The company has been posting strong organic growth in recent years, helped in no small part by the restrictive lending practices of the large high street banks post the 2008 financial crisis which has limited the availability of credit to SMEs. So, to capitalise on ongoing robust loan demand from this segment of the market, the company has made two acquisitions since I initiated coverage: Academy Leasing, a provider of equipment finance and an equipment and vehicles broker to the SME market; and Bradgate Business Finance, a leading independent specialist provider of 'hard' asset finance to clients buying business equipment within the construction, recycling and haulage sectors.
The benefits of doing so are that 1pm can now act in a broking capacity, referring deals for cash commissions, and allowing risk to be better managed; its loan book is more diversified thereby reducing reliance on any one particular sector; funding lines are more accessible and costs are lower as the larger scale of the operation has derisked the proposition to 1pm's own lenders. Also, both Academy and Bradgate can now fund deals that they would have otherwise brokered on.
This change in revenue mix was evident in the half-year results with 1pm's 'own book' assets and loans portfolio growing by 8 per cent to £71.8m between the end of May and November last year, while at the same time a quarter of new lease contracts were brokered on for commission. In terms of the overall revenue mix, the original Onepm Finance operation increased revenue by 13 per cent to £4.23m to account for more than half of turnover of £8m, and the two acquisitions accounted for the balance of which £1m was commission income from broking on equipment and vehicle contracts. The upshot is that the company's half-year pre-tax profit rose by 20 per cent to £2.05m, although the rise in EPS lagged behind, up from 2.91p to 3.08p, reflecting a higher average share count to take into consideration the additional shares issued to fund the acquisitions.
Of course, credit quality is critical in this type of business so it's worth noting that the £250,000 bad debt write-off in the six-month period accounted for only 0.7 per cent of the total loan portfolio on an annualised basis, bang in line with the run rate of impairments last year and well below that of competitors. Write-offs have been historically low, reflecting strict underwriting criteria, the ability to reclaim equipment on which the loan is secured, and the incorporation of director guarantees into loan agreements to mitigate default risk. Importantly, no single customer accounts from more than 0.35 per cent of the total loan book, and an average contract value of £14,200 is manageable in the event of a loan going bad.
The bottom line is that 1pm is on course to deliver a 16 per cent hike in full-year pre-tax profit to £4.3m in the 12 months to the end of May 2017, as analyst James Fletcher at broker Cenkos Securities forecasts. True, EPS will fall slightly from 6.5p to 6.3p, but this only reflects the extra shares issued to fund the aforementioned strategically important acquisitions. More important is that if the company can grow its loan book to £80m by May next year, as Mr Fletcher believes is achievable, and I have no reason to doubt this, then annual revenue is forecast to rise from £16.5m to £19.5m and deliver an additional £1m of profit for shareholders. On that basis, EPS rises to 7.6p.
Economic outlook and interest rate risk
I don't think those estimates are unrealistic especially when you take into consideration the robust economic backdrop: having posted the highest economic growth rate amongst the G7 nations last year, forecasters at the Bank of England have belatedly cottoned on that the UK economy has been doing rather well, contrary to the predictions of governor Mark Carney post the EU referendum, and is now likely to continue doing so. In fact, central bank economists now expect the UK economy to grow by 2 per cent this year, up from a forecast of 1.4 per cent in November and 0.8 per cent in August. If the economy continues to outpace the Bank's forecasts, then a reversal of last August's needless cut in base rate may be on the cards.
This raises the issue of interest rate risk for alternative lenders such as 1pm. Bearing this in mind, I would point out that the company has a policy of matching the duration between its own lending and funding lines, and aims to maintain a stable fixed net margin at between 10 and 13 per cent on its lending to customers, the vast majority of whom are classed as prime or near prime borrowers. Furthermore, given that around 30 per cent of receivables are funded by its own capital, then there is a significant buffer in place to cover bad debts, not that this has been an issue. By comparison, leasing companies generally contribute about half that level of their own capital when making loans, so 1pm's lending practices are pretty conservative. It's worth flagging up too that as the loan book scales up then there is scope for 1pm's cost of funding (around 5.7 per cent a year) to be reduced to nearer the company's 4 per cent targeted level.
True, finance director Helen Walker is stepping down from her position in May, as we have known for some time, but the new incumbent James Roberts looks a decent replacement, currently holding the same position at Catalyst Business Finance Limited, a provider of invoice and loan financing in the alternative finance sector for growing UK SMEs. I see news of his recent appointment as a positive as it removes uncertainty over the changeover. Also, although investors may be wary of buying into finance companies just as the government is about to trigger Article 50 to start the tortuous process of leaving the EU, the fact remains that the UK economy has done incredibly well since the EU referendum, and the trading outlook for 1pm has clearly been unaffected by the short-term uncertainty.
So, although 1pm's shares have fallen back since I last rated them a buy at 70p in the autumn ('High fives', 4 Oct 2016), I feel that on 1.2 times book value, a modest 10 times earnings estimates, falling to just eight times in the 2017-18 financial year, and offering a 1.2 per cent dividend yield, they are attractively priced with 40 per cent potential upside to my 85p a share fair valuation. Buy.
K3 warns
While I was carrying out extensive research on my 2017 Bargain Shares Portfolio, retail software company K3 Business Technology (KBT:255p), the Salford-based supplier of software to the retail, manufacturing and logistics sectors and provider of managed IT and web-hosting services, issued a profit warning.
I have followed the company for some time, having first advised buying at 220p a couple of years ago ('Tapping into retail growth', 16 Sep 2014), and last reiterated that advice at 350p ('The inside track', 14 Sep 2016), so the 20 per cent share price slump post the profit warning has eroded a chunk of those paper gains.
The main issues concerns trading in the key selling month of December, which was impacted by a softening in market conditions, lengthening of sales cycles around larger deals, and an accelerating shift to cloud-based solutions among customers. Although K3's management team insist that these deals have merely been delayed, not lost, and the company remains firm on pricing, the fact remains that cash profit is expected to come in £3.5m below prior guidance for the financial year to the end of June 2017, prompting analysts at both Edison Investment Research and finnCap to rein back their cash profit estimates from around £16m to £12.4m based on flat revenue of £89m. This implies a 12 per cent fall in pre-tax profit to £7.7m, to produce EPS in the range between 16.7p and 17.7p, a significant shortfall on Edison's previous estimate of 26p, and way below last year's reported figure of 23p even though the company has made a number of acquisitions that have boosted the bottom line.
Moreover, those forecasts are before accounting for exceptional costs resulting from a senior management reorganisation that has streamlined the operating structure with the aim of enhancing sales opportunities and delivering cost savings. It's come at a price, though, as K3 will book a one-off cost of £3m in the full-year results, and analysts now think that year-end net debt is likely to be nearer £10m or double the level they had previously forecast, albeit management guidance is to expect £3m of annual savings from the restructuring.
The good news is that the pipeline of prospects across the company's business segments is growing, while the increasing proportion of cloud-based deals will help it build a higher and more stable level of recurring revenue, although in the short term the transition to subscription revenue streams and away from licences will depress revenue.
The company is due to report half-year results next month and the one-off costs and weaker trading in December mean that the figures are not going to make for a pleasant read. However, ahead of the next trading update alongside those results, I am going to give the management team the benefit of the doubt for now. What I need to see is evidence of conversion of the pipeline and cross-selling opportunities into firm sales, some of the deferred orders coming through, and improvements in working capital management to lower debt levels.
Trading on 15 times depressed earnings estimates - representing a 25 per cent discount to the small-cap UK software and IT services average - I would hold the shares for their recovery potential if you followed my earlier advice. Hold.
MORE FROM SIMON THOMPSON...
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