likely to have a further positive impact upon volumes in FX and fixed income markets throughout the coming year and therefore; offers scope for an easing of the downward pressure upon earnings which ICAP has experienced since the crisis years.

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Market for post trade risk and information services remains healthy; division continues to grow

While revenues and profits declined at ICAP during the first half of 2014, none of this was the fault of the group’s post trade risk and information services division, which posted yet another positive performance.

We wrote previously about how we are attracted to this area due to healthy organic demand and a consensus anticipation that this trend will continue to evolve with the regulatory environment in developed markets.

Furthermore, we are also attracted to the high margin nature of the business, which was reflected in the full year performance for 2013. Here, the group reported post trade risk and information revenues which were equivalent to 15% of total group revenue. However, the contribution to earnings was 32.5%.

For the first half of 2014 revenues in this division grew by 12%, with a substantial portion of this coming from the TriOptima platform which offers portfolio compression and reconciliation services to institutional customers investing in OTC derivatives.

Looking ahead, management remain optimistic that this business will continue to grow strongly, while maintaining the view that the threat from competition has been reduced due to the successful implementation of a joint ICAP- multiple bank ownership structure of the Traiana platform and services.

share prices plummeted as a result after reaching our price target in early November, shortly before the release of half year results

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Cost savings program is likely to support earnings in the second half

Despite the grim news relating to first half numbers, and in addition to the better longer term outlook; there are also reasons to be positive about ICAP’s performance in the second half of 2014. Most notably, the group cost reduction program remains on track to deliver annualised savings of £60 million for the full year, with the majority of this expected as a credit to the income statement in the second half.

Current management estimates see a £43 million boost to the full year bottom line as a result of progress toward the group target of £60 million benchmark.

We see this as offering scope to offset the impact of lower trading margins for the period and therefore, is a factor in our revised earnings expectations for the group.

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Dividend and valuation update

Despite a tough year to date, ICAP has given every indication that its dividend will remain in place and unchanged for the 2014/15 financial year. This should see total dividends of 22.0 pence with 6.6 pence paid as an interim dividend and the remainder coming as a final dividend following year end.The implied yield based upon current prices is 5.28%.

From a valuation perspective and in light of the half year update, we are below consensus in our earnings expectations for the current year, with full year eps unlikely to exceed 25.0 pence per share in our view.

This places ICAP on a forward earnings multiple of 16.6X 2014 which is broadly in line with the wider sector for ICAP, indicating that there are limits to the likely degree of further upside for ICAP over the near term. In light of our revised earnings expectations, we view ICAP shares as fairly valued at or around our current price target of 415.00 pence.   

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Summary

All in all we continue to hold a positive outlook for ICAP. In short, we believe that an evolving monetary policy environment and the theme of “divergence” will support a revival in FX and rates volumes over the medium to longer term, which should aid a recovery in earnings.

This is while we expect organic demand for regulatory and risk solutions to continue to underpin growth in post trade risk and information services, which over the longer term; is likely to prove a significant net contributor to earnings.

Furthermore, we are encouraged by the group’s disciplined focus upon cost reduction as a means of supporting long term value addition as well as stable shareholder returns in the near term.

Despite this, we view the earnings performance of the first half as likely to constrain further upside for ICAP shares in the immediate future. This is as on a valuation basis, there is no longer a discount attached to ICAP’s shares and while the future earnings outlook has improved, uncertainties still exist in this regard.

As a result, we see little scope for a premium valuation to become sustainable at ICAP in the near term.

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