Alpha FX is a corporate FX broker which helps companies formalise their foreign exchange policies and then applies forward-based hedges to execute the strategy. A “forward contract” is its primary tool and basically allows corporates to lock in at today's exchange rate – but for delivery in up to two years' time, when they might need the currency for their overseas payroll or to import goods and materials or export finished goods. When you use such currency forwards, a small deposit is usually required of between 5% and 10% but the balance of each transaction is not due until the currency is needed and the conversion settles.
Since 2013, the number of companies using its FX service has trebled to over 220 and now includes ASOS and Sports Direct. Until now Alpha FX was using its own cash as collateral for running many of these forward contracts but cash generation wasn’t keeping apace with how quickly it was taking on new clients. It was therefore turning away business (a nice problem to have) so it listed on AIM to raise more cash as collateral. Rather intriguingly, when making its forecasts Liberum, the company broker, ignores the fact that Alpha FX has just raised that new capital. This is why I think Alpha FX is potentially well set for an enormous ‘beat’ on forecasts.
Collateral gearing likely to lead to eps “beat”
I first wrote on Alpha FX last month and since then I have met with chief executive Morgan Tillbrook, which has only served to confirm my already positive view of prospects.
I meet a lot of CEOs each year but this guy is obviously precocious and determined. Tillbrook is only 34 and look at what he has already achieved despite his self confessed lack of formal qualifications.
He established Alpha FX in 2009, just a year after selling his first business, an online poker tournament, to Sky. The last three years has seen Alpha FX on an explosive growth trajectory with both sales and profits growing by an average of 70% annually. Based on £1.8bn of FX volume traded and a £400m forward book, last year it recorded a pretax profit of £4.3m on sales of £8.4m. A juicy 51% margin.
Liberum is ‘only’ looking for a 23% jump in pretax profit this year to £5.3m and 30% growth to £6.8m next but these assume the company carries on only using its self generated cash. This is obviously not the case and Alpha FX is now fully funded to run a £1.3bn forward order book and profits have scope to reach £16.3m. Tillbrook seems ultra confident and directors have agreed to a three year lock in on their shareholdings so I am happy to follow. Management and the board hold 48%.
Banks still 85% of the market
As Tillbrook says, most corporates turn to the banks to carry out their FX hedging, generally for reasons of convenience. But the sector had its own ‘big bang’ in 2000 when financial regulation was passed covering retail FX trading but which exempted FX contracts being carried out for commercial purposes.
With relatively low barriers to entry, a number of brokers were established and to date they have captured 15% of the market, with 85% still in the hands of the banks such as Barclays, HSBC and Lloyds. Some commentators might think the market is saturated and Tillbrook agrees, colourfully adding that “it is saturated with crap.” Before he came along there just wasn’t anyone doing CFX well.
Alpha FX has been able to differentiate itself from the rest of the broker pack through technology and through the company’s unique culture. These are the special reasons why Alpha FX is attracting around 50 new customers every year, why existing customers are transacting more business with it and why the average revenue amongst the front office staff is higher than its rivals. Four points spring to mind.
No target driven salesmen
First, until now, the basic service offered by banks has tended to be ‘execution only’ and they are heavily circumscribed by legacy technology, legacy people and a legacy culture. They provide spot, forward and options for corporates to make their foreign exchange transactions but there tends to be very little advice provided and when it is, it tends to be limited to just directional estimates of future FX rates.
At the other end are the brokers that operate with highly commissioned salesmen who are ruthless and will create an urgency amongst their client base to trade in order to hit their monthly revenue targets.
It is worth remembering that exchange rates are a ratio between two currencies. So, if something happens overseas to weaken a country’s currency, the Pound can strengthen as a result – or vice versa. For example, there have been wild gyrations in the US Dollar since the surprise election of Donald Trump last year. At first there was optimism that his plans to cut taxes, reduce regulation and increase infrastructure spending could help to boost the value of the Dollar. But more recently, there have been concerns about weak economic data and questions about whether Trump will be able to move his agenda through Congress. An emotional response to this kind of stuff encourages the wrong client behaviour, says Tillbrook – a situation not helped when you get a call from one of his rivals’ highly commissioned salesmen encouraging you to trade. Unlike those commissioned salesmen, Alpha FX’s salesmen have no monthly revenue targets. This is the first part of understanding the Alpha FX story.
Instils discipline amongst clients
The second point I make is that the company puts a lot of emphasis on its pre-sales effort of understanding its clients’ requirements.
The big firms might be sophisticated and have their own policies on hedging but for the small and medium sized ones, it largely boils down to the best guess direction of FX rates by the finance director who will place intermittent trades. Tillbrook has created a hybrid service (consulting and trade execution) that looks to instill a sense of discipline by putting in place a hedging policy to replace large once off trades.
Alpha FX gets the finance director to adopt a new mantra - not to second guess market movements. Instead, Alpha aims to formalise the timing of currency purchases and helps businesses decide when, how much and how far forward to buy currency and spots, so that they can get on with running the business.
Hedging mechanisms used
The hedging mechanisms that Alpha FX presently employs is limited to forward contracts (later this year it will also include currency options, which will enable it to run even more sophisticated strategies by combining the two). A forward contract is a contract to fix the exchange rate on an amount of money for a pre-determined period of time. The delivery period is either a fixed date or within a specified window e.g 1st to 30th January.
A UK fashion retailer, for instance, might purchase clothes from China and India – two countries that tend to bill in US dollars. To minimise transaction risk, the retailer ideally might want to hedge its US dollar cost exposure across a number of retail seasons.
A suitable hedging strategy put forward by Alpha FX might be to use pound cost averaging or to ‘layer’ hedges. A layered hedging policy starts by forecasting the exposures over a medium-term horizon, generally 18 months to two years, which is normally in line with the corporate financial model Alpha FX will develop. A number of hedges – for different notionals and over different time periods – are then executed.
An appropriate hedging programme might see, say, six-month, 12-month and 18-month hedges executed in layered proportions, such as 80%, 50% and 20%, respectively. Here’s how it could work: once the initial six-month (80%) hedge matures, the original 12-month hedge (50%), which now has six months left to run, is topped up to 80% using a new 30% hedge. In turn, the original 18-month hedge (20%), which now has 12 months to run, is topped up to 50%, also using a new 30% hedge. A new 18-month hedge then captures 20% of the exposure, and so on.
In comparison, previously the client may only have operated a single rolling hedge and when that matured, a new one would be put in place. It is obvious that the layered approach offers reduced volatility as, over time, it achieves a blended/averaged forward rate. There are also fewer mark-to-market swings as the hedges are layered at varying rates and in smaller sizes.
Technology is third differentiator
Third, to support its operations, over the past six years Alpha FX has developed a suite of proprietary technology to handle everything from lead generation to client management. Tillbrook, in fact, did much of the early coding himself and it now includes a bespoke client portal that allows FDs to view existing FX positions; report live market valuations; stress test exposure based on the hedges in place; and calculate what potential collateral is needed. On top of that it also simplifies their FX reporting requirements - all the fair value accounting malarkey introduced under accounting standard FRS102.
How does Alpha FX make its money?
Fourthly, an important innovation pioneered by the group is that its remuneration is transaction based. When a client gives them an order, they don't charge a fixed fee but instead take a commission from each trade. For example, if a client puts in a trade order to buy £1m of US$, the company would typically receive £4,600 in commission.
This commission is based on the particular currency pair, the creditworthiness of the client and also the period the forward will cover. Alpha FX doesn’t offer ‘live’ prices on the platform for this reason - each trade has to be negotiated with the dealer on a case by case basis.
No proprietary positions / risk
As I am learning, a currency forward represents a binding obligation, which means that the contract buyer or seller cannot walk away if the “locked in” rate eventually proves to be adverse. Therefore, to compensate for the risk of non-settlement, Alpha operates a “matched principal model” so when booking a foreign exchange trade for its clients, it immediately enters into a matched contract with a banking counterparty. This ensures no risk on its part. Alpha FX has to pay the counterparty a deposit. If a client’s credit rating is not that good then Alpha will itself call the client to put up the deposit.
Historically, the largest counterparty has been Lloyds and the pricing there is around 2bps. The difference between the rate it provides the client and that which it receives from its counterparties is the “spread” and this averaged 46 basis points last year.
Tillbrook adds that because it has made huge inroads to bigger corporates including ASOS, Global Data and Holland & Barrett, the average deal size is escalating. Also, because a currency can swing 10pc a year and there are 100 ticks a week, larger clients are less fixated on the absolute spread but more about the service levels they are receiving. If anything, spreads and margins are likely to widen further.
Clearly at any one time, Alpha FX is going to have multiple forward contracts running across 100s of clients. The banking counterparties mark-to-market all open forward contracts at the end of each working day. If there is a net adverse movement, Alpha FX is required to pay more margin. It then asks clients to deposit additional cash against its own margin call.
Alpha FX’s system is able to monitor exposure limits in real time on a live mark-to-market basis. The system also automatically sends payment reminders to clients, removing much of the administrative burden.
Plans assault on Europe
Tillbrook has expanded the number of consultants at a frantic pace, with 24 now (up from 13 a year ago). These consultants are organised into small units and are each supported by a research analyst, a small corporate dealer (who manages the small accounts to free up the consultants) and a strategist (to support the hedging process and are consultants in-waiting).
Tillbrook elaborated to SCSW that salesmen will earn 8% of the “spread” from orders placed by their existing clients and can double this to 16% if adding new clients. It takes a few months to train new consultants before they become properly revenue generating but despite the increase in consultant numbers, the average revenue per client has been growing (> £400k).
The business is still only scratching the surface of the CFX market; one study shows UK companies export £445bn of goods and services - so Alpha FX has less than a 0.4% share - whilst Tillbrook also intends on launching an assault on Europe this year. A high PE but the growth rate is electrifying. I remain a buyer.
