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Why I think this small-cap stock could be undervalued

Many commentators in the financial press predicted a rapid demise for the UK spread-betting industry, once the European Securities and Markets Authority (ESMA) and the Financial Conduct Authority (FCA) began to scrutinise retail financial trading. In July 2018, the ESMA subsequently applied strict rulings in the UK and throughout Europe, shackling clients’ trading ability.

Forcing retail brokers to place financial health warnings on their sites from July onwards woke up many spread bettors to the industry’s perils. Statements such as “77% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider, you should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money” aren’t the most welcoming of messages.

However, the wider industry may have discovered an equilibrium, after the ESMA and the FCA announced their rulings, as there appears to be a reduction in the haemorrhaging of client numbers. The hard core of remaining bettors who continue to use UK spread-betting firms’ services might now fall into two distinct groups: customers who consider themselves to be more professional, or those who are more financially savvy and have the financial wherewithal to commit themselves (longer term) to the industry and markets.

Earlier this month, CMC Markets (LSE: CMCX) published its FY 2019 results. These are the first set of figures after the ESMA rulings came into effect, which forced brokers to offer certain guarantees to clients and limit the levels of leverage on offer. CMC’s operating income was £130.8m, while the net profit came in at £6.3m. In a direct comparison to previous years, the slump is apparent – in 2018 the income was £187.1m and for 2017 £160.8m.

Looking further into the CMC data, it appears the firm has lost circa 10% of its active clients in the latest financial year, down to 53,308. Its profit per client is also down, to £2,068. Based on the new ESMA/FCA framework, which immediately excluded many customers from being able to trade through CMC’s platform, this loss could be considered small. The number of trades executed through its platform is only down 6%, whilst the value of these trades are down 13%.

The CMC share price has peaked at 207p during the past 52 weeks, whilst the low has been 74.30p. Priced at 88p at the time of writing, the shares are down circa 70% from their peak of 290.5p in July 2016 and are approximately 60% less than their 240p listing price in 2016. These shares may have plenty of upside and little prospect of downside, I believe, now that the impact of tighter regulation has been absorbed.

Despite the impact of the authorities’ restrictions, CMC hasn’t been cowed;  it has continued to expand into other areas. The firm expects its German subsidiary to become fully operational by October 2019, pending final regulatory approval. Bearing in mind the stronger regulations in place in Germany, this could give an indication of how compliant CMC has become to ensure its business operates throughout Europe, precisely in accordance with the revised parameters. The firm has also white-labelled its service for the Australia and New Zealand Banking Group.

The firm has streamlined costs and ploughed significant sums into platform development over recent years, therefore its overheads and one-off capital costs could be regarded as under control. It must also be noted that when the Swiss franc suddenly spiked up 30% in January 2015, causing several brokers to collapse, CMC calmly weathered its positions, an indication that its systems were and still are robust.   

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Paul Holmes has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.