Nevertheless, the Great Salad-oil Swindle really was serious. It cheated financial services group American Express (US:AXP) out of about $1.7bn (£1.3bn) in present-day money and, more important for readers of Investors Chronicle, it provided Warren Buffett with one of the buying opportunities that defined his career.
Amex was legged over by a hoodlum, Tino de Angelis, into providing loans secured against tank-fulls of soybean oil. At one point de Angelis theoretically owned more of the stuff than the entire inventory of salad oil in the United States. When the truth was revealed that the tanks contained more water than oil it was Amex’s stock that tanked – rapidly, its price almost halved. However, the young Buffett – this was in the days before Berkshire Hathaway (US:BRK.B) – spotted that Amex’s core businesses – the travellers’ cheques and the charge card – were undamaged. He bought 5 per cent of the company and, in the following five years, its value rose five times.
Largely because of Buffett’s involvement, Amex and the salad-oil swindle has become the template for assessing recovery situations via two key questions: how does a damaged company’s underlying value compare with its diminished market value? Does it have core operations whose value covers its market value, with the rest of the business thrown in for nothing?
Fast-forward to the present and cross to this side of the Atlantic and we have another financial services group whose share price has been mauled by a specific event in a discrete part of its operations – consumer finance group Provident Financial (PFG), whose shares are 77 per cent below their five-year high following a botched restructuring in its consumer-credit division (see Bearbull, 8 September 2017).
Is the Provvy a proxy-Amex situation? The superficial similarities and quick-and-easy analysis point that way. Assume that Provident Financial can return fairly rapidly to making average profits, capitalise those at a cost of capital that includes a demanding return for its equity component – say, 12 per cent – and, after deducting net debt, there is still value per share of almost £13 compared with a market price of 840p.
The problem with this is that Provident Financial isn’t nearly as good at generating cash as it is at declaring accounting profits. Twice in the six years 2011-16 free cash – what’s left over for shareholders – has drained out of the group. More alarming, not once in that period was free cash greater than the annual cost of dividends and cumulatively Provident Financial generated £171m of free cash yet paid out £744m in dividends. Arguably, its bosses ran up additional debt solely to pay dividends that the company could not afford; at least net debt rose by £638m – or 72 per cent – while the company dished out £573m more in dividends than it generated in free cash.
It is less clear why the group is so poor at generating cash. It’s not as if it offers cheap loans – interest received on its loan book has averaged 59 per cent over the past five years. And, in their way, both its main divisions look suitably profitable. Of the two, consumer credit – where management messed up replacing part-time agents with full-time ‘customer experience managers’ – runs on tighter lending margins but employs comparatively little capital. The other – Vanquis Bank, a credit card for consumers with an iffy credit rating – generates fatter margins but ties up more capital, thus generating a lower return on assets.
However, Vanquis is growing fast. Since 2011, its profits have quintupled as revenues have tripled and it is feasible to see it as a standalone operation whose value would pretty well match the group’s current £1.25bn market value – capitalising average net profits for the past five years as a 10 per cent annuity produces a figure clear of £1.1bn. Yet Vanquis has troubles of its own. It is on the wrong end of an investigation by its industry regulator into a late-payment insurance plan that it offered to its customers. The threats implicit in that investigation – politically, these are not good times for consumer-credit firms – make it more difficult to slot the Provvy’s recovery story into the Amex category.
Besides, there is also a question about the credibility of its bosses. True, the former chief executive walked after August’s brutal profits warning. Yet, pro-tem, his place has been taken by the chairman, Manjit Wolstenholme, who was looking on cheerfully as the company distributed more than it could afford for several years and embarked on a disastrous restructuring plan. When a new chief executive is installed, she must look to go; ditto the long-standing finance director.
All of which means I would not rush to buy the shares. Sure, it’s tempting because, almost certainly, the Provvy is no basket case, but the matter of that poor cash flow isn’t resolved. If it’s simply because operating costs are too high, then at least they are moving in the right direction – they were 88 per cent of interest income in 2011 but 69 per cent in 2016. Even so, I would wait for the share price to show some momentum before buying and I’d hardly expect a recovery on the scale of Amex after the great salad-oil scandal.
