Michael Spencer’s new vehicle, Nex Group, has had a shaky start.
Less than a year after the City entrepreneur split ICAP, the interdealer broker he founded, creating Nex, a £2.7bn group focused on electronic trading in over-the-counter markets, the group has stumbled.
Early this month, Nex warned on profitability, as operating margins have been squeezed at its post-trade unit, which runs the plumbing for deals in fixed income and derivatives markets and accounts for nearly half of group profits.
Nex said extra spending on temporary staff and blockchain technology would cut margins by nearly a third.
The warning prompted a 6 per cent fall in the company’s share price — but the stock has since bounced back. Investors who have largely bought into Mr Spencer’s vision — and pushed Nex’s share price up 42 per cent this year — appear to be keeping the faith.
They are now relying on Mr Spencer to bring costs back down and generate more business to prevent any further profit warnings.
Mr Spencer, who earned hundreds of millions selling the other half of ICAP to rival Tullett Prebon for £1.3bn last year, sees the mix of new regulation and technological advances as akin to the equity market’s Big Bang in the 1980s. He remains Nex’s largest shareholder, with a 17 per cent stake.
The next six months are crucial for Mr Spencer and Nex as they will show whether the bet he has made on emerging trends in off-exchange markets will begin to bear fruit when new European markets rules come into effect.
If Mr Spencer does not get it right, investors expect either Deutsche Börse or the London Stock Exchange to come in with a bid for Nex, even though Mr Spencer has always publicly rejected the speculation.
“There’s a fear that there’s too much taken on trust, that this will either be turned around or Nex will be taken out by one of the big exchanges,” says Paul McGinnis, an analyst at Shore Capital, the sole broker out of 11 to have a “sell” rating on the stock.
Since the split with ICAP, Nex has been redesigning the post-trade business, to try to unify disparate brands and services. The project has been spearheaded by Jenny Knott, who joined from Standard Bank in 2015.
The overhaul has come at a cost. The company has warned that operating profit margins, which were 29 per cent in the year to March, will tumble to 20 per cent in the six months to September, before rebounding in the second half. The group has retained its long-term target of “at least 40 per cent” by 2020.
Bank of America Merrill Lynch, its house broker, cut its estimates for Nex’s post-trade business for the year to March 2018 by 28 per cent to £57.8m and 21 per cent to £73.8m for 2019.
Michael Spencer group chief executive of NEX
Other analysts have questioned if the company’s spending will slow and earnings rebound. In its last financial year, Nex spent £84m on IT costs. That included £38m of continuing depreciation and amortisation charges, up 35 per cent year-on-year.
“We think it is totally right for a company to be prepared to take a short-term hit to profitability if the pay-off is significant,” says Philip Middleton, an analyst at BofA. “Management must be highly confident of the benefits of this decision [to take costs upfront].”
One effort to cut rising IT costs is by putting more of Nex’s applications on emerging blockchain technology. This project, called Infinity, accounted for four percentage points of the first-half margin shortfall. Nex wants to use the customer trading data it receives for various services, and turn it into a “golden source” record for all deals, before it is sent to regulators, clearing houses and other financial institutions.
However, others claim this comes with challenges.
“There can be several repositories of this data across an organisation. Though most firms aim to produce ‘golden copy’ records, most are a shade of brown,” says Virginie O’Shea, research director at Aite Group.
The January introduction of Mifid II, Europe’s sweeping markets legislation, requires tougher standards on the quality of data for deals in the fixed income and derivatives markets, which should boost demand for Nex’s services.
Nex’s transaction reporting unit processes about 5m deals a day under current European rules, roughly a quarter of all reportable transactions. However, Nex hired more staff to be ready for the new Mifid regulation in January, a move that pushed up costs at the post-trade unit by three percentage points.
But the business had turnover of just £3m in the five months of Nex’s ownership last year and is expected to only consistently be profitable by the end of next year. Specialists in transaction reporting warn Nex may have to raise prices, but that could deter users and push them to rival services run by the LSE and MarketAxess.
Some analysts say Nex should not rely on a suitor appearing if it does not fix its problems.
“A value-creative return at any premium to the current price looks challenging,” says Mr McGinnis.