Lewis Robinson

_{Disclaimer: I have a very material personal interest in S&U Plc shares. A portfolio I help to manage has a very large weight in S&U Plc shares. Hence, I cannot help but be biased. Please do your own research – my projections are mine alone.}

Recap

If you’re new to the S&U story, I first wrote about the business last December, in a post called Credit Where Credit is Due.

It’s a long exposition of why I think S&U is a great business, with great management, and why it is a wonderful long-term hold for patient investors.

But better still, and hot off the press, I had a great time presenting S&U to the Stockopedia/PIWORLD Virtual Stockslam on Wednesday. It’s a virtual event where 10 private investors get three minutes to each pitch their favourite stock, and three minutes to answer questions from a discerning audience.

Where are we today?

So, in line with my thoughts at the StockSlam, I wanted to update the analysis I put together last December.

I still hold S&U and, indeed, I have been buying – not selling – since that 2020 blog post, despite seeing the share price rise from £18.20 to £29.00. Depending on your point of view, this highlights either my strong conviction or my startling lack of risk management.

In a nutshell, though, here’s why I remain so excited:

• Concerns people held last year – regarding viability, solvency, appropriateness of debt, whatever – have all melted away
  • Rightly or wrongly, people were panicky, and despite S&U’s very robust financial condition, investors I spoke to worried about potential risks in a small cap lending business. This is no longer the case now the world is looking rosy, high yield spreads are compressed, and borrowing costs in the economy remain low
• Existing loan performance is far ahead of even my bullish expectations
  • I thought there would be some ‘scarring’ effect for the coming years as a result of COVID. Instead, we have a business enjoying its best loan collection performance in years. As a consequence…
• The balance sheet looks exceptionally conservative, and provisions releases should boost profitability
  • Provisions made in 2020 were very high, to account for future non-payment of loans. They were made at uncertain times. In actuality, customers are paying very well; so I suspect these provisions will slowly revert to more ‘normal’ levels, giving us a few years of boosted profitability
• I have rarely seen management so openly optimistic on growth
  • My hunch is that the work ‘behind the scenes’ at Advantage to take more control of their own destiny – opening up new sales channels, and forging closer partnerships – is now paying off. Given how profitable this business is, growth is the single most important metric to accelerating returns

The Technical Bit: Provisions

To start with the technical bit first, then, let’s discuss provisions and provisioning.

Provisions represent money already put aside – taken through the income statement as a cost – for liabilities expected to be incurred in the future.

The nature of lending – whereby you give out money and hope to get it back later – makes the level and amount of provisioning crucially important if you want to understand a lender. The easiest way to show excellent near term profits is to lend out money, recognise accounting income as you are accruing interest fees, and stick your fingers into your ears when it comes to the possibility that you won’t get it back again.

So ideally, what you want to see as an investor is a cautious provisioning position on the books. This would mean that prior and current earnings are conservatively stated – because the business is recognising lots of potential losses up front. It also means that there is potential for provision releases and outperformance in the future. At the very least, adverse macroeconomic conditions will be taken with poise – because the directors accounted for the possibility aleady.

Does S&U meet those criteria?

Well, you’ll note that provisions are almost at their all-time high, near to the levels seen in 2011 and 2012. Importantly, the book now is of better quality than it was then: the credit scorecard has become more tightly calibrated over the last decade, and customer cohorts have become more predictable.

So I would say, on a like-for-like basis, the company is as well-provisioned as it has ever been.

The key remaining question, then, is how well the book is currently performing. If the book is performing terribly, and customers are not paying, they need those provisions! If the book is performing well, we have our hidden value. Let me highlight two quotes from the company:

“This [deliberately cautious] approach to growth during the pandemic has borne fruit both in record collections and new customer quality across the Group”

“The second quarter has seen basic live collections at £38.3m, a record, and at 94.4% of due, which is the best performance since October 2017”

Compound this with the strongest used car market in living memory, and I’m extremely comfortable with existing loans. The directors, prudently, set aside plenty of provisions last year in incredibly uncertain times. But consumer balance sheets are looking very healthy, the group is working hard to improve collections practices – so there is ‘self-help’, too – and hence, the group now looks over-provisioned. The release of this will boost profitability over the coming years.

The Fuzzy Bit: Growth

If the provisions are the boringly technical reason for why I’m so optimistic, my feelings on growth are much less quantifiable. But having listened to management on their latest InvestorMeetCompany call – available to all investors here – I’ve increased my forecasts for growth over the coming years. I take management views on growth rates with a large pinch of salt as I think most management teams are prone to excessive over-optimism and view their job at least partly to ‘sell the story’. I don’t think S&U are doing this – I think the data and market support their views.

Variously, on the call and release, Graham Coombs referred to momentum ‘increasing’, Graham Wheeler referred to a 25,000 loan target in 2022 (noting they were ‘quite confident’ that would be achievable), and Anthony Coombs referred to increasing borrowing facilities to give headroom for ‘accelerated growth’.

I believe much of this confidence comes from the new sales channels that Wheeler has been working on for the last eighteen months. Advantage is very reliant on brokers, and he identified that there was scope for broader distribution than this – including through, for example, price comparison sites and partnerships with other businesses (prime lenders, for instance, or affinity partnerships with customer overlap). This appears to now be paying off, with accelerating deal flow through these sources.

To put things in context, in 2018 the group wrote 24,518 loans with an average advance of £6,207, supporting an increase of almost £60m in the lending book.

25,000 loans, at an average advance of £7,000, would represent over £20m more capital advanced than in 2018 – admittedly on a larger existing base – but it would blow broker forecasts of low single digit growth out of the water.

Even if you temper their enthusiasm a little – the current monthly run-rate is almost 23,000 loans per year, according to Graham in the presentation – there is almost no way market forecasts can be even near to correct with respect to growth in coming years.

My forecasts

I am constantly tweaking my forecasts for the businesses I hold. I want to be as close to the truth as possible: certainly not too aggressive, but also not too conservative. The latter point is critically important if you want to hold great businesses for the long-term.

The abridged table from my forecasts, above, shows my latest ‘best guess’ for the next few years for the group. You will see that I expect very strong profit growth in 2024 and 2025: but I will note that I am only assuming that the group reverts to a return on equity of around 16%, a level consistent with its historic performance and certainly not anomalously high. All of my assumptions are not dissimilar from historical norms – my risk-adjusted yield is not too aggressive, my central cost assumptions remain similar to the past, and although my CoGS assumption may look a little light as a percentage of total receivables, this is primarily thanks to the fact that Aspen represents a growing proportion of the book, and cost of sales is significantly lower there by virtue of the larger loan size.

I am also, you will note, assuming that the 25% tax rate goes ahead as announced. Many investors and much of the sell-side seem to be ignoring this incoming grenade.

On pricing

One of the questions I received pitching S&U at the StockSlam – and indeed, a question I get all the time when discussing many stocks is this:

“Look at the price-to-tangible book at S&U: it’s now around 1.8x, around the top of its historic range. Where is the upside going to come from?”

I did a poor job of responding off the cuff on the call.

The truth is that I think the question is absolutely fundamental. As an investor, you need to ask yourself a simple question: are you pricing stocks in the short-term, or are you valuing them in the long-term? Is the aim of your endeavour trying to figure out what a stock is worth, or is it trying to figure out where it’s likely to be imminently priced?

When I bought Judges Scientific – my old key holding – at 13x earnings in 2014, I bought on the basis that it was a wonderful business with excellent reinvestment prospects and potential for significant earnings growth.

But people always asked why the business should be worth more than a mid-teens multiple, given where the market was trading, and given the fact that Judges’ business largely consisted of consolidating smaller businesses at bargain prices around 3-6x earnings.

I didn’t really care about the historic trading range, and I didn’t particularly care for people who thought that Judges buying businesses for 5x meant that Judges itself could only be worth 5x. Call me a purist, if you like: if I see a business that has a capacity of growing at very strong rates, with a good return on invested capital, I will do the maths to try and figure out what I think that business is fundamentally worth, and that will often justify a multiple meaningfully different from historic ranges or market norms.

Too many people, I think, are hostages to historical trading ranges. If this is you, ask yourself why you are really bothering to do fundamental work in the first place. You are better off looking at spread charts of trading multiples and buying things at the bottom of the range. My very strong suspicion is that this will be a poor endeavour in the long run.

I think a much, much more sensible approach is to work from principles. For instance:

• S&U has never made a loss; it was profitable through the GFC, and still comfortably profitable last year, despite putting away a huge amount in provisions (which now look unecessary)
• S&U has clear, actionable growth prospects, requiring ‘more of the same’
• S&U’s balance sheet is meaningfully less leveraged than other banks and financial businesses
• S&U’s management is much better than your average: how many management teams do you hear that, like Graham Coombs, answer a question on acquisitions by pointing out that the base rate of success in business acquisition is very low, and that should make one cautious?

It is clearly cut from a different cloth than the majority of listed businesses. So I would choose these facts as my starting point for thinking about ‘fair value’, not what people have historically been paying for S&U – something which I don’t give a hoot about.

I am a patient man. Over the last year, the market has decided that S&U isn’t worth ~7.5x earnings, but 11x. I think that one day, people will conclude that 11x earnings remains the wrong price for a business of S&U’s quality. If they don’t, I’ll have to console myself with my expectation of the dividend and double digit earnings growth in the interim. There are worse fates in life!

_{Disclaimer: I have a material personal interest in Macfarlane shares. A portfolio I help to manage has a large weight in Macfarlane shares. Hence, I cannot help but be biased. Please do your own research – my projections are mine alone.}

Elevator Pitch

Macfarlane is a packaging distributor with 26 core sites around the UK. It stocks boxes, wraps, tape and plenty more, and sells to customers like Dunelm, Halfords and Honeywell, as well as a raft of smaller businesses.

Boring, sure – but boring is often resilient. Customers avoid managing their own warehouses full of various dimensions of packaging. Macfarlane’s scale gives it buying economies, while manufacturers avoid having to deal with hundreds of small customers. A well-run distribution business is hard to dislodge, because for every party involved, the alternative is a world with a lot more hassle. It can be mismanaged, though, as long-standing CEO Peter Atkinson found in 2003 when he took the reins of a packaging empire stretching from Guadalajara to Glasgow.

Within two years Atkinson had steadied the ship, and from that baseline in 2005, Macfarlane has grown normalised earnings from ~£1.5m to my estimate of over £17m in 2021. Accounting for dilution, that’s an EPS CAGR of 14.0%, while paying dividends along the way. A substantially above-market return.

Better yet, the return I’ve just described isn’t obvious. Non-cash accounting charges other companies would routinely adjust aren’t mentioned. Property provisions for rationalising the network – which other management teams would call ‘one-off restructuring expenses’ – aren’t broken out. That’s an opportunity, as economic earnings are more than 20% higher than reported.

But perhaps the most compelling element here is the timing: Macfarlane just announced their best H1 ever by an enormous margin. The business is firing on all cylinders as eCommerce packaging demand drives significant growth, and the recovery in the group’s core industrial business is beginning. Careful expansion into Europe provides further upside.

The market earnings multiple in the UK is around 17x. I think you’re getting Macfarlane at about 12x earnings – a big discount, particularly considering Macfarlane is a far superior business to most. It is better managed, more resilient, more predictable and its growth plans simply require ‘more of the same’. Investors are getting a winner for a discount price.

The Business

So, first things first: let’s dive into the exciting world of packaging distribution.

Macfarlane buys packaging from the big manufacturers – Smurfit Kappa, for example – and holds it in their 26 distribution centres.   Smurfit doesn’t want to deal with Macfarlane’s 20,000 customers. Tinkering with delivery route optimisation and holding custom stock for rapid delivery is not their game. Hence, distribution is a win-win; it aggregates demand and reduces cost-of-service for manufacturers.

Customers – like Argos, Dunelm or Glasses Direct – place orders with Macfarlane, typically for next day delivery. These guys don’t want warehouses stuffed with huge amounts of packaging. They won’t get the best price from manufacturers compared to Macfarlane, which buys in serious volume. Nor are they experts in packaging, an unloved and unsexy part of the world of commerce. Having a consultative partner is a big help.

Of course, some big customers do go direct, and some use a mix of distribution and manufacturer. Ikea uses Macfarlane for part of their needs.  But Amazon doesn’t need them at all – Amazon is big enough and complex enough to negotiate and manage their own packaging supply chain. Luckily for us, we don’t care about Amazon anyway – incessantly squeezed margins and a lopsided relationship is no way to run a business. Dunelm and Ikea are meaty customers, and even small businesses offer plenty of margin potential.

Peter Atkinson, CEO, likes to point out that the actual cost of packaging is not that material in the grand scheme of things. Think about part breakage and damages. Or the nightmare of dealing with your own packaging logistics – likely in a facility that doesn’t have the space or the layout to effectively store these materials. If you’re a growing retailer, do you want your warehouse to be stocking your £25 candles, or do you want to be stocking bulky pieces of cardboard – which you could receive as you need from Macfarlane? Like any good salesperson- Macfarlane’s pitch is to persuade the customer to see that the price is not the primary concern:

It’s important to note here that Macfarlane predominantly sells products for ‘moving goods around’ as opposed to for ‘marketing products’. Macfarlane does not stock Kellogg’s cornflakes boxes. They might be providing a big brown cardboard box in which 32 cornflake boxes are packed for shipment to a cash-and-carry. Or, better yet, they’ll sell a box and some void filling for a hydraulic pump part – because about two-thirds of Macfarlane’s business is exposed to industrial end-markets. This doesn’t mean it’s all completely standard; for most of their customers, they’ll source, procure & hold onto branded boxes, in a more consultative and value-add relationship. See this video of Lakeland, below, which highlights it nicely:

Packaging distribution has grown up as a local business. Partly this is because of the low-value, relatively high-volume nature of packaging; when you’re operating on thin margins, you can’t afford to ship halfway around the country to service far-flung customers. And those customers – whose whole operations will be disrupted without packaging – don’t want to take a risk on a supplier 200 miles away. Macfarlane spends about 3% of its revenue on logistics. For a business making 6-8% margins, that’s a material cost.

Peter has an interesting further theory as to the history of the industry, though, which I’ll loosely transcribe from this video. It’s worth watching if you want an introduction to the business:

“The reason the industry is fragmented is because these sorts of products aren’t very high profile for organisations; they’re very low on their priority list, so they often delegate to someone quite low down the food chain in terms of decision making. Their natural reaction is to use a local supplier – and because the sophistication of the way they plan and order these sort of things – like bubble wrap and boxes – isn’t very good, they want an insurance policy – and the best insurance policy is to have someone local. And hence, the industry has grown up as a series of local companies”

I find these sorts of ideas fascinating. Business structures often end up the way they do for silly, human-sounding reasons.

Anyway, the fragmented and local market is plain for all to see, and it’s a big boon for current investors, particularly if you get on board with a consolidator like Macfarlane. Packaging distribution is not a business where you want to open a greenfield site today. 6% EBIT margins are not causing competition to batter down the doors, and private equity is not fascinated by a total addressable market which probably has the potential for £75m of operating profit in the UK. It’ll take you years to acquire the customers to run an efficient distribution centre from scratch.

So you end up with sticky customers in a sleepy market without aggressive price competition and disruptive new entrants. Companies service their local areas and retain their customers unless they screw something up.

As to long term growth, there are both positives and negatives. Environmental concerns, on one hand, suggest that we should be using less packaging. Indeed, a drive to use less (for cost reasons and eco reasons) is a constant feature of the business. On the other, we are all sitting at home in an increasingly piecemeal and fragmented supply chain, buying boxes of vegetables to be delivered twice a week and mobile phone cases on Amazon. Industrial production is unlikely to get less specialised any time soon. I don’t know where this all pans out, but I am content with the assumption that Macfarlane’s end markets are flat to modestly growing.

All of this is the business school theory – the stuff they write case studies about. Luckily for us, we have actual data we can consider to get to the fundamental question we care about: is this a good business?

Financial History

Surprisingly, yes. I say ‘surprisingly’ because 30% gross margins are not software-like, by any stretch of the imagination. But when you are churning your inventory ten times a year, you are getting plenty of bites at the apple. And – more importantly – it’s highly predictable and incredibly reliable. Packaging is an unusually resilient industry because of its involvement in almost every sector of the economy. eCommerce is only exacerbating this trend. Macfarlane’s gross profit still rose in COVID-hit 2020.

Ponder that point for a second. Macfarlane faced headwinds, like all businesses. Many of their large customers are in the aerospace market, which was obviously battered in 2020. The overall level of GDP – which is typically the correlate for packaging consumption – fell by 10%. I can’t think of a better testament to the resilience and diversity of the business than the fact that profitability still improved last year.

Investors under-rate predictability, in my view. Predictability allows for effective cost management. Logistics costs, staffing costs, inventory levels and negotiations with suppliers are much, much easier when you know that demand will be there on the other side. It turns business into a game of continuous improvement – how to squeeze a little more cost out, how to negotiate slightly better prices, how to manage the network geographically. This is all much harder when you’re sweating about where tomorrow’s sales will come from.

And all of that means you get a long-term financial profile that looks like this:

The dark and dreary days of the GFC are barely noticeable; the distribution business still doubled profits from 2008 to 2012. You won’t find many small-cap businesses with smoother earnings profiles than this.

It’s been profitable growth, too: the group has deployed approximately £60m of incremental capital in the last 15 years to support group level EBIT growth of ~£12m. That’s an excellent return, and as I describe later, I think that meaningfully underestimates the value creation because of the group’s conservative accounting and because 2020 figures will shortly be blown out of the water.

Macfarlane isn’t unique in this sector, either. If I look at their competitor set – other large packaging distribution businesses in the UK (all private) – we see a similar story of stability and resilience. These businesses are consistently profitable, to a greater or lesser degree, with overall average annual margins of 5.5%. That’s not dissimilar from Macfarlane historically, and a little lower than their 8% target:

The outlier in that chart, by the way – the one with margins shooting into the stratosphere – is Kite Packaging, a company with roots entangled with Macfarlane. Indeed, its formation only came about when a botched acquisition Macfarlane completed under the old management team led to the departure of a number of key executives. Sure enough, they remain a thorn in the side twenty years later!

Still, it’s important not to read too much into charts like this – I have pulled the data from Companies House with no knowledge of the inner workings of these businesses. Do they have similar depreciation policies? The same property structure (leased vs. owned)? Management remuneration equivalent with respect dividends vs. salary? While we can’t know that, it should give some comfort that Macfarlane is neither unusually profitable nor operating in an industry with large variability. Everyone is making money.

My hope is that Macfarlane – which is now pushing on 25% market share in the UK, they reckon, about 2.5x their largest competitor – should be able to earn margins at the top end of that group. They target 8%. I suspect if they stopped acquiring, consolidated to the operating base they’d want to work with today and ran for maximising short-term outcomes, they could comfortably beat that.

Manufacturing

One thing I have neglected to mention in the entire write-up so far is Macfarlane’s manufacturing division. I don’t think it is hugely material to an analysis of the group. In the last full year, it made £381k of operating profit – against £14.0m for the distribution side.

Granted, that was an unusually low figure – substantially below where it should be in a business segment that has hovered around £1m in EBIT for the past decade. COVID hit manufacturing harder than distribution since it relies more heavily on aerospace and other industries more severely impacted than, say, home improvement retail.

Manufacturing has two sub-segments. Packaging Design & Manufacture, while not hugely relevant from a group financial perspective, can be seen as an important facilitator of group sales. This typically produces bespoke packaging for niche or high-value products – an industrial customer needing to transport a sensitive and expensive part, for instance. Around 15-20% of the division’s sales are to the packaging distribution business.

The Labels business, on the other hand, has less to do with the broader group. It produces labels for consumer products and sells to the likes of PZ Cussons and McBride. It appears to be an OK business, throwing out a little EBIT, but it has no obvious benefit to the core distribution segment.

In the half-year just passed, manufacturing profitability improved significantly, both organically and through the acquisition of GWP. Management restructured during the pain last year, so I expect they will carry this improvement in profitability through to the full year. None of this changes my story for the group as a whole. Manufacturing is an enabler that will hopefully throw off a little extra profit. It is not core to the investment story.

Framing the Opportunity

Everything I’ve said above reiterates Macfarlane as a steady, slow organic growth business. I think that’s a fair characterisation. The flip side of packaging’s stability is, well, its stability.

But management has squeezed more juice out of this market with a consistently executed acquisition strategy. Indeed, the inorganic front has been the only operational cash consumer in the last 15 years. Organic growth has been achieved with shrinkage in the group’s PP&E. Better management of suppliers means net working capital has shrunk, too.

By my estimates, Macfarlane has spent £60-70m in the last 15 years, predominantly with internally generated cash. That spend, combined with organic growth, has produced an EBIT increase from £1.5m to £17m in 2020. This figure – the return on incremental capital – is a more meaningful statistic, and a better guide to the future than group level, point-in-time calculations. You can calculate it however you want, but I won’t quibble if you get anywhere from 15-25% pre-tax. Any number you pick in that range is meaningfully better than the average UK company and indicative of a shrewd and disciplined capital allocator at the helm.

But before we get into recent figures and the future, let’s just wrap up our review of the past by consdering last year’s financials. I hope to explain why I think the group’s reported figures are meaningfully underestimating the free cash flow this business can produce.

As I mentioned right at the start of this post, Macfarlane’s potential isn’t handed to you on a plate. In the most recent set of results, management began adjusting for the most obvious ‘costs which aren’t costs’. In my view, though, even their adjusted numbers are more conservative than the unadjusted numbers many management teams produce. Looking at 2020, for instance:

• The group reported £10.2m of net profit. No adjustments were shown. Free cash flow, on the other hand, came in at £15.9m – an early hint that things are looking rosy
• I ignore the amortisation of acquired intangibles – an accounting treatment whereby you write-off some of the value of companies you purchased. Macfarlane’s acquisitions are not depreciating in value, so this non-cash cost is accounting fiction. And this is big, at £2.5m – or ~25% of reported net profit
• The group also increased its provisions across the board. Net inventory provisions increased by £576k, a material sum on £16m of fast-moving stock. Provisions on receivables were increased by £838k, despite an aging profile which looks a little better. Property provisions due in respect of dilapidation on leased premises were jacked up by £1,766k.

Prudent provisioning is a classic sign of management conservatism – but extreme prudence on the provisioning front cannot recur every year. You cannot continually put aside much more in inventory and receivable provisioning than you write off.

Likewise, dilapidations on the exit of leased properties are, of course, a real cost. But they relate to the exit from two long-term leases, reducing the group’s property costs in the future. Each instance relates to a separate, non-recurring and long-term beneficial decision to improve the efficiency of the group. These are the costs you like paying, and they are as much ‘investments’ as they are ‘costs’, notwithstanding the accounting.

I hope my point is clear: I don’t think Macfarlane created £10.2m in economic value last year; I think they certainly made ~£12.6m, ignoring that silly amortisation. And I think we can have a robust debate about how we view the provisioning and the recurring or non-recurring nature of property adjustment costs.

Current Momentum

If you’re with me so far, I hope you agree that the company is cautious and not prone to exaggerating its virtues. You might acknowledge that the sector and particularly Macfarlane itself is stable and favourable for long-term investors. And you probably agree that, with a long history of cash earnings exceeding accounting earnings, there’s more to Macfarlane than meets the eye.

Hence, one might conclude that 2021 would produce another solid but unspectacular performance, continuing a long history of not surprising investors.

You would be wrong; because H1 2021 was a brilliant six months for Macfarlane.

Operating profit doubled on revenues up 26.5%. Indeed, EBIT of £11.1m was approximately 72% of full-year forecasts prior to the release of this set of figures.

Brokers have raised forecasts – but H1’s profit is still 51.3% of that fresh figure. Even if the group had no seasonality, that would be a harsh assumption, I think. Macfarlane completed two acquisitions this year, and they came partway through the first half. The simple mechanical effect of a few more months of contribution from those will add a few hundred grand of profit.

But, more importantly, Macfarlane has historically displayed a pronounced H1/H2 split:

Now, there are some clear reasons for caution. Input prices have been increasingly aggressive, and Macfarlane will need to manage its customers carefully to effectively pass on these price rises. One other thing I haven’t quite figured out is how their two newly acquired businesses contributed £1.9m of EBIT in the few months they were owned. It’s much more than I was expecting. And the industrial recovery is yet to properly come through in the numbers, which is both a negative and a positive in that it leaves a little upside on the table for the next couple of years.

Perhaps this year will be the first in Atkinson’s tenure that H2 is weaker than H1, which will be necessary to meet market forecasts, despite the obvious signs of very strong trading. I don’t think it will be.

Tying it Together

The reasons I find Macfarlane so exciting today also make the business difficult to forecast.

We have never seen an H1 performance this strong before. That makes it hard to know whether it augurs an exceptionally strong H2, or if the existence of such an anomalous event should make us more cautious as to our predictions.

Likewise, conservative accounting means I am directionally comfortable with earnings figures, but it also makes things hard to predict. I never want to make blanket assumptions that management are overprovisioning, and start to adjust or assume that’s the case. That feels dangerous to me. So I would rather comfortably sit in the knowledge that profits are always likely to be cash-backed, and that the accounts are simply a prudent reflection of the truth.

Still, we have to try and put something on paper. Here is my current best guess for where FY 2021 will pan out:

I hope I’ve made my assumptions fairly clear in the table above. I will reiterate that these forecasts contain a wider band of uncertainty than usual: on the one hand, you might consider that assuming Macfarlane will have its first-ever H2 margin reduction is punitive. On the other, you might think that assuming 10% organic growth is aggressive given much stronger comparators than in H1. I look forward to any and all debate in the comments!

But let’s say you agree with me, and think they’ll earn ~£17m this year. This puts them, at the time of writing, on a P/E multiple of 12.4x for the year which will soon end.

What’s a fair multiple to pay for Macfarlane?

Well, multiples are simplifications of proper DCF analysis, and you can distil down to two things: how fast is a business growing, and how safe is the business? Safer – more ‘bond like’ operations, with smooth cashflows and little variability in results, deserve a higher multiple. Likewise, businesses with the opportunity to grow – either organically or acquisitively – also deserve higher multiples.

How does Macfarlane stack up?

Let’s take the latter first; the growth. Macfarlane is manifestly not in an explosive market. But – through consistent organic improvement and a repeatable and reliable acquisition strategy, they have grown at mid-teen rates for a long period of time. The ‘follow your customer’ program, moving cautiously into Europe alongside customers they know and trust, is an increasing focus of the group. And the pension deficit – which had been a millstone around the group’s neck for the last decade – is no longer an issue. I think Macfarlane can continue to do what they have been doing and continue to get a little larger and a little better every year.

And as to the first factor, stability, I don’t need to reiterate what I’ve said above. If market fundamentals don’t persuade you – crucially, packaging’s relevance to every sector of the economy – the financial track history of the business should. Investors recognise this in other packaging companies, which trade at full multiples.

The market multiple at the moment is somewhere between 16-18x. In my view, Macfarlane’s clear and executable growth strategy and the defensive nature of its business means it is certainly a more worthwhile investment than the average company. Hence, I think a 180-190p price target for the company is both realistic and achievable, likely after the market wakes up to how well they are trading.

That said, it’s not how I think about valuation. Every business I buy, I intend to hold for many years. Hence, I mostly think in terms of expected return, not point-estimates.

With the pension deficit issue behind it and a balance sheet with only a little net debt (which is being paid down rapidly), Macfarlane is set fair for the medium term. I wouldn’t be surprised if we see an EPS CAGR in the low-teens, combined with cash returns of 2-3% annually. That gives me an expected return in the mid-teens, with lower risk than the vast majority of other investment cases I see. Given the investment landscape today, that’s compelling.

It’s a long way from sex, drugs and oil & gas exploration, but I think Macfarlane makes a great bedrock to a portfolio.

_{Disclaimer: I have a very material personal interest in S&U Plc shares. A portfolio I help to manage has a very large weight in S&U Plc shares. Hence, I cannot help but be biased. Please do your own research – my projections are mine alone.}

Elevator Pitch

I’m a firm believer that, if your stock idea is a solid one, you should be able to explain it in one minute. No bells and whistles, no complications. So here goes:

Yeah, yeah, I know what you’re thinking. “You must be a bloody fast talker to fit that into a minute”. Luckily, I am.

Advantage Finance

Let’s go into a little more detail on the key division I mentioned above – Advantage Finance.

Advantage Finance is a provider of non-prime, hire purchase car finance: they help people with imperfect credit records buy used cars. They lend around £6,500 on a typical deal for about 4 years. The customer makes a fixed monthly payment and ends up owning the car.

If you’re already dragging your cursor up to the top right of the screen to close the window, give me a little more time. I also hate investing in financials: they’re opaque black boxes. Trust me when I say – like you told your first girlfriend – that S&U is not like the other guys.

Here is why it’s worth giving them at least a couple of minutes:

In any other sector, S&U would be lauded as the success story it is, and investors would be pontificating about growth runways and how high the multiple should be. Because it is a financial, they are not: they lump it in with the banks (inefficient and bureaucratic) or the spivs and chancers (profitable, until they spectacularly blow up).

But Advantage is neither. It is better: it is differentiated, hard to replicate and surprisingly resilient. Why?

Most obviously, it is because non-prime credit is meaningfully less competitive than the prime space. You cannot fight the banks. Banks are lending machines, with incredibly low funding costs and a business model predicated on maximising both assets and leverage. That is not the game Advantage plays. Advantage is a business built, from the ground up, on good underwriting. Just as we stock pickers are looking for misunderstood and mispriced companies, Advantage is looking for mispriced creditor groups.

And it can do that because, when you leave prime behind, the competition thins out rapidly. Lending where you have to (shock horror) underwrite some risk of non-payment, which can’t be captured by a broad macroeconomic overlay, is hard. You need data. You need twenty years of track record lending to self-employed van drivers in Hull who’ve had a CCJ, and you need to be able to appraise their current income and their propensity to pay.

The upside of doing that work is that you make actual returns. Advantage is currently charging, on average, a flat 17% interest rate on lending. It’s true that a small proportion of Advantage’s customers can’t pay or require some help. But the risk-adjusted yield – a measure of the revenue minus the required impairments, in cases where you don’t get your money back – is still excellent. Advantage’s underwriting ensures that they are getting paid for the risk they take:

Let me address the ethical elephant in the room early: yes, this is non-prime credit, and yes, the interest rates are high. They are not payday lending high, but they are high. And as you are reading an investment blog, statistically speaking, you are probably rather comfortably off, and you probably feel your eyes twitching at those double-digits. You can likely borrow at 3% APRs, not 28%.

I think Advantage Finance provides a good service lending to people who otherwise could not get finance, and they price appropriately for the significantly increased risk they are taking. If you’re on the fence, I’ve included a bit more on the ethics of Advantage Finance in the accordion text below.

Prior to COVID, Advantage was growing nicely. Reported financials lag underlying business growth because new borrowers in a year only meaningfully contribute to profitability and revenue in the next year. So although 2020 was a slow-growth year from an accounting perspective, that actually reflected the caution in the prior year, which saw the group contract lending quite meaningfully in the face of tougher competition and worsening loan quality.

That trend reversed in 2020, and coming into the crisis we hence had good visibility on future growth: receivables (money lent to customers) at year-end January 2020 were up from £259m to £281m and advances (new money lent) were up 15% year-on-year. In other words: 2021 was shaping up to be another solid year in a track record full of solid years.

Aspen Bridging

Aspen Bridging is S&U’s internally founded new division, writing property bridging loans. I will keep this section fairly brief, as Aspen is not currently hugely relevant to the valuation of S&U. Receivables are around £20m (less than a tenth of Advantage), profitability is a single-digit percentage of the group’s total, and growth in the last two years has been slower than I had expected.

Rates are from 59-89bps a month, in addition to the usual entry/exit/variation fees which beef up returns. Allowing for a bit of loss (defaults should be low, and loss given default should be minimal, barring fraud) I expect this is a 10-12% return on capital business in the medium term, with lower returns than the car finance business being somewhat ameliorated by better security and the much bigger size of the addressable market.

While certainly better than the bank mortgage business, I do get the sense that bridging is becoming increasingly competitive. I view it as less differentiated than car finance, and I also think it’s trickier to carve out a real niche in a segment with residential security. The beauty of the car finance business is that it is not far from unsecured lending – the loans are undercollateralised, not overcollateralised – which gives you, as a lender, a lot of scope to add value if you can correctly appraise customer propensity and ability to pay. Bridging is not like that. Everyone uses similar valuation reports to value the same four walls. The question is how aggressive you’re willing to be to get the deal, or how you can add value through speed and relationships.

All of that said, I’m happy to be proven wrong. S&U give off noises about trying to scale this bit of the business quite quickly, and I suspect the current size is substantially below where they want it to be: a real ‘second pillar’ of the business would require an order of magnitude more lending than they’re at currently.

What it does highlight, though, is the group’s entrepreneurialism. The group decided it need another leg to stand on, looked at hundreds of acquisitions, found none priced at levels at which they wanted to transact, and so started a business from scratch. I think investors very often overlook what decisions like this say about businesses and management teams. Boards nearly always choose to buy, not build. Building is hard work and takes time. Buying is immediate: immediately exciting, immediately accretive. The trade-off, of course, is that you shell out a premium to do it; you pay someone else to sweat for eight years of their life to build a business so you can be impatient.

You can divine a lot about management’s attitude toward shareholders, and their stewardship of company capital, from decisions like this. S&U’s management treat their capital as a precious and scarce resource. That attitude permeates an organisation.

COVID Impact

Call me crazy: but I think that, despite the share price fall, COVID may actually be a positive in the long-term for S&U as a business. Or, at the very least, that the obvious negativity has three silver linings which mitigate much of the damage. In order of importance in my mind, I see:

• Better long term risk-adjusted yields: tough economic environments scare capital out of the non-prime sector, boosting returns for the survivors
• Cost reduction: S&U has taken a good deal of cost out, particularly in loan acquisition and underwriting (not, importantly, staff)
• Better investor perception: capital markets will get a fresh reminder of how different S&U is from its ‘peers’, as they will trade profitability through calendar 2020

But before I wheel you off into the sunlit uplands, let’s deal with the very real negatives. S&U lends money to non-prime customers. Non-prime customers – and the clue is in the name here – are more likely to struggle in tough economic environments. Ergo, COVID and the associated impact must be terrible for S&U. Right?

Point one in the defence of S&U, which I mentioned in the preamble, is the financing structure. S&U is exceptionally conservative compared to most financial companies. The below chart shows the equity ratio for S&U and a selection of non-prime lending peers. In essence, it shows how much of the lending a group does is backed by shareholder equity instead of bank loans.

You will note that for S&U, every £5 of lending is supported by ~£3 of book equity: they lend mostly their own money, with a little external funding to improve shareholder returns.

For most peers – and Provident Financial is probably the best comp – £5 of lending is supported by ~£1 of book equity.

It is hard to overstate how important I think this is from a long-term stability perspective. Non-Standard Finance, which you see in the chart, came into the crisis with the most levered position. They come out of the crisis likely to breach their banking covenants, with going concern status propped up by ‘the assumption of lender and shareholder support’.

S&U comes out of the crisis having paid off some of their bank debt, never having furloughed any staff and still paying a (modestly reduced) dividend. The difference is stark. That S&U makes a far better RoE than its sector, despite much lower leverage, is testament to how good underwriting quality is.

Point two in the defence of S&U is the group’s excellent performance in the last financial crisis. In 2008 and 2009, the group grew profits both years. They will not manage that this time – the FCA’s hamfisted approach to payment holidays and the extreme levels of uncertainty around the economy in 2021 necessitate conservative provisioning – but that GFC performance served as an important bedrock for me when I was buying in March and April, when the world seemed a scary place indeed.

Fundamentally, we have to consider that in a typical year the group is earning a 25% risk-adjusted yield, and impairing 6-7% of its loan book. In 2009/10/11 that impairment reached 11%. But when you are making a 25% risk-adjusted yield, you have a lot of slack. Impairments can double and your position is still sound and profitable. Typical investor heuristics about how quickly financial companies blow up just don’t apply here: this is not a bank lending at 2.2%, where a 3% impairment rate destroys the business.

So in terms of immediate solvency risks, the first thing people panic about with respect to lenders, I see essentially none. Further, I believe we have already seen most of the impact of COVID in S&U’s financials. The half-year reported a very large additional impairment to account for uncertainty around coronavirus: the company has ‘taken its medicine’ and written loans down in advance of actual defaults. I suspect H2 results will see the group prudently putting a little more aside in impairment.

The slowdown in lending through lockdown is perhaps the bigger medium-term ‘damage’ from COVID. Payment holidays, the irrelevance of credit reference records and the economic uncertainty have all conspired to see Advantage reduce lending significantly in the first half of this year. The group’s previous glide path to £40m of net profit is hence set back a couple of years: less lending means lower future profits.

Those are the negatives, and they are real. But let’s be honest: in the grand scheme of things, these are not earth-shattering problems. Modestly less profit on the existing loan book, to allow struggling customers extra time and to write off what is necessary, and a slower growth rate in 2020 and likely 2021. When we have a significant proportion of corporates losing money in 2020 or having to raise money in the middle of a market sell-off – something a surprising number of ‘stable’ companies did – S&U’s woes seem eminently manageable in comparison.

As to the key positive?

Well, if we look back ten years, I note that the post-GFC period saw the best loans that Advantage Finance has ever written. Scroll up to the ‘risk-adjusted yield’ chart above and you will see levels pushing 30%. Why? Because crises make lenders retrench. Most companies are not financed like S&U, and do not have the institutional setup to zig when others zag. They see distress in the market and stop lending to any customers except the very most creditworthy. That pushes otherwise good business to the hands of S&U, who are able to lend at good rates to customers who will experience extremely low default rates.

I don’t think Coronavirus will lead to the sort of incredible returns we saw in 2013 and 2014 – I don’t get the sense that capital has withdrawn to the same extent as it did then – but this mechanism is worth bearing in mind. And, just to whet our appetite, in S&U’s latest investor presentation we got the tiniest taste of a movement in this direction:

The chart is hard to read if you have not seen it before, but it is interesting. The blue line shows the proportion of customers who make their first payment on time – a simple measure, but an instructive one, because you will note that is correlates quite strongly with the red line – which shows the ultimate loss ratio on a cohort of customers. The observation is thus that if a cohort of customers mostly makes its first payment, it is likely to have a lower observed loss ratio for the full loan term.

The dotted red line is the area of uncertainty – because these are loan cohorts which have not concluded yet, we do not know the ultimate loss ratio.

Tantalisingly, you will note that the loans the group underwrote in May and June have first payment performance not seen since the post-GFC days. I am cautious about the continuation of this trend, but if we see first payment percentages staying at anything like this level, we have a very positive indicator for the future health of the book indeed. We may not be ‘getting back to pre-COVID levels’, we may be significantly exceeding them.

Management

It is hard to write about management, because views on management are inherently subjective. To stay rooted in fact for a moment, I note that:

• The management team currently in place are exceptionally long-tenured. The Coombs brothers (Chairman and Deputy Chairman) have been leading the business in various forms for 45 years, while Chris Redford (Finance Director) has been in the group for two decades. Only Graham Wheeler (CEO of Advantage Finance) is a fresh face, following the retirement of the previous MD after two decades on the job.
• They have overseen a superb, multi-decade track record of double-digit shareholder value creation
• They and their families own around half of the company between them

That, in itself, is a good starting place.

More important to me, though, is my assessment that they are fundamentally good people. It is always hard for investors to acknowledge that one of the most important parts of an investment thesis is as woolly as this – a judgement on management competence and integrity – but there is no getting around it. If you are investing for the long-term, you are backing a management team, and you need to be very sure they are taking care of your money.

Their honesty and competence is not something I can persuade you of, so I won’t try. Instead – if you are interested – I invite you to read everything you can. S&U has annual and interim reports stretching back to 1999 online. Anthony Coombs, the chairman, also does a good job of trying to update the market through alternative channels – you can find a bunch of interviews with him on Youtube. I like this fairly recent one with Graham Neary:

There is also a recent results presentation on InvestorMeetCompany, if you want a more fulsome discussion of the business, as well as a chance to see the wider management team present.

You will discover, if you do dig through enough interviews with Anthony, that his line never changes. He starts nearly every interview by talking about the ‘identity of interest’ between management and outside shareholders, given their common objective in improving returns. ‘Steady and sustainable growth’ is a phrase I half-suspect Anthony has embroidered into his lapel. (I originally wrote ‘tattooed on his arm’, but considering Mr. Coombs is an ex-Tory MP of the old school variety, my wager is on the embroidery)

I love this. This is a management team with an unfailing focus on shareholder returns by doing the right thing for the long term.

Financials

I have thus far tried to lay out why I think that:

• S&U is an excellent business to own for the long-term
• COVID-19 is a blip in the long-term history of the group, not a structural challenge. In fact, it may prove to be mildly helpful in coming years
• Management are honest, straightforward, and aligned with us as outside shareholders

What should one pay for all of these characteristics?

I know what I think is the wrong price: and that’s £17.60, or a little over tangible book value, or 7.3x earnings.

I tossed and turned over how to present this section because there is no getting away from the fact that financial accounting is complicated and subjective. Revenue is not, as one might assume, the interest received in an accounting period: it is instead the output of a spreadsheet amortising a loan balance down and trying to keep a constant return on capital based on the assumed IRR of that loan. Receivables are stated after provisions which are entirely a product of assumptions about future macroeconomic indicators and default rates.

This means you have to trust management and believe they are on your side.

But it also makes forecasting difficult, if not impossible. To forecast the profit number for this year, I need to read the collective mind of the management team. What do they think unemployment will be? How conservative will they be in making provisions for customers who have not defaulted but may do so in the future?

If you are smarter than me – and have a good way of forecasting results at companies like this – please get in touch. I would love to compare notes and try to think about a framework. I have a few different models for trying to estimate revenue in cohorts, and a simple ‘cash accounting’ approach to the Advantage business which is instructive but hard to translate back to financials. I am also always trying to figure out what I can read from the tea leaves of the provisioning numbers.

But to simplify down to its very basics, we can boil S&U down to a few variables:

• How big will Advantage’s loan book be in three years’ time?
  • What will the risk-adjusted yield be on that loan book?
• How big will Aspen Bridging’s loan book be in three years’ time?
  • What will the risk-adjusted yield be on that loan book?
• How much will the company have to pay to acquire those loans (to brokers and intermediaries)?
• How much central cost will the group have?
• How much interest will the group pay?

And if we spin up an ultra-simple model with those assumptions (I’ve hidden a few calculation cells below to keep it light, but you will get the general gist):

… we see a group which can make £34.4m in a few years’ time with realistic assumptions about the pace of lending and the profitability of that lending. Note that I have given the group no credit for an improvement in risk-adjusted yield (so no ‘improving market’, despite early indications) and only assume that, by 2024, Advantage’s loan balances are ~19% above their prior peak. This business was growing at that rate in a single year not long prior to COVID.

I am assuming fairly rapid growth at Aspen Bridging based on their public pronouncements, which suggest their deal pace accelerated quite rapidly around the middle of this year. I also know management want this to be a much larger part of the group, so I suspect they will be very keen to drive growth. That said, it does not change the model that much if we slow down growth there: I am only assuming a 10% risk-adjusted yield versus a 4% cost of debt funding, so the differential is not enormous.

My bet is that the group will get to around that £34.4m net profit number in 2024, and once the COVID-smoke clears, the group will be back to trading on the 12x earnings multiple – equal to a slightly sub-2x tangible book multiple – on which it has spent a decent chunk of the last decade.

That equates to £34 a share, sometime in 2023 or 2024 depending on how forward-looking the market is at that time. In the meantime, the group will pay you a healthy 6-7% dividend yield.

Frankly, I still find this a very low multiple for a business of S&U’s quality. How many other companies have the track record here, with such evident management quality? I struggle to find them. I would happily pay 12x for a business of S&U’s pedigree. I am fortunate that the market is not asking it.

Ultimately, the valuation here is your margin of safety on expected returns. At the current valuation, if S&U never grow their loan book again investors are still looking at a 12%+ RoI investment without any multiple expansion. Hell, if S&U were forcibly told never to lend money again – and simply run down their existing loan book – you still make money at the current price. That is how much cash this group throws off. And with a management team of this quality – with this much of their own money invested – it is never likely to be a value trap. If they cannot profitability invest, they will not squander the money on vanity projects. They will give it back, as they have been doing for decades.

S&U has been left behind in the vaccine rally. It is one of those forgotten stalwarts in the dusty corners of the small cap market, with a couple of posts a month on the bulletin boards and very little sell-side coverage.

And all of this is why I have so much money alongside the folks at S&U Plc. It is not riskless – no investment ever is. There is always the chance that controls are breached or something goes catastrophically wrong: that’s investing. But I am sitting alongside two individuals with a lot more to lose than me, and the risks which are in their control seem to be managed very well indeed. The company is ethical, soundly financed and ably managed. I suspect that, sooner or later, the market will see these virtues, too.