Summary
Close Brothers Group plc (CBG.L) is a UK-based merchant banking group offering lending, deposit taking, wealth management, and securities trading services. The company experienced a sharp stock price decline of over 60% following the Financial Conduct Authority’s (FCA) announcement of its investigation into Discretionary Commission Arrangements (DCAs). Although the stock made a substantial recovery in the following months, most of the gains were reversed after the company announced its decision to sell its asset management division. Despite this, we believe the company is currently undervalued, as its already strong capital position will be further bolstered by the sale, providing ample financial flexibility to manage the investigation. Moreover, by divesting its asset management division, the company can refocus on its core strength in banking, where it holds a competitive advantage as a specialist lender in niche segments of the market.
Bear Case
On January 11, 2024, the FCA launched an investigation looking into “whether motor finance customers have been overcharged because of the past use of DCAs.” DCAs allowed lenders to give brokers discretion over the interest rates charged to customers, where higher rates resulted in higher commissions. The FCA is considering a consumer redress scheme to address the potential harm caused to customers, which creates significant uncertainty for Close Brothers, as it was involved in this practice through its motor finance division before it was banned in 2021.
In anticipation of the redress scheme, Close Brothers announced on September 19, 2024, its decision to sell Close Brothers Asset Management (CBAM), a move that led to another sharp stock price decline. The sale raised a lot of concerns with management, as it appeared to be a desperate measure rather than a well-thought-out transaction. Then again, the decline was exacerbated by a recent ruling by the Court of Appeal which extended fiduciary duties for motor dealers acting as credit brokers, potentially increasing liabilities from similar claims. Overall, uncertainty around the investigation is at its highest point, and potential damages appear to be substantial. Nonetheless, Close Brothers remains far from financial distress, with a strong balance sheet and its core banking operations performing well, presenting an attractive entry point as market sentiment hits peak pessimism.
Part I: Strong Capital Position and Preservation Measures to Weather the Ensuing Investigation
As of its latest financials, Close Brothers has £1,374.8 million of common equity tier 1 (CET1) capital (which consists of the highest-quality capital, including common shares and retained earnings, that can absorb losses immediately) and £10,701.2 million risk weighted assets (RWAs) (which represent the bank’s assets weighted by risk to determine the amount of capital needed to cover potential losses). With these two metrics, we can get important ratios: the CET1 capital ratio, which measures the core capital as a percentage of risk weighted assets, the tier 1 capital ratio, which includes CET1 plus additional tier 1 capital such as certain subordinated debt, and the total capital ratio, which includes tier 1 capital plus tier 2 capital, representing supplementary capital available to absorb losses. Close Brothers has a CET1 capital ratio of 12.8%, a tier 1 capital ratio of 14.7%, and a total capital ratio of 16.6%, all comfortably exceeding the regulatory minimums of 9.7%, 11.4%, and 13.7%, respectively, and standing in line with industry peers. [Pg. 21]
Close Brothers has opted to further strengthen its capital position through a series of preservation measures, each expected to add on its own £100 million of CET1 capital. These include the FY24 dividend suspension, initiatives to optimize RWAs and reduce costs, the sale of CBAM, and a potential FY25 dividend suspension, with plans for reinstatement after the investigation concludes. Collectively, these actions are expected to increase CET1 capital by around £400 million by July 2025, raising the CET1 capital ratio to 14-15%. This strategy ensures Close Brothers is well-prepared to meet any potential liabilities from the investigation, while maintaining its historically strong capital metrics.
The redress scheme is anticipated for 2026, though the exact timeline for the conclusion of the investigation remains uncertain, particularly since the FCA has missed previous deadlines in this case. The potential cost is also unclear, as it will depend on several unknown factors such as the time period covered, the reference rate applied, and whether it will be a proactive or a reactive scheme. However, Close Brothers has clearly outlined the steps it plans to take, and has already begun their execution, addressing much of the uncertainty.
Part II: Banking Core and Strategic Strength in Specialist Lending
While the sale of CBAM is regrettable given its growth potential, our focus when considering Close Brothers lies in its banking division. Since its establishment in 1878, banking has been the core of Close Brothers’ operations, long before the acquisition of CBAM in 2011. In terms of operating income, banking contributes £724.9 million (~77%) compared to CBAM’s £157.8 million (~17%), and in terms of adjusted operating profit, banking contributes £205.4 million (~120%) (over 100% as it offsets central functions costs and slight losses from the securities trading division), compared to CBAM’s £12.2 million (~7%). [Pg. 9] This is not to downplay CBAM’s contribution, as its sale will reduce overall profitability and growth, but rather to underscore that the financial impact will be limited to these proportions, as the banking division not only generates most of the revenue but also disproportionately drives profitability.
Close Brothers’ banking division operates in the commercial, retail, and property finance segments, delivering strong results through a focus on specialist lending to small and medium-sized enterprises (SMEs). By targeting niche markets with limited competition—where other banks often lack the expertise or personal relationships required—Close Brothers has achieved a robust net interest margin of 7.4%, significantly above the typical 2%–4% range for traditional banks. Additionally, excluding non-recurring items from the prior year, banking income grew by 4% in 2024, driven by a 6% increase in the loan book. [Pg. 8]
Fundamentals and Valuation
Over the last five years (2020 – 2024) revenue has increased from £1,001.2 million to £1,509.7 million (a CAGR of 10.81%), while net profit has slightly declined from £109.5 million to £100.4 million. This decline in profit, despite strong income growth, is largely due to regulatory provisions and restructuring costs. In 2024, both revenue and net profit saw significant improvements, increasing by 22% and 24%, respectively. [Pg. 192]
In 2024 the company experienced a net cash outflow from operating activities of £382.0 million, compared to an inflow of £1,021.4 million in 2023. [Pg. 196] This was primarily driven by increased lending activity and significant repayments of loans and overdrafts from banks. Despite this, the company has a very strong level of liquidity with a liquidity coverage ratio of 1,034%, substantially above the regulatory requirement of 100%.
In essence, we consider the company to have solid growth potential and a very strong balance sheet, even though it has delivered mixed results due to one-off costs and typical operational fluctuations. The current challenges have significantly depressed its valuation, with the stock trading at a P/B ratio of 0.19x and a P/E ratio of 3.46x, compared to its 10-year averages of 1.60x and 11.15x, respectively. While the investigation may result in high costs and changes in the structure of the company, potentially leading to lower valuation multiples even after the investigation, we believe that once the uncertainty subsides, a substantial increase is likely.
Downside Risks
Since the likelihood of bankruptcy due to the FCA investigation is extremely low given the company’s robust balance sheet, the primary risk lies in the possibility of a redress scheme so significant that it forces the issuance of equity to meet minimum capital requirements. This scenario, though possible, remains improbable due to Close Brothers’ strong capital position. For context, assuming constant RWAs of £10,701.2 million, CET1 capital would need to fall to £1,038.0 million to breach regulatory thresholds. This is £736.8 million below the company’s expected CET1 capital of £1,774.8 million after factoring in the planned £400 million capital increase.
Still, the risk of equity dilution remains a real concern, and while this scenario would require an extraordinary outcome from the investigation, it cannot be dismissed entirely, making this a high-risk investment. Moreover, the handling of this case underscores growing concerns about the unpredictability and retroactive tendencies of the UK regulatory environment, which particularly affects smaller companies like Close Brothers.
Conclusion
The FCA investigation has forced Close Brothers to take significant steps, including suspending its dividend, selling its asset management division, and, as of late, temporarily halting motor finance activities to avoid further regulatory scrutiny (though these operations have now largely returned to normality). Despite these drastic measures, Close Brothers’ strong track record and prudent management have ensured a robust capital position, enabling it to navigate the investigation. Once resolved, the company’s high profitability and competitive advantage in niche lending markets are expected to drive a strong recovery. Overall, at current depressed valuations, Close Brothers presents a compelling deep-value investment opportunity, even though substantial uncertainty will remain until the investigation is over.
Disclaimer: This report represents our opinion and is not financial advice.