Sunday 23 June 2013

FSA Group Ltd (FSA)

Nigel Littlewood is a professional investor and close friend and colleague. Nigel mostly specialises in Australian small cap stocks and has been a big believer and backer of FSA. Nigel recently wrote this article on FSA, which I thought was worth sharing. 

Please note this article was prepared before the recent stock market sell-off. Figures have not been adjusted. I hope you enjoy the read. Also note that Nigel Littlewood is not licensed to provide financial advice. 

Kristian 

Disclosure: own FSA (and so too does Nigel Littlewood) 

FSA GROUP A quality micro cap and specialist finance services company

FSA was born back in 2000 when four eager debt industry individuals got together to start their own business in the debt agreement industry.  Two of the original founders, Deborah Southon and Tim Maher, remain with the company today.

WHAT ARE DEBT AGREEMENTS?

Since the end of the Second World War and the introduction of consumer finance, the level of money borrowed by consumers in the western world has steadily increased. Credit card debt in Australia now totals $36bn generating interest costs of $6.2bn p/a. There are several drivers to this but whatever the reasons, most people are now used to living with debt. However in the last 20 or so years, consumer debt started to reach epidemic proportions and individual bankruptcies started to soar which clogged courts and led to social and financial problems for individuals and government.

As a proposed solution, a debt agreement, was introduced into the Bankruptcy Act (1966) in 1996. A debt agreement is a simple way for an indebted borrower to come to a payment arrangement with their creditors. A debt agreement provides creditors with a superior return compared to bankruptcy and provides the borrower or debtor with a payment arrangement they can afford and ultimately avoid the stigma of bankruptcy.

The industry is overseen by the Insolvency and Trustee Service Australia. More information is available at www.itsa.gov.au.

HOW DO THEY WORK?

Basically when a borrower gets to a point where they cannot repay their debt i.e. they are insolvent, they can approach their lender(s) and try to negotiate a debt agreement. However, most people don’t possess the skills or confidence to do this so they call FSA (or a competitor) who assesses their financial position, negotiates on their behalf with the creditor(s) and then administer the agreement over its life to (ideally) a successful completion. FSA gets paid a percentage (15-20%) of money collected over the life of the agreement.

That is where FSA started and within a couple of years, they had backed the company into a public shell and FSA was born. The future of FSA was in the hands of the executive directors Tim Maher and Deborah Southon. They would both prove to be very competent asset allocators and sensible managers and with the vast majority of their own wealth in FSA shares, appropriate shareholder-friendly incentivisation is in place.

As the company grew it became the largest broker of non-conforming home loans in Australia. Some people who call FSA end up refinancing their home mortgage to repay their unsecured debt rather than entering a debt agreement. The pre-GFC debt boom and associated securitisation market resulted in FSA exploiting the opportunity and providing its own non-conforming home loans rather than just broking other companies’ products. This created another arm to FSA along with debt agreements and the smaller factoring business.

The GFC has slowed the growth of this division but the home loan book has performed exceptionally well with nominal capital losses and an average LVR of about 67%. During the GFC the capital provider (Westpac) stood by FSA and the business continued to perform.
The macro environment has finally started to turn in FSA’s favour as banks start to clamber for market share. While this is a real positive and in coming months could lead to an increase in both the size of the home loan warehouse facility and an improvement in its terms, it is incredibly important to appreciate that through the worst debt crisis since 1929, FSA didn’t lose capital for its lender or shareholders and maintained a strong relationship with its bank when many other businesses simply failed.

WHO ARE THE EXECUTIVE DIRECTORS

When investing in the small cap space there is perhaps no more important single element than the quality and integrity of the senior management team.

Over the last 8 years I have got to know Tim Maher well and seen him manage his business through various challenges including the GFC. During this time, I believe Tim has performed brilliantly, nobody is perfect but Tim is smart, motivated, energetic, and appropriately conservative with an entrepreneurial flair and what I affectionately term, a bit of mongrel. Tim is not afraid to get in the ring if he needs to. 

I have used Tim as a benchmark for small cap managers in my investing and find few his equal. In recent years he has become a passionate student of Warren Buffett and capital allocation and investment theory. This ultimately contributed (along with some friendly shareholder prodding) to his decision in mid 2011 that the best allocation for excess capital in the business was to buy back stock at what we all agreed was ridiculously cheap. When Tim announced the buyback (and first dividend) the stock was 27c, trading on a P/E of about 4 times and below its NTA. The company has since bought back around 13m shares (10%) and paid 4.95c in divs.

Tim owns about 36% of FSA and his first priority is to conserve that wealth, consolidate and grow when low risk opportunities present themselves.

Joint founder Deborah Southon who owns 10% of FSA complements Tim. Deborah runs the debt agreement side of the business and sits on the board. She probably knows this industry better than any other executive in Australia and has done an outstanding job consolidating FSA’s position as the dominating market leader in the industry with market share over 50%.

BUSINESS SUMMARY
FSA has three distinct divisions:
   Services
This division consists of debt agreements, personal insolvency agreements and bankruptcy. It contributed circa 78% of last year’s pre tax profit of $14.9m.This industry was explained above but FSA is the industry leader both by market share circa 51% and by technology and marketing spend. It is the dominant player in the industry.
   Home Loans
This division contributed $4.1m (NPBT) last year representing 27%. These loans are classified as non-conforming. Therefore, the margin is high along with the risks however, FSA’s experience and track record show that if it’s managed carefully and growth is not chased exuberantly, an attractive return on capital is generated in this business. Ongoing negotiations may lead to a change in the size and terms of funding but I have not factored in significant growth at this stage although the division has big potential.
   Small Business
This division consists of factoring finance which, is still small. It reported a loss last year due to restructuring costs. Its loan pool grew last year from $12m to $25m at the end of the 2012 fiscal year. While this business is still small, it has the potential for plenty of future growth albeit at a measured pace.  I expect it will contribute around $1m NPBT in 2014.

FINANCIALS

The current share price of 75c with shares on issue of 125m provides a market cap of $94m, there is however around $10m of excess cash on the balance sheet that can be backed out for valuation purposes although the conservative nature of management is such that I don’t expect that capital to be returned to shareholders outside of the (potential) ongoing buyback and regular dividends.
The company has provided NPAT guidance this year and I’m expecting a result around $10.5m providing a P/E of 9x or 8x if we back out the excess cash. Free cash flow is close to NPAT due to the nature of the business so another dividend at the end of the financial year is likely. I’m expecting 2.25c ff making 4c for the full year, equating to a payout of circa 48%. The board has no stated payout ratio but I know Tim and Deborah would ideally like to pay a higher dividend each year, business permitting.

The company has no corporate debt on its balance sheet. The debt from Westpac that sits within the non-conforming home loan warehouse and the factoring finance warehouse is secured by the underlying assets and is non-recourse and limited recourse respectively to FSA.

For 2014 I expect some growth in the home loan division, a flat result in debt agreements and growth in factoring providing npat around $12m (9.6c p/s).

This provides a forward P/E of around 6.5 times based on further accumulation of excess cash (circa $6m after total div payout of $6.25m) on the balance sheet (EV of circa $80m). If FSA pays out 5c (52%) it will yield 6.7% fully franked based on the current price of 75c.

Given FSA is hardly using any additional capital to grow, its profit is effectively free cash flow. If we invert the multiple of 6.5x (as Warren Buffett might) we get a free cash flow yield of about 15% (after tax). That means if you could buy the whole business and consolidate it, that is the yield you would be looking at….Not bad in this environment I’m sure you will agree.

RISKS

As with all investing there are risks. Businesses have problems that’s a fact of life and things happen but when you have a market dominating position, strong IP, debt free balance sheet and good management, risk is somewhat mitigated.

Australians since the GFC have gone from being net savers of zero to savings around 10% of their earnings. If this trend accelerates it is possible the debt agreement business in time starts to reduce in size. Currently, FSA administers around 5000 new agreements per year. If this falls, earnings will fall in that division.

The funding of both warehouses may not be renewed and this shuts down both divisions (assuming no replacement funding can be found). Given Westpac stuck with FSA thru the GFC, I see this as a remote risk.

Key man, Tim is 41 years old (Deborah is around the same age but I’m too afraid to ask), fit, just married and about to have his first child. He is highly motivated to be with us for a long time although I think every shareholder should send him a letter warning him off his occasional cigarette. No doubt in any small business key man risk must be considered but both Deborah and Tim can fill in for each other.

The board has been with Deborah and Tim for a long time and accumulated a great deal of IP however I expect much of the board to undergo a generational change in the next few years.

The home loan
business is leveraged to employment and property prices. A significant deterioration in either or both of these variables pose potential risks for this division.

Factoring is a fairly high risk business subject to fraud and small business failure. As this business grows its risk reduces via customer diversification.

The market as always posses its own risk or at least volatility. During the  the GFC in a fit of fury and fear, FSA shares dropped from highs of $1 to lows under 20c for no great (company specific) reason. Volatility is part of investing and its important (as long term value style investors) to keep your eyes on the company rather than the market.  We should be endeavouring to exploit market volatility not be victims of it.

UPSIDE

As I like to say: consider the downside first and only then consider the upside. For taking the risks above we obviously want a much better return than the risk free rate.

Upside will come from dividends and that I’m confident about. Upside should come from modest earnings per share growth over time and the incremental increase in share price. Even if the P/E stays the same, the share price should increase by the eps growth. Next if the company continues to buyback shares, this should lead to increase in eps. Given where the share price is, cash in the bank is earning around 2.5% (before tax) and buying shares back (as illustrated above) is yielding 15% after tax so buying shares makes sense. 
Its worth pointing out that this stock is not leveraged to GDP, global interest rates or central bank activities while so many businesses are leveraged to the economy doing well. FSA is largely insulated and in some ways is counter cyclical.

Finally, there is a fair chance that after many years of institutional neglect, FSA will receive some institutional shareholders and thereby see a P/E re-rating. This is a maybe and not something that I would bank on but it is a possibility. With a rerating from 9x to 12x, the share price would move up 30%.

VALUATION

This of course, is always difficult because ultimately it’s a function of future earnings being discounted back to today at an appropriate discount rate to reflect the risks taken in the business.

Given the nature of the business, the free cash flow yield, strong balance sheet, sound management, I am a happy holder of this quality micro cap and expect it to move into the small cap range over time. I would be most surprised if this company did not provide satisfying investment returns for long-term patient investors who like a regular dividend.

I am a shareholder of FSA. 

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