S&U Plc – Credit Where Credit Is Due

_{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.