FSA finds opportunity in insolvency

Australia has long been ‘The Lucky Country’. However, sunny as it is today, we know there’ll be the occasional bout of rain, and a stumbling Chinese economy would bring one hell of a rain cloud. We know that trying to predict the weather is a fool’s game, but there’s no harm in being prepared.

We’re always on the lookout for recession-proof businesses, which is one reason we like Woolworths, ResMed and Sydney Airport. Wouldn’t it be nice, though, if there were a business out there that doesn’t just survive recessions but actually thrives in them? That’s what brought us to FSA Group but, before we pull it apart, let’s first meet Joe to put the company in context.

Joe’s 29. He bought his first home last year and splurged on furniture and a new entertainment system using his credit cards. He’s just back from a buck’s party in Thailand, also on credit, and it’s time to start paying off the debt. But then his car’s transmission fails, another $4,000, and he’s unexpectedly put out of work. The months go on, still no job, and the missed payment fees are coming in faster than he ever thought possible.

If you were in Joe's position, what would your options be? You could ignore the letters from your bank, but it doesn't take a financial wizard to work out that paying 20% interest will compound your troubles in the blink of an eye.

You could also declare yourself bankrupt. A trustee will be appointed who will sell your assets and recover any income you earn over about $50,000. You’ll lose control of your finances and you'll need your trustee’s written permission to leave the country, not to mention the ordeal of being taken to court.

Your final option is to negotiate with the bank for a smaller payment to settle your debts, or to freeze them until you get back on your feet, by signing what is known as a Part IX Debt Agreement.

In 1996, a tweaking of the Bankruptcy Act introduced debt agreements as a ‘form of insolvency outside bankruptcy’ that were intended to be more accessible for individuals with modest incomes and low levels of indebtedness.   

Few people, however, have the skills or inclination to negotiate with their creditors, and this is where our star of the show comes in.

Debt agreements

There are 39 registered debt agreement administrators in Australia, but competition is low and one company dominates the industry. FSA Group, best known for its Fox Symes brand, administers 50% of all debt agreements and this market share has been maintained for over a decade.

Around 10,000 debt agreements are signed each year and that number has grown at around 8% a year over the past decade as more people opt for a debt agreement rather than bankruptcy (see Chart 1).

What’s more, the number of debt agreements signed tends to move in sync with interest rates, household debt and unemployment. Just when the economy looks at its worst, FSA’s debt agreement segment is at its best. Service fees increased 30% during the crisis in 2009 and profits significantly more.

Good and bad

Debt agreements protect your assets and offer more flexible terms of repayment. The banks also love FSA as they reclaim an average of 63 cents per dollar of debt, far more than they would generally recover if the debtor declared bankruptcy, so the company has some powerful allies.

Debt agreements aren’t for everyone, though. They’re still considered an ‘act of bankruptcy’ and leave you with a permanent listing on the National Personal Insolvency Index.

And they’re certainly not cheap. FSA’s fees can often amount to 22 cents per dollar of debt. This isn’t paid upfront but instead spread across the usual five-year term of the agreement. It’s a good deal when the alternative is paying 20% interest, but for people with no assets to protect and very low incomes, bankruptcy can actually be the more cost effective option.

Perhaps most burdensome of all though is that the applicant will have a credit agency listing for seven years, which makes it almost impossible to get any sort of credit card or loan. This has historically been the biggest complaint customers have about debt agreements but FSA has turned lemons into lemonade.

Non-Conformist

Aside from its dominance of the debt agreement industry, FSA is also the largest broker of home loans where the borrower doesn’t meet standard lending criteria. These are known as ‘non-conforming’ mortgages.

Previously, FSA would simply help the debtor find a lender with which they could consolidate or refinance their loans. But in 2008, FSA took the bold move of lending directly to its customers so it could earn the interest income for itself.

It’s a pretty simple game. FSA’s average mortgage charges 10% interest, and the company pays around 6% to Westpac on the $230m revolving debt facility it uses to fund the division. It gets to keep the difference.

Despite higher default rates than standard mortgages, FSA’s Home Loans division has been very successful, growing from a standing start to an 11% share of the $2bn market in just five years. The division now contributes about a quarter of FSA’s total revenue of $64m (see Chart 2). Even in 2009, at the depths of the financial crisis, this division was churning out cash.

But we’re not fooling ourselves: the Home Loans unit carries a huge amount of risk due to its leveraged nature and $240m of debt, which also funds a small factoring finance operation. What's more, it's almost entirely with a single lender: if that funding is cancelled when it comes up for renewal in Oct 2015, FSA will quickly have to find a replacement.

The debt is, however, non-recourse to FSA, sitting in its own separate trust. If a crisis blew up this division, FSA might miss out on a quarter of its revenue, but it would only lose about 3% of its equity. FSA will never be another Forge.

Risks

There are also other risks to consider. We’re always extra cautious around companies whose main business relies on a specific piece of legislation (McMillan Shakespeare anyone). The Government could change Part IX of the Bankruptcy Act, but this time in a way that isn’t to FSA’s favour.

The risk of litigation is also ever-present. High fees and poor customers have a way of attracting the wrong kind of attention and the ACCC took legal action against FSA in 2004 for deceptive advertising (which was settled without FSA admitting to any wrongdoing).

While we think these risks are unlikely to crystalise any time soon, they'll always be lurking in the background.

Heads you win

What you get with FSA is one business that dominates a counter-cyclical and growing market, and another that could blow up without much damage to FSA itself but will churn out cash in the mean time.  We think it’s a case of ‘heads you win, tails you don’t lose too much’ but, as always, price is key.

FSA Group made a net profit of around $12m in 2013, so is currently priced at 11 times earnings and 2.3 times book value. Combined with a current dividend yield of 5.2%, it doesn’t look expensive for a business earning 20% returns on equity.

However, we’re happy to wait for a larger margin of safety before buying in, due to the extra dose of regulatory and litigation risk, and leave more room in the Sell price due to the company’s ability to benefit from times of crisis. We're starting coverage with HOLD.