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Part of my motivation for writing this blog is that
I believe passionately in allowing smaller investors similar access to my
own and the company's thinking that institutions expect to get. I have written
about this before, but it really is hard to see that small investors don't
lose out on AIM. They get less information, fewer chances to talk to senior
management and much less access to placings which are often done at below
the market price. Aside from outstanding exceptions like t1ps.com and Shares
Magazine, there is so little coverage of AIM stocks that small investors
really do need to do a lot of their own research. I would stress that the
views here are my own and not necessarily those of all of my board, but
again that is what an institution would get in a one on one meeting!
Among the main strategic issues our company needs to have a view on at
the moment are the following, in the context that Lombard Risk does business
with about 200 banks and quite a number of asset managers or hedge funds:
| a) |
How serious is the sub-prime crisis and the consequent effect on bank liquidity?
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| b) |
If it is serious how significant will that be for bank and asset management firms’ technology spending?
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| c) |
How is our own company’s current range of products placed within that? I have just put on record in my Chairman’s Statement that “the Group has had a record quarter for billings and has so far seen virtually no signs at all of a slowdown in spending by banks in those areas affecting the Group’s core businesses”.
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I am struck by the disparity between the gloom and caution I hear from
quite a few senior banker friends, and the fact that many of the traders
who are mostly in their 20s or early 30s seem to believe this is no more
than a short term correction. Perhaps it is simply because the latter have
never seen a full scale recession and that they are as dismissive of the
lessons of the past as any generation has been before them. Or they could
be right and for every experienced risk manager in London or New York forecasting
a downturn, there are Middle Eastern and Chinese investors waiting to snap
up bargains and recycle some of the vast oil or manufacturing trade surpluses
their countries are enjoying; a genuine new economy story in fact that few
in work today have experienced before.
Where does this leave banks? The biggest effect of the U.S. sub-prime crisis
followed by the incidents at Northern Rock, IKB, Landesbank Sachsen and
so on seems to have been to dry up the interbank market (the lending by
one bank to another). This is not because large banks have no liquidity,
but rather that at a time when there are rumours about the solvency of individual
banks no bank wants to be left having lent to that bank – there is
little income from lending to other banks and certainly no prizes for getting
it wrong. This in turn means that those banks that rely on net interbank
funding are being much more cautious about doing business in case they can’t
fund it. Presumably bank regulators are also making clear that this would
be wise! Add to this the fact that the business a bank would previously
not have taken onto its books but would have securitized or syndicated can
no longer easily be laid off, and this further dries up borrowers’
access to funding and also pushes up the price of the lending margin a bank
is going to charge. And to make it worse some of the loans that already
had been securitized have had to go back onto banks’ books. So in
summary I think that what this means for banks is the following:
| a) |
Banks already have had to cut back on their
corporate lending and this won’t end soon.
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| b) |
The lending margin on the new corporate lending
that banks have done has and probably still is going up in a period
of rationing of credit, and therefore profitability from lending may
still be holding up well.
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| c) |
The write-downs banks have had to take on sub-prime
and CDOs are now largely in the market although there are still difficult
valuation issues when there simply is no price for the size of position
a bank has, and it may well be that the mark to model approach used
by many banks still does not represent the worst case – why
else would a delegation of the big accounting firms have spoken with
the FSA about this subject recently?
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| d) |
The real issues for banks are:
| i. |
The one off write-offs on CDOs and sub-prime
have had at least a temporary adverse effect on bank capital
ratios and on the amount that banks can lend - unless like Citigroup,
Barclays or UBS they raise new money.
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| ii. |
Liquidity constraints for banks that
have less non-bank deposits than they do non-bank lending. Of
course fear can change this balance and rapidly erode a deposit
base, the extreme recent example being Northern Rock. Any such
fear strengthens strong banks and weakens weaker banks.
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| iii. |
Any possible increase in bad debts owing
to more borrowers having difficulty in re-financing will be
a threat to bank profitability balanced by the higher lending
margins banks are charging.
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My guess is that of these ii. is the issue now and iii. is going to
be the real issue, and it is to address both that the central banks
are injecting so much liquidity into the system. The European Central
Bank’s injection of EUR350 billion this week really is a very
large amount of money. |
Given the above issues for banks, it seems to me almost inevitable that
banks will be looking, in as discreet a way as possible, to reduce their
costs. Why discreet? Because in the current market, when every bank is questioning
the credit worthiness of all its customers, no financial institution wants
rumours going around that it itself is suffering from lack of liquidity.
That will inevitably mean deferring non-priority expenditure or growth justified
expenditure whether on recruitment, premises or technology. This will surely
hurt rental levels and occupancy rates in the City, event organizers, those
seeking large bank sponsorship, and anyone selling something a bank can
do without for a little longer.
I look at this macro picture and it argues for a firm like Lombard Risk
that supplies banks and asset managers/hedge funds to be lowering its revenue
forecasts for calendar 2008 and cutting its own costs appreciably ahead
of a likely downturn. But then I look at our own order book and find that
we have had a record last three months for billings and that our key issue
is managing implementation of multiple regulatory projects rather than any
lack of new business. I attend our weekly management meeting, and find that
our sales pipeline for 2008 is healthy and that new deals are there to be
done. This argues for not cutting back.
Every CEO or business leader receives lots of advice, both internal and
external, and has lots of data to look at. Inevitably not all of that data
or advice points in the same direction, but it is still a CEO’s job
to navigate through fog which will miraculously lift with the benefit of
hindsight. The present situation for us where the macro picture is worrying
while our own micro picture is encouraging is an unusual conflict in that
data. But here is our thinking at present:
| i) |
The regulatory software side of our business
is likely to be relatively immune to the overall issues in the banking
sector and the economy provided we do not see the disappearance of
many banks through mergers or the closure of London branches of foreign
banks. Banks have little choice but to comply with regulations, although
sometimes they do successfully lobby for delay in the implementation
of regulatory change.
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| ii) |
With credit risk such a big issue at the moment,
expenditure in the credit risk and collateral management area is likely
to remain strong, and our Colline product should actually benefit
from this. A bank doesn’t want to risk being the last bank able
to make margin calls from a risky derivatives counterparty because
it has sub-standard systems.
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| iii) |
We have been and intend to continue growing
the proportion of our headcount in Shanghai. In some areas like the
current regulatory surge we have had to add to UK headcount in the
short term, but in anything other than the short term the Shanghai
factor should allow us to reduce costs without reducing our delivery
capability.
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I am glad that unlike many technology firms our business model for 2008
doesn’t revolve around selling product or hardware upgrades for which
banks see only marginal benefit, since that kind of expenditure will surely
be at risk in 2008.
In summary I think that the business model we have at Lombard Risk should
allow us to perform well in relation to other software companies selling
to banks, and that we should almost be judged as a standalone company rather
than as an IT company. Our current share price of just under 5p values us
at below 1 x historic revenues, and well below 1 x analyst forecast revenues.
Quite a number of software companies trade in the range of 2-3 x historic
revenues. More than that I should probably not say!
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