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OPINION

Funded for earnings growth

Funded for earnings growth
April 10, 2014
Funded for earnings growth
IC TIP: Buy at 146p

The first of which is Bath-based 1pm (OPM: 65p), a niche provider of leasing finance to small- and medium-sized enterprises. The company is operating in a sweet spot right now and has just issued an upbeat trading statement for the first quarter of 2014. By sourcing clients through a network of 70 finance brokers, 1pm has been able to grow its business at quite a pace while at the same time maintaining strict underwriting criteria and credit management. As a result it has been able to deliver profitable growth while at the same time keeping bad debts down to a minimum.

The major constraint on the stellar growth being achieved is the capital needed to support the business. So to underpin demand for its finance, the company has raised £7.3m of fresh funding since May last year, including £2.5m of credit facilities this week. Interestingly, 1pm has been funding this growth by attracting investments from high net worth individuals and self-invested personal pension funds (Sipps). The company also raised £1.5m of new equity from fund manager Henderson Global Investors last year. This new capital has been put to good effect as 1pm reported a 25 per cent rise in net receivables to £15m at the half year stage at the end of November and analysts at WH Ireland predict the loan book will rise to £18.5m by the 31 May 2014 financial year-end.

Importantly, the lending risk is being spread without over exposing 1pm to any one customer: the average lease agreement is modest at £8,500, the average term is 40 months, and no single customer accounts for more than 0.4 per cent of the leasing portfolio. Indeed, bad debts only account for 0.6 per cent of the lending book. Furthermore, by fixing all borrowing and lending at fixed rates, and credit checking all businesses and guarantors to reduce default risk, it’s a profitable niche to be operating in. Analysts at WH Ireland predict the company will turn in pre-tax profits of £1.2m on revenues of £3.8m in the full year to end May 2014, up from £754,000 and £3m, respectively, a year earlier. On this basis, EPS rises from 2.63p to 3.1p.

And with new funding in place, 1pm looks on course to grow its loan book to £19.8m by May 2015 as analysts currently predict. On that basis, expect revenues to increase a further 10 per cent to £4.2m which would lift pre-tax profits by around 25 per cent to £1.52m and produce EPS of 3.95p. In my opinion, a prospective PE ratio of 16 doesn’t seem punchy for a business that is expected to grow EPS by over 27 per cent this year alone. In fact, it’s a sizeable ratings discount to larger rival Secure Trust Bank (STB) which trades on 21 times prospective earnings. Car finance and home credit lender S&U (SUS) is priced on 15 times earnings estimates, but to put that rating into some perspective analysts predict that company will generate EPS growth of 15 per cent this year or half the growth rate of 1pm.

It’s worth pointing out too that the improving UK economy should underpin demand for leasing finance from SMEs which means that the 1pm is in a sweet spot right now. The company is also enjoying success with its new business loan product and has raised the maximum loan size from £15,000 to £25,000 over a maximum term of three years. The aim is to generate a 21 per cent yield on this business.

So having recommended buying 1pm shares at 57p in my 2014 Bargain share portfolio, and with all parts of the business enjoying robust growth, I continue to see further upside to such an extent that I feel a price nearer to 80p is not an unrealistic target over the next 12 months. Trading on a bid offer spread of 63p to 65p, I continue to rate 1pm shares a buy.

 

Upgrades to drive Fairpoint’s re-rating

1pm is not the only company from my Bargain share portfolio that has been making the news. So has Aim-traded debt management specialist Fairpoint (FRP: 146p), a company I included in my 2013 portfolio when the price was below 100p. And even though you will have made a 50 per cent plus return on the high yielding shares, this is definitely not the time to bank profits. In fact, I now expect the earnings recovery to step up a gear and drive the share price up to my new target price of 190p, having upgraded my previous target range of 165p to 170p.

To recap, the company is one of the UK's leading providers of advice and solutions to financially stressed consumers. In recent years, Fairpoint has been successfully executing its strategy of diversifying revenue streams by using its robust cash generation from its core individual voluntary arrangements (IVA) activities to grow its debt management plan (DMP) and claims management businesses. And this week the company moved into legal services by announcing the acquisition of Leeds-based Simpson Millar LLP, a consumer-focused legal services practice mainly focused on family law, employment law, personal injury, and clinical negligence work. The company has over 250 employees based in 13 offices around the UK, having been founded over 150 years ago, and was the first ever UK law firm to obtain Lexcel Accreditation from the Law Society and, more recently, the first to obtain the Diversity in Business Accreditation.

A smart acquisition

It is a profitable niche to be practising in too: revenues have increased by over 40 per cent to £16.9m in the past four years, and in the financial year to end June 2013, Simpson Millar made cash profits of £1.5m. The deal has been well structured too with the initial consideration made up of £7m in cash to be paid from Fairpoint’s cash balances and bank facilities, and £2m in shares issued at a fixed price of 141p. As a result the acquisition should be immediately enhance earnings.

That’s because with Fairpoint tapping a new £20m low-interest credit facility, analyst Hannah Crowe at brokerage Equity Development calculates that the acquisition would have produced pro-forma incremental profits of £820,000 in Simpson Millar’s last financial year and added more than 1p a share to Fairpoint’s own EPS. Of course there is a £6m earn-out to take into consideration which will be based on the financial performance of the acquisition in the two financial years to end June 2015 and June 2016. Any additional consideration paid will be split 50:50 in cash and shares with the issue price of the new equity fixed at 141p a share.

Importantly, the vendors are restricted from dealing in the completion shares and the earn-out shares issued in respect of the financial performance of Simpson Millar for the 12 month period ending June 2015, until after 30 June 2016. For the 12 month trading period ending June 2016, the vendors are restricted from dealing in the completion shares and the earn-out shares until after 30 June 2017. That makes a lot of sense and means that with only 60 per cent of the consideration being paid upfront on completion, the partners in the firm are being incentivised to grow the business to hit both their earn-out targets and to maximise the value of the Fairpoint shares being issued to them.

Strategically, the deal makes a lot of sense as it offers Fairpoint an entry point into legal services to generate cross-selling opportunities with the rest of its operations. Moreover, as Hannah Crowe of Equity Development rightly points out, the LLP structure “makes it difficult to build up reserves and capital so the highly profitable partnership had to rely on a £2m plus overdraft (more than double the £1m in 2008) to finance its work in progress. However, once owned by Fairpoint it will not be inhibited by a shortage of capital.” That’s an important point because the business is being acquired on a no cash-no debt basis with the partners repaying the overdraft. So with Fairpoint having ample cash at its disposal to fund growth, there is a very reasonable case to be made that Simpson Millar will be able to maintain its eye-catching rate growth rate in the future and that’s without factoring in the significant cross-selling opportunities with the rest of Fairpoint’s businesses.

For example, Fairpoint’s core IVA activities incorporates over 19,000 fee paying IVAs under management, including 4,500 new IVAs written in 2013. On the debt management side, the company acquired 3,400 debt plans last year and since the start of January has spent a further £4m purchasing 9,000 plans to take the total to 24,000, up from less than 15,000 only 15 months ago. There is scope for further cross selling on the claims management services business too. Indeed, this division has already been benefitting from PPI claims generated from both the company's core IVA activities and DMP portfolios.

Expect earnings upgrades

Before news of the acquisition of Simpson Millar and likely earnings upgrades, analysts John Borgars and Hannah Crowe at Equity Development were forecasting current year pre-tax profits of £8.5m and underlying EPS of 15.5p. However, I would not be surprised to see EPS hit 17p this year, up from 15p in 2013, factoring in upgrades post the acquisition.

Importantly, with the benefit of a cash-rich balance sheet - Fairpoint had net funds of £2.8m at the end of December - and an asset-based revolving credit facility of £20m, the company has ample cash available to make further bolt-on purchases to add to its DMP and claims management businesses, while providing the funding needed for Simpson Millar to finance its work in progress.

The board also has the flexibility to maintain its progressive dividend policy, having lifted the payout by 9 per cent to 6p a share in 2013. The final dividend of 3.85p a share is paid on 19 June, so it’s not too late to buy in before the shares go ex-dividend on 21 May. For the current financial year, analysts forecast a dividend of 6.3p a share. But if EPS rises in double digits again this year, then it will enable the board to be more generous and raise the payout by far more than the 5 per cent growth predicted. In any case, the shares are well supported by a healthy 4.3 per cent dividend yield and are modestly priced on less than 10 times earnings ahead of what I expect to be upgrades of between 1p and 1.5p a share for 2014.

Interestingly, following the news of the Simpson Millar acquisition, shares in Fairpoint are pressurising a multi-year high of 146p, having traded sideways for the past three weeks as the rising 20-day moving average (around 140p) played catch up with the share price. I firmly expect the 146p level to be breached shortly to open up an assault on my new target price of 190p. Please note that I have upgraded my estimate of fair value from my previous range of 165p to 170p to reflect likely earnings upgrades post the Simpson Millar acquisition and the greater scope for earnings growth through cross-selling opportunities with the rest of Fairpoint’s businesses. Offering 30 per cent to my new target price, I rate the shares a buy on a bid-offer spread of 143p to 146p.

Please note that I am working my way through a long list of companies on my watchlist that have reported results or made announcements recently including: IQE (IQE), Pure Wafer (PUR), LMS Capital (LMS), Communisis (CMS), Eros (EROS), Inland (INL), Netplay TV (NPT), API (API) H&T (HAT), Air Partner (AIP) and Record (REC).