S&U Plc – Set Fair For Growth

_{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!