Some investors complain that with the markets so high one can’t find good value investing ideas. I disagree.
S&U (will be referred to as SUS, like its London stock ticker) is a non-prime hire-purchase motor finance and specialist lender. Simply put, it lends people money so that they can buy cars. Started as a small trading business back in 1938 it went through a few changes over the years from selling pans and pots, to home loans to car finance and bridging finance. The home lending business had been sold in 2015 and since then the company has been focused on car finance as well as on a small bridging finance pilot.
The non-prime-car-finance business, Advantage, was started in 1999. Throughout the various crises that came upon the world during that time, this business managed to put down an impressive 17-year streak of profit growth. The bridging finance operation, Aspen, is still new and tiny.
The company’s chairman, Anthony Coombs, is the grandchild of the company’s founder. The Coombs family still holds 44% of the company. S&U has that feature about it that I really like—an owner-operator with good track record and a lot of skin in the game. Another 20% of the shares are held by Wiseheights, which is a company that is operated to benefit Jewish causes and its main asset is SUS’ shares. The Coombs family takes decent (some would say high) salaries of about £330k/year but nothing too extravagant, their main fortune lays with the shares of S&U and as such, investors and the family are in the same boat.
Anyone with capital—and nowadays there are many “anyones”—can enter this business. All you need is some equity and you can start lending. As I learned from our successful investment with Credit Acceptance in the US, while entry barriers are really low, barriers to success—especially over the long run—are many.
If I were to summarize the business model in one sentence it would be “borrow at 4%, lend at 29%, and count the money.” However, things are not that simple.
In the finance business, especially when the interests of managers and owners diverge, there is a big temptation to inflate earnings and revenues over the short term. It takes a lot of discipline to insist on pricing your product for profit and not be afraid to lose business to an irresponsible competitor. Like J.P Morgan said “nothing so undermines your financial judgement as the sight of your neighbor getting rich.” It takes character to succeed in this business. Almost 18 years of rising profits, in good and bad times, as well as having skin in the game leads me to believe that the management team here is very capable and knows how to succeed in this business.
Since banking regulations have tightened following the financial crisis, many lenders have left the non-prime car lending arena and non-bank players in this industry have seized the opportunity. There are two main ways to finance a vehicle: Personal Contract Purchase (PCP) and Hire Purchase (HP). SUS is involved exclusively in the HP space and does not have any PCP exposure. You can read more about those types on various online sources but to make things simple, HP means that SUS buys the car and then rents it to the customer throughout the loan period after which, for a small fee, the borrower can obtain ownership on the car.
I recommend readers to read my Cambria post for more information about the car market in the UK. Bear in mind that SUS lends against cars that are 3-4 years old so while new vehicle count peaked, the target market for SUS is still in growth mode.
A few words about the market size and SUS’ market share: In 2016 there are 8.2m used car transactions. Out of those who purchased, there were 1.25m point of sale consumer used car finance deals. SUS underwrote 20,000 of those 1.25m deals, which means that it has a meager 1.6% of the total market. No matter how you slice and dice it (e.g. looking only at non-price etc.) the company has plenty of room to grow many years into the future.
Lastly, it is important to notice that the company is channel agnostic and whether the deal is done through brokers on the point of sale or through the internet does not matter much so disruption isn’t a big risk here.
The Inner Workings
There are 32 million people who are working in the UK. 12 million of whom have some impairment on their credit record. These impairments range from not paying the mobile phone bill to defaulting on loans. SUS’ average loan size is ~£6,000 and that will usually buy the customer a very good quality 3-4-year-old car that will last about five years and during that time it will serve the consumer very well. They like to lend against cars that have good fuel economy and are cheap to insure and maintain.
In the UK, lending at the dealerships is done mainly through brokers (85% brokers, 5% refinance, 10% direct). The brokers have incentive to close the financing but in the UK a broker that cheats will very quickly lose business as bad loans show up very fast in this business. So what keeps the dealers’ good behavior is the fact that they won’t be able to get away with passing bad business to the lenders. On top of that, I believe that the fact that SUS has its owners with boots on the ground ensures that the brokers know that SUS has long memory unlike other finance companies that experience high staff turnover and have short “institutional memory.”
While all players in this space have access to the brokers and to the same data sources that are used to make a decision, SUS uses its experience on top of that to find spots to lend where they know other financiers won’t go. To put that into numbers, SUS gets about 65,000 applications per month. 30% of those are approved in principle after 9.5 seconds by an automated system. However, out of those 20,000 applications, SUS will underwrite ~1700, or 3% of the total. As you can see, there is a lot of business to be done and SUS is very selective when it comes to lending.
Both of their main competitors aren’t focused solely on car finance and MoneyBarn, owned by Provident Financial has its fair share of trouble. The other competitor is Moneyway, which decided to pull out of the car subprime lending (not out of non-prime though) and has other segments in its business.
SUS usually lends about 90% of the car’s value. If the price of used cars drops it affects SUS as it repossesses some of the cars that it lends against. However, when prices drop, the consumer usually does not think about the value of the car in terms of the reference price but rather the utility value of the car. That is, they need a car to get to and from work etc. Also, if the customer decides to default, on top of the fact that his credit might degrade (remember, they do non-prime lending and not subprime so customers have something to lose when they default) SUS can still go after that customer for the rest of the loan’s balance!
Here is an example for what the company does (taken from company’s presentation):
One would expect a company with such characteristics to trade at a high PE that reflects the 20% growth that this business has been posting and the high-quality management. It indeed traded at around 16 times earnings until this ratio deteriorated to less than 10. The financial statements are pretty straightforward and easy to read, you can see them all here.
The company can easily earn north of 200p/share this year and given the current share price at the time of this writing (1982p/share) reflects a PE of less than 10, as I mentioned. Please note that unlike other companies, this company doesn’t adjust earnings. These are IFRS numbers, plain and simple.
Put the PE of 10 in perspective of 20% growth per annum, low gearing, high quality management with skin in the game and you get yourself a pretty bargain that can compound for many years in the future.
While there is no exact way to estimate intrinsic value, I suggest the following valuation. Company that shows high returns on equity, has a consistent track record of growth and is well-managed deserves a PE of 15. Indeed, the stock had received this multiple before Brexit occurred. If earnings will grow from the current ~200p/share base another 15-20% we are looking at earnings of ~235p in a year from now. Apply PE15 on that number and that gets us to ~3500p/share, which is 80% above the current price. While we are waiting for that, we enjoy a dividend yield of 5%, and growing.
This company’s volume is such a low percentage of the total market that it has a long growth runway and the impact of the company’s execution is much stronger than any macro trend as evidenced by impeccable track record during both good and bad times.
I don’t want to make this post highly technical, but it is worth mentioning that the company is very conservatively financed with total borrowing of 80m out of a balance sheet of £231m, out of which are £227m are receivables from customers (after loan loss provision). This is another “symptom” of a good and responsible management.
Looking at the stock chart below will make you wonder…
What happened in mid 2016 that made the share price drop from 2600 to 1900? Brexit. Many of the post-Brexit drops in stocks already corrected themselves, but for some reason, this didn’t happen for SUS. Meanwhile, the business progressed and PE shrank both due to the share price decline and thanks to increased profits. The Chairman referred to it in one of the trading updates:
Despite widespread assumptions of “post Brexit gloom“, consumer appetite for credit, partially reflecting a robust labour market, continues unabated. This apparent contradiction has been recently reflected, for both S&U and for others in the speciality finance sector, in what I view as an unjustified decoupling of S&U’s performance and prospects and our stock-market valuation. I am confident that our ambition and constant striving for the highest standards of service for our customers will be reflected in the growth, performance and value of the Group.
- Recession: the company earned respectable return on capital during the GFC, you can see the financial statements for Advantage, from the tough years here. That’s a relief.
- Loan provisions are going up: the chairman referred to it in the last set of results and mentioned “risk-adjusted yield” and “good interest rates” which means, that similarly to CACC in the US, the company prices the loans while taking higher losses into account.
- Regulations: this is always an unknown but the company is highly involved in a few regulatory bodies and seems to have its finger on the pulse.
The scariest risk is always the “unknown unknowns”, I wish I could write about it.
I’d love to hear your comments to this investment idea.
Disclosure: I hold a position in the shares of SUS. This isn’t an investment advice, just a discussion for the sake of sharing and learning.