S&U — Strong growth, cautious approach

Until 2015 S&U comprised two businesses: a home credit company, Loansathome4u, and Advantage Finance, the non-prime motor finance company. The home credit business had its roots in a business originally founded in 1938 by the chairman’s grandfather, Clifford Coombs but the decision was taken in 2015 to sell it to Non Standard Finance for a consideration of £82.5m, generating an exceptional profit of £50.5m. The sale was transformational and the funds released were partly allocated to the payment of a £15m special dividend with the balance available to support growth at Advantage and the launch of a new specialist lending activity. As a result S&U now comprises the fast-growing Advantage motor finance business and a nascent bridging loan activity that is currently at a pilot stage.

Advantage was formed in 1999 and is based in Grimsby with approximately 100 employees. The majority of the management team have been with the company since launch. Growth has been rapid with 36% compound growth in net customer receivables over the last five years to £193.5m at the end of January 2017. It has c 43,000 live customers and recorded just over 20,000 new transactions in FY17, an increase of 32%. Advantage focuses on the non-prime area of the market and its lending is primarily through about 40 brokers (85%), with the balance through dealerships or, to a limited extent, to existing customers. The brokers in turn source their business through dealer relationships and the internet. Almost all the loan applications are submitted to the Advantage web-based system which provides immediate in-principle lending decisions.

Most loans are in the £5,000 to £7,000 range, with a maximum loan amount set at £12,000: the average advance in FY17 was just over £6,000. The average original term in FY17 was 50 months with a flat interest rate of 17.9% (both have risen in recent years – Exhibits 4 and 5). The provisional approval rate for loan applications has been broadly stable in recent years and in the last financial year was 32%, with c 240,000 approved out of 750,000 applications. As noted, 20,000 actually signed up which is equivalent to less than 3% of original applications; the small ratio of deals signed to some extent reflects the increased use of the internet by buyers to source finance before shopping for a car and is not onerous for Advantage given the automation of responses to applications.

Advantage has achieved 17 years of consecutive profit growth, reflecting growth in the loan book together with successful credit control underpinned by the continuous refinement of a bespoke underwriting and scoring system developed in conjunction with Experian. Exhibits 1 and 2 set out key metrics relating to that growth.

In exhibit 1 the strong growth in receivables can be seen, reflecting continuous work at Advantage to enhance its systems and hence speed of service to brokers and dealers (97% of applications receive an automated decision within 10 seconds), in addition to maintaining and broadening its network of relationships. On the demand side the withdrawal of large banks from the non-prime market in the course of the financial crisis and the increase in incidence of customers with some lapse in their credit record created a larger opportunity for Advantage and other specialist lenders. In its FY16 presentation Provident Financial highlighted that, in addition to the departure of banks from this area, Cattles had c £1bn of subprime motor loans outstanding when it collapsed in 2008-10. More recently, new lenders have been drawn to the area and participants have acknowledged an increase in competition with Provident Financial citing 10 companies operating in competition with its Moneybarn subsidiary. Moneybarn itself has expanded substantially since its acquisition by Provident Financial gave it access to greater and lower cost funding. Nevertheless, Advantage, Provident Financial and others still see a significant opportunity to provide finance to underserved customers.

Advantage’s revenue has broadly increased in line with receivables and this can be seen more directly in Exhibit 2 where we have shown revenues as a percentage of average receivables. Over the period shown, revenues have averaged 39% of receivables although there have been some moderate fluctuations over the period. A number of factors can contribute to the variations in the revenue yield on receivables including the customer mix, where Advantage looks to fine tune its underwriting criteria to achieve a favourable risk/ reward balance. This is done against the background of changing market dynamics. The arrival of more competition in the market has meant some jockeying for position across the non-prime credit spectrum with some providers moving nearer to prime and others focusing on customers with a more patchy credit history. In the last year or two Advantage has tended to focus more on its traditional strength on serving true non-prime customers as others gravitated towards near prime. The reduction in yield evident between FY15 and FY16 reflected a combination of mix, the ending of insurance sales in July 2015 and, to some extent, competitive pressure.

Impairments as a percentage of receivables have fallen noticeably over the period (see Exhibit 2). Between 2007 and 2013 they averaged nearly 10% while in the last four years the average has been below 6%. S&U attributes the reduction mainly to the withdrawal of mainstream banks from the non-prime market, helping Advantage to attract nearer prime customers, together with refinement of its scoring system enabling improvements in the balance of risk and reward within the underwriting process. There was an increase in the impairment ratio in FY17 reflecting a change in mix and a small experimental move into the more sub-prime area of the market (see commentary on FY17 results for more discussion).

Profitability has risen substantially since 2007 increasing from c 20% to 42% in FY17 (for Advantage profit margin in Exhibits 2 and 3 we have shown profits after impairments, interest and other costs as a percentage of revenues). Contributory factors include the reduction in impairments, operational gearing as the business has grown and a reduction in funding cost. The interplay of pricing of loans and impairments is evident when we track revenue less impairments as a percentage of receivables (Exhibit 3). Over the period this risk adjusted yield on receivables has increased from 24% to 29% and in the last two years, after a reduction following the removal of insurance income in FY15, has been broadly stable at 30% and 29% reflecting successful management of risk versus pricing.

Aspen Bridging Finance is now open for business; up to £20m may be invested in bridging loans over 15 months, subject to market conditions. The loans, with a typical term of nine months and a maximum loan to value of 75%, will be made to individuals and businesses secured on residential and commercial property. The loans might be used to provide mortgage bridging, to facilitate completion of auction purchases, for business rental or to fund refurbishments prior to the arrangement of long-term finance. Loans will be in the unregulated sector (excludes those to owner occupiers or consumer landlords), which accounts for c 65% of the market. Mintel estimates a market size of £5bn per annum, expecting this to grow to £8.8bn by 2020 (compound growth of 21%). It is a sector where there is an ebb and flow of lenders and S&U note that margins have contracted over the last two years. Aspen is taking a circumspect approach to making its first loans as it aspires to achieve a nil bad debt record. As a new participant it is aware of the risk of exposure to less attractive opportunities that others have rejected and is happy to take a patient approach.

S&U’s full year results were close to our expectations with strong growth in receivables, revenues and profits. The main features were as follows with comparisons against FY16 results for continuing operations (excludes the home credit business operating result and the profit on sale).

On the regulatory front, Advantage Finance received its full consumer credit permission from the FCA in December. S&U notes that in addition to its statutory auditors it employs RSM as an internal auditor to provide assurance of operations and systems. Also, while Aspen Bridging Finance will initially operate in an unregulated area of lending, it will draw on support from RSM together with advice from law firms and valuers to ensure similar standards are followed, supporting sustainable development of the business.

Looking more closely at the change in product mix at Advantage, S&U provides figures for the average customer credit score (on Advantage’s own scoring system) by year of origination and in Exhibit 4 we have shown this together with the flat interest rate per annum. This underlines the point that there has been a balance between risk and pricing with the proviso that the ultimate outcome will depend on collection over the life of these loans. As noted earlier, the reduction in credit scores in part reflected the experiment in providing higher risk loans initiated during FY15 and ended in September 2016. S&U indicates that more recent customer scoring is above the FY17 average at c 868. The latest iteration of the credit scoring system has been introduced (Delphi 10) which improves affordability checks with specific geographical criteria and the benefits of this should start to become more evident this year. As would be expected, the arrears profile (not shown) reflects a similar story with a moderate decrease in the percentage of receivables where payments are up to date: for FY17 this was 86.75% compared with 91-92% for the previous three years.

Exhibit 5 shows how the original term of loans by year has followed an upward trend in recent years, in part reflecting competitive pressure and entailing some increase in risk (again potentially compensated by the rise in rates). The chart also shows another symptom of competitive pressure: the cost of sales per loan. After initially falling this has increased quite markedly over the last three years largely reflecting the increase in payments to the brokers which originate most of the loans. Here the increasing role of the larger internet brokers plays a role as well as competitor behaviour.

Reflecting loan growth during FY17, a net £33m was invested in Advantage leaving group net debt (excluding preference shares) at c £49.2m and gearing of 35% compared with £11.9m and 9% in FY16. On funding, the group increased its borrowing facilities by £15m to £85m in H217 and since the year end has added a further £10m bringing the total to £95m, including £30m of term loans and £65m revolving credit facilities.

The UK economy has shown greater resilience than expected following the Brexit vote and GDP estimates have been revised upwards since September last year. The Treasury survey of independent forecasts now shows a consensus expectation of 2017 growth of 1.6% followed by 1.4% for next year. Looking at two indicators that are likely to be significant for Advantage’s customer base, unemployment and consumer confidence, there is a slightly mixed message. Positively, the level of unemployment (Exhibit 6) has been following a downward trend since the financial crisis and the more volatile level of redundancies has fallen sharply from its peak although it is above its recent low point in 2013. It has subsequently been in a range between 4% and 5% with no clear upward trend. Consumer confidence, as measured by the EC indicator (Exhibit 7), has recovered substantially from its low point in 2009 but, unsurprisingly, has displayed some volatility recently, weakening from a high in 2014, flagging the potential for some softening of lending appetite if Brexit-related uncertainties or other economic or political concerns intensify sufficiently to impact sentiment.

For the moment however, the used car market in the UK has continued to show healthy volume growth since 2009 and this in turn has fed into robust demand for used car finance (Exhibit 9), with compound growth of 14% recorded in the Finance and Leasing Association data.

Looking ahead, delivery of current expectations of moderate GDP growth and stable unemployment would be favourable for S&U both in terms of the incidence of impairments and potential for further loan growth. The trading environment for Advantage appears set to remain competitive and while Secure Trust Bank (Moneyway) has reported an easing of pricing pressures following the withdrawal of a new entrant to the motor finance market, S&U notes that this has not had a noticeable effect on the Advantage business. Nevertheless, in common with Provident Financial (Moneybarn) and Secure Trust Bank, S&U sees good potential for continued strong growth in this area.

For Aspen Bridging Finance the outlook is less about the macro outlook given its pilot status and much more about establishing a profitable business within a specialist lending area. Here the conservative approach taken by the majority family-owned group provides comfort that capital protection is likely to remain the key consideration, reducing any pressure to build the loan book over a particular timescale.

We start by showing a summary of the key assumptions that drive our revenue estimates (and impairments) for the motor finance and bridging finance activities. Points to note here are that we assume a still strong but lower growth rate in motor finance receivables, a similar rate of revenue yield and a slightly higher percentage level of impairments either in relation to revenue or average receivables. The impairment estimate reflects the modest mix change already baked into the loan book and looking beyond the forecast period the cost of risk could ease back following more recent adjustment to the underwriting criteria. Our assumptions for bridging are tentative given the early stage of the business, but we allow for a loan book of £3m by end of FY18 and £15m by end FY19. Its estimated contribution to revenue for the years shown is less than 2% so our estimates are unlikely to be particularly sensitive to changes in assumptions here.

Further detail on the group P&L is provided in the financial summary (Exhibit 16 on page 11). Below the revenue and impairment lines we would only highlight that we have assumed a stable cost of sales ratio but a modest reduction in the percentage of administrative costs reflecting operational gearing. Below, in Exhibit 11, we summarise changes in our revenue, pre-tax profit, earnings per share and dividend estimates together with new estimates introduced for FY19. There are modest reductions in our FY18 estimates reflecting slightly more conservative assumptions.

As noted earlier, net debt (excluding preference shares) increased by £37.3m to £49.2m and, in Exhibit 12, S&U’s analysis of cash flow includes details for Motor Finance showing how the overall FY17 cash outflow of £33.2m (+20%) resulted from an increase in advances (+30%) balanced in part by collections that grew at a somewhat faster pace.

Looking ahead, our estimates suggest net debt rising to c £75m and £109m for FY18 and FY19, respectively as a result of further growth in receivables including Aspen Bridging loans. This would take net debt/equity to 65%, which is similar to the level in FY15.

We start by updating our peer group table of companies that have exposure to motor finance or are specialist lenders. The companies each have different product and growth profiles and include a wide range of market capitalisations so the comparison should be viewed with this in mind. S&U trades on a below average P/E and price to book (P/B) multiple and an above average yield.

There is quite a wide range of multiples and we put the book multiples in context in Exhibit 14, plotting price to book against returns on equity. The small sample means we would not draw strong conclusions from this but S&U appears centrally placed while Provident Financial’s high rating attracts a correspondingly high book multiple. Maintenance of strong growth and the potential for increases in return on equity at S&U hold out the prospect of a corresponding rerating of the shares.

Updating our ROE/COE valuation using the same assumptions as in our update published 13 February 2017 (a return on equity of 17% - between our FY18 and FY19 estimates, a cost of equity of 10% and growth of 5%) gives a valuation of 2,825p compared with 2,650p previously. This would imply a calendar 2017 multiple of over 14x which appears quite high in the context of our peer group table. This time therefore we ascribe a value of 2,700p, allowing a moderate premium to the peer average P/E to reflect the returns being earned and the potential for further strong growth from Advantage and scope to develop a valuable diversifying income stream from the bridging pilot.

If we reverse the ROE/COE calculation this suggests the current price is factoring in a cost of equity of c 12%, which appears conservative.

For reference we include a table comparing the recent price performance of the peer group. Here S&U appears to have had a relatively weak share price compared with the average although it is not alone in terms of its reduction from the 12-month high.