FSA Group: Interim result 2017

Consumer debt levels are at record highs. A prolonged period of low interest rates is lulling many borrowers into large loans and mortgages that they couldn't otherwise afford if interest rates were higher.

This is especially true for interest-only loans, which aren't cushioned by principal repayments. Interest-only mortgages now account for 40% of all approvals, up from around 30% in 2010. These types of loans have always been popular among investment borrowers but now, partly due to affordability, many owner-occupiers are also turning to these loans; one in four owner-occupiers now has an interest-only mortgage. With interest rates at record lows, this is a precarious situation.

If Australia's economy slows and unemployment edges up, a deluge of borrowers will hit the breadline. One of the few companies that benefits from times of crisis is FSA Group – Australia's largest originator of debt agreements and subprime loans.

FSA's revenue notched up 9% to $33.5m for the six months to December, which was surprisingly good given the healthy state of Australia's economy and low interest rates.

Services

The company's Services division, which administers debt and personal insolvency agreements, had a reasonable half with a 2% increase in new clients and the total number rising 4% to 19,553, which lifted revenue 4%.

Pre-tax profit, however, was flat at $6.5m due to an increase in administration expenses as the company lays the foundations for future growth. We're comfortable sacrificing a little profit growth today for a lot more tomorrow – one of our biggest concerns should another financial crisis come along isn't that FSA will go bust, it's that it won't have enough time to hire and train staff to fully take advantage of it, leaving money on the table.

Net profit rose 40% to $7.4m, though most of the growth was due to unrealised gains on derivatives.  

In 2015, FSA entered into two interest rate swap agreements, which effectively locked $80m of its funding at a fixed rate for 5 years. Rising bond yields during the half increased the value of these swap agreements to the tune of $1.6m before tax, though this is unrealised and doesn't affect cash flow.

Excluding the gain from derivatives, the company's underlying net profit still rose a healthy 12% to $6.2m.

Lending

Services accounts for around two-thirds of the company's underlying net profit, but it was FSA's Consumer Lending division that contributed the growth – pre-tax profit for the division rose 31% to $3.3m, which was helped by a decrease in bad debts.

Total loan pools were up 20% to $309m, making FSA the country's largest provider of home loans where the borrower doesn't meet standard lending criteria. These are known as subprime or non-conforming mortgages and are used to consolidate a client's debts. FSA's mortgage loan pools recorded a 14% increase, while personal loans almost tripled.

What most caught our attention in this result was a sharp decline in the number of home loans where payments are more than 30 days overdue. The 30-day arrears rate fell from 2.67% to 1.30%, which is unusually close to the 1.16% rate for prime mortgages. Given FSA is lending to people bankrupted or close to it, a higher rate of arrears is to be expected, but the company clearly has a knack for cherry-picking the best borrowers – the arrears rate for subprime mortgages is typically 4–5%.

The company increased its home loan facility with Westpac from $250m to $275m during the half and its personal loan facility from $20m to $30m. FSA intends to grow total loan pools to $500m over the next three years.

The Lending division carries significant risk due to its leveraged nature and, if the economy worsens, we expect a painful uptick in arrears. A worst case scenario could see the division wiped out entirely.

The debt is, however, non-recourse to FSA, sitting in its own separate trust, so a spike in client defaults wouldn't cause the company to go bust – just 3% of FSA's equity is at stake. Nonetheless, FSA would stand to lose nearly a third of its earnings, so the share price could still get hammered.

Management says underlying net profit should rise 10–15% in the 2017 financial year, with earnings per share between 10.85 cents and 11.33 cents. That puts the stock on a forward price-earnings ratio of only 12 or so, with a fully franked dividend yield of 5.1%. FSA certainly carries its share of risks, but we're being well compensated for them.

The stock has risen 42% since we upgraded it a year ago on 26 Feb 16 (Speculative Buy – $0.96) and we're pleased with the company's progress. We're raising our (Speculative) Buy price to $1.30, but that means the stock stays a HOLD. 

Note: With several substantial shareholders, FSA Group's stock is highly illiquid with a large spread between the bid and offer prices. To ensure you aren't caught overpaying, it's important that your buy orders have a limit price and are not made ‘At Market'.

Disclosure: The author owns shares in FSA Group.