Having followed the company's progress on the sidelines for some time, I recommended buying the shares at 25p a couple of months ago, targeting a year-end price of 35p ('A small-cap gem', 18 Apr 2016). I clearly wasn't the only one impressed by the investment case as my target was hit at the end of last month and is now likely to be surpassed. It was difficult not to be impressed by the company's financial results for the 12 months to the end of March 2016, which showed adjusted pre-tax profit surging by two-thirds to £3.5m on revenue up 12 per cent to £51.3m. Operating through two divisions, consumer finance (providing finance to consumers mainly for used vehicles) and business finance (providing finance to SMEs for vehicles, plant and equipment), Private & Commercial has over 11,000 loan agreements in place and increased receivables by 12 per cent to £112m in the 12-month period.
This means that over the past five years the company has increased its loan portfolio by a third and pre-tax profit has grown at an eye-catching compound annual rate of 34 per cent. Margins have improved, too, up from 11 per cent to 16.1 per cent, reflecting a sharp improvement in credit quality and the operational gearing effect on profit of higher lending on a stable cost base. The charge for loan loss provision fell from 1.6 per cent to 1.1 per cent of the book in the latest 12-month trading period and 90 per cent of borrowers are deemed to be prime credit risk. I would also flag up that new business orientations of around £6m to £6.5m per month are evenly spilt between consumer and corporate customers, which helps to diversify risk as does the fact that no single customer accounts for more than 0.5 per cent of the loan book.
The company is clearly on a roll, and £25m of headroom on existing credit facilities should easily fund the business for the next 12 months. However, the next stage of Private & Commercial's growth is what really excites me, the catalyst for which will be gaining a banking licence hopefully at the end of this year. If all goes to plan the company will then be able to tap the retail deposit market next summer. That's important for a number of reasons.
Banking on profitable gains
First of all, chief executive Scott Maybury believes the company's cost of debt funding can be reduced by "at least 200 basis points" from the current level of 5.6 per cent by accessing lower cost of debt with the aim of eventually having 75 per cent of new customer loans funded by customer deposits.
Second, around 80 per cent of all loan applications that come to the company's broker network belong to a higher credit grade, and are therefore not offered Private & Commercial's products. By having a banking licence, and moving up the credit quality spectrum, the company can increase its total addressable market significantly and keep a lid on impairment charges, too. In turn, this will accelerate the growth rate in receivables and enable the company to make headway towards its £250m loan book target. Modelling by analyst Jeremy Grime at house broker Panmure Gordon suggests that the company could have a £200m loan book by September 2018. Mr Maybury is even more bullish.
Third, assuming net interest margins hold steady, then the ongoing growth in lending will translate to a sharp rise in profit given the operational gearing of the business, but not at the expense of leverage ratios (receivables to equity shareholders' funds), which is predicted to be no higher by September 2018 than at present. This key ratio is currently just shy of five times.
Of course, a bank will have running costs, which Mr Maybury believes will be around £1.3m and the company will have to raise some equity funding to build a bank - Panmure has modelled in £10m of extra equity in the financial year to the end of September 2017. But it's well worth doing given the huge operational benefits, not to mention significant financial upside for shareholders, to be gained.
Accelerated profit growth potential
To put Private & Commercial's potential growth into some perspective, and having just upgraded earnings estimates for the third time in the past 12 months, Panmure now predict that profit can rise from around £3.8m in the 12 months to the end of September 2016 (the company is changing its reporting period to bring it in line with its majority shareholder), to £4.5m in the following 12 months, accelerating to £7.3m in the 2018 financial year. On that basis, expect EPS to rise by 44 per cent, from the 1.8p just reported to 2.6p, implying the shares are rated on 12 times forward earnings.
In my opinion, that's not a high rating for a UK-focused finance company that's clearly delivering, plans to declare a dividend of at least 0.1p for the year to the end of September 2016, according to Mr Maybury, and has a plan in place to take the business to the next level. Also, a price-to-book value of two times September 2016 forecast net asset value of 15p is hardly an exacting rating for a company that has just posted a fully diluted after-tax return on equity of 13.9 per cent, up from 10.2 per cent in the previous 12 months and representing a fourfold increase on five years ago.
I am not the only one excited by the potential here as, after last week's results, Panmure upgraded its target price from 31p to 38p, based on a targeted price-to-book value of 2.5 times. Analyst Robert Saunders at broker Stockdale is even more bullish, raising his target price from 30p to 42p. Of course, there is execution risk to factor in, but even so I think fair value is probably somewhere in between the two, which is why I am upgrading my target price from 35p to 40p, the equivalent of 15 times forward earnings for the September 2018 financial year, and representing 2.6 times likely book value at September 2016.
Trading on a bid-offer spread of 30p to 31p, and offering 30 per cent potential upside to my new target price, I continue to rate the shares a buy.
