Silver Chef's silver lining

.With the market having travelled 14% higher in the last six months and many stocks up by over 50%, it would not be uncommon for investors to believe the opportunity has passed.

But has it? At the smaller end of the market the aggregate performance has been poor relative to the large cap high-yielding companies.

I would regard some of the smaller companies as having more growth and more value than many of the popular large caps that grab all the headlines. Indeed, the best places to fish for investment opportunities are at the swimming holes that you have had to reach by carving your own path.

Silver Chef (SIV) was originally founded to alleviate growing home delivery pizza operators of their high start-up costs by providing finance solutions for pizza ovens. The company is now a provider of the popular rent-try-buy model for restaurants, coffee shops and takeaway outlets including franchised chains. And, keep in mind this industry is the one sector that remained well supported throughout the post GFC period when many other retail outlets suffered.

Silver Chef also has another division called GoGetta, which provides equipment finance to industries outside of hospitality.

The split between the two businesses is about 65:35 respectively, and Silver Chef enjoys a limited competitive landscape because the banks and large finance companies are reluctant to deal with many small café owners.

And while the scale of the business may be limited by the high number of smaller contracts, the way the model works is easy to understand. The equipment retailer/wholesaler introduces Silver Chef’s services to the customer at the point of sale as an alternative purchase solution. Silver Chef then pays the vendor the full price for the equipment (average $10,000) shortly after the customer has ordered the equipment. This incentivises the retailer/wholesaler to sell the package, and the lower up-front costs benefit the customer.

Customers sign a 12-month contract, at which point a bond equivalent to 12-13 weeks is paid. The customer then has the ability to purchase the equipment at any time during the first 12 months. Alternatively the customer can return equipment at the end of the contract period, enter a lease purchase agreement to buy the equipment over a three-year period at a reduced rental, or continue to rent with a reduced final purchase price. It really is a simple rent-try-buy model, and customers are typically contracted for about 2½ years.

Many investors who have examined Silver Chef have written it off because of a belief that there is a high default rate amongst failed café proprietors.

Happily for owners of the Silver Chef business, payments for rent/leases are direct debited weekly. Customer are contacted immediately when arrears are recognised. If Silver Chef chooses to repossess, the average time is about one and half months and Silver Chef has already received a three-month security bond.

In the most recent half-yearly results, the bad debt-to-rental income ratio was 0.5%, and the impairment loss-to-assets ratio was less than 0.75%. For Silver Chef there are costs associated with an equipment return, but these amount to about 10%, by volume, of all assets financed.

Silver Chef can then sell the equipment through the original dealer, offer the equipment to a new customer with a new agreement, or sell it at auction or online. The company has told analysts that 80% of returned equipment is sold within three months, at a loss of about 20%.

The GoGetta business is growing and management believes it will be bigger than the café/restaurant business. A world of categories is open to the company, as are overseas markets, and this was best demonstrated by the company’s recent expansion into New Zealand.

Another reason many investors have baulked at investing in Silver Chef is the very high net debt-to-equity ratio of 186%. Investors need to remember this is a finance company. It is true, however, that a very small problem on the asset side of a finance company can be a very big problem for owners of the smaller equity.

For this reason, it is important to keep an eye on the drivers (those metrics that I have discussed above). Importantly, the company diversified its funding base last calendar year by issuing a $30 million senior bond, maturing in September 2018, and coinciding with the release of the half-year results the company raised $5 million in equity through a share placement at $5.20 and a share purchase plan. This partly reflects the company’s intention to fund equipment purchases with a 70:30 debt/equity combination.

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The company has grown earnings per share every year with the exception of 2007 on a normalised basis, and by 38% per annum from 2005 to 2012. The company has also indicated its forecast EPS growth target is 10-20% per annum.

Intermittent set-backs to this growth can be expected in the year of, or after capital is raised, for equipment financing. But the longer-term returns on the capital raised should ensure overall steady growth.

I believe the company’s shares are trading at a premium to intrinsic value this year, but at a discount to future years, and investors looking for a relatively unknown or misunderstood business might want to take a closer look at Silver Chef.

I own share in the company because I believe the market is understating the future potential and overstating the risks.

Roger Montgomery is the chief investment officer at Montgomery Investment Management. If you would like the opportunity to discuss your portfolio and investment options with Roger or his team simply email office@montinvest.com.