Why I am buying ICAP plc

Why I am buying ICAP plc

10 Jan 2013

At first glance, ICAP looks like the kind of company that I don’t like to invest in. It is a financial service business whose employees are well rewarded for success. The normal problem with such companies is an implicit conflict of interest in that the shareholders find themselves in competition with the employees for a share of the added value. Shareholders of investment banks in recent years will be well acquainted with this idea.

A key fact about ICAP is that the CEO is the largest shareholder and, understandably, he appears to like dividends. Michael Spencer owns 16.7% of the company. The dividend for last year paid him 108 million lots of 22p. That’s £23.8 million on top of his executive remuneration of £5.5 million. This man’s appetite for dosh is huge by most standards but he is greedy on behalf of all shareholders: and it helps to know that ICAP’s annual charity day has now raised a total of £100 million.

ICAP is a large interdealer broker that matches professional buyers and sellers of all kinds of financial products (interest rate products, foreign exchange, bonds, commodities etc). It charges tiny commissions on huge transactional volumes. ICAP does not take positions. It is a pure broker that will know on a daily basis what its income is and what its costs are. Since the financial crisis hit, volumes have fallen and the company has been quick to cut costs. There are two ways in which costs are cut; first, by reducing headcount among the traditional broking staff; and secondly, by increasing the penetration of electronic trading (where profit margins are 40%). The increased use of electronic trading is a strategic goal that should improve underlying margins.

ICAP is a business with strong cash generation. Operating cash flow over the financial year is typically 20% of revenues. This funds the dividends. The full year dividend over the five years of the financial crisis has risen from 15.65p per share to 22p. In the first half of the current financial year (to March 2013) it was raised again, despite Michael Spencer reporting that “this has been one of the toughest periods in my 36 year career in the wholesale financial markets.” At 327p, the dividend yield is nearly 7%.

ICAP is due to release a trading update on 25th January. There is clearly a risk of disappointment again, especially given Mr Spencer’s admirable habit of telling it like it is. I am happy to buy ICAP now regardless, because it offers value and because I trust the management to do whatever has to be done. Nevertheless, I must admit to a small but intrusive feeling of optimism that trading flows for ICAP could be improving. Bond markets are showing signs of normalisation, by which I mean that the yields on bonds regarded as “safe” are a little less absurdly low and that yields on the bonds of some of the large Eurozone countries like Italy and Spain have fallen significantly from their highs. Last July, Italian 10yr yields were at a 520 basis point premium to those of Germany. Today that premium has halved to 260 basis points. An improvement in confidence might cause an increase in trading volumes.

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