Walk into Tim Odillo Maher’s office and your first thought is: this guy is obsessed with Warren Buffett. The bookshelf is something of a shrine.
Knowing that FSA Group’s chief executive is well read when it comes to value investing is a good start but, time and again, Odillo Maher has also shown he can put theory into practice when it comes to sound investing decisions.
Business Lending sold for good reasons
Services revenue down; derivatives hit profit
Lending increase marketing and staff for growth
In 2012 and 2013, the company bought back almost 10% of its outstanding stock at an average price of around 46 cents per share. The share price has more than doubled since then.
What’s more, Odillo Maher doesn’t shy away from taking a short-term hit to profitability if it means higher profits over the long term. And why would he – he has a 34% ownership stake in the company, with other management owning an additional 12%.
We’ll get to FSA’s full-year result in a moment, but what stood out about it wasn’t a particular number or forecast: it was a detailed explanation by Odillo Maher for why the company sold its Business Lending division in May. The explanation is on the long side, but worth reproducing in full:
‘[Factoring finance] is a commodity like product. Origination is primarily controlled by third party introducers who demand the lowest pricing for their clients.
The industry is highly competitive and has become even more so in recent years which has impacted margins. The Board did not believe, over the long term, that we could achieve an above average risk adjusted return, unless we provided our clients with a bundled offering which would require product diversification at a significant capital cost.
The Board was particularly concerned about the larger more concentrated lends and the need to continually underwrite risk on a daily basis which created an increasing dependency on skilled personnel. Another concern was an increase in small business failures.
In January 2016 the Board decided to investigate the sale the Business Lending division thus allowing us to focus solely on the consumer space which is our area of expertise. The Board felt it best if we focus on and compete in a space where we have a clear advantage, rather than in a space where we have no clear advantage, in fact arguably a disadvantage.’
This is exactly the kind of straight-shooting we like to see in management, and it’s clear that Odillo Maher is focused on all the right things: the company’s competitive advantages, supplier risk, opportunity cost, and risk adjusted returns to name just a few.
Services and Lending
FSA’s revenue (excluding Business Lending) was flat in the year to June at $62m. The Services division had a 3% fall in revenue and a 4% fall in pre-tax profits. This was disappointing, though largely expected given the healthy state of Australia’s economy – the Services division organises debt agreements between clients and banks to delay loan repayment, and so it does well when unemployment and interest rates are high.
|Year to June ($m)||2016||2015|| /–
|Fees from services||50.5||52.2||(4)|
|Net finance income||12.3||10.7||15|
|U'lying EPS (c)||9.9||10.3||(5)|
|Final dividend||4.0 cents, fully franked, (up 14%)
ex date 29 Aug
The worst part, though, was that new client numbers fell 4%, which caused the company’s market share to fall from 48% to 41% (FSA remains several times larger than its nearest competitor). Management said it was down to ‘staffing challenges’ and said the issue had now been resolved.
Services account for three-quarters of the company’s pre-tax profit, but it was Consumer Lending that provided the growth. The company’s loan pools – including subprime mortgages and personal loans – increased 18% to $282m, leading to a 15% increase in revenue.
However, pre-tax profit for the division only rose 3% to $5.2m due to an upfront investment in staff and marketing as the division sets itself up for future growth. Management’s goal is to grow the loan pools to $500m by 2021 and we’re more than happy to accept lower profits today in exchange for growth, given that the company’s return on equity and profit margin both consistently hover around the 15–20% mark.
The good Lending result was also helped by a decrease in bad debts due to Australia’s booming property market. The proportion of loans with repayments overdue by 30 days fell from 2.87% to 2.17%, the lowest level since the division started in 2008.
FSA’s net profit fell 18% to $10.7m, which was almost entirely down to one thing – 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. This was to reduce the risk that any increase in interest rates would make it too costly for the company’s subprime mortgage clients to continue making repayments.
However, the RBA’s recent decision to lower interest rates reduced the value of these swap agreements, which were arranged at higher rates. FSA was hit by a $2.4m pre-tax loss on the swap agreements, though this is unrealised and doesn’t affect cash flow. Excluding the loss from derivatives, the company’s underlying net profit fell 5% to $12.3m.
Management didn’t provide specific guidance but did say that it expects average earnings growth of 10% a year over the next five years. We like that management is now focused on its two core divisions: Lending offers decent opportunities for steady growth, and Services is a hedge against a deteriorating economy. With the problematic Business Lending division out of the way, a shareholder-friendly management, an underlying price-earnings ratio of 11 and fully franked dividend yield of 6%, we're raising FSA's price guide and upgrading to SPECULATIVE BUY.
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.