A 'transformative deal': six analysts on Rathbone's S&W merger talks
Over the weekend it emerged that Rathbones and Smith & Williamson are in talks on a merger worth up to £2 billion.
merger between the two rivals would create a £55 billion sector champion. Rathbones confirmed the discussions, adding that the combination 'would bring meaningful benefits for the stakeholders of both businesses'.
Although discussions are still ongoing and the companies pointed out that there is no certainty a transaction will be agreed, analysts were quick to comment.
Here are six reactions to the news.
Transformative deal for Rathbones
Stuart Duncan, analyst at Peel Hunt, said in a note that the attraction for Rathbones is the significant scale it will gain from Smith & Williamson.
He pointed out that the group operating margin was 16.6% for S&W based on reported financials to April 2017, while assets under management were £18.8 billion and funds under administration in the business services division were £9.2 billion.
'We would assume that this would bring significant benefits in terms of operational efficiency and leverage going forward, although at this point it is impossible to quantify the financial implications and the potential accretion to an enlarged group’s operating margins. There will be some additional challenges in completing any transaction – clearly the Tax and Business Services division brings complexity to any deal, while we also note that 30% of S&W is owned by Canadian investment management group AGF (with a significant proportion also owned by ex-employees and directors).'
He added that although there will be the usual integration risks due to the size of the companies, it has the ‘potential to be a transformative deal for Rathbones’. Peel Hunt is keeping its 'hold' rating on the stock with a price target of £26.30.
What happens when something goes wrong?
Jim Wood-Smith, CIO private clients and head of research at Hawksmoor pointed out several issues in operating ‘another investment behemoth’.
‘The welcome requirements of ‘suitability’ mean that all discretionary managers need to have a coherent investment process these days, even ones as large as this. Part of that means that the individual investment managers have to be constructing portfolios from more or less the same things. That is quite a constraint on a firm managing £55 billion (the alternative is that investment managers don’t do this, and that is even scarier).’
He said that by virtue of their own size, the funds will be biased towards the largest and most liquid stocks. He added: ‘if these giants are not invested into the largest and most liquid funds, what happens when something goes wrong, as it will? How does a manager sell potentially hundreds of millions of pound out of a fund? Hmmm'.
'What differentiates one giant from the next? It would be very unfair to name names in this diatribe against size, but what is it exactly that separates one discretionary manager of £20 billion, £50 billion or whatever, from the next? The asset allocations are never very far apart: hands up every major DFM [discretionary fund manager] who has a zero weight in US, or European, or Emerging Market equity? Anodyne conformity is the way the industry is being driven.'
Greater upside for investors elsewhere
Justin Bates at Liberum said: '‘The price has been rumoured in the press at £500 million-£600 millioj. This equates to 2.6%-3.2% of FUM [funds under management] and in-line with what we would consider to be a realistic range. The major caveat is we are not privy to detailed S&W financials.
'Strategically, the deal would seem to make sense, particularly given RAT has been struggling to drive organic growth much beyond 3% of opening FUM in recent years. RAT shares have performed strongly, +14% in one month, +50% in last year. The stock trades on a CY17 PE of 22x, falling to 20x and yields 2.2% rising to 2.3% and a P/FUM of 3.6%. In a sector that is consolidating rapidly we see greater upside for investors elsewhere e.g. Brewin Dolphin trades at a +20% PE discount to RAT with a yield of 4.0%.'
Overlapping offices offer cost savings
Analysts at Shore Capital pointed out that the overlap in regional offices should offer some cost savings but they 'expect minimal headcount reduction from front office staff (cultural fit will be the main challenge here)'.
'S&W’s staff costs were £75 million in the six months to Oct ’16, implying circa £150 million for the full year, of which we would expect the majority to be front office. Cost savings just from back office would therefore potentially need to be quite significant.’
Commenting on the price of £600 million being around 20.5x historic post-tax profit they added: 'A multiple of 20.5x equates to a post-tax return on invested capital of 4.9%. We would expect a hurdle rate for M&A of at least 10% (albeit not necessarily in year one), meaning any deal synergies would need to approximately double S&W’s current level of profitability for the deal to be value creative.'
Good cultural fit
Cantor Fitzgerald raised its target price on Rathbones from £23 to £27, retaining a 'hold' recommendation on the stock.
The analysts noted: 'The cultural fit looks to be good with both overlap in activities (private client wealth management) plus complementarities such as tax affairs. We would assume that there would be cost synergies involved in this deal.
‘Rathbones shares are currently trading on nearly 18x FY18E EPS estimate of 147p (consensus 142p). It appears that this high valuation partially already reflects speculation over a deal. The merger could involve circa 10% accretion over time from cost savings which would put the shares on 16x which is closer to the longer term average.’
The main risks, it said, will be staff retention, regulation, client flows, market levels and investment performance.
Taking the fight back to passive giants
Ryan Hughes (pictured), head of fund selection at AJ Bell, said: 'The news of a potential merger between Rathbones and Smith & Williamson is the latest evidence that we are in a period of consolidation in the asset management industry. Both of these business have remained at the periphery of the large asset managers and struggled to gain major traction, with many of their strategies remaining sub-scale.
'While there may be wider benefits from these two businesses coming together given that they do much more than just asset management, the ability to build greater scale has to be seen as a key opportunity as active managers look to take the fight back to the passive giants.
'A look at the fund ranges of both businesses actually reveals little overlap, highlighting the point that neither can be considered mainstream in their fund management line-up. That said, there is scope for potential consolidation in some areas of fixed interest and UK equities. It is worth noting that Rathbones contains the standout talent in Carl Stick, manager of the Rathbone Income fund and James Thomson, manager of Rathbone Global Opportunities, who has a fantastic long-term track record.
'With markets at elevated levels and passive managers such as BlackRock and Vanguard taking ever greater market share, there are likely to be further opportunities for mid-tier asset managers to come together, find synergies to cut costs and look to regain the impetus for active management.'