DBRS Confirms Canaccord Preferred Share Rating, Trend Now Negative

DBRS has today confirmed the Pfd-3 (low) rating on the Cumulative Preferred Shares of Canaccord Financial Inc. (Canaccord or the Company) following the announcement on December 15, 2011, that the Company would be acquiring Collins Stewart Hawkpoint plc (Collins Stewart) for consideration worth £253 million, or $407 million. However, the trend has been changed to Negative, given the relative size of the transaction, the current economic and market environment, and some ambiguity with respect to the longer-term financing of the cash portion of the transaction. Once Canaccord demonstrates that a successful integration has been achieved and that longer-term take-out financing has been provided, the Stable trend should be readily re-assigned, all else being equal. Today’s rating action follows additional analysis conducted by DBRS on the transaction, as well as an assessment of the acquired company, and clarifying discussions with the Canaccord management team.

The Company expects to fund the acquisition, which is expected to close in the first calendar quarter of 2012, with £152 million, or approximately $244 million, in cash, with the balance in Canaccord common shares. The Company expects to fund the cash portion of the acquisition with the $110 million preferred share proceeds received in June 2011, with the remainder to be financed initially by drawing on a $150 million short-term bank credit facility. This bridge facility is expected to be repaid in 2012, to the extent that it is drawn. Refinancing options may include using excess cash (if any), a term loan, convertible bonds, or preferred shares. For modeling purposes, DBRS has assumed that the cash portion of the transaction is partially funded with an incremental $150 million issue of preferred shares.

The proposed acquisition is significant, given that Collins Stewart is a U.K.-based broker-dealer that is about one-half the overall size of Canaccord. It is focused largely on capital markets activities in the United Kingdom, United States and Asia (accounting for 75% of revenues in the last 12 months). The remaining 25% of revenues come from its high net worth wealth management business in the United Kingdom, the Channel Islands, and in Switzerland. Within the capital markets business, revenues are split 64% for securities market making, 24% for advisory, and 12% for investment banking and underwriting. The wealth management and the advisory businesses tend to be less volatile than the market-making and investment banking businesses.

The Company’s criteria for pursuing acquisitions require that there be a good fit with Canaccord’s strategic objectives, that there be a strong cultural alignment, and that the acquisition is accretive to earnings. It appears to DBRS that all of these criteria are met with the Collins Stewart acquisition, in view of the diversification benefits, the addition of a strong management team, and good opportunities for expense and revenue synergies. The friendly nature of the acquisition suggests that integration and execution risks are manageable, especially given the Company’s experience in successfully integrating earlier acquisitions such as Genuity Capital Markets in Canada, Adams Harkness in the United States and T. Hoare & Co. Limited in the United Kingdom – although none of these were as material to the Company nor spanned as many jurisdictions as the proposed Collins Stewart transaction.

The Company’s primary interest in acquiring Collins Stewart, as in its earlier pursuit of The Evolution Group PLC, is to grow its U.K. wealth management business, which has good synergies with its market-making businesses while providing a more stable source of fee-based income. The U.K. wealth management business continues to have attractive margins. At the end of June 2011, Collins Stewart had the equivalent of $12.5 billion dollars in assets under administration (AUA), complementing the $15.7 billion in AUA at Canaccord. However, the Collins Stewart AUA consists of higher-margin and more fee-based discretionary accounts than that of Canaccord, which continues to be more transaction-oriented. The acquisition of Collins Stewart will also add to the Company’s capability in the U.S. capital markets business, providing much-needed scale and broader coverage of both issuers and investors. In the United Kingdom, there will be good opportunities to extract expense synergies as the combined Company achieves greater market presence, being one of the largest independent broker-dealers in that market. Collins Stewart also brings good growth potential in Asia, with complementary operations to Canaccord’s own advisory business in China and its 50% interest in Canaccord BGF, a capital markets provider with operations in Australia and Hong Kong. The addition of complementary businesses will allow the Company to more rapidly achieve its goal of becoming a global investment dealer with a presence in 12 countries and the ability to list on ten stock exchanges, including, with the acquisition of Collins Stewart, two Singapore exchanges.

On a pro forma basis, using the last 12-month results for both companies, the combined company would have had a debt plus preferred share capital ratio of 23.2% and a debt plus preferred-to-EBITDA ratio of 1.3 times. The pro forma fixed charge coverage ratio, assuming the incremental $150 million preferred share issue, is 9.0 times, which remains reasonable for the rating. While the acquisition stresses the Company’s financial flexibility in the current environment, there is a strong case to be made for the acquisition from a strategic perspective.

Benefiting from revenue and expense synergies associated with larger and more diversified operating platforms, the Company is well-positioned to grow its revenues and earnings substantially when the global capital markets stabilize. In the meantime, the more stable wealth management and advisory revenues of Collins Stewart add favourable diversification to the Company’s overall business risk profile, which otherwise remains concentrated in the small and mid-cap Canadian equity markets. While the Pfd-3 (low) rating with a Stable trend assigned to the Canaccord preferred shares in June 2011 took into account anticipated volatility associated with broker-dealers, this material acquisition in the current uncertain economic and market environment introduces an additional degree of risk that cannot be ignored. The ambiguity regarding longer-term take-out financing was also a consideration in assigning a Negative trend at this time.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Global Methodology for Rating Banks and Banking Organisations, which can be found on our website under Methodologies.