Chief executive Scott Maybury was in buoyant mood at the company’s results presentation at the end of last week noting that with a banking license now granted, the company’s ability to accept retail deposits from customers from next summer will be transformational to the business and its profitability. He has a point as the average cost of wholesale funding on Private & Commercial Finance’s existing debt facilities which support £122m of receivables on its balance sheet cost the company around 6 per cent a year, whereas Mr Maybury points out that a three-year retail bank term deposit currently only offers an interest rate of around 1.3 per cent to savers.
Of course, the hefty differential between the two rates will not all be pure profit for Private & Commercial Finance as there are costs involved in running a bank which Mr Maybury calculates at about 100 basis points. Capital expenditure of £2.5m on IT systems to support a ramp up in lending to both consumers and businesses will be needed over the next five years and the bank’s start up costs will be around £1.25m next year, rising to £1.5m in 2018, according to Mr Maybury.
However, there is no doubt in my mind that if the company can treble its receivables to £350m as the board are targeting over the next three years, and maintain a return on equity after tax of 12.5 per cent based on a return on average assets of 2.5 per cent, then there is scope for a material step change in profits. The other benefit of a lower cost of funding is that the business will be able to lend to higher quality borrowers to whom it is currently unable to offer commercially attractive lending terms. True, net interest margins may get a bit squeezed, but this is offset by a higher quality customer base and prospects of lower delinquencies.
Not that defaults are an issue as a 20 basis points fall in bad loans to one per cent of the loan book, coupled with a 13 per cent increase in receivables to £122m on the back of £68.4m worth of new business lending in the 12 months to end September 2016, led to a 38 per cent hike in the company’s pre-tax profits to £4m, or £200,000 higher than analysts at brokerage Panmure Gordon had been expecting. Fully diluted EPS rose by almost a fifth to 1.9p and with the board committed to adopting a progressive dividend policy as the company returned to the dividend list for the first time in 13 years by declaring a payout of 0.1p a share.
Importantly, Mr Maybury notes that there has been no change in consumer and business confidence amongst its customer base since the EU Referendum, an assertion supported by the fact that new business volumes actually rose from £31m in the first half to over £37m in the second half to end September 2016. The company has a £70m loan book with 8,500 retail customers with an average deal size of £11,500 at inception, of which 86 per cent finances second hand motor vehicles, while the £52m business loan book has a larger loan size of £26,000 and its 2,700 customers are generally raising finance for commercial vehicles and plant.
Access to a retail deposit base offers Private & Commercial Finance the opportunity to fund higher ticket items for businesses in particular, and increase the proportion of prime borrowers from the current blended rate of 29.3 per cent of the book. Less than 10 per cent of all borrowers are deemed sub-prime, with around 60 per cent classified as "near prime".
In terms of forward guidance, Mr Maybury is targeting a loan book of around £140m to £143m by the end of 2017 financial year (September year-end), so on this basis the £65m headroom on existing bank facilities will easily support this objective without taking into account any fresh capital flows received when it can accept retail deposits next summer. On this basis, analysts at Panmure Gordon are forecasting a 12.5 per cent hike in pre-tax profits to around £4.5m in the 12 months to end September 2017. Assuming the company’s loan growth ramps up as planned, the brokerage is expecting pre-tax profits more than 50 per cent higher at £7.3m on net revenues of £77m in the 2018 financial year to lift EPS to 2.6p, implying the shares are currently being rated on less than 12 times earnings two years out.
Of course, the company just can’t let receivables soar without having adequate capital to support the growth even if it succeeds in its objective to fund a £350m loan book by the end of 2019 with £250m of retail deposits. Without an equity raise, the ratio of receivables to net assets would rise from five times to around 12 times in three years times. Mr Maybury is aware of this and believes that the £50m market capitalisation company will need to raise around £10m of new equity at some stage if it is to ramp up lending to £750m in five years time.
However, with the shares rated on an attractive forward PE ratio, priced on a modest two times book value, and with the company’s cost of capital set to be materially lower in the coming years, then there should be a fair amount of investor interest in a new share issue as and when Private & Commercial decide to tap shareholders.
So, having recommended buying the shares at 24.5p ('A small-cap gem', 18 Apr 2016) and reiterated that advice after the company posted a bullish pre-close earnings beat ('On the financial beat', 25 Oct 2016), I am very comfortable with my target price range of 35p to 40p. Buy.
A royal investment
Shares in Palace Capital (PCA:370p), a property investment company focused on commercial property outside London, are within pennies of the 380p minimum target price I outlined when I initiated coverage on the shares at 335p ('A royal investment', 17 Oct 2016).
Half year results released late last month fully support the re-rating. Rental income on the £184.8m portfolio edged up to £13.7m while the average cost of debt on £82m of borrowings secured on these assets improved by 20 basis points to 2.9 per cent, so helping to deliver a 20 per cent hike in underlying EPS to 10.8p excluding valuation gains on the portfolio. Net asset value per share rose slightly to 419p, implying the shares are being rated on an 12 per cent discount. That’s still not a punchy valuation for a company that has delivered net asset value per share growth in excess of 90 per cent over the past three years, and is building a shrewd reputation for buying off-market and adding value to assets through active property asset management and refurbishments.
The point being that a number of the company’s sites have potential to deliver valuation uplifts including Hudson House, a 103,000 sq ft office building directly opposite York Railway Station. The directors believe the site is currently worth just shy of £15m and has potential for further upside when redeveloped. The company has obtained planning consent to convert the property into 82 residential units as well as create 37,000 sq. ft. of grade ‘A’ office, and has also obtained an alternative planning consent to convert the building into 139 residential units.
Other developments of interest include the 200,000 sq ft Sol Central development in Northampton which was acquired for £20.7m on a net initial yield of 8.86 per cent in May 2015. The site includes a 10-screen cinema, casino, 151-room hotel, gym and 375-space car park, but had not been trading at its optimum level for a number of years, and significantly the scheme lacked restaurants. The directors of Palace Capital are addressing this issue to enhance the leisure offering, measures that should enhance the value of the asset too. They also see valuation upside in a 75,000 sq ft multi-let 1970s office building in Manchester that was acquired in August for £10.6m. When current rent-free periods end the property will produce a net income of £775,000, and this will increase further once 13,500 sq ft of vacant space is refurbished and let out to generate a 13 per cent-plus return on equity.
In the meantime shareholders have been rewarded with a 28 per cent hike in the interim payout to 9p a share to give a rolling 12-monthly dividend of 18p a share and an historic yield of 4.8 per cent. Given the company’s modest balance sheet gearing, and potential to offload assets to realise investment gains racked up over the past few years, there is potential for further dividend hikes especially as analysts at Arden Partners expect EPS of 21.3p in the 12 months to end March 2017 to rise to 22.7p the year after.
So, if you followed my earlier advice, I would run profits.
CareTech on the upgrade
Aim-traded CareTech (CTH:305p), a leading provider of specialist social care services, supporting adults and children with a wide range of complex needs, has issued an upbeat set of full-year results, and ones that fully vindicate my decision to rate the shares a buy at 275p ahead of the announcement (‘Exploiting undervalued situations’, 31 Oct 2016).
Having commenced coverage when the shares were 230p ('Time to take care', 16 Mar 2015), and advised buying over the summer at 237p ('CareTech on major buying spree', 23 Jun 2016), share price momentum is now clearly building and my 320p target price looks well in sight. In fact, it’s starting to look conservative relative to analysts as John Cummins at brokerage WH Ireland lifted his fair value estimates from 350p to 380p post results. There was a lot to like about the statement to justify that decision.
Not only was the rise in underlying pre-tax profit from £22m to £26.1m in the 12 months to the end of September 2016 slightly better than expected, but with the benefit of a lower charge EPS shot up by a fifth to 38p. Cash generation from operating activities was very healthy, rising by 11 per cent to £34m, so much so that net debt was largely unchanged at £156m even though the company spent almost £42m on acquisitions, paid out £5.2m on dividends, and a further £7m on tax and interest payments. A ground breaking rent transaction raised almost £30m of proceeds, freeing up cash for some earnings accretive acquisitions but not at a high cost as the company is only paying rent of £1m on the £30m worth of properties sold. Moreover, it has security of tenure on these properties.
This deal highlights the substantial value in the company’s freehold estate of properties which have been independently valued by commercial surveyors at £304m, a significant premium to their £267m carrying value in CareTech’s latest accounts. Or put it another way, once you mark property to market value then the company’s book value per share rises to around 293p. This means the shares are only trading on a small premium to book value even though it’s clear that the company is generating both a high return on capital on its assets, and a decent cashflow yield too. I would also flag up that the current freehold estate is modestly geared on a loan to value ratio of just over 50 per cent, so offering scope for CareTech’s board to make further earnings accretive acquisitions.
Furthermore, shareholders have been rewarded with a 10 per cent hike in the dividend per share to 9.25p and Mr Cummins at WH Ireland expects the payout to be lifted to 9.6p in the current financial year, implying a prospective dividend yield of 3.2 per cent.
Factoring in a normal tax charge in the new financial year, and taking into account the full benefit of acquisitions made, and upside from refurbishments, analysts expect pre-tax profit to rise to £28.5m to produce EPS of 35.6p in the 12 months to the end of September 2017. On this basis, the shares are rated on just 8.5 times forward earnings, hardly an exacting valuation. It’s also worth pointing out that deals in the sector are being agreed at valuations much higher than the one attributed to CareTech. For example, the disposal of 22 behavioural health facilities by Acadia Healthcare was recently priced on an enterprise value to cash profit multiple of 10.5 times, significantly above the 8.7 times multiple CareTech is being valued on for the financial year to September 2017 based on the company delivering a 7 per cent rise in cash profits to £39.7m.
So, having upgraded my target price from 300p to 320p six weeks ago when I previewed the full-year results (‘Exploiting undervalued situations’, 31 Oct 2016), I feel there is scope for CareTech’s share price to continue to make further gains and I am upgrading my target again to 345p. This is based on a fair value for the company’s equity of £221m, so after factoring in net debt of £156m, this implies a cash profit multiple to enterprise value of 10 times.
On a bid-offer spread of 300p to 304p, I rate CareTech’s shares a buy.
Planned updates
I note some reader comments on previous articles regards debt solutions and legal services company Fairpoint (FPO:20p) whose share price collapsed on Friday last week.
I would point out that I recommended selling the shares at 105p in September this year ('Clear cut investments', 19 Sep 2016), having previously advised holding them at 107p in the summer ('Fairpoint exits debt solutions', 27 Jul 2016). I originally included the shares in my 2013 Bargain Shares Portfolio at 98.25p. The company had paid out total dividends of 22.75p a share by the time I recommended exiting the holding in mid-September this year.
Finally, I plan to write updates on a number of companies on my watchlist that have reported results, trading statements or other noteworthy announcements recently including: asset manager and stock brokers WH Ireland (WHI) and Walker Crips (WCW); asset manager Miton (MGR); car dealer Cambria Automobiles (CAMB); hotels group easyHotel (EZH) and Elegant Hotels (EHG); defence company Cohort (CHRT); property companies Urban&Civic (UANC), Local Shopping REIT (LSR) and Conygar (CIC); private equity group Oakley Capital (OCL); oil explorer and producer Faroe Petroleum (FPM); housebuilders Inland (INL) and Telford Homes (TEF); support services group Bilby (BILB). I will also be looking at whether the market back drop favours playing my favoured housebuilder first quarter trading strategy.
Clearly, it will take time to publish articles on all these companies, but rest assured they will receive my full attention in due course, holidays permitting.
