Join our community of smart investors
OPINION

A non-standard investment

A non-standard investment
March 2, 2015
A non-standard investment

But this process is well worth going through as the new issue market has provided me with a number of successful investment recommendations over the past year or so including: Flowtech Fluidpower (FLO), the UK's leading specialist supplier of technical fluid power products; Entu (ENTU), a supplier and installer of energy-efficient home improvement products; and replacement window and doors firm Safestyle (SFE). These companies have a couple of things in common: they were all priced on single digit earnings multiples and came to the market with the promise of an above average dividend yield. With investors hunting for yield in a low interest rate environment the income stream from these investments has proved attractive. For good measure, I have found another company which potentially offers a chunky income stream for shareholders, and one that only listed on the main London stock market a fortnight ago, Non-Standard Finance (NSF: 103p).

 

An income and growth play

In effect, the company is a cash shell, having raised £98m of fresh capital net of expenses at 100p a share through a placing with institutional investors. Float costs were just over £5m, and at the current share price the company has a market capitalisation of £108m, or 10 per cent more that that cash pile.

The board’s plan is to use these funds to acquire at least one, if not two or three companies operating in the UK non-standard consumer finance sector within a six-month period of listing. This is the lending market for individuals who find it difficult, or nigh on impossible to access credit through mainstream financial institutions, a trend that has been growing post the financial crisis as banks have sought to reduce exposure to higher risk lending. In some cases, they have exited lending to this segment altogether.

It’s a huge market to tap into as Non-Standard Finance’s board of directors, led by the former chairman of sub-prime consumer lender Provident Financial (PFG), John Philip de Blocq van Kuffeler, estimate that non-standard consumer finance accounts for 40 per cent of all secured, and 30 per cent of unsecured lending in the UK. In total, financial organisations lending in this market advanced around £70bn of unsecured loans in the financial year to end March 2014. Data from the Council of Mortgage Lenders shows that UK consumers made applications for £189bn of secured loans in the same period, of which 40 per cent were declined, implying that the non-standard segment of the secured loans market is worth a further £75bn. In aggregate, there are 100 non-standard lending businesses currently operating in the UK, of which Non-Standard Finance’s board believe around 20 companies could be of interest to the company.

It’s a growth market too as the impact of tighter lending criteria in mainstream loan markets, and the impact of a wage squeeze since 2007, resulted in 2m more individuals resorting to non-standard loans in 2013, compared with only 10m in 2007. But the market has not been able to meet this extra demand as increased capital requirements on lenders – due to EU regulatory reforms and the recent initiatives introduced by the UK’s financial regulators, Prudential Conduct Authority and Financial Conduct Authority – has led to a 30 per cent decline in new loan advances since 2007.

In turn, this has created an opportunity for Non-Standard Finance to use its highly experienced board and the financial backing of some heavy-weight institutions to cherry-pick acquisitions in this area and scale up these operations by using the company’s well-financed balance sheet and access to future funding through the debt and equity markets. Bearing this in mind, and the fact that Non-Standard Finance is only a cash shell, it’s important to consider the investment criteria that will be applied to any potential acquisition.

 

Strict criteria to drive bumper returns

Firstly, the directors intend to seek out acquisitions that will generate a target annual return on equity of between 20 per cent to 30 per cent. Specifically, companies will be sought with potential to grow lending balances by at least 20 per cent a year; offer strong yields underpinned by APRs of between 50 to 100 per cent; and with impairment levels implying an attractive ratio of risk to the APR. The company will also aim for a cost-to-income ratio of 50 per cent or below once the business has been scaled up. In turn, this will enable the strong cash generation from the lending operations to be recycled back to shareholders through regular and growing dividends, and to fund future lending and acquisitions.

Of course, when Non Standard Finance’s auditors and board of directors do their due diligence on any acquisition they will have to pay close attention to the compliance record of the company being acquired; the track record of customer defaults and accuracy of historical reporting; the culture of the organisation; robustness of financial controls in place; sustainability of lending margins; strength of the current management team; growth potential and scalability of the product offering; and the future funding needs of the business. This doesn’t come cheap and the board have earmarked on an annual basis around £1.5m of the £98m funds raised in order to identify target companies. This sum excludes legal and due diligence fees incurred to execute the transactions. In the meantime, the cash raised from the listing will be placed on short-term deposit with interest income being used to cover working capital expenses.

 

Follow the smart money

True, there is a speculative element to buying the shares ahead of the company’s first acquisition. But I feel it’s worth doing. I am not the only one thinking this way as star fund manager Neil Woodford was a cornerstone investor in the recent float. His fund management group, Woodford Investment Management LLP, invested a total of £20.5m in return for a 19.5 per cent shareholding in the company. Invesco Asset Management, his former employer, made a similar sized investment, Legal & General has taken a 4.75 per cent stake and Marathon Asset Management owns 5.36 per cent. Combined these four institutions own 48.6 per cent of the equity.

The management team are incentivised too as they own 2.8 per cent of the shares in issue. Mr van Kuffeler owns 2.1m shares, or 2 per cent of the equity, acquired at an average price of 22p each; and the other four main board directors own a combined total of 840,000 shares, or 0.8 per cent of the equity, acquired at an average price of 38p each. These directors are locked in for one year post the listing.

The point being that with the shares trading around their float price of 100p, we are able to get on board at prices close to the insiders and some pretty shrewd backers too. During his time at Invesco Mr Woodford increased an investment in his Perpetual Income Fund 23-fold over a period of 25 years, a performance which made him one of the outstanding fund managers of his generation. He is no one’s fool and certainly wouldn’t have sanctioned a purchase of almost 20 per cent of Non-Standard Finance’s equity unless he could see the income and growth potential from this business.

I am also comfortable with the track record of the board of directors. Miles Cresswell-Turner was a partner at private equity group Duke Street Capital and specialised in the finance sector and has also worked as corporate banker with HSBC’s leveraged finance department. Finance director Nicholas Teunon was previously the chief finance officer (CFO) at Marlin Financial Group, a consumer debt purchasing company. Before that, he was the CFO of FTSE International for five years prior to its sale to the London Stock Exchange.

Non-executive Charles Gregson is a heavy hitter too and the current chairman of FTSE 250-listed inter-dealer broker ICAP (IAP). He was also the chairman of Wagon Finance, a sizable motor finance group, for a decade and worked with Mr von Kuffeler as deputy chairman of Provident Financial until 2007. Another non-executive, Robin Ashton, spent 24 years at Provident Financial where he worked as both the finance director and chief executive during his career with the company. In my view, that’s a strong board of directors and one with relevant industry experience.

 

Understand the business model

Clearly, no matter what acquisitions the company’s board pull off, you have to be comfortable with making money from a segment of society who are much less fortunate than many of us. Indeed, of the 12m individuals who fail to meet the lending criteria of the mainstream banks, many will be earning less than the minimum wage (around 8 per cent of the total UK workforce), some will be migrants who do not meet the requirements of the mainstream financial institutions (recently arrived migrants account for 3 per cent of the UK’s total workforce), and others will have impaired credit histories. In fact, there were over 500,000 county court judgements issued last year in the UK, the effect of which will make it nigh impossible for thousands of people to raise credit in a normal way and at normal interest rates.

So to take advantage of this opportunity, Non-Standard Finance is specifically targeting acquisitions in the following sub-sectors all of which are focused on sub-prime unsecured lending:

■ Guaranteed loans – primarily loans between £2,000 and £7,500 lent to an individual with a guarantee issued by a family member or friend who is a home owner.

■ Consumer loans – generally unsecured personal loans of between £200 to £600, advanced to low-income borrowers with impaired credit ratings, and for a term of one to three years.

■ Rent to own – a facility enabling credit impaired borrowers on low incomes to buy consumer goods from specialist shops offering weekly repayment terms.

■ Home collected credit – the provision of loans of between £200 to £1,000, repaid to collectors in person on a weekly basis. This is a large mature market catering for around 2m customers.

Given the profile of the targeted borrowers, by their nature APRs on these loans will be much higher than mainstream lending rates. And this is how Non-Standard Finance will generate the strong cash flow and return a portion of this back to shareholders through chunky dividends. There will of course be scope to add value to the businesses being acquired by scaling up the operations and tapping cheaper lines of credit than the current operators have access to. Please note that the company does not intend to make acquisitions in car finance, second charge mortgages, non-standard mortgages, bridging loans and payday loans, so the area of lending is quite well defined.

 

Favourable risk:reward

So if you can live with the nature of this business, and believe that the directors will successfully pull off deals that meet the criteria I have outlined above, then the high return on equity being targeted is likely to generate very positive shareholder returns. As way of comparison, Provident Financial is currently priced on over six times book value and generated a post tax return on equity of 28 per cent last year. Its shares offer a dividend yield of 3.6 per cent.

In the circumstances, I am happy to recommend buying Non-Standard Finance’s shares at 103p in the market now, a small premium to the price paid by the insiders and also to book value, ahead of the acquisitions the company's board are targeting. Medium-term buy.

Broking for bumper profits

Aim-traded private wealth management firm and corporate broker W.H. Ireland (WHI: 92p) has reported full-year profits well ahead of market expectations this morning following December’s trading update. In fact, the company’s adjusted operating profit of £1.45m was not only well above guidance of “between £1m to £1.1m” given at the end of last year, but was also significantly up on the £900,000 reported profits in the 2013 fiscal year.

As I detailed in my previous article (‘Broking on a profit surge’, 3 December 2014), according to chief executive Richard Killingbeck a number of “genuinely one-off items” dampened the IFRS profits in the trading period, but the underlying trend is clearly positive. In the 12 months to end November 2014, total assets under management (AUM) on the private wealth management side rose by 8.4 per cent to £2.7bn, of which higher margin discretionary and advisory funds accounted for 62 per cent of the mix. Indeed, drill down through the numbers and discretionary funds increased by almost 43 per cent to £722m in the period.

I understand that W.H. Ireland’s new Milton Keynes office is now profitable and its Isle of Man office is expected to at least break-even or report a small profit in the current year. Mr Killingbeck has told the Investors Chronicle that the Isle of Man office has a large pipeline of new business too and the aim is to target AUM of £200m for each office within three to five years of each opening. Excluding gains from natural market movements – the FTSE 350 has risen by 5.5 per cent since the company’s November 2014 year-end – W.H. Ireland has brought in a further £50m to £60m worth of AUM in the past three months alone.

The growth in the private wealth management arm, which accounts for £21m of the company’s annual revenues of £30m last year and two thirds of its recurring revenues of £10m, has compensated for the lack of corporate broking fees from client fundraising in the second half of last year when the market for equity and dept placements suffered from the autumn’s market chill. Still, with retained revenues of £3.2m from 97 corporate clients, and equity markets recovering strongly, then I would a better showing in the current year.

W.H. Ireland’s board are confident enough to have sanctioned a 33 per cent rise in the payout to 2p a share (ex-dividend date 12 March 2015) and are targeting a payout ratio of 30 to 35 per cent of net profit. Bearing that in mind, the board’s guidance is for pre-tax profit of between £2m to £2.5m for the 12 months to end November 2015. If the company achieved the top end of that range then this would translate into a 25 per cent hike in the payout per share covered three times over by EPS of 7.86p.

Of course there are risks, the main one being the forthcoming UK general election and potential for ongoing political uncertainty. Interestingly, analysts John Borgars and Gilbert Ellacombe at research firm Equity Development believe that there will be second general election by November, a view that may not be in the forefront of investors’ minds right now, but one that has scope to undermine returns from UK equities if this transpires. And W.H. Ireland is likely to be fined by the regulator F.C.A. for its control procedures in the first half of 2013, a period during which previous management were in control of the company, I would hasten to add. Still, with cash on its balance sheet of £7.5m, and net funds of £6m, then the company has substantial resources available. Indeed, the board continues to look at value enhancing acquisitions on the private wealth management side to deploy some of this surplus cash.

In any case, I feel these risks are fully factored into the company’s current valuation. That’s because net of cash, the company has an enterprise value of just £15.5m, or less than half the value of its private wealth management business based on its discretionary funds being valued at 3 per cent of the £722m under management; advisory funds valued at 1.5 per cent; and conservatively nil value being placed on the low margin execution only funds. That would leave the profitable corporate broking business in the price for free too. And these valuation figures are underpinned by merger and acquisition activity in the sector as the recent Towry/Ashcourt Rowan deal was executed on the basis of AUM being valued at 3 per cent and assets under administration at 1 per cent.

In the circumstances, I am happy to maintain my longstanding buy recommendation on W.H. Ireland’s shares having first advised buying them at 68p ('Broking for success', 1 August 2011). With the benefit of client capital raisings coming through, new mandates on the private client, and a more profitable business mix following last year’s reorganisation, the platform looks firmly in place for a profit surge this year. My target price is 140p. Buy.

MORE FROM SIMON THOMPSON...

Please note that since the start of February I have written articles on a total of 56 companies all of which are available on my IC homepage... and are detailed in chronological below with the relevant web links for ease of reference.

Flowtech Fluidpower: Buy at 130p, target 165p (‘A fluid performance’, 2 February 2015)

Inland: Buy at 57.5p, target 70p (‘A fluid performance’, 2 February 2015)

UK housebuilding sector: Run profits (‘A fluid performance’, 2 February 2015)

Globo: Conditional buy at 47p, target 60p (‘Going Global’, 3 February 2015)

Epwin: Buy at 92p, target 140p (‘Going Global’, 3 February 2015)

SeaEnergy: Buy at 21p, target 60p (‘Going Global’, 3 February 2015)

Fairpoint: Buy at 119p, target 190p (‘A valuable point to make’, 4 February 2015)

Greenko: Buy at 123.5p, target 225p to 230p (‘A valuable point to make’, 4 February 2015)

Safestyle: Buy at 165p (‘A valuable point to make’, 4 February 2015)

600 Group: Buy at 15.5p, target 24p (‘Engineering growth’, 5 February 2015)

Global Energy Development: Speculative buy at 42p (‘Engineering growth’, 5 February 2015)

Pure Wafer: Hold at 42p (‘Engineering growth’, 5 February 2015)

Faroe Petroleum: Buy at 75.5p, target 94p (‘A slick operator’, 6 February 2015)

2014 Bargain share portfolio updates:

Barratt Developments: Run profits at 458p; Taylor Wimpey: Run profits at 135p; 1pm: Buy at 67p; Bloomsbury Publishing: Hold at 148p; Camkids: Hold at 21p; Fortune Oil: Sit tight at 10p; Charlemagne Capital: Hold at 11p; Arden Partners: Hold at 47p; PV Crystalox Solar: Hold at 10.5p (‘How the 2014 Bargain share portfolio fared’, 6 February 2015).

2015 Bargain share portfolio buy recommendations:

Mountview Estates, Crystal Amber, H&T, Pittards, Inspired Capital, Record, Netplay TV, Arbuthnot Banking, AB Dynamics and Stanley Gibbons (‘Bargain share portfolio 2015’, 6 February 2015).

Oil price (‘Profiting from the oil price slump’, 9 February 2015)

Getech: Buy at 45p, target 67p (‘Exploit a chart break-out’, 10 February 2015)

Moss Bros: Buy at 93p, target 120p-130p (‘A triple play of chart break outs’, 11 February 2015)

Manx Telecom: Buy at 189p, target 210p (‘A triple play of chart break outs’, 11 February 2015)

Oakley Capital: Buy at 155p, target 180p (‘A triple play of chart break outs’, 11 February 2015)

Walker Crips: Buy at 45p, target 54p (‘Delivering on a plan’, 12 February 2015)

Trakm8: Buy at 92p, target 120p (‘Zoming in on a profitable price move’, 16 February 2015)

Trifast: Buy at 111p, target 140p (‘Earnings upgrades to drive re-ratings’, 17 February 2015)

600 Group: Buy at 16.5p, target 24p (‘Earnings upgrades to drive re-ratings’, 17 February 2015)

Pittards: Buy at 135p (‘Earnings upgrades to drive re-ratings’, 17 February 2015)

GLI Finance: Buy at 62.5p, target 80p (‘Income plays with capital upside’, 18 February 2015)

BP Marsh: Buy at 135p, target 170p (‘Income plays with capital upside’, 18 February 2015)

Henry Boot: Buy at 205.5p, target 249p (‘A bootiful investment’, 19 February 2015)

Jarvis Securities: Take profits at 435p (‘Decision time’, 23 February 2015)

Avation: Buy at 142p, target 200p (‘Decision time’, 23 February 2015)

Inland: Buy at 63p, conservative target 70p (‘Decision time’, 23 February 2015)

Globo: Buy at 49.25p, target 60p (‘Catalysts for re-ratings’, 24 February 2015)

Communisis: Buy at 56p, target 85p (‘Catalysts for re-ratings’, 24 February 2015)

SeaEnergy: Buy at 25p, target 60p (‘Catalysts for re-ratings’, 24 February 2015)

Netcall: Take profits at 71p (‘Taking profits’, 25 February 2015)

Eurovestech: Hold at 8p, target 10p (‘Taking profits’, 25 February 2015)

GLI Finance: Buy at 62.5p, target 80p (‘Taking profits’, 25 February 2015)

Amino Technologies: Run profits at 137p, target 150p ('Riding bumper profits', 26 February 2015)

Tristel: Buy at 80p, target 100p ('Riding bumper profits', 26 February 2015)

32Red: Buy at 60p, target 75p to 80p ('Riding bumper profits', 26 February 2015)

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'