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OPINION

A small-cap gem

A small-cap gem
April 18, 2016
A small-cap gem

In fact, on the back of that announcement analyst Robert Sanders at brokerage Stockdale Securities has raised his pre-tax profit estimates from £3.4m to £3.5m for the 12 months to end-March 2016, implying that the company will report fully diluted EPS of 2p, a performance that represents 50 per cent-plus growth on the previous year, and means the shares are priced on a modest 12 times earnings. Not only is that rating attractive, but there is a raft of other positive factors to suggest the shares could re-rate significantly over the course of this year.

I am not the only one thinking this way as the share price is now tantalisingly close to its January highs, and within a few pennies of the last bull market high water mark of 26p dating back to 2007. A close above that important level would signal a major chart breakout and one well worth following as there is virtually no overhead resistance until the 35p level, my year-end target price.

 

Funded for growth

The fundamental case is just as compelling, too, as the fast-growing company is well funded to maintain the robust loan growth it has been producing in recent years.

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 around 12,000 loan agreements in place and receivables of £112m at the end of March 2016. The loan book is funded through bank credit lines, including a new £10m facility with the British Business Bank (BBB), the commercial division of the UK government's economic development bank. That facility also promotes the company to a small group of asset finance providers chosen to support the BBB's investment programme.

Private & Commercial's loan growth has been steady, growing by around £11m in each of the past two financial years and is spread across a diversified and high-quality range of borrowers. Around 55 per cent of all new business originations are in the top two credit grades and no single customer accounts for more than 0.6 per cent of the loan portfolio. The average deal is around £11,600 at inception on the consumer side and £25,000 for business loans with a high level of repeat business. Risk assessment is stringent on all proposals submitted, so much so that the company rejects half of all business finance applications and 60 per cent of consumer ones. As a result, impairments account for 1.6 per cent of the average loan book, and falling.

Moreover, as the company scales up, its return on investment has been increasing, too, so much so that its return on average assets, a key performance indicator, exceeded the 2.5 per cent medium-target rate in the past 12 months, having increased from 2.2 per cent in the previous financial year, and from 1.5 per cent 12 months earlier. A new target rate will be announced in the June results. Fully diluted after-tax return on investment has shot up too, from 6.2 per cent in the 2014 financial year to over 14 per cent in the past 12 months.

This sharp rise in profitability reflects improving operating margins on the back of falling impairment charges, as well as the operational leverage of the business. Headcount has been static at 49 employees over the past couple of years, and the company uses an internet-based proposals system, eQuote, that enables fast decision-making, so this offers potential for further improvements in profitability through the expansion of the receivables portfolio. Analysts feel the business should make pre-tax profits of £4m in the 12 months to end-March 2017.

 

Scalable model

Furthermore, this business model has potential to scale up considerably if Private & Commercial is successful in obtaining a banking licence. Its pre-application phase is largely complete and a formal application with all documentation should be ready to lodge with both the Financial Conduct Authority and the Prudential Regulation Authority by the end of June, so banking status could be achieved by the year-end.

This could be a game changer because there is a substantial difference between the wholesale cost of bank debt for the company and the rates challenger banks offer on retail deposits. In fact, three-year fixed-term retail deposit rates are around 3 per cent, or half the rate Private & Commercial is charged on its wholesale funding.

The benefits of having a banking licence to tap into cheaper retail deposit funding are obvious as it would enable the company to penetrate even lower-risk areas of lending - the average yield earned is currently around 12 per cent on all business and consumer loans - and so lower default risk, while maintaining a net interest margin of between 2 to 3 per cent. It would also help accelerate a ramp-up in lending towards its medium-term target of £250m.

An increasing proportion of non-broker-sourced business - over 14 per cent of new business originations of £63m came from direct channels in the 12 months to end-March 2016 - will help drive growth too, especially as the company's profile will be boosted by its presence in the retail deposit market, and thus bringing it to the attention of a wider base of potential borrowers. The withdrawal of mainstream lenders, particularly in SME lending, can only be beneficial for smaller players like Private & Commercial.

Interestingly, the company appointed David Bull as its new finance director last summer. He previously held the same role at Hampshire Trust Bank, a UK challenger bank that specialises in asset, commercial and property finance, as well as providing savings and deposit accounts to individuals and businesses. Prior to that he was interim chief financial accountant at the Bank of England between 2011 and 2013 and has held finance roles at Deutsche Bank, Heritable Bank and KPMG. He qualified as a chartered accountant in 1996.

His relevant experience of SME-focused lending operations aside, Mr Bull has been successfully through the banking licence application process. He is also backing himself, having bought 165,000 shares at 23p earlier this year, so has some skin in the game. The experience of chairman David Anthony will be useful, too, as he was previously chief executive of Hitachi Capital (UK), during which time it became one of the UK's leading finance groups, with assets of over £1.5bn. He was previously a non-executive director of challenger bank Secure Trust Bank (STB), a company I have followed closely, and which has successfully exploited its banking licence to fund a £1bn-plus loan book.

 

Balance sheet strength

It's worth noting that Private & Commercial has a much cleaner balance sheet now following the conversion into equity of all bar £956,331 of its legacy convertible unsecured loan stock (CULS) notes, which carry a 6 per cent coupon rate. In November 2012, the company issued £5.9m of CULS in a placing and open offer, and the following September placed an additional £4m at par. The funds were used to repay debt and enable the rapid expansion in lending volumes. The remaining CULS can be converted into ordinary shares at the price of 8.5p on any interest date before the final maturity date of 30 September 2016.

So by my reckoning the company had pro-forma equity shareholders' funds of £23.2m at the end of March 2016. This means that, after factoring in the conversion of the outstanding CULS later this year and the net profits earned in the six months to end September 2016, I estimate that Private & Commercial will have net assets of almost £26m in six months' time. On this basis, its price-to-book value is set to fall to around 1.5 times, a 50 per cent-plus discount to Secure Trust Bank (after taking into consideration that company's recent sale of its Everyday Loans subsidiary).

True, its larger rival generates a post-tax return on equity (ROE) of 21.8 per cent, or 50 per cent more than Private & Commercial, but with its loan book growing fast then the gap in this key measure of profitability will narrow sharply in the coming year, making the disparity in their price-to-book value multiples a glaring anomaly. Both have similar leverage ratios of receivables to shareholders' equity.

Private & Commercial also has the full support of a majority shareholder, Bermuda Commercial Bank (BCB), which will own 67 per cent of the fully diluted issued share capital of 170m shares when the outstanding CULS are converted into equity at the end of September this year. BCB is a former subsidiary of Barclays (BARC) and is now a fully owned subsidiary of Somers Limited, a company listed on the Bermuda Stock Exchange, following the merger with Bermuda National Bank in October 2012. Somers also owns a 62.5 per cent holding in Waverton Investment Management, a UK wealth manager with $6.5bn (£4.5bn) assets under management, a 44 per cent economic interest in Ascot Lloyd, a UK IFA, and a 21 per cent interest in Merrion Capital, an Irish financial services group. The company has a market value of $153m (£108m).

 

Risks

Of course any investment carries risks and the key one for Private & Commercial Finance is the successful management of credit risk to maintain a loan portfolio across a well-diversified customer base to ensure that arrears are minimised. I feel the company is doing just that and has sensible funding arrangements for its counterparty liabilities to financial institutions too. Indeed, all loans and receivables are at fixed rates over the term of the contract and interest rate swaps are used to reduce interest rate fluctuations. All lending is in sterling, so there is no currency risk.

Another risk is that the company may not recover some or all of its advances in the event of a customer default. This is mitigated by maintaining a diverse portfolio of customers, spreading risk across a variety of assets and sectors, lending for a period of time appropriate to the assets' lives and forming detailed assessments on both the value of the security and the customer's ability to service the debt. Specialist third-party asset and vehicle valuations are obtained, where considered necessary.

Fast-growing small-cap companies also run the risk of overtrading, but with £28m of committed facility headroom on its credit lines the company is well funded to meet its immediate growth plans. Admittedly, there is a risk that other companies will be attracted by the high rates of return earned on lending in Private & Commercial's market segments, although as long as the UK banking sector remains reticent to lend to anything other than the highest quality credit then I foresee an undersupply of credit providers in the SME and consumer credit markets.

 

Target price

Having considered both the technical and fundamental case for investing, and weighed up the company-specific business risks, I feel that Private & Commercial's shares are well worth buying on a bid-offer spread of 24p-24.5p ahead of the full-year results on 9 June 2016. My year-end target price is 35p, the equivalent of 2.2 times my estimate of end-September 2016 book value and equating to a prospective PE ratio of 16. For good measure, analysts at Stockdale Securities predict a maiden dividend per share of 0.1p to be declared in those results, rising to 0.3p in the current year, implying a forward dividend yield of 1.3 per cent. Buy.