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AIM listed financial spread betting group London Capital Group (LCG) has issued a profits warning today and its shares have duly tanked by 10p to 52p, valuing the company at £27.6 million. Declaring an interest first, London Capital (like several other sensible enterprises) advertises on TomWinnifrith.com, I wonder if the market has over-reacted a tad. Net cash is, after all, £21.5 million (or was at 30th September). So is this a high risky buy? Or perhaps not.
I am instinctively not drawn to spread betting firms. They are commodity businesses – they all offer essentially the same product. Growing profits is thus down to two things:
1. Growing market share. That either comes from heavy ad spend which sucks up a stack of free cashflow or from signing white label deals where other folks do the marketing and you simply gain incremental revenue.
2. The market being volatile. This encourages all the day traders/swing traders/momentum traders to place lots of bets. The past three months have been dire on that score. The first half was not great. The money firms like London Capital makes is largely on index betting ( not individual equities, gold etc). Hence what this industry needs is for the FTSE 100 to jump all over the place not rise slowly and then retreat slowly as it has of late.
With a high fixed cost base profits are really geared to volumes. And so in the first half, revenue was broadly stable at £18.4 million and that lead to an underlying profit before tax of £2.05 million ( down from £3.01 million but still respectable). Today we are told that Q3 saw a stonking loss and thus underlying pre-tax profit after nine months was just £0.6 million. That suggests that Q3 was dire.
London has responded by saying that it is cutting costs. It states:
“The Board had decided to adopt a prudent approach to respond to the falls in revenue and has already cut discretionary costs. In addition, the Board is undertaking a review of its overseas subsidiaries and an efficiency review to reduce controllable costs further to ensure the business can adapt to the low income environment currently being experienced. “
Assuming that the climate gets no worse that should move it back towards break-even but the reality is that London Capital will stay at somewhere either side of breakeven until market conditions change and we simply do not know when that will be.
There is one other P&L issue. The company made a big provision for dealing with complaints levied to the Financial Ombudsman Service relating to the management of a now deceased Spot FX Fund in 2009. It has fully provided for this but today said that it had settled with 37% of punters and so was writing back £700,000 of provision. This is something I basically ignore. It is best to look at the underlying business.
The net cash position at 30th September might encourage some bulls. But I note that net cash at 30th June was £35.5 million so it has fallen sharply during the third quarter. Moreover not all of that cash is free cash. Perhaps a little under half of it has to be held as regulatory capital as London is FSA authorised. Having said that I cannot see this firm going bust. It does have a strong balance sheet and should be able to push itself back towards breakeven even in the current climate.
The bear case is that you simply do not know when a recovery will happen. The bull case is that in calendar 2011 this business made £7.1 million pre-tax profit. In even half normal conditions there is no reason why it could not do £5 million plus on an annual basis. Valuing that on even six times earnings plus net cash and the share price would double.
I have no idea when the recovery will come. But it will at some stage. As such if you can pick up a few shares at around 50p now and just sit it out then at some stage you should double your money. It might happen next year, it might be 2014 or 2015 but at some stage your patience will be rewarded.
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