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IFA stocks to take a turn for the better

Quoted financial services distributors have generally been a disaster for investors over the last year.

Share prices have fallen on average by 40 per cent but Inter-Alliance is down by 90 per cent. The listed Kingsbridge Holdings looks likely to disintegrate into a shell.

Only two firms have survived reasonably intact. The share price of St James&#39s Place, a product provider with a tied distribution tier, is down by only 13 per cent. Prestbury, which was floated in late 2002, is up by 31 per cent.

But there are positive signs that the sector is starting to recover. Demand is certainly picking up. Lead indicators, such as Isa sales, are significantly stronger than earlier this year. Firms report record sales in June and July. Barring a 9/11-type disaster, the demand for advice should start to grow strongly.

Drivers include the rising complexity of tax regulation, the stockmarket recovery and the need for consumers to use housing equity to fund pension gaps. The shakeout after the consumer credit bubble will help advisers as households rebuild their balance sheets.

The news from advisory firms is also positive. All have cut overheads, sometimes severely. For example, Inter-Alliance has reduced costs by 40 per cent to £21m. This means that most of the sector should be profitable during the early part of 2004. With the market recovering, profitability should increase sharply after that.

The future regulatory regime is now reasonably clear and should generate no major issues. Profess-ional indemnity insurance and regulatory capital issues mean that many smaller businesses will continue to leave the industry. This will reduce competition for advisers and should help increase profitability.

We continue to believe that regulatory changes, particularly multi-ties, offer a one-off opportunity to improve the terms on which advisers trade with providers.

However, the industry continues to have significant structural issues. The legacy from the polarised regulatory regime is a fragmented industry. Without consolidation, future levels of profitability will be low.

This is for two reasons. First, distribution firms are too small to have bargaining power versus product providers.

Second, advisers capture too much value, hence gross margins are low. The continuing flow of new entrants, such as Thinc, does not help the situation.

The recent strategies adopted by most firms have centred on recruitment and small acquisitions. We believe this will be insufficient for IFAs to achieve our target levels of profitability. Therefore, consolidation, involving the bigger quoted and unquoted players, is the most realistic way forward.

Eight firms could lead this process – Inter-Alliance, Millfield, Berkeley Berry Birch, Lighthouse, Bank-hall, Tenet, Aegon grouping and Sesame. In practice, personality clashes, different cultures and lack of stockmarket quotes or cash mean that most will struggle to initiate the process. In addition, the poor track record of recent acquisitions has made management teams nervous.

The stockmarket effectively gives virtually no value to the distribution of financial services. Apart from Millfield and St James&#39s Place, the market capitalisation of distributors is little more than their cash. Once profitable, the sector is likely to be re-rated with price/earnings ratios of around 30 times next year&#39s profits.

However, without embedded value, for example from wraps or funds under management, p/e ratios are unlikely to exceed 12-15. A left-field acquisition by a provider, which remains a realistic scenario, would drive up valuations further. However, there will be no return to the IFA bubble of 2002.

Earlier this year, Durlacher was pessimistic on the future for IFAs and other distributors of financial products. Positive newsflow on consumer demand and imminent profitability means that we have now changed our view. Share prices should start to increase from their current low points. We are now recommending investors to buy into the sector.

If any readers would like a copy of the full report please email Claire.goode@durlacher.com.

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